The Securities and Exchange Commission seems to be trying quite hard not to take a position on whether U.S. companies can require their shareholders to arbitrate federal securities claims, instead of litigating them in court.
Earlier in February, SEC Chairman Jay Clayton endorsed the issuance of a no-action letter in which the Division of Corporation Finance gave the green light for a registrant to omit from its proxy statement a shareholder’s proposal to amend the bylaws to require the arbitration of federal securities claims.
But the division and the chairman ducked the question of what the federal securities laws—the laws for which the SEC is responsible—have to say about the mandatory arbitration of federal securities claims.
Instead, the division issued its no-action letter on the basis of an opinion issued by the Attorney General of New Jersey, where the corporation is incorporated, opining that New Jersey law prohibits the bylaws from being amended as proposed. Therefore, the company could omit the proposal from its proxy statement under SEC Rule 14a-8(i), which authorizes the rejection of a proposal that would violate state law.
Will Address in ‘Measured and Deliberative Manner’
The SEC chairman similarly declined to be drawn in 2018, when Rep. Carolyn Maloney (D-N.Y.) asked whether the SEC would allow a U.S. company to conduct an initial public offering if its governing documents compelled the arbitration of federal securities claims. The chairman replied that resolving this “complex” question is “not a priority,” and that the SEC will address it “in a measured and deliberative manner” in the context of an actual IPO.
When the issue last arose in 2012, the SEC blocked Carlyle Group’s IPO, on the basis that contracts mandating the arbitration of federal securities claims run afoul of provisions in the 1933 and 1934 Acts invalidating attempts to waive compliance with the statutory requirements. The issue was not litigated in 2012, but this time the disappointed shareholder has vowed to challenge the company’s rejection of his proposal.
Whether shareholders can be required to arbitrate federal securities claims raises an abundance of legal and policy questions. The ultimate legal question is whether the federal securities statutes guarantee access to a court, and thereby override the Federal Arbitration Act’s mandate to enforce arbitration agreements.
‘Stout Uphill Climb’
As the U.S. Supreme Court observed in its recent decision in Epic Systems Corp. v. Lewis, a party resisting arbitration on that ground faces a “stout uphill climb,” as, over the last three decades, “every” attempt to “conjure conflicts between the Arbitration Act and other federal statutes” has failed.
Nested within that ultimate legal question is a host of other tricky legal issues. The Federal Arbitration Act presupposes that the parties have entered into a “contract” to arbitrate. But do corporate bylaws constitute a “contract” between the company and its shareholders?
The Supreme Court has told us that state law generally determines whether there is a contract to arbitrate. What if—as New Jersey’s Attorney General recently opined—under state law, bylaws regulate only matters of internal governance, and therefore can have no impact on investors’ federal securities claims? Is that limitation of New Jersey law preempted by the Federal Arbitration Act, as the shareholder argued? Or does it survive under the principle, set forth in several Supreme Court opinions, that preserves generally applicable state-law rules that do not single out arbitration clauses for disfavored treatment?
Further, do the anti-waiver provisions in the federal securities laws invalidate an agreement to arbitrate federal securities claims, as the SEC apparently thought in 2012? How to reconcile that view with earlier Supreme Court rulings that brokerage firms can compel their customers to arbitrate federal securities claims because the statutory anti-waiver provisions only invalidate waivers of the substantive protections of the securities laws? Can those decisions be limited to the kinds of arbitrations at issue in those earlier cases—SRO-sponsored arbitrations subject to SEC oversight, such as those now run by FINRA?
The policy questions surrounding the mandatory arbitration of federal securities claims also defy easy answers.
Is the shareholder correct in his suggestion that federal securities litigation just “recirculates money within the same investor base, minus attorneys’ fees?” If he is, will mandatory arbitration help? Or could it make things worse by denying defendants ready access to some of the procedural mechanisms available in federal court, such as consolidated multi-district proceedings and motions to dismiss patently unsustainable claims?
And will arbitration render enforcement less fair, by denying compensation to retail investors whose individual claims are too small to justify the expense of an arbitration proceeding?
However these issues are ultimately resolved, presumably the SEC will not want them adjudicated by a state court, operating without the benefit of the SEC’s views. So if the shareholder makes good on his vow to sue, perhaps the SEC will actually have to take a position soon.
Andrew Rhys Davies is a partner with Allen & Overy in New York and assists clients with their U.S. litigation and regulatory problems, focusing on securities and financial services, and cross-border matters involving jurisdictional and comity issues. In 2016 and 2017, Andrew served as Assistant Solicitor General for the State of New York, representing the state and its agencies in appellate litigation.