Private equity firm Carlyle, apparently trying to do an end-run around the potential for class-action litigation as it prepares to go public, has ignited a debate about whether a company can require shareholders to use binding arbitration rather than class-action lawsuits to settle disputes.
The firm, which is preparing to conduct an initial public offering this spring, included in its Jan. 10 registration statement a provision mandating that all shareholder disputes be settled through arbitration, and that all arbitration be brought in an individual capacity; class-action arbitration would be prohibited.
Historically, the Securities and Exchange Commission has disliked the idea of mandatory shareholder arbitration charter provisions. In 1990 the Commission blocked an IPO by a savings and loan company because it included a shareholder-arbitration clause in its corporate charter. The company ultimately removed it.
The SEC has not revisited the issue since then, securities experts say, because no other company has included a mandatory shareholder arbitration provision in their governing documents. “Carlyle puts the question to them pretty directly,” says Douglas Smith, a partner in the law firm Gibson Dunn.
Now corporate governance experts are waiting to see if the SEC will approve Carlyle's registration statement. If the SEC approves Carlyle's registration statement with the arbitration clause in place, it will be the first domestic publicly traded issuer to have a clause of this sort, says Adam Pritchard, a corporate and securities law professor at the University of Michigan. The SEC declined to comment on its upcoming decision.
If the arbitration clause is allowed, that could result in a “pretty quick trend” of businesses, both pre-IPO and those already public, moving to adopt something similar, Smith says.
A spokesperson for Carlyle, and lawyers representing the firm, declined to comment.
Some securities law experts argue that Carlyle might get more leeway with the SEC because it is a limited partnership rather than a corporation. “Limited partnerships are more creatures of contract than they are state and corporate law,” Smith says. Unlike a typical corporation and its shareholders, limited partnerships sell “common units” instead of stock. This effectively means that these so-called “unit-holders” agree to buy into the limited partnership and the pre-existing governance structures that come along with it.
In Carlyle's case, for example, if a unit-holder buys into the partnership already aware of the arbitration provision, “It's easier for a court to say, ‘You knew at the time you bought in, or you should have known at the time you bought in, so don't come to me and complain that it's unfair',” Smith says.
Because of this partnership structure, unit-holders' rights are often more restricted than what a shareholder gets in the usual corporation. For example, Carlyle's partnership agreement also states that arbitration must happen in Delaware, and all arbitration proceedings and awards must be confidential. Investors who buy Carlyle shares automatically will have agreed to the provision, the filing said.
Similar Shareholder Proposals
While Carlyle is the first to try to write mandatory arbitration into its registration statement in quite a while, two other skirmishes are pending that could bring arbitration to companies that are already public. In those cases, a couple who hold shares of Pfizer and of Gannett are seeking to have proposals included on upcoming proxy ballots that would amend the companies' charters to require the arbitration of shareholder disputes. They are sometimes called “reverse shareholder activists,” since the outcome they seek is seen by some to benefit the company more than shareholders.
“Some company will end up having to spend a reasonable amount of money litigating to establish whether [shareholder arbitration agreements] really are enforceable, and what the limits are to them.”
The purpose of the proposals, say stockholders Donald and Susan Vuchetich, who filed them, is to reduce a company's cost of defending itself against costly class-action lawsuits.
That shareholders are recommending such a proposal shows that litigation isn't always the avenue of choice. “The benefit of arbitration is improving the efficiency of the process,” Smith says. “That should be of interest to all shareholders.”
So far, however, Pfizer and Gannett don't seem to be embracing the Vuchetich's gesture. Both companies have sent no-action letters to the SEC, asking permission to omit the proposals from their proxy ballots. The companies argue that the arbitration requirement would violate Section 29 of the Securities Exchange Act, which voids any contractual provision that would seek to waive any right under the statute.
The companies also argue that the arbitration requirement would violate Delaware corporate law, which they say gives shareholders the right to litigate claims in the Delaware Court of Chancery absent a clearly expressed intent to arbitrate.
“In light of the Commission staff's policy position, the lack of precedent and the anticipated costs of litigation if the bylaw amendment were to be implemented, it would be unduly burdensome to ask the company's shareholders to vote on a matter that more properly should be addressed by Congress or the Commission,” Kevin Vold, a partner with law firm Hogan Lovells, wrote in the no-action letter on behalf of Gannett.
The following excerpt provides details on the Carlyle partnership agreement:
Our partnership agreement will contain provisions that reduce or eliminate duties (including fiduciary duties) of our general partner and limit remedies available to common unitholders for actions that might otherwise constitute a breach of duty. It will be difficult for a common unitholder to successfully challenge a resolution of a conflict of interest by our general partner or by its conflicts committee.
Our partnership agreement will contain provisions that waive or consent to conduct by our general partner and its affiliates that might otherwise raise issues about compliance with fiduciary duties or applicable law. For example, our partnership agreement will provide that when our general partner is acting in its individual capacity, as opposed to in its capacity as our general partner, it may act without any fiduciary obligations to us or our common unitholders whatsoever. When our general partner, in its capacity as our general partner, is permitted to or required to make a decision in its “sole discretion” or “discretion” or pursuant to any provision of our partnership agreement not subject to an express standard of “good faith,” then our general partner will be entitled to consider only such interests and factors as it desires, including its own interests, and will have no duty or obligation (fiduciary or otherwise) to give any consideration to any interest of or factors affecting us or any limited partners and will not be subject to any different standards imposed by the partnership agreement, otherwise existing at law, in equity or otherwise.
The modifications of fiduciary duties contained in our partnership agreement are expressly permitted by Delaware law. Hence, we and our common unitholders will only have recourse and be able to seek remedies against our general partner if our general partner breaches its obligations pursuant to our partnership agreement. Unless our general partner breaches its obligations pursuant to our partnership agreement, we and our common unitholders will not have any recourse against our general partner even if our general partner were to act in a manner that was inconsistent with traditional fiduciary duties. Furthermore, even if there has been a breach of the obligations set forth in our partnership agreement, our partnership agreement will provide that our general partner and its officers and directors will not be liable to us or our common unitholders for errors of judgment or for any acts or omissions unless there has been a final and non-appealable judgment by a court of competent jurisdiction determining that the general partner or its officers and directors acted in bad faith or engaged in fraud or willful misconduct. These modifications are detrimental to the common unitholders because they restrict the remedies available to common unitholders for actions that without those limitations might constitute breaches of duty (including fiduciary duty).
Source: Carlyle Registration Statement.
Then again, Pritchard argues that such a proposal isn't inconsistent with Delaware law, which allows the use of corporate charters to embody agreements between a corporation and its shareholders. And even if it were deemed inconsistent, the Federal Arbitration Act would preempt the Delaware law, he says.
The provisions submitted by Carlyle and the Vuchetiches also come after the U.S. Supreme Court's support of arbitration in two recent decisions. Most recently, the Court in CompuCredit v. Greenwood held on Jan. 10 that a right to sue provision in the federal consumer credit statute doesn't prohibit the enforcement of an arbitration agreement. In another case last year, AT&T Mobility v. Concepcion, the court found in favor of AT&T Mobility, granting companies broad authority to settle disputes through arbitration.
“It's very hard for the SEC to make the argument that the arbitration clause violates the anti-waiver provisions of federal securities laws after the CompuCredit decision, because the anti-waiver clause at issue is no different from the ones in the federal securities laws,” says Pritchard.
The pressure placed upon the SEC to address mandatory shareholder arbitration comes at a time when the SEC also is studying mandatory arbitration agreements between investors and brokers, as required by the Dodd-Frank Act.
Dodd-Frank amended both the Exchange Act and the Investment Advisers Act to permit the SEC to “prohibit, or impose conditions or limitations on the use of, agreements that require customers or clients of any broker, dealer, or municipal securities dealer to arbitrate any future dispute.”
Even if the SEC were to enforce mandatory shareholder arbitration agreements, the next question would be whether those clauses would stand up in court. “Some company will end up having to spend a reasonable amount of money litigating,” Smith says, “to establish whether these really are enforceable, and what the limits are to them.”