Weighing in on what has been a heated debate—and one drawing out some strange bedfellows—on Feb. 11, the Securities and Exchange Commission issued a “no action” letter to Johnson & Johnson stating that it will not intervene if the company excludes from its proxy materials a shareholder proposal that would force investor disputes into mandatory arbitration.
Mandatory binding arbitration is a contract provision that requires the parties to resolve contract disputes before an arbitrator rather than through the legal system. The proposed bylaw would also prohibit class actions and included a five-year sunset provision unless reapproved by shareholders.
A key to the SEC staff determination was New Jersey Attorney General Gurbir Grewal’s assertion that—as claimed by Johnson & Johnson—the arbitration proposal would violate state law, specifically the New Jersey Business Corporation Act.
“The proposal, if adopted, would cause Johnson & Johnson to violate New Jersey state law,” the SEC’s Division of Corporation Finance wrote. “In light of the submissions before us, including in particular the opinion of the Attorney General of the State of New Jersey, that implementation of the proposal would cause the Company to violate state law, we will not recommend enforcement action to the Commission if the company omits the proposal from its proxy materials in reliance on rule 14a-8(i)(2). To conclude otherwise would put the company in a position of taking actions that the chief legal officer of its state of incorporation has determined to be illegal.”
Rule 14a-8 permits exclusion of a proposal that, if implemented, would cause the company to violate any state, federal, or foreign law to which it is subject. The company has argued that the proposal, if implemented, would result in a violation of both federal and state law.
“I agree that the proposal would be contrary to the public policy interests underlying the federal securities laws, and that it would seriously undermine the goals of investor protection and transparency on the part of those who issue and sell securities,” Grewal wrote. “I write separately, however, to advise the Commission that the proposal is also excludable under Rule 14a-8(i)(2) for the additional reason that adoption of the proposed bylaw would cause Johnson & Johnson to violate applicable state law.”
Shareholders—represented by Hal Scott, a Harvard Law School professor and a trustee for a fund holding Johnson & Johnson shares—argued that, despite the opinion of the New Jersey Attorney General, the fund “continues to believe that the Company has not met its burden of establishing that it is entitled to exclude the proposal on the grounds that it would, if implemented, violate state law. To the contrary, the Trust continues to believe that the Proposal, if implemented, would be lawful and that, at most, its validity under state law is unsettled, which is not sufficient to meet the Company’s burden.”
“While this is a significant victory, investors need real and lasting protections, which is why Congress must immediately ban forced arbitration. This issue will not go away because corporate interests will continue to hound the SEC to restrict the rights of investors. We must ensure that the SEC continues to allow investors to hold corporate wrongdoers accountable.”
Lisa Gilbert, VP of Legislative Affairs, Public Citizen
Amid growing controversy over the decision, SEC Chairman Jay Clayton delved into the fray via a public statement. “The issue of mandatory arbitration provisions in the bylaws of U.S. publicly listed companies has garnered a great deal of attention,” he said. “The ability of domestic, publicly listed companies to require shareholders to arbitrate claims against them arising under the federal securities laws is a complex matter that requires careful consideration.”
Clayton said that, on various occasions, he has been asked about this issue in the hypothetical context of whether the staff of the Division of Corporation Finance would declare effective the registration statement of a domestic company seeking to include mandatory arbitration provisions in its governing documents at the time of its initial public offering.
His standard response: “If the issue were to arise in an actual initial public offering of a domestic company, it would not be appropriate for resolution at the staff level but would rather be best addressed in a measured and deliberative manner by the Commission.”
The issue has arisen again, but it is now presented in a different context. A domestic, publicly listed company has received a shareholder proposal that would require the company to take steps to adopt mandatory arbitration provisions, Clayton explained. The company has asked the Division for informal guidance on whether the company may exclude the proposal from its proxy statement under Rule 14a-8. In the context of Rule 14a-8, the staff does not independently adjudicate the legality of any provision of state law and was not doing so in this matter. Instead, it relied on the attorney general’s opinion that implementation of the proposal would violate state law.
“In light of the submissions, and in particular the letter of the attorney general of New Jersey, I believe the approach taken by the staff—to not recommend enforcement action in this complex matter of state law—is appropriate,” Clayton wrote. “In light of the unsettled and complex nature of this issue, as well as its importance, I agree with the approach taken by the staff to not address the legality of mandatory shareholder arbitration in the context of federal securities laws in this matter and would expect our staff to take a similar approach if the issue were to arise again. I continue to believe that any SEC policy decision on this subject should be made by the Commission in a measured and deliberative manner.”
“More generally, it is important to note that the staff’s Rule 14a-8 no-action responses reflect only informal views of the staff regarding whether it is appropriate for the Commission to take enforcement action,” he added. “The views expressed in these responses are not binding on the Commission or other parties and do not and cannot definitively adjudicate the merits of a company’s position with respect to the legality of a shareholder proposal. A court is a more appropriate venue to seek a binding determination of whether a shareholder proposal can be excluded.
“The SEC did the right thing by deciding not to take action against Johnson & Johnson and protecting investors against forced arbitration,” Lisa Gilbert, vice president of legislative affairs for the consumer advocacy group Public Citizen, said in a statement. “While this is a significant victory, investors need real and lasting protections, which is why Congress must immediately ban forced arbitration. This issue will not go away because corporate interests will continue to hound the SEC to restrict the rights of investors. We must ensure that the SEC continues to allow investors to hold corporate wrongdoers accountable.”
Debate over using the proxy process to promote mandatory arbitration has amplified in the past couple of years.
In July 2017, former SEC Commissioner Michael Piwowar extended this invitation to public companies: “For shareholder lawsuits, companies can come to us to ask for relief and put mandatory arbitration into their charters.” Speaking before the Heritage Foundation, he urged pre-IPO companies to try including mandatory shareholder arbitration provisions in corporate charters to see how the SEC reacts.
Scott, often seen as a pro-consumer/shareholder voice, may have laid the conceptual groundwork for the Johnson & Johnson proposal when he praised Piwowar’s comments in a post on Columbia Law School’s Blue Sky Blog on Aug. 21, 2017. “To some, this idea may be unfamiliar or even controversial,” he wrote. “But, as someone who has studied the U.S. securities class-action system and its impact on our capital markets extensively, I know this policy is a sound one that serves U.S. investors and markets well.”
Scott supported the right “to opt out of the costly and ineffective system of securities class-action litigation and into a system of mandatory arbitration to resolve issuer-stockholder disputes.”
“Such arbitration provisions may be included in a company’s charter, as Commissioner Piwowar suggests, or adopted through a shareholder proposal to amend a company’s bylaws,” he added. “Commissioner Piwowar’s offer is an important one, because it should be up to shareholders to decide whether they wish to resolve securities law disputes through arbitration or class actions. Preserving shareholder choice on this matter is especially critical because of the demonstrated problems that securities class actions create for investors and markets … U.S. securities class actions do a poor job of compensating investors because shareholders themselves bear the costs of these lawsuits. Given the high costs and uncertain benefits of these suits, shareholders may view individual arbitration as a more appropriate mechanism to resolve issuer-stockholder disputes.”
Meanwhile, the regulatory view of mandatory arbitration continues to shift in line with political power.
In July 2017, the Consumer Financial Protection Bureau finalized a rule banning financial services companies from using mandatory arbitration clauses and restored consumers’ right to file or join group lawsuits. Companies could still include arbitration clauses in their contracts but could not use arbitration clauses to stop consumers from being part of a group action. The rule included specific language that companies will need to use if they include an arbitration clause in a new contract.
The rule was short-lived. By November, with Republican majority votes in the House and Senate and Presidential approval, the rule was vacated in accordance with the Congressional Review Act.