Every few years, going back to at least the 1980s, a trial balloon is floated on the topic of whether the Securities and Exchange Commission should allow companies to impose mandatory arbitration for shareholders.
This time around, a suggestion came by way of relatively new SEC Chairman Jay Clayton with remarks amplified by coverage by Bloomberg.
Clayton testified before the Senate Banking Committee recently that any such move would take significant time to hash out among the full Commission, if only to dispel illusions that such a change would come quickly, if at all.
Clayton would very likely, however, have at least one vote in favor of it. The most recent debate began in the summer of 2017 when Commissioner Michael Piwowar spoke at the conservative Heritage Foundation and took the opportunity to urge pre-IPO companies to try including mandatory shareholder arbitration provisions in corporate charters should they so choose.
Aside from the SEC, the battle over mandatory arbitration requirements has become a divisive issue for Democrats (who see the requirements as an affront to consumer protections) and Republicans (who demand them as an alternative to costly, lawyer-enriching class-action lawsuits).
In July 2017, for example, the Consumer Financial Protection Bureau finalized its rule banning companies from using mandatory arbitration clauses, which are widely used by financial services firms.
“Arbitration can have benefits, even for the average investor, including a cost-effective and quick forum presided over by an expert for resolving disputes. That's the general framework for arbitration and why businesses often elect arbitration for disputes between themselves.”
Paul Helms, a partner with law firm McDermott Will & Emery
“Arbitration clauses in contracts for products like bank accounts and credit cards make it nearly impossible for people to take companies to court when things go wrong,” the CFPB said in a statement at the time the rule was finalized. “These clauses allow companies to avoid accountability by blocking group lawsuits and forcing people to go it alone or give up. Our new rule will stop companies from sidestepping the courts and ensure that people who are harmed together can take action together.”
The CFPB’s rule restored consumers’ right to file or join group lawsuits. It included specific language that companies will need to use if they include an arbitration clause in a new contract.
Nevertheless, the White House was among the fiercest critics. “The evidence is clear that the CFPB’s rule would neither protect consumers nor serve the public interest,” it wrote in a statement. “Rather, under the rule, consumers would have fewer options for quickly and efficiently resolving financial disputes. Further, the rule would harm our community banks and credit unions by opening the door to frivolous lawsuits by special interest trial lawyers.”
The rule faced immediate repeal under the Congressional Review Act. In October, the Senate formally killed the ban in a vote largely along party lines. The vote had been a 50-50 tie, but Vice President Mike Pence cast the deciding vote to kill the ban.
Paul Helms, a partner with law firm McDermott Will & Emery, defends clients in government investigations, principally investigations by the SEC. He takes a measured view of the polarizing topic and hopes the Commission does the same.
“I think you can see arguments on both sides for arbitration provisions,” Helms says. “Arbitration can have benefits, even for the average investor, including a cost-effective and quick forum presided over by an expert for resolving disputes. That’s the general framework for arbitration and why businesses often elect arbitration for disputes between themselves.”
“Sometimes I think if they had an opportunity to understand some of the benefits consumers might also want that,” he added. “On the flip side, I certainly understand the consumer protection concerns, which really come from the sense that arbitration between a business and its customers, or an institution and its clients, can be one-sided at times and that average, everyday investors could lose.”
One of the struggles for the Commission “is if all of this gets tied up in broader political discussions that affect both of the parties,” Helms says. “That’s where it makes a lot of sense to step back and think about this question from the standpoint of the agency’s mission and really examine the costs and benefits.”
For example, he says, the Commission has a strong interest in a robust private securities litigation mechanism “that can support the enforcement side of the house.”
“You can have reasonable disagreement about the mechanism for that private securities litigation,” Helms says. “Is arbitration the right way to do that? The harder question is whether class arbitration is the way to do that. That’s really the lurking question here.”
SEC Investor Advocate Rick Fleming on the legality of shareholder arbitration
The following is from a Feb. 24 speech by Rick Fleming, the SEC's Investor Advocate.
As a legal matter, I believe the Commission has been on solid footing when objecting to companies forcing shareholders into arbitration. Securities Act Section 8(a) allows the Commission to refuse to accelerate the effective date of an issuer’s registration statement upon considering, among other things, the facility with which the rights of the issuer’s securities holders can be understood, the public interest, and the protection of investors. If an issuer chooses to file a registration statement with a forced arbitration provision, I would urge the Commission and staff to make use of Section 8(a).
More broadly, Securities Act Section 14 and Exchange Act Section 29(a) state that any condition that would bind a person to waive compliance with those laws is void. The Supreme Court has upheld the validity of arbitration clauses in brokerage customer agreements, but, for the reasons I’ve already stated, I would suggest that arbitration is not a viable option for investors—particularly small investors—in cases involving fraud on the market or other corporate misconduct. In my view, if private remedies are an important part of the enforcement mechanisms for the ‘33 and ‘34 Acts, and forced arbitration provisions would render those remedies illusory for public company shareholders, then those arbitration provisions are void because they would undermine the enforcement of substantive provisions of the Acts.
Admittedly, there are legal arguments to be made on the other side. The law in this area is messy, particularly in the context of an offering that is reviewed by the SEC, and this specific issue has not been addressed by the Court. But, before public companies push this issue and try to go down this road, it’s worth considering where it may ultimately lead. For instance, if investors are blocked from seeking redress in an egregious case, it is not difficult to imagine calls for the SEC to receive greater resources and expanded enforcement powers (such as the ability to seek full restitution) to make up for the loss of private causes of action.
Or, perhaps more likely, investors may pursue other avenues to deter the use of forced arbitration. Not long ago, investors were outraged when a company went public with non-voting shares, and they turned to the index providers for a market solution that would prevent passive investors from being forced to buy the shares. If a company strips away the ability of investors to seek class actions, investors could go down that same road and ask the index providers to keep the company off the index. Before long, if the SEC fails to act, the index providers could step into that vacuum and become the de facto regulators of corporate governance in this country.
Commissioner Robert Jackson, although forcefully against mandatory arbitration, also called on his fellow Commissioners to make sure that any decision wasn’t made hastily. He addressed the issue during a speech in February at an investor forum in Washington D.C.
“The securities industry is eager to slip mandatory arbitration of shareholder disputes into an upcoming IPO,” Jackson said. “The idea is that our Division of Corporation Finance will be forced to approve the IPO, stripping shareholders of their right to their day in court—and radically altering the balance between shareholders and corporate insiders.”
Jackson says he has expressed a great deal of skepticism about proposals like these in the past.
“I do not have the sense that what we have in corporate America today is too much accountability,” he said. “I think we can all agree that the way to decide this isn’t through a clandestine effort by corporate lobbyists. Whatever the SEC decides, we should do it only through a careful, public rulemaking process. In short: If we’re going to take away investors’ right to their day in court, I hope my colleagues on the Commission can agree that we should, at least, do so in the light of day.”
Jackson said that the SEC’s enforcement attorneys cannot handle the policing of corporate misbehavior on their own. It must be done as part of joint effort between the government and private investors looking to hold bad actors to account. Nowhere is this clearer than in the area of shareholder recovery of losses from fraud.
In 2016, roughly sixty cents of every dollar returned to investors in corporate-fraud cases came through private rather than SEC settlements. “Giving investors their day in court is even more important when the stakes are highest—such as in the wake of a significant corporate fraud,” Jackson said.
Another example he cited: After scandals at Worldcom, Enron, Tyco, Bank of America, and Global Crossing, investors recovered more than $19.4 billion in private lawsuits. By contrast, the SEC obtained $1.75 billion.
“Shareholder suits also help us at the SEC identify and address corporate wrongdoing,” he added. “Scholars have observed that investor lawsuits are as good, if not better than the government in targeting certain securities-law violations … The public also benefits when private litigants use courts, because a public hearing gives judges a chance to tell corporate insiders what the law expects of them.”
“Holding wrongdoers to account tells the public that we take corporate fraud seriously—and sends a signal to insiders, the bar, and investors, that being unfaithful to investors doesn’t pay,” Jackson argued. “Arbitration, on the other hand, is usually conducted in a closed-door proceeding, depriving investors of their chance to air their objections—and the rest of us the knowledge of what the law is.”
So, how do we move forward from here? For starters, Jackson says, there is a need for “rigorous answers” to the many legal questions raised by any policy proposal requiring investors to rely on private arbitration rather than the courts. What would the effect of SEC action in this area be for state law? What would the Delaware courts say about the relationship between forced arbitration and a board’s fiduciary duties? Would SEC approval of such provisions even be consistent with the federal securities laws?
What would be the practical effect for SEC enforcement priorities—especially at a time when our regulators are increasingly being asked to do more with less? If investors are soon barred from bringing suits in court, then the burden of investigating and litigating these cases may fall entirely on the SEC. How much would Congress need to appropriate to make sure we have enough resources to do the job?
“Given the sheer scale of private enforcement of our securities laws, I’m skeptical that the government could ever fully prevent corporate wrongdoing on its own,” Jackson said.
Calling mandatory arbitration “an illusory remedy” for public company shareholders, Rick Fleming, the SEC’s investor advocate, savaged the idea of mandatory shareholder arbitration during the Practising Law Institute’s annual SEC Speaks event on Feb. 24.
“The idea of forced arbitration has been promoted as a way to reduce costs of securities litigation for public companies and thereby remove a perceived disincentive for companies to be public,” he said. “Reportedly, it is too easy for plaintiffs’ firms to bring dubious cases and win settlements, and some have argued that class-action lawsuits, even meritorious ones, fail to compensate harmed investors in any meaningful way.”
There may be some validity to these concerns, he said, “but stripping away the right of shareholders to bring a class-action lawsuit seems to me draconian and, with respect to promoting capital formation, counterproductive.”
Fleming’s argument, like Jackson’s, is that the government has traditionally played a limited role in policing markets, as evidenced by the fact that only 4,600 SEC employees oversee approximately $72 trillion in securities trading each year. “Because of the limited scope of the SEC’s resources, investors themselves have typically borne a large share of the responsibility for policing the markets and rooting out misconduct,” he said. “Over the years, Congress, the Supreme Court, and former SEC commissioners have recognized the importance of private suits in helping to protect investors and deter wrongdoing.”
Advocates for mandatory arbitration suggest that arbitration provides a sufficient way for investors to seek redress, even if investors are denied the right to pursue class-action lawsuits. “But, as a practical matter, unless a class-wide remedy is available, there is often no other recourse for investors with small holdings,” Fleming said.
“Some have observed that class actions generally result in ‘institutional shareholders effectively suing themselves,’ paying high costs for the defense while giving plaintiffs’ attorneys a large share of any settlement,” he added. “But institutional investors, who presumably have the economic incentives and resources to pursue individual arbitration, have been vocal in their opposition to forced arbitration … In my view, there is considerable value in seeing companies held accountable for wrongdoing, even if the compensatory mechanism is imperfect.”