Arbitration Provisions in Corporate Governance Documents

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday April 27, 2012 at 9:11 am
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Editor’s Note: The following post comes to us from Carl W. Schneider, special consultant to Ballard Spahr LLP and former special adviser to the SEC’s Division of Corporation Finance. This post is a summary of an article by Mr. Schneider that appeared in 26(3) INSIGHTS: The Corporate & Securities Law Advisor (Wolters Kluwer Law & Business, March 2012).

The financial press and blogs were abuzz in late January 2012 about the Securities Act of 1933 (Securities Act) registration statement filed by The Carlyle Group L.P. for its initial public offering. Its limited partnership agreement required all shareholder disputes with the partnership to be resolved by mandatory, binding and confidential arbitration. The provision included a prohibition against shareholders bringing class actions. Much of the discussion that was critical of the provision focused on the elimination of class actions and not on the pros and cons of arbitration as such.

According to published reports, the SEC advised Carlyle that it would not grant an acceleration order permitting the registration statement to become effective unless the arbitration provision was withdrawn. As a practical matter, Carlyle had no means to challenge the Commission and no practical alternative other than to withdraw its arbitration provision, which it did.

I object to the process by which the SEC killed Carlyle’s arbitration provision.

  • Arbitration provisions in corporate governance documents are not inherently objectionable. Whether a particular clause is objectionable from a policy viewpoint depends on its terms.
  • State law, not the SEC, should determine what intra-corporate arrangements are or are not permissible. Even when dealing with basic fiduciary duties, state law allows some leeway for private internal ordering of relationships through governing documents. [1] Under this principle, the SEC has no proper mandate or jurisdiction to veto arbitration provisions.
  • There are many instances of federal law superseding or adding to state law, or influencing corporate governance through disclosure requirements, but all arise from explicit Congressional action or rulemaking provisions where there is an opportunity for public input. [2] In contrast, a decision to deny acceleration is an inappropriate, non-transparent, non-accountable and unreviewable “under-the-table” way of making policy decisions not unique to a particular registrant.
  • It is a very bad precedent, and I contend, beyond the scope of its authority, for the SEC to use an effectively unreviewable power – the denial of acceleration – as a means to block an offering that meets all disclosure standards because the SEC objected to the arbitration provision. [3]

The Merits of Arbitration: The fuss about Carlyle’s arbitration provision is largely misdirected. Many of the attacks on Carlyle’s arbitration provision really objected to the elimination of the right to pursue claims through class actions, and not to mandatory arbitration as such. However, the two subjects are not necessarily linked.

If parties agree to arbitration – corporate governance documents being agreements for this purpose – they can detail the manner in which the arbitration will be conducted. The traditional objections to arbitration can be eliminated by the agreed terms for conducting the arbitration.. It is perfectly possible to draft an arbitration provision that expressly provides, among other matters, for the right to bring class actions (as a client of mine once did); [4] the obligation of the arbitrator to follow the substantive law of a particular jurisdiction; the arbitrator’s obligation to deliver a written opinion; that right to appeal the arbitrator’s initial opinion to an appellate arbitrator(s); and mediation preceding arbitration.

Arbitration vs. Traditional Litigation: There are inherent objections to traditional litigation as a very inefficient and cumbersome dispute resolution mechanism. Parties could favor arbitration to court proceedings for several reasons:

  • Resolution of a dispute by traditional litigation can take a long time, because of endemic court delays. Arbitration can be accomplished more quickly.
  • The trial time consumed for the actual litigation and expense is likely to be less in arbitration compared to court proceedings.
  • The result is more likely to be correct under the law from arbitrator(s) who have been selected for expertise in the subject matter of the dispute, compared to a judge who may lack any relevant expertise or a jury that may have limited capacity to deal with complex issues.

I readily concede that all of these reasons favoring arbitration could be debated. Many would disagree with each one, and might have many other reasons to favor traditional litigation. I do not argue that anyone should favor arbitration in corporate governance documents – only that companies should have the opportunity to use such provisions if they desire to do so.

Arbitration Issues Are Unlikely to Go Away: Arbitration has become an increasingly common feature of commercial and business relationships. The trend of Supreme Court decisions is strongly in favor of arbitration. It is likely that arbitration proposals affecting public companies and investors will continue to arise. Eventually, the SEC will be required to articulate and support a coherent and consistent policy on arbitration of shareholder claims, especially if it proposes to forbid them in corporate governance documents. [5]

We have an anomaly. The SEC permits a situation where investors must arbitrate when they have claims against their brokers in their capacities as customers. But the SEC refuses to allow a similar requirement when investors have claims against their companies in their capacities as shareholders. If investors do not like Carlyle’s arbitration provision, they have literally thousands of alternatives in which to invest, and Carlyle shareholders will constitute only an infinitesimal portion of the investing public. In contrast, a customer who objects to his or her broker’s arbitration agreement would have difficulty in finding another broker anywhere in the country that does not have a similar term in its customer agreement.

I encourage companies to experiment with arbitration provisions of their own designs. Public companies may amend their governing documents to adopt arbitration provisions. If a proxy statement is required to accomplish the amendment, which may not be the case, [6] the SEC does not have a mechanism to delay a proxy solicitation that is equivalent to its power to deny of acceleration of Securities Act registration statements. If one company adopts an arbitration provision in this manner, the flood gates may be opened. I encourage shareholders to submit Rule 14a-8 proposals to adopt arbitration bylaws, as indeed some have already done. [7]

A Better Solution: By forcing Carlyle to abandon its arbitration provision, the SEC did not preempt some massive incipient fraud, where investors would loose their life savings if it failed to take immediate action. It is not the SEC’s role to protect investors from making their own informed choices. There was no emergency to justify denial of an acceleration order as a means to enforce a perceived public policy objective that was not specific to Carlyle. If investors really wanted to buy Carlyle shares with full knowledge of Carlyle’s arbitration provision, there is no great public harm in letting them do so. The same would be true if a few other companies slipped through the net before the SEC took the “remedial” action suggested below, assuming it perceived a real public policy-based concern that it had a mandate to address.

The SEC has clear statutory, and virtually unlimited, power to control the rules of the market places (referred to as self-regulatory organizations or “SROs”) where publicly owned securities trade. [8] By changing the SRO listing standards, the SEC has a legitimate vehicle to impact the internal governance of public companies in a transparent and above-board manner. If the SEC believes that there is a need to interfere with companies’ choices relating to arbitration, it and the public would be better served by directing the SROs to adopt a listing standard on this subject. The process would start with a published proposal and supporting analysis, on which all interested parties would have a right to comment.

Any proposal would no doubt produce a variety of conflicting responses from business groups, shareholder activists, institutional investors, regulators, proxy advisors, lawyers who represent various interested parties, legislators and academics, among others. A clear standard could be formulated by a transparent rulemaking process where all views are solicited and considered.

Conclusion: I am concerned with the abruptness by which the SEC killed the Carlyle provision, with no articulation of its objection beyond the fact that it disapproves of arbitration provisions in governing documents. Its action will discourage other companies from experimenting with more benign provisions, to which there might be no legitimate objection. The issue of how arbitration should be treated is far too important to be resolved by ad hoc SEC Staff (or even Commission) decisions to deny acceleration of Securities Act filings. What concerns me most about the Carlyle situation is the arbitrary and unreviewable process by which the SEC pressured the elimination of Carlyle’s provision relating to a subject over which the SEC had, at best, a very questionable mandate to regulate.

Endnotes

[1] Just days before the SEC killed the Carlyle provision, the Delaware Chancery court in Auriga Capital Corp. v. Gatz Properties, LLC, 2012 WL 361677 (Del. Ch. Jan. 27, 2012) firmly instructed limited liability company managers and controlling members that they must discharge the traditional fiduciary duties of care and loyalty unless the members have otherwise expressly agreed to modify or waive those default duties in the relevant operating agreement. Thus, even basic fiduciary duties can be modified or eliminated if the governing documents so provide.
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[2] In some cases federal law applies by virtue of a federal statute – e.g., the SEC regulates the subject of proxy solicitation because Congress so provided in Section 14(a) of the Securities Exchange Act of 1934 (Exchange Act). In some cases, federal law effectively controls corporate governance and other intra-corporate relationships because of disclosure requirements. The disclosure requirements are sometimes expressed with a double whammy in the following general form: “(1) Disclose whether the company complies with … (Standard X) and (2) if not, explain why not.”[2] Few companies fail to comply with the standard. Federal law also controls intra-corporate relationships to a considerable extent by virtue of the listing standards of the marketplaces on which securities.
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[3] Securities Act §§ 8 and 8A give the Commission power to delay effectiveness of a registration statement by issuing stop orders and cease and desist orders, respectively. The power to issue these orders is limited by statute to cases where the Commission finds that the registration statement is on its face incomplete or inaccurate in any material respect or a violation of the Securities Act has been or is about to be committed. These provisions require due process, including notice and opportunity to be heard by the registrant. Given the specificity of these statutory provisions, it is unimaginable that Congress intended the Commission (or Staff) to have power to derail a registration statement for reasons that involve no disclosure inadequacy, no violation of the Securities Act or any other law, and without giving the registrant either a reasoned written statement of its objection or a forum to challenge the Commission’s action.
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[4] I represented a client over 20 years ago that had an arbitration agreement in its charter. Our client’s provision expressly allowed arbitration to be conducted as class actions. The SEC advised us that it would never accelerate our IPO registration statement unless we eliminated the arbitration provision, which we were effectively forced to do. Regarding our client’s earlier experience, see Schneider, Arbitration in Corporate Governance Documents: An Idea the SEC Refuses to Accelerate, 4(5) Insights 21 (May 1990); Schneider & Towers, Pennsylvania Corporate Practice and Forms: The Ballard Spahr Manual, Chap. 24 (2011 Ed.).
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[5] In October 2011, the Charles Schwab brokerage firm amended its customer arbitration agreement (1) to prohibit customers from participating in class actions against the firm in any forum, and (2) to deny arbitrations from consolidating similar cases. The Financial Industry Regulatory Authority (FINRA) brought an administrative complaint against Schwab on February 1, 2012, charging Schwab with FINRA rules violations. FINRA News Rel. 2-1-12. FINRA alleged that the change in Schwab’s agreement affected 6.8 million customers. Schwab immediately commenced a law suit to enjoin the FINRA proceeding. It seeks to establish that its revised arbitration agreement is enforceable under federal law and the recent Supreme Court decision in AT&T Mobility LLC v. Concepcion, 131 S. Ct. 740 (2011), in which the court allowed AT&T to enforce a ban on class actions in its consumer contracts. The SEC has ultimate oversight over FINRA’s rules. Eventually, the SEC is likely to be involved in the questions raised by the Schwab dispute.
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[6] In many states, directors alone have the power to amend bylaws. In many states, shareholders holding the requisite majority of shares can act by consent without a meeting, and in these states there may be sufficient shareholder votes to adopt a bylaw or charter amendment without the need for a public proxy solicitation.
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[7] Gannet Co., Inc. received a proposal to adopt a bylaw requiring arbitration of shareholder claims up to $3 million. It has been reported that Pfizer received a similar proposal.
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[8] The SEC has the statutory power to approve or disapprove SRO rules. More significantly, it can initiate changes, by ordering SROs to adopt or amend their rules. Indeed, there can be an extended chain of command, where Congress itself directs the SEC to direct the SROs to adopt listing standards with specific effect — e.g., §§ 952 add 954 of the Dodd-Frank Act added §§ 10C and 10D, respectively, to the Securities Exchange Act. The new sections direct the Commission to direct the SROs to adopt listing standards relating to compensation committees that meet detailed standards and to compensation “clawbacks,” respectively.
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  1. Arbitration: Coming Soon to a Transaction Near You?…

    In the latest of a series of decisions dealing with the enforceability of arbitration agreements, the U.S. Supreme Court in its 2011 decision in the AT&T Mobility LLC v Concepcion case held that the Federal Arbitration Act preempts state laws……

    Trackback by The D & O Diary — March 11, 2013 @ 2:46 am

  2. I believe strongly in arbitration, but also that it not be the only avenue for relief. Often, regulators will do nothing about violations of FINRA rules. Arbitration is not suitable for every case, and many investors’ losses are too small, or individually too impractical to bring by any means other than a class action lawsuit. The purpose of class actions is to right wrongs as a whole, and many organizations may otherwise benefit from committing wrongs, which they purposely design to be impractical to correct.

    Comment by Finra Arbitration Attorney — May 12, 2013 @ 11:23 pm

  3. [...] Spahr law firm on the Harvard Law School Forum on Corporate Governance and Financial Regulation (here), the idea continues to have its advocates and it seems likely that sooner or later there will be a [...]

    Pingback by Arbitration: Coming Soon to a Transaction Near You? | The D&O Diary — January 30, 2014 @ 6:45 pm

 

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