Wake up, shareholders! Your right to sue corporations may be in danger
Do you believe that securities class actions and shareholder derivative suits have any salutary effect on corporate governance – that directors and officers are less likely to misbehave when they’re liable to shareholders (their nominal bosses) in court? If so, you ought to be very worried about a pair of developments in the last week that offer a theoretical framework to end shareholder class actions. If, on the other hand, you’re of the view that shareholder litigation is merely a transfer of wealth from corporations to plaintiffs’ lawyers, with little actual return to investors, you might want to start thinking about how to use the new rulings to stop that from happening.
Let’s look first at the U.S. Supreme Court’s 5-3 decision last week in American Express v. Italian Colors. That case, as you know, was brought by small businesses that believed American Express was abusing its monopoly in the charge card market by requiring them also to accept Amex credit cards carrying higher fees than competing credit cards. The Supreme Court said that even though the merchants had statutory antitrust rights under the Sherman Act, they had given up their right to sue Amex as a class when they signed arbitration agreements barring such suits. It was of no matter, the majority said, that the cost of arbitrating an individual antitrust claim would dwarf the recovery of any single small business: The merchants signed contracts that included arbitration clauses and those contracts bound them. (Or, as Justice Elena Kagan put it in a memorable dissent: “Here is the nutshell version of today’s opinion, admirably flaunted rather than camouflaged: Too darn bad.”)
The Amex ruling immediately drew the ire of consumer and employment rights advocates, who argued that it gives corporations the power effectively to insulate themselves against all sorts of legitimate claims by cutting off escape routes from class action waivers in mandatory arbitration clauses. But what about shareholders? In a very smart column on Monday, Kevin LaCroix of D&O Diary raised the question of Amex‘s potential impact on securities fraud and shareholder derivative class actions. Does the court’s ruling, he asked, mean that “the broad enforceability of arbitration agreements reaches far enough to include the enforceability of arbitration agreements and class action waivers in corporate articles of incorporation or by-laws?”
Why shouldn’t it, after all? Shareholders sue corporations and corporate boards under a pair of laws passed in the 1930s, meaning that their federal statutory rights are no more powerful than those of the merchants who tried to sue Amex under the Sherman Act. So why can’t corporations, as LaCroix suggests, impose mandatory arbitration and class action waivers on shareholders?
They may well be able to under this Supreme Court, Duke law professor James Cox told me Tuesday. Cox said he believes that sooner than later, some private start-up or company engaged in an initial public offering will include a mandatory arbitration provision in its corporate charter. The company will have to be able to show that shareholders consented to the provision, just as the merchants in the Amex case agreed to mandatory arbitration, Cox said, “but I could easily imagine this court fantasizing that when you buy shares of the company, you consent.”
What about the Securities and Exchange Commission? When the private equity fund Carlyle floated the idea of shareholder arbitration in an IPO in 2012, the SEC quietly objected and Carlyle ended up dropping the proposal. Though the SEC has never permitted the IPO of a company with a mandatory arbitration clause, Cox told me he believes the SEC “has limited power” to block such provisions if a corporation really wants to litigate the issue up to the Supreme Court.
“Given human nature,” added Harvard law professor John Coates, “someone will try it.”
Coates told me, however, that he believes there’s a key difference in the relationship between shareholders and corporations and Amex and the merchants who sued it (and, for that matter, cell phone customers and AT&T Mobility in the 2011 Supreme Court case Concepcion v. AT&T Mobility, which first upheld mandatory class action waivers). Shareholders are the nominal owners of the corporations they sue in securities class actions and the nominal overseers of the directors and officers targeted in derivative suits. They don’t sign the same kind of contracts as the Amex merchants or consumers or employees, so, Coates said, courts are likely to regard with skepticism corporate claims that shareholders knew they were waiving rights when they bought stock.
That would be especially true, Coates told me, if corporations attempted to impose shareholder arbitration through a by-law amendment rather than in a corporate charter. Shareholders would then have a good argument that they didn’t have adequate notice and didn’t consent to give up the right to sue in court. (Indeed, both Coates and Cox have signed affidavits for a union fund fighting a mandatory arbitration clause imposed via a by-law by the real estate investment CommonWealth; a Maryland state court has upheld the validity of the by-law in a separate case brought by hedge fund shareholders that bought stock after it was enacted.)
The question of adequate notice to shareholders really got interesting thanks to the second development I mentioned: a decision Tuesday by Chancellor Leo Strine of Delaware Chancery Court, who ruled corporations may adopt by-laws mandating that shareholder litigation be conducted in the forum of their choice. By-laws, Strine said, are “part of a binding broader contract among the directors, officers, and stockholders.” Certificates of incorporation authorize directors and officers to amend corporate by-laws, the chancellor wrote. Investors should understand that relationship when they buy their shares. So when the board legitimately enacts a by-law amendment, Strine said, it does so with the contractual consent of stock owners. “In other words, an essential part of the contract stockholders assent to when they buy stock,” he wrote, “is one that presupposes the board’s authority to adopt binding bylaws.”
You see the theoretical power of the two rulings in combination? A company could evade the SEC’s IPO strictures by imposing mandatory shareholder arbitration through a by-law amendment rather than in a charter, pointing to Strine’s language on shareholders’ implicit contractual consent. Then, when shareholders claimed their statutory rights were cut off because they couldn’t vindicate securities fraud or breach of duty claims through individual arbitration, the corporation could point to Amex and say, “Tough luck.” It would be frighteningly ironic if Strine’s ruling on corporate by-laws, which seems intended to drive shareholder litigation to Delaware, ended up driving corporations to arbitration instead of litigation in any forum.
Doomsday has not yet arrived for shareholder litigation, and perhaps it never will. Another Harvard law professor, Jesse Fried, cautioned in an email that forum selection by-laws are “very different animals from arbitration provisions, especially when the shareholders can change the by-laws if they are really unhappy about them.” Strine’s ruling Tuesday included a caveat noting that forum selection by-laws regulate just where suits are brought, not what suits shareholders may bring (nor, by extension, whether they can bring suits at all). Fried and Coates both told me that Delaware courts will question whether mandatory shareholder arbitration clauses are consistent with a board’s fiduciary duties to shareholders. Fried added that corporate defense lawyers may also be philosophically (and financially) opposed to moving shareholder claims to arbitration; Coates posited that corporations may prefer to resolve shareholder claims through class actions rather than through endless individual arbitrations. (I have my doubts on that score.)
Opponents of mandatory shareholder arbitration can also point to specific laws as evidence that Congress intended shareholder claims to be litigated on a classwide basis, including the Private Securities Litigation Reform Act and the Securities Litigation Uniform Standards Act, both of which assume that shareholders will litigate as a class. The Supreme Court, moreover, has not (to my knowledge) suggested diverting shareholder claims to arbitration, even though it has spent a lot of time in the last couple of years tinkering with the mechanics of securities class actions. For that matter, the court’s securities rulings haven’t been nearly as hard on plaintiffs as some of the court’s other class action decisions.
Nevertheless, the law professors all regard mandatory shareholder arbitration attempts as a near certainty, especially if the Maryland courts don’t undo CommonWealth’s by-law. The shareholder class action bar and big pension funds have been pretty resilient in the face of the obstacles Congress and the courts have put in its way. Mandatory arbitration could be their final stand.
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