Shareholders beware: Federal judge OKs corporate arbitration clause

By Alison Frankel
March 27, 2014

Complaining about mandatory arbitration clauses in consumer and employment contracts is like whining about the weather: an exercise in futility. Whatever slim hope remained for opponents of mandatory arbitration after the U.S. Supreme Court’s 2011 ruling in AT&T Mobility v. Concepcion was extinguished last year in the court’s decision in American Express v. Italian Colors, which said that arbitration clauses are valid even if they effectively preclude people from enforcing their statutory rights. After the Italian Colors ruling came down, I speculated that corporations would next take advantage of the Supreme Court’s enthusiasm for arbitration by enacting provisions to require shareholders to arbitrate their claims against the company or its directors.

Law professors James Cox of Duke and John Coates of Harvard told me that some intrepid business was bound to attempt to impose arbitration on its shareholders, either in the charter of a company first offering shares to the public or in a bylaw amendment for an already public company. The profs said that the Securities and Exchange Commission, which has historically opposed mandatory shareholder arbitration, might not be able to stop a corporation that chose to fight all the way to the Supreme Court. The biggest obstacle to requiring shareholders to give up the right to sue in court, Coates told me, would probably be the issue of providing adequate notice. Would courts agree that shareholders had consented not to sue simply by purchasing the stock of a corporation with a mandatory arbitration provision?

We now have an answer to that question from a federal judge in Boston – and it’s one that should embolden corporations considering shareholder arbitration clauses. On Thursday, U.S. District Judge Denise Casper refused to invalidate a mandatory shareholder arbitration clause in the bylaws of the notorious Commonwealth real estate investment trust. Casper said that under the principle of res judicata, she was bound by two previous opinions from a Maryland state court judge who found that the Commonwealth arbitration clause was valid. But even if she were ruling on the merits of the provision, Casper said, she would find that shareholders hadn’t shown mandatory arbitration to be unenforceable.

The shareholders, represented by Chimicles & Tikellis, had argued that Commonwealth unilaterally imposed the unconscionable bylaw amendment without providing notice to or seeking consent from investors in the REIT. (Among the name plaintiffs were a pension fund and individual investors who bought stock in the REIT before the 2009 arbitration clause was adopted.) Shareholders attributed the worst of intentions to the Commonwealth trustees, whom they accused of foisting the clause upon investors “to well-insulate themselves…from liability and from having to defend themselves from shareholder allegations of corporate mismanagement,” Chimicles argued in a motion for declaratory judgment. “If this arbitration clause is deemed valid, it will undermine the foundation of shareholder suits and managerial misconduct will go undeterred and unchallenged by shareholders.”

Commonwealth’s lawyers at Skadden, Arps, Slate, Meagher & Flom by now have the company’s defenses down to a science. As I mentioned, the REIT’s arbitration clause was previously challenged in two derivative suits last year in Circuit Court in Baltimore, where the company is incorporated. The first complaint was by hedge funds engaged in a hostile takeover bid for Commonwealth. Their case was compromised because they had acquired their shares after the mandatory arbitration bylaw was adopted, but the second suit was brought by shareholders whose ownership predated the 2009 clause. Judge Audrey Carrion concluded in two opinions that the stock purchase date wasn’t important. Shareholders had constructive knowledge of the corporate bylaws because they’re referenced in the REIT’s stock certificates, she held. “Because bylaws constitute part of a binding flexible contract among the directors, officers, and stockholders, CWH stockholders are on notice (that) the board itself may act unilaterally,” she said. (Carrion’s second ruling came down just last month, after Judge Casper heard oral arguments in the Boston federal court case, but Skadden filed the opinion as supplemental authority in the federal litigation.)

Casper also found that shareholders had constructive knowledge of the arbitration clause via Commonwealth’s stock certificate, regardless of whether they bought their shares before or after the bylaws were amended in 2009. Nor was she swayed by the SEC’s discouragement of shareholder arbitration clauses, because, she said, the Commonwealth provision doesn’t preclude shareholders from asserting Exchange Act claims but merely specifies a forum for them. (Shareholders had pointed out that the arbitration provision, as a practical matter, makes it almost impossible for investors to arbitrate claims against Commonwealth because it bars fee-shifting, but Judge Casper said they hadn’t shown that arbitrating against the REIT would be cost-prohibitive.)

The Boston ruling isn’t the first time a federal judge has refused to strike down a public company’s mandatory shareholder arbitration clause. As Skadden pointed out in Commonwealth’s opposition to the motion for declaratory judgment, in a 2008 ruling called Stender v. Gerardi, U.S. District Judge Edward Nottingham of Denver ordered shareholders in the Archstone REIT to arbitrate a claim against the company’s trustees based on an arbitration provision in Archstone’s declaration of trust.

But Commonwealth’s arbitration provision is much more sweeping than the Archstone clause, which presumably made the Commonwealth’s mandatory shareholder arbitration more vulnerable to accusations that it violates public policy considerations. So Casper’s finding that Commonwealth was within its rights to impose arbitration on shareholders – at a time when corporations are increasingly likely to make use of mandatory arbitration provisions in other contexts – should have more ripples than the Archstone decision.

Shareholder lawyer Kimberly Donaldson Smith of Chimicles told me the firm is still evaluating the decision. Judge Casper, she said, didn’t rule on the merits of investors’ underlying claims that trustees breached their duties to shareholders. The trustees named in the shareholder suit were ousted two days ago, and a new board will be elected. It’s not clear, Smith said, that the REIT’s arbitration provision extends to shareholder claims against former trustees, which is what the defendants in the Chimicles suit now are.

Commonwealth counsel Robert Saunders of Skadden was traveling and didn’t respond to an email requesting comment.

(Reporting by Alison Frankel) (Reporting By Alison Frankel)

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