A new movement would push companies to adopt provisions that could limit shareholders' ability to protect and enforce their rights in courtrooms across the country.
These terms would require all shareholders — including pension funds and other institutional investors — to submit to arbitration any claims they have involving their investment, or impose outright bans on shareholders participating in class actions. More than just limiting litigation, such provisions threaten to undermine the integrity of our financial markets by removing judicial oversight not only of corporations' compliance with federal securities laws, but also of corporate directors' compliance with their fiduciary obligations to shareholders.
A pair of U.S. Supreme Court decisions — AT&T Mobility LLC vs. Concepcion et ux. (2011), and American Express Co. et al. vs. Italian Colors Restaurant et al. (2013) — have enabled corporations to avoid liability in any class action simply by including a forced arbitration clause in a service agreement, employment agreement or other contract. By upholding class waivers, these decisions override state laws demanding accountability of corporate fiduciaries and make no exception for federal statutory rights.
Corporations have begun to seize on arbitration provisions as a way to limit shareholder rights. Because bylaws establish the contractual terms that govern a corporation, these provisions fit within the framework for forced arbitration created by recent Supreme Court precedent. And because these provisions have been adopted unilaterally by boards without shareholder approval, they represent a threat to sound corporate governance that balances the rights of shareowners against the responsibility of managers to run the business.
The seriousness of this threat cannot be overstated. In Corvex Management LP et al. vs. CommonWealth REIT et al., shareholders of a real estate investment trust brought an action last February, arguing the company's board breached its fiduciary duty by taking unlawful actions to prevent or delay a shareholder vote on a takeover bid. The REIT's bylaws contained a mandatory arbitration provision and ban on class actions, including shareholder derivative suits, or legal actions brought by shareholders on behalf of a corporation, often against directors or executives and alleging improper management, the corporation hasn't pursued.
On May 8, a Maryland circuit court, citing the Supreme Court precedent on a forced arbitration agreement, dismissed the litigation holding that shareholders' claims had to be submitted to arbitration even though the REIT's board unilaterally adopted the bylaw without shareholder approval.
On July 1, in Sandalwood Debt Fund A LP et al. vs. KPMG LLP, the Appellate Division of the Superior Court of New Jersey forced investors into arbitration based on provisions in a hedge fund's engagement letters with its auditor. The plaintiffs — limited partners of feeder funds for Bernard Madoff — brought suit against KPMG after being advised that the funds had lost substantially all of their value. Holding that the claims were derivative, the court dismissed them as being subject to an arbitration provision in the fund's engagement letter with KPMG, despite the fact that the limited partners had no say in retaining KPMG and did not consent to the terms of engagement.
The Delaware Court of Chancery might unwittingly have aided the movement to eliminate judicial oversight. In Boilermakers Local 154 Retirement Fund and Key West Police & Fire Pension Fund vs. Chevron Corp. et al., Chancellor Leo Strine last June upheld the enforceability of bylaws, unilaterally adopted by boards, which required all litigation relating to the internal affairs of the corporations be conducted in Delaware.
If Delaware law allows boards, through the adoption of bylaws, to dictate the forum for resolution of all shareholder disputes, this may allow directors of Delaware-incorporated corporations to designate arbitration as the exclusive forum through a bylaw adopted without shareholder approval. Once it is established that boards are empowered under state law to designate a forum for resolving shareholder disputes, directors can rely on federal law to designate arbitration as the only available forum. By creating a contractual right for boards to adopt forum selection clauses in corporate bylaws, Mr. Strine might have opened a Pandora's box.
Forced arbitration clauses containing class-action waivers in bylaws or corporate charters will have the effect of disallowing shareholders to pursue any legal remedy. Institutional investors will have no access to the courts at all. And individual investors will have no way of pursuing any claims since collective action is the only available option for them. This would effectively immunize companies and their directors and officers from class-action claims. Class actions under Rule 10b-5 of the Exchange Act of 1934 could be eliminated as well.
The availability of judicial review of director misconduct is essential to the integrity of our public markets. If judicial oversight is eliminated, corporate law — and the existence of the fiduciary standard — no longer would be developed by judges in the public eye, but would be written in secret by arbitrators who might not have any particular expertise, and whose decisions are unreviewable. The Supreme Court has essentially encouraged corporations to create a one-sided arbitration system that deprives investors of meaningful access to justice, while shielding corporate directors from being held publicly accountable for breach of fiduciary duties.
It is also important that shareholders maintain a private right of action as a companion to SEC enforcement. Consider the comments of Harvey Goldschmidt, former SEC commissioner: “It would be a shocking turning back to say only the commission can bring fraud cases. Private enforcement is a necessary supplement to the work that the SEC does. It is also a safety valve against the potential capture of the agency by industry.”
Private actions supplement the SEC's enforcement efforts by providing deterrents to corporate wrongdoing in the form of litigation subject to public review. Mr. Goldschmidt was right. Compared to regulatory action, private litigation is a much more effective means of returning value to investors injured by corporate fraud. In the past three years, the SEC has recovered $2.73 billion in penalties, disgorgement and other relief in litigation stemming from the financial crisis, according to a report, “SEC Enforcement Actions, Addressing Misconduct That Led To or Arose From the Financial Crisis,” citing key statistics through Sept. 1. Private litigation during this same time period resulted in judgment or settlements of more than $16 billion, according to a March 5 report.
Arbitration is not an equivalent remedy to judicial oversight. Appeals and other litigation procedures are unavailable in arbitration. The secretive nature of arbitration is a boon to defendants, and eliminates a key device for shareholders to force change. As for class-action waivers in bylaws, disallowing the right of shareholders to proceed collectively means the end of any legal remedy for many investors and will shield defendant companies and their directors and officers.
Investors need to stand up and take action to prevent corporations from eliminating judicial oversight of wrongdoing. State legislatures should bar companies incorporated in their states from permitting directors to adopt arbitration bylaws without explicit shareholder approval. Federal lawmakers should make clear that eliminating the ability of individuals to protect their statutory rights is inconsistent with our nation's securities laws.
Jay Eisenhofer and Michael Barry are directors of the law firm of Grant & Eisenhofer PA, which represents public pension funds and other institutional investors in shareholder and corporate governance legal matters.