By Shannon Collins
A no-action letter last month put the U.S. Securities and Exchange Commission’s stamp of approval on Johnson & Johnson’s move to bar a shareholder vote at its annual meeting on the use of mandatory arbitration for securities disputes between the company and its shareholders.
Last spring, U.S. Securities and Exchange Commission chairman Jay Clayton discussed the possibility of supporting a mandatory arbitration provision that would bar class actions as part of an initial public offering, according to two Reuters articles. See Alison Frankel, “SEC chair Clayton is in no rush for mandatory shareholder arbitration,” Reuters (April 27, 2018) (available at https://reut.rs/2EJlRX4), and Alison Frankel, “The case against mandatory shareholder arbitration,” Reuters (Aug. 22, 2018) (available at https://reut.rs/2Tmptby).
While arbitration is an invaluable dispute resolution tool, the use of mandatory processes in consumer and employment cases with class-action waivers generated controversy before the Supreme Court signed off on permitting them last year in employment cases, and in 2011 in consumer contracts.
In IPOs, mandatory individual arbitration would eliminate shareholder class actions, which is a mechanism frequently used to prosecute securities fraud suits—often after share price fluctuations following the initial offerings.
The class-action model allows for more shareholders to participate in litigation against fraud and have their voices heard, while individual arbitration may remain confidential and result in varying terms and decisions, according to a coalition of organizations seeking to bar mandatory shareholder arbitration under the securities laws. See Letter to SEC Chairman Jay Clayton, (Jan. 16, 2018) (available at http://bit.ly/2NJdRJs).
Clayton’s comments caused an uproar from several organizations and resulted in the formation of a consumer-group coalition, Secure Our Savings. SOS comprises the Consumer Federation of America and the Consumers Union, along with attorneys from the American Association for Justice, Public Justice, and Public Citizen, among many others.
Johnson & Johnson has been the center of attention of mandatory shareholder arbitration news. Hal Scott, a Harvard Law professor who represents a trust that owns J&J shares, issued an open letter to the health care giant on behalf of the trust encouraging a shareholder proposal for mandatory dispute arbitration, including disputes involving securities fraud.
Micah Hauptman, financial services counsel at Washington, D.C.’s Consumer Federation of America, wrote in response to an email inquiry that he believes such clauses “would violate the federal securities laws and would be inconsistent with longstanding SEC policy on the matter. In addition, such clauses would violate state law because they would exceed the bounds of the internal affairs doctrine.” See also Barbara Roper and Micah Hauptman, “A Settled Matter: Mandatory Shareholder Arbitration Is against the Law and the Public Interest,” Consumer Federation of America (Aug. 15, 2018) (available at http://bit.ly/2UpR1ZR).
In response to Scott’s proposal, New Brunswick, N.J.-based J&J submitted a request to the SEC asking for a no-action letter that would allow the company to exclude the mandatory arbitration proposal from J&J’s annual meeting proxy statement.
The basis of J&J’s exclusion is 1934 Securities Exchange Act Rule 14a-8(i)(2), which allows for companies to exclude shareholder proposals “if the proposal would, if implemented, cause the company to violate any state, federal, or foreign law to which it is subject.” J&J said it believed that the proposal would cause it to violate federal securities law, as well as New Jersey state law.
J&J claimed in its letter to the SEC that the proposal violates Exchange Act Section 29(a), which voids provisions that “bind any person to waive compliance with any [part of the act] . . . or of any rule or regulation thereunder.”
The U.S. Supreme Court has held that Section 29 applies only to waivers of substantive provisions, not procedural provisions. Shearson/American Express v. McMahon, 482 U.S. 220 (1987) (available at http://bit.ly/2ECOyVh). Therefore, J&J could not claim that mandatory arbitration violates Exchange Act Section 27 (granting exclusive jurisdiction of claims under the act to U.S. District Courts). J&J instead argued that mandatory arbitration would violate Exchange Act Rules 10b and 10b-5 prohibiting securities fraud.
Though J&J noted that the Supreme Court has held that arbitration provisions do not cause a waiver of compliance with substantive Exchange Act provisions, the SEC has allowed for exclusion of arbitration proposals based partially on arguments of Section 29(a) violations. J&J relied on those exclusions as precedent.
J&J also raised public policy concerns, arguing that arbitration agreements should be made on an individual basis rather than by corporate organizational documents.
In contrast, Hal Scott assured in his supporting statement that his proposal in no way violates state or federal law. (See the link above to the J&J letter on the SEC’s website; Scott’s proposal and supporting statement are exhibits.)
He wrote that the Supreme Court has held that mandatory individual arbitration provisions aren’t in conflict with the federal securities laws, and that New Jersey law allows for the provision because the state views corporate bylaws as a contract between corporations and stockholders.
Scott supported his proposal by highlighting the billions of dollars companies can spend on shareholder lawsuits. “We believe arbitration is an effective alternative to class actions,” he wrote. These suits also can be frivolous and result in a waste of both time and money for all parties involved, according to Scott.
After evaluating the parties’ arguments on the complex securities laws, Commissioner Clayton released a Feb. 11 statement backing the J&J request. The SEC response assured that, should J&J exclude Scott’s shareholder proposal, the SEC would not seek enforcement action.
Clayton’s statement emphasized that the no-action response is neither an acknowledgment nor a denial that Scott’s proposal violates Rule 14a-8(i)(2), but rather is just a statement that the proposal will not be enforced.
The New Jersey laws carried the no-action determination. Clayton states that no New Jersey precedent applies to the matter perfectly, but he seemed to be more inclined to believe that the proposal could violate state law.
That view was reinforced by a determination by N.J. Attorney General Gurbir Grewal, who advised the SEC in January that the proposal violates New Jersey law. “We view this submission as a legally authoritative statement that we are not in a position to question,” wrote SEC Corporation Finance Division attorney-adviser Jacqueline Kaufman in the agency’s no action letter.
In a Wall Street Journal article, Clayton indicated that he “wants to avoid a brawl” for now over a topic as divisive as this one, choosing instead to toe the line rather than spark a political fight.
With news of this SEC decision, Hal Scott remains optimistic about the possible future of mandatory shareholder arbitration. He spoke to Reuters about plans to appeal the SEC’s recommendation and discussed his reaction to the filing.
While he is unconvinced the appeal will succeed, he sees opportunity for future proposals like the one he submitted to J&J in the SEC’s deliberate omission of an affirmative statement regarding the legality of mandatory shareholder arbitration in the no-action letter.
This, according to Scott, is the most significant development so far. According to the Reuters article, the move “leaves open the prospect of mandatory shareholder arbitration for corporations based in states whose corporate codes would permit it.”
With the SEC permitting exclusion of shareholder proposals for mandatory arbitration, it raises a question of whether any company undertaking an IPO will be able to implement such a proposal.
The SEC at least appears hesitant to make a ruling on whether it believes mandatory arbitration violates any state or federal laws. If the SEC continues to allow exclusions like J&J’s, however, it may effectively result in the SEC taking the position that these arbitration provisions likely violate state or federal law.
A determination like this may be best left for Congress, rather than the SEC—though Clayton, according to Reuters, has vowed to have the full commission decide the issue of shareholder arbitration and the FAA, rather than piecemeal Corporation Finance Division opinions, when the time is ripe.
Regardless, this is an unsettled area of law that, once resolved, potentially will have immense impact on the landscape of public offerings, corporate governance, litigation and ADR.
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The author, a CPR Institute Spring 2019 intern, is a student at the Benjamin N. Cardozo School of Law in New York.