By Shannon Collins
Harvard Law School Professor Emeritus Hal Scott filed a complaint in a New Jersey federal court against health care giant Johnson & Johnson on behalf of a shareholder trust seeking to force J&J to hold a shareholder vote on barring arbitration in disputes between the company and its stockholders.
The U.S. Securities and Exchange Commission had previously issued a no-action letter that allowed J&J to exclude the provision from proxy materials based on a New Jersey law interpretation.
Scott, on behalf of the Doris Behr 2012 Irrevocable Trust, alleged that J&J violated federal securities laws by excluding the proposal he sent the company in November, on behalf of the trust, from its proxy materials for the shareholder meeting, scheduled for this week.
The complaint sought declaratory judgment stating that J&J violated the federal securities laws, in addition to injunctive relief under which J&J would be required to submit supplementary proxy materials to the shareholders, including Scott’s original proposal.
The injunction would have allowed a vote to go forward at the April 25 shareholders meeting, and also include a statement from J&J affirming that Scott’s proposal violates neither federal nor New Jersey laws. The injunction also requested that J&J be prohibited from excluding any future, similar proposals.
U.S. District Court Judge Michael Shipp, of Trenton, N.J., denied the trust’s order to show cause on March 29 in an unpublished opinion, letting the SEC letter and J&J action stand. (Available here.)
But Prof. Scott, joined by two law firms in his work on behalf of the trust, may have tapped into a future use for mandatory arbitration. For background, see Shannon Collins, “Mandatory Shareholder Arbitration: J&J View Passes SEC’s Test,” CPR Speaks blog (March 18). The blog post discusses the back and forth between Scott and J&J over Scott’s shareholder proposal. The controversial proposal advocates for a change to the J&J by-laws requiring all disputes brought by shareholders against the company to go through individual arbitration.
Per J&J’s request, the SEC issued the no-action letter stating the agency would not act against J&J if the company excluded Scott’s proposal from the proxy materials for its annual shareholder meeting.
In a brief supporting a “Motion for Order to Show Cause Why a Preliminary Injunction Should Not Issue,” Prof. Scott and the trust argued that J&J violated federal securities laws by excluding Scott’s shareholder proposal from the proxy materials.
Under 17 C.F.R. § 240.14a-8, all shareholder proposals must be included in the proxy materials unless they fall under one or more of several statutory exceptions. One of these exceptions, 14a-8(i)(2), allows exclusion of a proposal if it “would, if implemented, cause the company to violate state, federal, or foreign law to which it is subject.”
The SEC premised its no-action letter in large part on a statement from the New Jersey Attorney General Gurbir Grewal, who concluded that the proposal would violate state law. (Johnson & Johnson’s headquarters is in New Brunswick, N.J.) Grewal contended that recent changes to New Jersey law voids by-laws with forum-selection clauses regarding federal securities law claims. He also relied on the Delaware Chancery Court case Sciabacucchi v. Salzberg, 2018 WL 6719718 (Del. Ch. Dec. 19, 2018), holding that by-law amendments generally only relate to matters of internal concern, and forum selection is an external concern.
The trust’s main focus in its suit was the legal validity of its 2018 proposal. The trust argued that the arbitration-requirement proposal violates neither federal nor state law. It also argued that the N.J. Attorney General’s opinion predicting state courts are likely to follow Delaware Chancery law prohibiting mandatory individual shareholder arbitration is not dispositive on the issue.
The trust relied principally on the Federal Arbitration Act, and the recent Supreme Court case of Epic Systems Corp. v. Lewis, 138 S. Ct. 1612 (2018), as support for the legality of its proposal. The trust asserted that N.J. Attorney General Grewal did not identify any New Jersey statutory language or court decision that expressly applied to shareholder arbitration concerning federal securities law claims, and thus the proposal would not cause the company to violate state law.
The trust further bolstered its claim by declaring that even if New Jersey state law were to prohibit such a proposal, that state law would be preempted by the FAA, which would permit the proposal.
The FAA mandates that contractual arbitration provisions must be enforced. The trust argued that corporate by-laws are contracts between shareholders and the corporation, citing several New Jersey cases. It follows then that arbitration agreements in company by-laws should be enforced under the FAA just as they would in express contracts.
Therefore, following the Epic Systems case—which permitted predispute mandatory arbitration provisions with waivers of class processes as a condition of employment–shareholder arbitration of federal securities claims do not violate federal law. The trust stipulates that agreeing to arbitrate federal securities laws in no way waives compliance with the 1934 Securities Exchange Act. Waiver of compliance is prohibited by § 29(a).
Arbitrating securities law claims still preserves a shareholder’s right to enforce securities laws, the trust argued, it just does so through a specific proceeding.
The trust strongly advocated against the deference given to Sciabacucchi by the N.J. Attorney General, stating that it is not the law of New Jersey and that corporations are free to ignore it until it is. It also attempted to distinguish Sciabacucchi from the present situation by pointing out that Sciabacucchi concerns a forum-selection clause. Arbitration, the trust contended, is an entirely different matter because it is protected by the FAA.
Furthermore, the trust maintained that Sciabacucchi cannot be extended to another state regarding arbitration because the Sciabacucchi holding only applies to a subset of contracts; corporate by-laws and certificates of incorporation. Under the FAA, rules that forbid enforcement of arbitration agreements must apply to every contract in the state equally. Therefore, applying Sciabacucchi and treating contracts unequally would run afoul of the FAA.
Sciabacucchi held that corporate by-laws will only apply to internal affairs. Securities claims have been held to be external by the Delaware court, so J&J countered that including the proposal in its by-laws would be unenforceable.
J&J additionally consulted Pennsylvania law and concluded that New Jersey would likely follow corporate precedent from the state decision Kirleis v. Dickie, McCamey & Chilcote P.C., 560 F.3d 156 (2009). The Pennsylvania Kirleis court held in this case that arbitration clauses in corporate by-laws would not be enforceable unless shareholders expressly consent to the arbitration provision.
The trust points out, however, that the court recognized that it is generally assumed that shareholders and directors have knowledge of and accept the corporate bylaws. Emphasizing this, the trust pointed out that Pennsylvania has not affirmatively ruled that express agreement trumps the presumptive consent of by-laws by shareholders.
But J&J predicts that Pennsylvania would require express consent over a presumption of consent, and further predicts that New Jersey would use Pennsylvania as persuasive authority and follow suit. Once again, the trust pointed out that while the arbitration clause may be unenforceable, including an unenforceable provision in corporate by-laws is in no way a violation of state or federal law.
Prof. Scott’s brief criticizes the New Jersey Attorney General’s reliance on recent amendments to New Jersey corporate law by pointing out that that N.J. Stat. Ann. § 14A:2-9(5)(a), while authorizing certain forum-selection clauses in corporate by-laws, does not prohibit arbitration provisions and so the proposal does not violate any state law.
In response to the trust’s motion, Johnson & Johnson attorney Andrew Muscato, counsel to Skadden, Arps, Slate, Meagher & Flom in New York, wrote in a March 27 letter to U.S. District Court Judge Michael Shipp, in Trenton, N.J., that the trust failed to satisfy a single prong of the four-part test for a preliminary injunction.
Muscato particularly highlighted the trust’s lack of irreparable harm, pointing out the ample time the trust had to bring its claim against the company. Muscato posited that if the trust truly suffered irreparable harm, it would not have waited more than four-and-a-half months to bring suit.
The trust defended this delay in a letter also dated March 27 by claiming that it would not have had sufficient Article III standing prior to the release of the proxy materials. Up until the actual distribution of the proxy materials, the trust’s only injury was the potential for future harm, the letter stated.
The trust insisted that standing questions can be raised at any point during litigation and it refused to take the risk of bringing suit too early only to have its claims subject to rejection as premature several years down the line.
Muscato rebutted the standing issue introduced by the trust by citing several cases in which shareholders brought suit prior to the distribution of proxy materials.
Muscato insisted the reason for emergency relief was undue delay by the trust. If the trust had taken action sooner, then the complex matter could have been resolved.
Judge Shipp ultimately declined the order sought by the Trust for failure to show irreparable harm, agreeing with Muscato and J&J. (Linked above.)
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Historically, courts have favored arbitration, but the shareholder arbitration requirement proposals faces a volatile moment for the alternative dispute resolution process. SEC Chairman Jay Clayton seems to be open to the idea of shareholder arbitration in a publicly traded company. But groups like Secure Our Savings have strongly advocated against forced arbitration of shareholders.
The recent #MeToo movement has resulted in a push for repeals of arbitration clauses in employment contracts, specifically as they relate to sexual harassment.
So the potential ramifications of the J&J shareholder proposal could be go beyond the parties and have an effect on corporate governance. If it passes, it even could initiate a domino effect in which company after company implements mandatory individual shareholder arbitration. Should this occur, Congress could decide to step in and create a uniform standard for these clauses . . . or bar them altogether.
Either way, there is doubt about the future of processes to address shareholder disputes.
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The author is a CPR Institute Spring 2019 intern.