Saturday, March 21, 2015
So, I repeatedly threatened that I’d eventually post a summary of my paper on arbitration clauses in corporate governance documents – and well, now you’re all finally being subjected to it.
This post was originally published at CLS Blue Sky blog, but I've made some minor edits and added a new introduction.
For many years, commenters have argued that at least some shareholder disputes can and should be arbitrated, rather than litigated, and that this could be accomplished by amending the corporate “contract” – namely, its charter and/or its bylaws – to require arbitration. The possibility was raised in articles by John Coffee and Richard Shell in the late 1980s, and the idea has resurfaced many times since then, including this year by Adam Pritchard. For almost as long as the idea has been kicked around, there have been warnings that if arbitration clauses are “contractually” binding by virtue of their presence in corporate governance documents, then they may be subject to the Federal Arbitration Act (FAA), which would preempt state attempts to regulate/oversee their use. Coffee discussed that possibility in his 1988 piece on the subject; more recently, Barbara Black and Brian Fitzpatrick have sounded further alarms.
For foes of shareholder litigation, this is a feature, not a bug; though they rarely say so explicitly, whenever anyone relies upon FAA cases to justify the insertion of arbitration clauses in corporate charters and bylaws, they are implicitly advocating the idea that not only are charters and bylaws “contracts” for FAA purposes, but that federal law requires their enforcement, regardless of the preferences of the chartering state. After the Supreme Court decided AT&T Mobility LLC v. Concepcion, the notion was particularly powerful, because it meant that corporations would be free to use arbitration clauses to require that shareholder claims be brought on an individual, rather than class, basis. Given the economics of shareholder litigation, this would almost certainly mean the death of most shareholder lawsuits.
And that’s where my paper comes in.
[More under the cut]
The FAA requires that arbitration clauses in “contracts” be enforced according to their terms. In a series of decisions involving a single Maryland-based REIT, two courts separately held that corporate bylaws are akin to ordinary contracts and equally subject to FAA analysis. However, in my forthcoming article, Manufactured Consent: The Problem of Arbitration Clauses in Corporate Charters and Bylaws, I argue that the charters and bylaws of a publicly traded corporation are not contractual in the sense intended by the FAA. This issue is particularly important because the Delaware legislature will soon consider amendments to the Delaware General Corporation Law that would ban charter or bylaw provisions that prohibit shareholders from bringing claims in Delaware courts; if the FAA does apply to charters and bylaws, that legislation would likely be preempted.
Passed in 1925, the FAA requires that written contracts to settle disputes by arbitration “shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract.” According to the Supreme Court, the FAA represents a substantive expression of federal policy, applicable in both state and federal court, that invalidates any state legislative or judicial scheme that evinces distrust of the arbitral forum. So, for example, the FAA preempts state laws requiring obtrusive disclosure of arbitration clauses in adhesion contracts, and laws requiring access to a judicial forum for certain state law statutory claims. In this manner, the FAA “ensure[s] that private agreements to arbitrate are enforced according to their terms,” and “give[s] effect to the contractual rights and expectations of the parties.”
There is a long history of courts referring to a corporation’s constitutive documents as “contractual” in nature. It is this conception of charters and bylaws as contracts among private parties that animates the argument in favor of permitting corporations to mandate arbitration through their governing documents. Because private parties may contract to arbitrate their disputes, the argument goes, so too may shareholders agree (via bylaws and charters) to arbitrate shareholder disputes. Thus, over the years, there have been various proposals from scholars and commenters to move shareholder disputes into arbitration by inserting arbitration clauses in corporate governing documents. These proposals often include a ban on class action litigation, so that any shareholder arbitration would be conducted on an individual, case by case basis. In the wake of Delaware decisions such as Boilermakers Local 154 Retirement Fund v. Chevron Corp., permitting corporations to adopt forum-selection bylaws, and ATP Tour, Inc. v. Deutscher Tennis Bund, permitting corporations to adopt fee-shifting bylaws, these proposals gained new urgency. And, because the FAA preempts state law attempts to limit contracts to arbitrate, if corporate charters and bylaws are, in fact, contracts, no state – including Delaware – has the power to forbid the use of arbitration clauses in corporate governance documents.
In Manufactured Consent, I argue that despite the contractual language that is used to describe corporate charters and bylaws, these documents are not subject to the FAA, for three basic reasons.
First, the FAA only applies to disputes “arising out of” the contract containing the arbitration clause. Despite this fact, many of the arguments in favor of arbitration of shareholder disputes lump securities claims and internal affairs/corporate governance claims together. As I've written about here before (at this point I feel a bit as though I'm tilting at windmills, but I am nothing if not persistent), this is a serious category mistake. American law distinguishes between the contract that governs the transfer of a security between buyer and seller, and the “contract” that forms the corporation and delineates the responsibilities of managers and shareholders. Charters and bylaws implicate the latter, but not the former.
Corporate governance regulation concerns the balance of power between its shareholders, its officers, and its directors, and generally falls within the rubric of “internal affairs.” Matters within this category – such as the scope of directors’ fiduciary duties, permissible charter and bylaw terms, and shareholder voting rights – are controlled by the law of the state of incorporation, regardless of whether the corporation has any real economic ties to that location.
Securities regulation, by contrast, concerns the terms on which the corporation may seek financing in connection with sales of financial instruments. Contracts regarding the transfer of securities between buyers and sellers – as well as claims alleging fraud in connection with such a transfer – fall outside the scope of internal affairs. As a result, courts do not look to the chartering state when evaluating claims brought under the securities laws – state or federal.
Thus, simply as a matter of corporate law and theory, corporate governance documents, essentially by definition, do not dictate matters outside corporate internal affairs. Charters and bylaws do not control the terms of securities sales, and litigation-limiting clauses contained therein cannot limit shareholders’ attempts to bring securities claims in court.
Delaware recognizes this fact. In Boilermakers, the court held that corporations are only permitted to adopt forum-selection clauses concerning “intra-corporate” litigation, defined to mean litigation governed by the internal affairs doctrine; anything outside of that category would not be a proper subject for a bylaw under Delaware law. ATP Tour, as well, limited its discussion of fee-shifting bylaws only to claims concerning intra-corporate litigation. Justice Ridgely, a member of the Delaware Supreme Court at the time of ATP, even wrote an essay affirming that ATP’s holding was confined to internal affairs claims. And Delaware’s new proposed legislation – which authorizes the selection of Delaware courts as the forum for disputes, and prohibits fee shifting – is limited to corporate governance/internal affairs claims, demonstrating again that Delaware recognizes that corporate constitutive documents concern only matters that generally fall under the internal affairs rubric. It could hardly be otherwise: the State of Delaware has no authority to make the policy judgments necessary to decide whether and how corporate directors can, consistent with their fiduciary duties, adopt or invoke charter/bylaw provisions purporting to limit claims brought under the securities laws of another jurisdiction.
In sum, the FAA is not implicated by charters and bylaws that attempt to mandate arbitration of claims outside the realm of internal affairs, because securities disputes do not “arise out of” these documents.
Second, even if we limit our discussion to corporate governance/internal affairs claims, corporate charters and bylaws are not “contractual” in the FAA sense.
The FAA, and the Supreme Court jurisprudence interpreting it, is predicated on the existence of an arbitration clause that is part of a contractual relationship, meaning an arm’s length bargain reached by autonomous, consenting parties, each of whom is presumed to be capable of protecting her own interests, without the need for judicial intervention.
But corporate law is organized around the presumption that dispersed shareholders of a publicly-traded corporation are incapable of bargaining on their own behalf, making it necessary to entrust decisions regarding their welfare to corporate directors. Delaware law explicitly disables shareholders from having control over the corporation, and vests corporate directors with the power to dictate corporate functioning, precisely because it presumes that corporate directors are better positioned than shareholders to gauge what is in the corporation’s best interest. In this model, protection against shareholder exploitation is only minimally predicated on consent, and maximally predicated on fiduciary duties. Judicial oversight is necessary because it is these duties, defined by the state (via common law), that ensure that shareholders are not exploited. When directors take action in their capacity as directors – including the adoption of an arbitration clause, or the choice to invoke such a clause – the propriety of their actions is judged by state-imposed standards, and is therefore noncontractual for FAA purposes.
To put it more concretely, under Delaware law, if corporate directors adopt a litigation limiting bylaw – such as an arbitration provision – they must do so in a manner consistent with fiduciary duties. If they seek to amend the charter to include such a provision, they must propose it in a manner consistent with their fiduciary duties. Once an arbitration provision has been adopted, corporate directors must invoke the provision in a manner consistent with fiduciary duties. The fiduciary duties imposed under this scenario are substantive, and are themselves a construction of Delaware law. The FAA has no vocabulary to analyze these obligations; under the FAA’s conception of contract, each party acts independently of the other to protect his or her own interests. The FAA does not and cannot speak to what duties are substantively imposed on a fiduciary; its entire premise, as articulated by the Supreme Court, is that autonomous parties do not need paternalistic intervention to protect their interests. These differences render the FAA – which is predicated on principles of contract law – unsuited for application to the governance documents of publicly traded corporations.
Third, the Supreme Court has held that federal law favors arbitration not merely out of respect for the private choices of the parties, but because arbitration is faster, cheaper, more informal, and more private than ordinary litigation. But intra-corporate litigation, concerning the scope of directors’ governance powers, necessarily concerns the rights of all stockholders in the corporation. These disputes concern a single res – the corporation – in which all stockholders have stakes. They are thus incompatible with the procedural informality and default confidentiality of arbitral proceedings. Certainly, one could imagine arbitral procedures that would mimic a courtroom in terms of publicity and formality – the American Arbitration Association has developed procedures for class arbitration, for example – but to do so would rid arbitration of the very virtues that the Supreme Court believes underlie the FAA. This fact demonstrates, once again, that the FAA is incompatible with corporate governance disputes.
 See John C. Coffee, Jr., No Exit?: Opting Out, The Contractual Theory of the Corporation, and the Special Case of Remedies, 53 Brook. L. Rev. 919 (1988); G. Richard Shell, Arbitration and Corporate Governance, 67 N.C. L. Rev. 517 (1989).
 Adam C. Pritchard, Halliburton II: A Loser’s History, 10 Duke J. Const. L. & Pub. Pol’y __ (2015), at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2574393
 Coffee, supra, at 961.
 Barbara Black, Arbitration of Investors' Claims Against Issuers: An Idea Whose Time Has Come?, 75 Law & Contemp. Prob. 107 (2012), at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1899538
 Brian T. Fitzpatrick, The End of Class Actions?, 57 Ariz. L. Rev. __ (2015), at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2576304
 131 S. Ct. 1740 (2011)
 9 U.S.C. §2.
 Del. County Emples. Ret. Fund v. Portnoy, 2014 WL 3339945 (D. Mass. Mar. 26, 2014); Katz v. CommonWealth REIT, No. 24-C-13-001299 (Cir. Ct. Balt., Feb. 19, 2014); Corvex Management LP v. CommonWealth REIT, No. 24-C-13-001111, 2013 WL 1915769 (Cir. Ct. Balt., May 8, 2013).
 Francis Pileggi, Delaware Proposes New Fee-Shifting and Forum Selection Legislation, at http://www.delawarelitigation.com/2015/03/articles/commentary/delaware-proposes-new-fee-shifting-and-forum-selection-legislation/ (Mar. 6, 2015).
 9 U.S.C. §2.
 Doctor’s Assocs. v. Casarotto, 517 U.S. 681 (1996).
 Perry v. Thomas, 482 U.S. 483 (1987).
 Stolt-Nielsen S. A. v. AnimalFeeds Int’l Corp., 559 U.S. 662, 682 (2010).
 Green Tree Fin. Corp. v. Bazzle, 539 U.S. 444, 458 (2003).
 See, e.g., Airgas, Inc. v. Air Prods. & Chems., Inc., 8 A.3d 1182 (Del. 2010).
 See, e.g., Michael R. Bloomberg, City of New York, and Charles E. Schumer, U.S. Senate, Sustaining New York's and the U.S. Global Financial Services Leadership 21, 103 (Jan. 23, 2007); Committee on Capital Markets Regulation, Interim Report 72, 74-84 (Nov. 30, 2006); Hal S. Scott and Leslie N. Silverman, Stockholder Adoption of Mandatory Individual Arbitration for Stockholder Disputes, 36 Harv. J.L. & Pub. Pol'y 1187 (2013); Paul Weitzel, The End of Shareholder Litigation? Allowing Shareholders to Customize Enforcement Through Arbitration Provisions in Charters and Bylaws, 2013 B.Y.U.L. Rev. 65; Claudia H. Allen, Bylaws Mandating Arbitration of Shareholder Disputes?, 39 Del. J. Corp. L ___ (forthcoming).
 See, e.g., M. Todd Henderson & Adam C. Pritchard, From Basic to Halliburton: Judges Make the Securities Class Action Mess, Then Refuse to Clean it Up, 47 Regulation 4 (2014), at http://object.cato.org/sites/cato.org/files/serials/files/regulation/2014/12/regulation-v37n4-4.pdf.
 73 A.3d 934 (Del. Ch. 2013).
 91 A.3d 554 (Del. 2014).
 See, e.g., Hal Scott & Leslie Silverman, SEC’s Silent Opposition to Arbitration Bylaws is Speaking Volumes, 35 Nat’l L.J. 39 (2013); Allen, supra n.9.
 9 USC § 2.
 Sagarra Inversiones, S.L. v. Cementos Portland Valderrivas, S.A., 34 A.3d 1074 (Del. 2011).
 Larry E. Ribstein and Erin Ann O’Hara, Corporations and the Market for Law, 2008 U. Ill. L. Rev. 661, 694.
 12 Joseph C. Long, Blue Sky Law § 4 (2014); Friese v. Superior Court, 134 Cal. App. 4th 693 (Cal. App. 4th Dist. 2005) (sale of stock is not internal affairs).
 73 A.3d at 952 & n.78, 960 n.129.
 91 A.3d at 558.
 Henry duPont Ridgely, The Emerging Role of Bylaws in Corporate Governance, http://www.delawarelitigation.com/files/2014/11/The_Emerging_Role_of_Bylaws_in_Corporate_Governance-copy.pdf, at 16.
 AT&T Mobility LLC v. Concepcion, 131 S. Ct. 1740, 1748 (2011).