Mandating Arbitration of Securities Claims via Corporate Governance Documents?

Since Delaware decisions like Boilermakers Local 154 Ret. Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013) and ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014), there have been renewed calls for corporations to amend their charters and/or bylaws to require that shareholder lawsuits – including securities lawsuits – be subject to individualized arbitration. 

This is actually a big interest of mine – I’m currently working on a paper concerning the enforceability of arbitration clauses in corporate governance documents.  Critically, I do not believe these decisions support the notion that arbitration provisions can control securities claims – at best, they suggest that arbitration provisions in corporate governance documents can control governance claims (i.e., Delaware litigation – concerning directors’ powers and fiduciary duties). 

[More under the cut]

For the past several years, various commenters have proposed that all shareholder claims – both governance claims brought under state law, and securities claims – be arbitrated, rather than litigated.  This could be accomplished, the argument has proceeded, by including an arbitration clause in the corporation’s charter and/or bylaws.  Corporate charters and bylaws have often been described as “contracts,” and the Federal Arbitration Act (FAA) requires that “contracts” for arbitration be enforced according to their terms.

In cases like AT&T Mobility v. Concepcion (2011) and American Express Co. v. Italian Colors Restaurant (2013), the Supreme Court held that under the FAA, contractual arbitration clauses are enforceable even if they require that claims be brought on an individual, rather than class, basis.  Therefore, it has been proposed that corporate governance documents could similarly require that all shareholder claims be arbitrated individually – thus essentially allowing the corporation to opt out of class action liability.

In Boilermakers Local 154 Ret. Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013), the Delaware Chancery Court held that a forum selection clause inserted in a corporate bylaw would be binding on all shareholders; and in ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014), the Delaware Supreme Court similarly held that corporate bylaws can contain fee-shifting provisions requiring that unsuccessful plaintiffs reimburse the defendants’ attorneys’ fees and costs.

These decisions inspired a renewed push for corporations to adopt arbitration clauses.  For example, in the wake of Boilermakers, Hal Scott and Leslie Silverman wrote an article in the National Law Journal arguing in favor of arbitration clauses as a way of eliminating federal securities class actions.  Claudia H. Allen has a piece forthcoming in the Delaware Journal of Corporate Law arguing that such clauses are valid and enforceable, both as to securities claims and governance claims.

Additionally, as I previously posted, two separate courts recently upheld an arbitration clause contained in the bylaws of the publicly-traded CommonWealth REIT.  In particular, the District of Massachusetts enforced the clause as applied both to state law governance claims, and federal securities claims.  (Eventually, an arbitral panel held for the shareholders on some of the governance claims, but rejected their securities claims.)

The problem is that Boilermakers was very adamant that the forum selection clauses at issue only applied to intra-corporate litigation, i.e., governance claims.  As then Vice Chancellor Strine wrote:

[T]he forum selection bylaws are addressed solely to internal affairs claims governed by state corporate law. In other words, the forum selection bylaws only regulate where a certain set of claims, relating to the internal affairs of the corporation and governed by the law of the state of incorporation, may be brought....

73 A.3d at 959-60 (bolding mine).  It was on this basis that the court upheld the bylaws.

ATP adopted a similar limitation.  In that case, once again, the Delaware Supreme Court suggested that a fee-shifting bylaw could only apply to intra-corporate litigation.  As the Court wrote:

A fee-shifting bylaw, like the one described in the first certified question, is facially valid. Neither the DGCL nor any other Delaware statute forbids the enactment of fee-shifting bylaws. A bylaw that allocates risk among parties in intra-corporate litigation would also appear to satisfy the DGCL’s requirement that bylaws must “relat[e] to the business of the corporation, the conduct of its affairs, and its rights or powers or the rights or powers of its stockholders, directors, officers or employees.”

ATP, 91 A.3d at 558 (bolding mine).  Notably, the substantive claims in ATP involved both intra-corporate disputes and alleged antitrust violations, but nothing in the Delaware Supreme Court's decision suggested that the bylaw could extend to the antitrust aspect of the plaintiffs' case.

Joseph Grundfest and Kristen Savelle have advocated inserting forum selection clauses in corporate governance documents, but have similarly recognized that they likely only apply to intra-corporate disputes:

Charter provisions are interpreted as though they are contract provisions, and inasmuch as contract rights can legitimately be regulated through forum selection provisions, it follows that stockholders’ rights to pursue intra-corporate claims can also be regulated through ICFS [intra-corporate forum selection] provisions. To be sure, this conclusion would arguably not follow (or not hold as strongly) if the forum selection provision sought to regulate the right to pursue causes of action that were not intra-corporate in nature because then the provision would not be seeking to regulate the stockholder’s rights as a stockholder and would be extended beyond the contract that defines and governs the stockholders’ rights. Thus, ICFS provisions do not purport to regulate a stockholder's ability to bring a securities fraud claim or any other claim that is not an intra-corporate matter, and the dominant forms of ICFS provisions are drafted expressly to preclude such applications.

Joseph A. Grundfest & Kristen A. Savelle, The Brouhaha over Intra-Corporate Forum Selection Provisions: A Legal, Economic, and Political Analysis, 68 Bus. Law. 325 (2013) (bolding mine).

This section of Grundfest and Savelle’s article was cited by the Boilermakers court.

What’s the difference between securities claims and intra-corporate claims?  Well, securities claims concern the terms on which a security is purchased or sold in the market – an in particular, whether someone made a false statement in connection with the purchase.  Intra-corporate claims, by contrast, concern the corporation’s governance structure.  They concern the obligations of the directors and officers under the corporation’s governing documents.

American law draws a distinction between securities regulation on the one hand, and corporate governance regulation on the other.  Not only are they controlled by entirely different statutory schemes, but they are subject to very different choice of law principles.  Corporate governance issues are part of the “internal affairs doctrine,” which requires that all matters be determined by the law of the chartering state – regardless of whether the corporation or its shareholders have any other connection to that state.  Securities regulation, however, is not part of the internal affairs doctrine – it’s considered “external” to the corporation - just like antitrust.  (See discussion at Larry E. Ribstein and Erin Ann O’Hara, Corporations and the Market for Law, 2008 U. Ill. L. Rev. 661; Daniel J.H. Greenwood, Democracy and Delaware: The Mysterious Race to the Top/Bottom, 23 Yale L. & Pol'y Rev. 381 (2005)).

If a subject is outside the purview of the corpoation's internal affairs, it is, by definition, outside the control of the corporate charter and bylaws.

To put it another way, when a security is purchased on the secondary market, the corporation has no contractual relationship with the security purchaser in her capacity as a purchaser.  Even assuming that charters and bylaws are “contractual,” the corporation’s contractual relationship with a stock purchaser begins only after the purchase, and – essentially by definition – concerns only her rights as a holder of corporate stock.  Securities fraud claims concern the investor as purchaser or seller, and for the typical claim – a purchase in reliance on false information from someone other than the issuer –  there is no contractual relationship with the corporation at the moment the harm is inflicted, i.e., at the moment of purchase.

American law thus draws a sharp distinction between the contract that governs the transfer of a security between buyer and seller, and the “contract” that forms the corporation and allocates power between its managers and shareholders.  Securities fraud claims arise under the former, and do not implicate the latter.  Given this division between the regulation of the purchase and sale of securities, on the one hand, and the corporation’s internal affairs, on the other,  a corporation’s documents for internal governance cannot purport to bind the terms on which its securities are purchased and sold on the public secondary market. 

To be sure, the lines between corporate governance on the one hand, and securities regulation on the other, can be blurry.  In one area where the two overlap, most states allow corporations to issue “restricted” securities, that can only be transferred from one holder to another with a right of first refusal held by the corporation or other shareholders.  The restrictions are typically governed by the charter or bylaws, and are considered a matter of corporate internal affairs, even if they concern the sale of securities.  But these securities are, by definition, not offered to the public for resale on the secondary market.  Moreover, the purpose of permitting such restrictions is closely tied to the regulation of corporate governance, namely, to allow corporations to maintain control over who can participate in corporate management.

Another blurry area concerns Section 14 of the Exchange Act, which involves regulation of corporate proxies.  This would ordinarily be an area of internal affairs, but Section 14 is considered to be securities regulation.  

But in general, the lines do exist, and they carve out corporate governance as a separate sphere from securities.

In any event, the FAA only applies to arbitration clauses contained in “contract[s] evidencing a transaction involving commerce” that concern “controvers[ies] thereafter arising out of such contract or transaction.” Securities fraud claims do not usually “arise out of” the corporate charters and bylaws, unless “arising out of” is interpreted to mean but-for causation in the sense that if the corporation did not exist, it would have no securities to sell.

So corporations cannot “contract” to arbitrate securities claims simply by amending their governing documents.  At the very least, the FAA would not apply to such provisions.

The implications get pretty complicated very quickly.

For example, let's say that one state - West Carolina - declared that it would, as a matter of state law, enforce such clauses inserted into the charters of West Carolina corporations.  And then say that a resident of East Carolina bought stock in a West Carolina corporation whose charter contained an arbitration clause, and then sued for fraud in a court in his home state, under East Carolina law.  East Carolina would be under no obligation to enforce the arbitration clause because - once again - securities claims are not subject to the internal affairs doctrine, and therefore East Carolina would not have to follow West Carolina law on the subject.  

These kinds of issues among the states could create havoc for nationally traded securities (which is, again, why the lines are typically drawn as they are).

To be honest, though, I rather suspect this analysis should apply even if the clause purports to govern intra-corporate claims, because - well, I disagree with Boilermakers, and the Grundfest & Savelle article.   I think that corporate governance documents cannot regulate lawsuits in general for the same reason they cannot regulate securities fraud claims in particular - the process of bringing a lawsuit is not part of the corporation's internal affairs.  But even if you accept Boilermakers, it does not lead to the conclusion that corporate governance documents can extend to any kind of claim a shareholder might bring - and securities claims are outside the sphere of what corporate governance documents regulate.

 But.  The implication of this analysis is that one major barrier to the adoption of arbitration clauses – the SEC’s opposition – is moot.  The SEC has historically objected to the inclusion of arbitration clauses in corporate governance documents on the ground that they improperly waive litigants’ rights under the federal securities laws.  Even if the SEC was legally correct about that – and after Italian Colors, the SEC’s position looked pretty dubious – the SEC certainly has no jurisdiction over whether shareholders do or do not waive rights to bring state law governance claims.  So the SEC’s opposition should no longer be a barrier to the adoption of such clauses.

For me, then, the more interesting question concerns not securities claims, but intra-corporate claims.  More specifically, the proper question is whether – Boilermakers and ATP notwithstanding – corporate governance documents really are contractual in the sense intended by the FAA – and whether arbitration clauses inserted in such documents therefore must be enforced in accordance with FAA precedent (with respect to intra-corporate claims).  And that’s basically the problem I’m working on now.