Saturday, September 6, 2014

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.

Ann Lipton | Permalink


Hi Ann,

This is a fascinating project that I look forward to reading. Does your take on whether governance documents are contractual depend on whether the corporation is publicly traded or not?

I have one minor quibble with your assessment of the SEC’s position on arbitration. It was my understanding that the SEC based its anti-arbitration position on Section 14 of Securities Act and Section 29 of the Exchange Act, which prohibit contractual waivers of rights under the securities laws. I could be mis-reading Italian Colors, but it strikes me that it does not resolve this issue. But, as you point out, it’s beside the point since corporate governance cannot apply to purchases and sales of securities anyway.

Posted by: Urska | Sep 6, 2014 10:40:39 AM

Hi, Urska! Yes, that's the basis for the SEC's objection. The reason I think Italian Colors kills it is that Italian Colors says that a contract to arbitrate disputes, even individually, is not the equivalent of a waiver of substantive rights - even if it means as a practical matter smaller claims are locked out of court. There's still a sliver of hope for securities cases, in that Italian Colors mentioned how Congress dealt with the small-claims problem in antitrust with treble damages - that's a totally different regime than securities. But I don't think that'll turn out to be much of a difference.

As for my paper - only publicly traded corporations (and then I acknowledge that the CWH case involved a REIT, not a corporation, but the courts didn't seem to see a difference and most caselaw doesn't draw a distinction). Because yeah, close corps and other kinds of entities raise different issues.

So that's in progress- I hope to have a draft I'm not ashamed to show people relatively soon!

Posted by: Ann Lipton | Sep 6, 2014 10:55:37 AM

I follow the Italian Colors argument to a point. That is, just because a substantive right is much more difficult, or even practically impossible, to enforce through individual arbitration does not imply that an arbitration waives the substantive right. But sections 11 and 12 of the Securities Act, to use them as an example, authorize investors to sue in “any court of competent jurisdiction.” (I’ll concede that am not a Supreme Court aficionado so perhaps “court” includes arbitration. Does it?)

In any event, I think your argument can extend more broadly than only to reporting corporations. At what point are governance documents no longer contractual? The 12(g) threshold is awfully high. You clearly know a lot on the matter, so I can’t wait until you are ready to share the draft.

Posted by: Urska | Sep 6, 2014 5:28:23 PM

The problem with the Section 11 argument - i.e., treating the right to sue in court as itself a substantive right that can't be waived - is that the SCt has already held that you can require arbitration of securities claims, and it doesn't count as a waiver - so the only issue is class claims, and Italian Colors says that waiving the right to bring an action as a class isn't a substantive waiver of a right. Also, in CompuCredit v. Greenwood, the Supreme Court rejected a similar argument, i.e., that a grant of a right to sue in court counts is one of the substantive rights that can't be waived, i.e., court access. According to CompuCredit, the substantive right is the right to impose liability, not the right to a judicial forum.

As for 12g threshold - yeah, you're right. I took the easiest case first, and am contrasting with close corporations (where there are decisions upholding arbitration clauses because there's direct contractual privity - the purchaser personally agreed to arbitrate when taking the stock, so you don't need to rely on corporate governance law - ordinary contract law binds them). But I'd love to talk to you about potential variations more, actually - when the draft is less messy I hope you don't mind if I hit you up for help!

Posted by: Ann Lipton | Sep 6, 2014 5:42:29 PM

Thank you so much for this. I am troubled by the result because it seems inconsistent with the language of the securities acts which are specific about the right to litigate in court and the prohibition of any waiver, but I’m hardly the authority on the matter. And I’d love to read your draft when you are ready!

Posted by: Urska | Sep 7, 2014 6:06:34 AM


After the two Shearson cases, McMahon and Rodriguez, it's clear that predispute agreements to arbitrate securities claims are enforceable and do not violate the anti-waiver clauses. So I'm not sure those clauses have any relevance,

I think you're right that the real question is whether the plaintiff really has agreed to arbitrate the claim. Unless I'm missing something, that's not really a securities law question, except in the broadest sense. The question is not really whether the plaintiff can waive his or her right to sue in court--the answer is yes. The question is really whether the plaintiff has done so. And I think I agree with you. The argument for consent with respect to corporate law issues is nowhere near as strong as the argument for consent with respect to securities law issues.

Posted by: Steve Bradford | Sep 7, 2014 6:47:18 AM

Hi Steve! In the context of the securities laws, the SEC's position has been that an arbitration clause that waives class actions, specifically, violates the antiwaiver provisions of the securities laws, Shearson notwithstanding. In the SEC’s view, because small claims cannot be brought outside of the class context, an arbitral class action waiver functions as a substantive waiver.

Two years ago, Adam Pritchard at Michigan helped organize some shareholder-proposed bylaws that, if adopted, would have required shareholders to bring securities claims in individual arbitrations. The SEC allowed the targeted companies to exclude those bylaws from the proxy, on the ground that the class waivers functioned as an illegal waiver of substantive rights

But after Italian Colors, I don't think the SEC’s position holds - the Supreme Court has held that waiver of the class action mechanism is not the equivalent of a substantive waiver of a right.

In the past, the SEC has also expressed the view that Shearson et al allowed predispute arbitration clauses in the context of securities claims in part because of the existence of SEC oversight of the arbitral procedures. The SEC has argued that when that oversight is absent, predispute arbitration agreements may function as illegal substantive waivers. And it's true that Shearson did make a big deal about the SEC's oversight.

That said, the SCt has really strayed far from requiring agency oversight in its most recent arbitration jurisprudence - so I don't think that argument holds either.

So, point being, SEC has objected to arbitration clauses in corporate charters on the ground that they violate the antiwaiver provisions of the securities laws, even after Shearson - not because of lack of consent, but because even if there is “consent” in some sense, they functioned as an impermissible waiver of substantive rights. But I think that position is quite weak, especially after the last few years.

That said, if charters/bylaws can't control securities claims, because they aren't part of the "contract" on which securities claims are based, then none of this matters. In that case, the only remaining issue is whether charters/bylaws can require arbitration for state law governance claims.

Posted by: Ann Lipton | Sep 7, 2014 7:14:17 AM

Great post. I'm surprised by the number of commentators who gloss over the distinction between true intra-corporate disputes -- which are arguably subject to by-law regulation under 8 Del C. 109(b) -- and securities claims. But I'm concerned many courts will not read ATP as you do, and I'm not sure your reading is correct. The DE Supreme Court's opinion in ATP observed that the district court certified questions to it only because the Third Circuit held that the enforceability of the by-law should be determined before the district court addressed the preemptive effect of federal antitrust law. With that background, it's easy to read the Supreme Court's opinion as covering the enforceability of the by-law as applied to the federal antitrust claims. On the other hand, the Supreme Court's treatment of the limitations imposed by DGCL 109(b) is cursory at best, particularly compared to the analysis in Boilermakers. It will be interesting to see how this plays out.

If mandatory arbitration by-laws could apply to securities claims on a contractual theory, then presumably fee-shifting by-laws could apply as well.

Posted by: PK | Dec 23, 2014 9:02:32 AM

PK - I'm glad you liked the post! As for ATP, I'm sure courts won't read it as I do, at least outside of Delaware, since everyone seems to be glossing over this distinction. That said, the ATP decision was clear about it being limited to intracorporate disputes - it actually said so, as the quote above indicates. And of course Boilermakers was explicit on this point.

Delaware doesn't even have a language for dealing with these provisions outside of intracorporate disputes. Like, how is a Delaware court supposed to determine if a director acted in accordance with fiduciary duties by requiring a securities claim to be arbitrated, or invoking a forum selection clause? Both ATP and Boilermakers suggest this is part of the inquiry in gauging whether a litigation-limiting clause accords with director fiduciary duties, but there's no language in Delaware law for that inquiry outside the context of intracorporate litigation.

Posted by: Ann Lipton | Dec 23, 2014 9:09:55 AM