Friday, April 5, 2019
Where we last left off in our saga, Professor Hal Scott of Harvard Law School, as trustee for the Doris Behr 2012 Irrevocable Trust, sought to introduce a shareholder proposal at Johnson & Johnson to amend the corporation’s bylaws to require arbitration of federal securities claims by any J&J stockholder, on an individual basis. (You can read a full accounting of all of this, with links, here)
J&J sought to exclude the proposal on two grounds. First, that the proposal would cause the company to violate federal law because an arbitration bylaw of this sort would act as a prohibited waiver of rights under the Exchange Act, and second, that the proposal would violate state law because – as Delaware Chancery’s decision in Sciabacucci v. Salzberg made clear – corporate bylaws and charters only govern claims pertaining to corporate internal affairs, and cannot impose limits on non-internal affairs claims, like federal securities claims. J&J was boosted in this latter effort by an opinion letter from the NJ Attorney General agreeing that NJ law would be in accordance with Delaware on this issue. In light of the NJ AG letter, the SEC granted J&J’s request for no-action relief.
Undaunted, the Trust has now filed a complaint in the District of New Jersey, alleging that J&J violated the federal securities laws by excluding the proposal, and seeking an injunction requiring that J&J circulate supplemental proxy materials before the April 25 shareholder meeting. J&J’s argument in response has mainly focused on what it claims is the Trust’s unreasonable delay in bringing the matter to court, which belies any claim of irreparable harm.
Without wading into that dispute, I want to talk a little about the Trust’s complaint and supporting briefing.
Starting with the proposal itself, it states that “The shareholders of Johnson & Johnson request the Board of Directors take all practicable steps to adopt a mandatory arbitration bylaw” governing disputes between shareholders and the company arising under the federal securities laws, and prohibits class claims or joinder. It then contains a supporting statement: “The United States is the only developed country in which stockholders of public companies can form a class and sue their own company for violations of securities laws. As a result, U.S. public companies are exposed to litigation risk that, in aggregate, can cost billions of dollars annually…”
I realize this isn’t the main issue, but I have to pause to observe that while I enjoy the United States/Canada rivalry as much as anyone, I’m not sure I’d go so far as to deny that Canada is a developed country. As a result, the proposal may run afoul of Rule 14a-8(i)(3), which prohibits proposals that contain false information. That strikes me as an alternative ground for exclusion. (I believe Japan and Australia also permit securities class actions, and the list could probably be broadened depending on how “class action” is defined).
Leaving that point aside, I have to engage in another bit of nitpicking. The complaint’s introductory statement says: “The Trust is seeking shareholder approval for a proposal that would amend Johnson & Johnson’s bylaws and require the company’s shareholders to resolve their federal securities law claims through arbitration rather than costly class-action litigation” This, of course, is inaccurate; the proposal does not amend the bylaws, but rather requests that the directors amend the bylaws. Even if it passed, the directors would be free to ignore it.
But moving on to the heart of the matter, the preliminary injunction brief has a few main arguments:
First, the Trust argues that under the Federal Arbitration Act, agreements to arbitrate federal securities claims must be enforced according to their terms. That statute provides that “[a] written provision in any … contract evidencing a transaction involving commerce to settle by arbitration a controversy thereafter arising out of such contract … shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract.” 9 U.S.C. § 2. Thus, it claims, it is impermissible to single out agreements to arbitrate federal securities claims and declare them unenforceable.
On this latter point, I’m inclined to agree; though there once was an argument that the securities laws themselves treat arbitration agreements and bars on class claims as an impermissible waiver of substantive rights, after American Express v. Italian Colors Restaurant, that argument has far less force.
That said, the unspoken assumption of the Trust’s argument is that a corporate bylaw constitutes an contract to arbitrate for FAA purposes, and that federal securities claims “aris[e] out of” state law corporate constitutive documents. These are both points that are very much in dispute, as I discuss in my Manufactured Consent paper.
Second, the Trust argues that a state law rule that would limit the enforceability of an arbitration bylaw is similarly preempted by the FAA.
In this case, the state law rule at issue is simply one that holds that corporate bylaws can only govern internal affairs claims – not a rule that singles out arbitration specifically. For that reason, it would seem that the FAA has little role to play, for that statute only “preempts any state rule discriminating on its face against arbitration…[and] also displaces any rule that covertly accomplishes the same objective by disfavoring contracts that (oh so coincidentally) have the defining features of arbitration agreements.” Kindred Nursing Centers v. Clark, 137 S.Ct. 1421 (2017).
The Trust has an answer to that, however: it claims that limiting the rule only to corporate bylaws and charters is itself an impermissible act of discrimination against arbitration agreements. The rule at issue here does not apply to all contracts, but only some contracts – namely, the corporate contract – and for that reason, it runs afoul of the FAA’s command that arbitration agreements may only be invalidated on the same grounds as would exist for “any contract.”
I admit, there’s some superficial textual appeal to that argument – one of the maddening aspects of this area of law is that it is impossible to tell what counts as “discrimination” against arbitration without a baseline for comparison, and that baseline can be elusive – but as I understand it, in the Trust’s reading, states have a choice: Either they can allow corporations to include arbitration agreements in their bylaws – which can then govern disputes that have nothing to do with the corporate form or the corporate constitutive documents themselves, or the laws that ordinarily govern them – or states can create a rule that all contracts formed under state law must pertain only to corporate internal affairs. That seems to me to go well-beyond a nondiscrimination principle for contracts to arbitrate, and would also seem to be in some tension with the Supreme Court’s recognition of the particular need for a choice-of-law principle unique to the corporate form, namely, the internal affairs doctrine. See CTS Corp. v. Dynamics Corp. of America, 481 U.S. 69 (1987).
Which just illustrates one of the problems with applying the FAA to corporations. The entire corporate form is structured by state law rules, from distinctions between what goes in the bylaws versus matters that must be in the charter, to how charters are amended versus how bylaws are amended, to what counts as a quorum, to who has the power to call meetings and under what circumstances, to when written consent can substitute for a shareholder vote, and so forth. If you say that rules specific to the corporate form cannot be applied to arbitration provisions, you undermine states’ ability to dictate corporate structure.
Third, the Trust argues that Sciabacucci was wrongly decided and does not in fact represent the law of Delaware – which, well, again, eventually it will be appealed and we’ll know one way or the other.
Fourth, the Trust claims that there is no reason to believe that NJ law follows Delaware law on this point. On this, I take no position, other than to note that in addition to the NJ AG’s opinion, Professor Jacob Hale Russell wrote an analysis of NJ law which is now available on SSRN.
Finally, the Trust argues that even if the proposed bylaw would be unenforceable, it still would not violate either state or federal law for J&J simply to enact it, recognizing that, if J&J chose to enforce it against a stockholder in court, the bylaw would be declared ineffective and nonbinding. Therefore, the proposal is not excludable on the grounds that it would cause J&J to violate the law.
This is also an intriguing point, which gives rise to the general question whether it would be a violation of a Board’s fiduciary duties to enact a bylaw that purported to bind stockholders, but that it knew would be unenforceable in a court of law. Would that be a misuse of the corporate machinery? Impermissibly deceptive? It would certainly seem to be beyond the scope of the Board’s powers to enact – that’s the whole basis of the Sciabacucci decision – which itself would be a violation of state law.
Anyhoo, that’s as far as my thinking takes me – but, as I said, the most immediate argument before the court right now is whether the Trust waited too long to seek a preliminary injunction, so we’ll see what happens from here.