The issue of mandatory arbitration bylaws is a hot potato—and a partisan one at that (with Rs tending to favor and Ds tending to oppose). And in this no-action letter issued yesterday to Johnson & Johnson—granting relief to the company if it relied on Rule 14a-8(i)(2) (violation of law) to exclude a shareholder proposal requesting adoption of mandatory arbitration bylaws—Corp Fin successfully passed the potato off to the State of New Jersey. Crisis averted. However, the issue was so fraught that SEC Chair Jay Clayton felt the need to issue a statement supporting the staff’s hands-off position: “The issue of mandatory arbitration provisions in the bylaws of U.S. publicly-listed companies has garnered a great deal of attention. As I have previously stated, the ability of domestic, publicly-listed companies to require shareholders to arbitrate claims against them arising under the federal securities laws is a complex matter that requires careful consideration,” consideration that would be more appropriate at the Commissioner level than at the staff level. However, as Clayton has previously indicated, mandatory arbitration is not an issue that he is anxious to have the SEC wade into at this time. To be sure, if the parties really want a binding answer on the merits, he suggested, they might be well advised to seek a judicial determination.

SideBar

As discussed here, the concept of mandatory arbitration of shareholder claims has been run up the flagpole a few times in the past. The idea took hold in the late 1980s, when SCOTUS concluded that stock brokers could enforce mandatory arbitration agreements with customers. However, in subsequent encounters, the SEC has not been particularly receptive to the idea. When a private equity fund sought to go public in 2012 with a provision in its partnership agreement requiring mandatory individual arbitration of any disputes, including disputes under the federal securities laws, Corp Fin advised that it would not accelerate effectiveness of its registration statement, and the provision was withdrawn. Then, in an interesting turn of events, binding shareholder proposals were submitted at several companies seeking to amend their bylaws to include mandatory shareholder arbitration provisions. (If this seems a bit curious, the argument submitted by the proponent was that the costs of frivolous class action litigation were ultimately borne by the shareholders, and preventing these suits would therefore benefit shareholders.) Some of these companies, attempting to exclude the proposals from their proxy statements, contended that they should be excludable under Rule 14-8(i)(2)— on the basis that implementation would cause the company to violate applicable law—because implementation would violate Section 29(a) of the Exchange Act. Section 29(a) declares void any provision “binding any person to waive compliance with any provision of this title or of any rule or regulation thereunder….” Since the bylaw prohibited claims subject to arbitration from being brought in a representative capacity, that is, in class actions, the company argued, the provision effectively waived shareholders’ abilities to bring claims under Rule 10b-5. The SEC allowed exclusion of the shareholder proposal, agreeing that there was some basis for the view that implementation of the proposed bylaw amendment would cause the company to violate the federal securities laws.

In what again seems to be an odd role reversal, a Harvard professor and shareholder of Johnson & Johnson submitted a proposal requesting that the board adopt a mandatory arbitration bylaw applicable to “disputes between a stockholder and the Corporation and/or its directors, officers or controlling persons relating to claims under federal securities laws in connection with the purchase or sale of any securities issued by the Corporation.” The bylaw would also prohibit class actions and include a five-year sunset provision unless re-approved by the shareholders. And again, curiously, the company fought to exclude the proposal on the basis of Rule 14a-8(i)(2), that the bylaw would violate federal and state law.

More specifically, the bylaw, the company argued, would violate federal law because it would, among other things, “weaken the ability of investors in Johnson & Johnson’s securities to pursue a private right of action under Exchange Act Section 10(b) and Rule 10b-5.” In addition, the company maintained, the staff has “long taken the view that including arbitration clauses in the governing documents of U.S. public companies is contrary to public policy.” In any event, echoing Chair Clayton, the company contended that a shareholder proposal was not the best place to address this issue. In response, the proponent argued that SCOTUS has frequently held that “mandatory individual arbitration, under the auspices of the Federal Arbitration Act, does not conflict with the ability of an aggrieved party to vindicate rights provided under any federal statute absent ‘a clearly expressed congressional intention’ to the contrary.”

The company then expanded its argument, contending that the proposal, if implemented, would also violate state law, resulting in costly litigation, and submitting in support an opinion of NJ counsel. Although, interestingly, the NJ opinion staked out a position in favor of arbitration, it ultimately concluded, notwithstanding the absence of NJ case law on point, that implementation of the proposal would likely violate NJ state law on two bases. Looking to precedent from Delaware, the opinion contended, first, that NJ does not permit the company to mandate in its bylaws arbitration of federal securities law claims, and second, that the bylaw would not be binding on future shareholders who did not approve the provision. The proponent disagreed, arguing that other Delaware case law supports the concept that “an external claim can be addressed in a charter or bylaw provision if it arises out of a relationship between the corporation and its shareholders qua shareholders.” Second, the proponent maintained that, under “basic principles of corporate law,… bylaws are a contract between a company and its shareholders, the terms of which shareholders accept when they become shareholders, and which are subject to amendment.”

Into the midst of this debate the company then submitted a letter from the Attorney General of the State of New Jersey, the state’s chief legal officer, which advised the SEC the proposal was excludable under Rule 14a-8(i)(2) because “adoption of the proposed bylaw would cause Johnson & Johnson to violate applicable state law. Longstanding principles of New Jersey law limit the subject matter of corporate bylaws to matters of internal concern to the corporation. Under New Jersey law, as under Delaware law, forum-selection provisions relating to claims under the federal securities laws do not address matters of internal concern, and bylaw provisions purporting to dictate the forum for such claims—including but not limited to mandatory arbitration provisions—are void.” Moreover, the NJAG argued, recent amendments to the New Jersey code specifically addressed forum-selection bylaws, but did not authorize forum-selection bylaws relating to federal securities law claims, thus reinforcing the NJAG’s position. Among other things, the proponent urged the SEC not to give the NJAG Letter “any special weight” because the AG was just interpreting Delaware law to reach a conclusion about New Jersey law.

But to no avail. The staff gave plenty of special weight to the NJAG—in fact, the staff’s no-action relief rode entirely on the back of the NJAG: “When parties in a rule 14a-8(i)(2) matter have differing views about the application of state law, we consider authoritative views expressed by state officials….We view this submission [by the NJAG] as a legally authoritative statement that we are not in a position to question.” In addition, the staff made the point, in granting the no-action request, that it was “not expressing its own view on the correct interpretation of New Jersey law [or] whether the Proposal, if implemented, would cause the Company to violate federal law. Chairman Clayton has stated that questions regarding the federal legality or regulatory implications of mandatory arbitration provisions relating to claims arising under the federal securities laws should be addressed by the Commission in a measured and deliberative manner.” In light of the staff’s position as a dispenser of only informal views regarding the propriety of Enforcement action, not as a body opining on the legality of the proposal, Corp Fin suggested that the “[p]arties could seek a more definitive determination from a court of competent jurisdiction.”

In his contemporaneous statement, Clayton observed that this issue has previously arisen in the “hypothetical context” of whether Corp Fin would be willing to declare an IPO effective if the company had included mandatory arbitration provisions in its governing documents. At the time Clayton had “stated that, if the issue were to arise in an actual initial public offering of a domestic company, it would not be appropriate for resolution at the staff level but would rather be best addressed in a measured and deliberative manner by the Commission.” Now the issue has come up again in a different context, and Clayton agreed that the approach taken by the staff was appropriate:

“Since 2012, when this issue was last presented to [Corp Fin] in the context of a shareholder proposal, federal case law regarding mandatory arbitration has continued to evolve. Further, I am not aware of any circumstances where the Commission has weighed in on the legality of mandatory shareholder arbitration in the context of federal securities law. In light of the unsettled and complex nature of this issue, as well as its importance, I agree with the approach taken by the staff to not address the legality of mandatory shareholder arbitration in the context of federal securities laws in this matter, and would expect our staff to take a similar approach if the issue were to arise again. I continue to believe that any SEC policy decision on this subject should be made by the Commission in a measured and deliberative manner.”

More generally, Clayton emphasized that the non-binding, informal nature of staff views expressed as part of the no-action process “do not and cannot definitively adjudicate the merits of a company’s position with respect to the legality of a shareholder proposal. A court is a more appropriate venue to seek a binding determination of whether a shareholder proposal can be excluded.”

SideBar

You may recall that, back in July 2017, then SEC Commissioner Michael Piwowar had, in a speech before the Heritage Foundation, advised that the SEC was open to the idea of allowing companies contemplating IPOs to include mandatory shareholder arbitration provisions in corporate charters. As reported, Piwowar “encouraged” companies undertaking IPOs to “come to us to ask for relief to put in mandatory arbitration into their charters.” (See this PubCo post.) As discussed in this PubCo post, at the same time, in Senate testimony, SEC Chair Jay Clayton, asked by Senator Sherrod Brown about Piwowar’s comments, responded that, while he recognized the importance of the ability of shareholders to go to court, he would not “prejudge” the issue. According to some commentators at the time, to the extent that these views appeared to indicate a significant shift in SEC policy on mandatory arbitration, they could portend “the beginning of the end of securities fraud class actions.”

But in subsequent Senate testimony, Clayton put the kibosh on these signals. According to an article in Pensions & Investments, in testimony before the Senate Banking Committee in February 2018, Clayton indicated that barring shareholder securities fraud litigation was not in the offing. In questioning, Senator Elizabeth Warren, asked whether Clayton would support the “enormous change” of allowing companies to adopt mandatory arbitration provisions. According to the article, “Mr. Clayton said that while he could not dictate whether the issue comes before the Securities and Exchange Commission, he is ‘not anxious to see a change in this area.’” In addition, he observed, “‘If this issue were to come up before the agency, it would take a long time for it to be decided, because it would be the subject of a great deal of debate. In terms of where we can do better, this is not an area that is on my list of where we could do better,’ Mr. Clayton told the committee.” [Emphasis added.] (See this PubCo post.)

The following month, at a meeting of the SEC’s Investor Advisory Committee, Clayton delivered an opening statement that explained why mandatory arbitration provisions were “not on my list of near-term priorities.” In Clayton’s view, the SEC has limited rulemaking capacity and resources, which should be reserved for matters that were more pressing for investors and markets, more central to the SEC’s core “mission” and were ripe for consideration and addressable with a reasonable time commitment. With regard to mandatory shareholder arbitration provisions, he was “not anxious for this issue to come before the agency. This is a complex issue that invokes divergent and deeply held perspectives and could inevitably exhaust a disproportionate share of the Commission’s resources.…This does not mean that the topic is not worthwhile to discuss, and I encourage those with strong views to support their position with robust analysis.” Nevertheless, Clayton clarified that he had “not formed a definitive view on whether or not mandatory arbitration for shareholder disputes is appropriate in any particular circumstance. I believe any decision would be facts and circumstances dependent.” (See this PubCo post.)