On September 1, 2020, the California Superior Court, San Mateo County, granted a motion to dismiss a putative securities class action brought under the federal Securities Act of 1933 because the company’s charter provided that such lawsuits may only be maintained in federal court. The ruling was long awaited by companies, securities litigators, and observers of the decade-long saga of IPO litigation in state courts. It is the first ruling enforcing such a provision after the Delaware Supreme Court upheld their validity under Delaware law earlier this year in Sciabacucchi.
The ruling confirms that companies about to go public—whether through a public offering, direct listing, or SPAC transaction—should adopt a federal forum provision in their charter or bylaws to eliminate the risk of duplicative securities class actions being filed in state court to extract a quick settlement. The ruling also suggests that a federal forum provision adopted after the going public event may also be enforceable under certain circumstances. Finally, the language of the provision matters and should be carefully weighed with experienced counsel.
The Decade-Long Battle over State IPO Litigation
The federal Securities Act of 1933 allows shareholders to sue the company, the signatories of its registration statement, any company control persons, and any underwriters, in connection with a registration statement that allegedly suffers from material misrepresentations or omissions. The plaintiff is not required to plead fraud. Strict liability applies to the company (while the other defendants benefit from an affirmative due diligence defense that realistically can only be established after incurring significant costs of discovery). Most public companies that experience a stock drop after going public are targeted by such lawsuits, styled as class actions and seeking damages sometimes ranging in the billions. Most of these lawsuits are dismissed by federal courts. So plaintiffs began filing them in state courts.
The origins of the debate over IPO securities litigation in California state courts can be traced back to 2012 (at least), when, in a case challenging the IPO of Pacific Biosciences, the San Mateo court denied a motion to stay or dismiss duplicative state litigation in favor of an existing federal lawsuit. An important detail: the ruling was by the same judge who, this week, enforced the federal forum provision in Restoration Robotics. The subsequent trajectory of the Pacific Biosciences case traced a pattern that would become familiar to California companies over the next eight years: defendants obtained dismissal of the allegations in federal court, only to have to settle the same claims in state court, where more lenient standards prevail. The settlements caused D&O insurance premiums and deductibles for companies about to go public to skyrocket.
Defendants began removing the state cases to federal court. Federal courts divided on the issue. East Coast courts held the removals were appropriate. West Coast courts held the opposite. The issue reached the United States Supreme Court in 2018. In Cyan, over the objection of the Securities and Exchange Commission, which had filed a brief as a friend of the court, the Supreme Court agreed with the West Coast courts and held (i) that Securities Act class actions could not be removed from state court to federal court and (ii) that both state and federal courts had concurrent jurisdiction over these lawsuits.
Cyan was a setback, but hardly the end of the effort to protect companies from abusive securities litigation in state courts. In the years prior to Cyan, Delaware courts had held that a company could specify in its charter or bylaws the forum in which shareholder litigation concerning breaches of fiduciary duty could be filed. Such a provision became known as a Grundfest Provision, named so after the Stanford law and business professor and former SEC Commissioner who invented it. In 2018, a few months after Cyan, the California Court of Appeal enforced such a forum provision in Bushansky v. Soon-Shiong.
Even before Cyan was decided, companies began adopting analogous charter provisions selecting federal courts as the exclusive forum for Securities Act litigation. The provisions were challenged promptly by the plaintiffs’ bar, who scored an initial success when the Delaware Court of Chancery rejected such provisions as invalid. That decision was overturned in March 2020 by the Delaware Supreme Court, in Salzberg v. Sciabacucchi.
Sciabacucchi held that federal forum provisions were facially valid as a matter of Delaware law. The Delaware Supreme Court acknowledged that the application of such provisions to the specific facts of a case would have to be decided by each presiding court, but expressed its hope that the courts of sister states would enforce such provisions for several reasons. First, the Delaware Supreme Court noted that federal forum provisions are fully consistent with federal law and policy, as illustrated by cases allowing arbitration of Securities Act claims  and allowing parties to establish by contract where litigation may be filed. Second, the Delaware Supreme Court reiterated that the bylaws of a Delaware corporation represent a binding contract between shareholders and the company, and that the reach of this contract is not limited just to the internal affairs of a Delaware corporation, but would encompass any intra-corporate dispute between shareholders and the company, such as securities litigation.
After Sciabacucchi, companies that had adopted federal forum provisions in their charters and faced claims in state courts quickly moved to enforce such provisions and dismiss the state lawsuits.
The California Court’s Ruling in Restoration Robotics
Aware of its own prominent role in the debate over the locus of Securities Act litigation, the San Mateo court’s ruling began with a summary of the decade-long efforts by companies to concentrate Securities Act litigation in federal courts, as discussed above. The San Mateo court then noted that it had denied an earlier motion by defendants to enforce the federal forum provision (filed before the Delaware Supreme Court decided Sciabacucchi). The California court acknowledged that its earlier denial was due to the fact that the Delaware Court of Chancery had initially ruled for plaintiffs in Sciabacucchi, invalidating federal forum provisions. With the Delaware Supreme Court’s reversal of the Chancery decision, the San Mateo court felt compelled to grant defendants’ request that it reconsider its earlier denial of the motion to dismiss.
Then, in an unexpected turn, the San Mateo court held that Sciabacucchi and Delaware law did not apply to the enforceability of Restoration Robotics’ federal forum provision. Indeed, the San Mateo court expressed considerable skepticism about the reasoning of the Delaware Supreme Court. It characterized the Supreme Court’s ruling as limited to the facial validity of federal forum provisions, and “basically irrelevant” to the issue whether the provision was enforceable, a curious statement given that Sciabacucchi prompted the San Mateo court’s reconsideration of the earlier denial.
The California court went on to criticize the Delaware Supreme Court ruling as based on an “elliptical chart of gradations it invented”—a reference to a visual diagram in which the Delaware justices sought to delineate the reach of the internal affairs doctrine by means of several concentric orbits. The San Mateo court also faulted the Delaware Supreme Court over its interpretation of the federal precedents in Rodriguez, Bremen, and Matsushita, which the court believed were not pertinent to the federal forum provision issue. For example, the San Mateo court characterized Rodriguez as expanding the choice of a plaintiff as to where to litigate a Securities Act claim to include arbitration. The San Mateo court did not dwell on the fact that, in Rodriguez, the arbitration provision at issue was mandatory, and its effect had decidedly been to restrict plaintiffs’ ability to sue in any court.
Finally, the San Mateo court held that the Delaware Supreme Court had overreached beyond the limits of the internal affairs doctrine, and that California law—not that of Delaware—applied to the enforcement of the federal forum provision. According to the San Mateo court, Sciabacucchi’s urging of the courts of sister states to enforce federal forum provisions was little more than dicta. That too is an unusual conclusion, because the Delaware Supreme Court’s ruling in Sciabacucchi is based on a conclusion that the charter and bylaws of a Delaware corporation reach all intra-corporate disputes, not just internal affairs. The concept is not novel, although perhaps its trajectory could be described as elliptical since it has been endorsed by California courts adopting Delaware precedent.
Despite the San Mateo court’s criticism of Sciabacucchi, it ultimately concluded that California law mandates enforcement of the federal forum provision. Under California law, the San Mateo court noted, once the defendant invokes a forum selection provision, the burden shifts to the plaintiff to show that the provision is unconscionable both procedurally and substantively.
With respect to the first prong, the San Mateo court found that the federal forum provision was not only procedurally unconscionable, but “[i]ndeed, glaringly so.” The California court noted that a corporate charter is a contract of adhesion, and the company’s disclosures in documents filed publicly with the SEC were oppressive because they were made in small print, and the provision itself was only in an exhibit to a 154-page prospectus. The San Mateo court’s objection seems somewhat at odds with securities law holding that public disclosures in SEC filings give investors notice of the matters therein. Indeed, the entire U.S. securities regime is arguably based on this principle, although, over the years, the level of detail in disclosures has tended to increase, not least as a result of securities litigation.
Notwithstanding these misgivings, the San Mateo court’s analysis next took a sharp pro-defendants turn. The court observed succinctly that the federal forum provision was not substantively unconscionable. The court noted the federal forum provision does not take away any right to litigate, but merely limits such litigation to federal courts, a result that hardly shocks the conscience, given that the Securities Act is a federal statute. Finally, the San Mateo court appeared to feel fortified in its conclusion by the large body of binding California appellate precedent enforcing forum provisions in the context of shareholder fiduciary duty litigation, such as Bushansky.
Turning to federal law, the San Mateo court rejected plaintiffs’ contention that federal law prohibits the waiver of state court jurisdiction. The court noted that every time a plaintiff sues in federal court it waives state court jurisdiction.
As a result, the San Mateo court granted the motion to dismiss by the company. In an interesting twist, the court rejected, without prejudice, the joinder of venture capital funds named as defendants under Section 15 of the Securities Act, as purported control persons of the company. The court noted that the venture capital firms had not signed the charter and therefore were not in contractual privity with plaintiffs. The court did not appear to consider whether the venture capital firms were, in fact, third party beneficiaries of the contractual federal forum provision. California law allows such beneficiaries to sue for enforcement of a forum selection clause.
A few takeaways:
- The San Mateo court’s ruling isn’t definitive. The rulings of California Superior Courts are not precedential in value, not even in the same county. The ruling itself is subject to appeal. That said, it is notable that this particular court, and this particular judge, were persuaded by the merits of forum selection clauses. If plaintiffs were to appeal, they may generate a precedential ruling by an appellate court.
- When should a company adopt a federal forum provision? Ideally, before an offering. That said, if a company somehow failed to adopt a federal forum provision before the offering, it is not too late to adopt it after the offering. The court’s ruling did not depend on the timing of the provision’s adoption; indeed, the court concluded that the provision had been procedurally unconscionable. The court’s reasoning left open the possibility that a federal forum provision adopted after the offering could still be enforced, as long as it was not substantively unconscionable.
- Does this apply only to IPOs? No. Federal forum provisions are useful in the context of any Securities Act litigation. That could happen after a follow-on offering, after a direct listing, and even after a SPAC transaction.