Here’s an interesting turn of events with regard to the case involving the mandatory arbitration shareholder proposal to Johnson & Johnson. You may recall that, last year, a Harvard law professor submitted a shareholder proposal to Johnson & Johnson requesting that the company adopt mandatory shareholder arbitration bylaws. Corp Fin issued a no-action letter to J&J granting relief if the company relied on Rule 14a-8(i)(2) (violation of law) to exclude the proposal. (See this PubCo post.) In that letter, the staff relied on an opinion from the Attorney General of the State of New Jersey advising the SEC that 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.” The issue was so fraught that SEC Chair Jay Clayton felt the need to issue a statement supporting the staff’s hands-off position and advocating, in effect, that the parties seek a binding answer in court—which is exactly what happened. On March 21, the proponent of the proposal filed this complaint. (See this PubCo post.) Now, two big public pension funds have sought to intervene and, as a result, the case may have now taken on larger dimensions.
In the complaint, the plaintiff (shareholder proponent) argued that the shareholder proposal would not cause the company to violate NJ state law because “neither Johnson & Johnson nor the New Jersey Attorney General has identified any New Jersey statute or court decision that prohibits the enforcement of the arbitration agreements,” and, even if the NJ courts declined to enforce, that still would not mean that including the provision in the company’s bylaws would amount to a violation of NJ law. That is, a “company does not ‘violate’ state law by entering into an arbitration agreement that happens to be unenforceable under the law of that state.” Nor, according to the proponent, would the proposal cause the company to violate federal law, because “the Federal Arbitration Act requires the enforcement of arbitration agreements, and Johnson & Johnson has been unable to identify any federal statute that ‘manifest[s] a clear intention to displace the Arbitration Act.’” Even if state law were shown to prohibit enforcement, he contended, it would be preempted by the Federal Arbitration Act and void. The plaintiff also stated that he intends to submit the “proposal again for the 2020 shareholder meeting, and…will continue submitting this proposal each year until the proposal is adopted by the shareholders.”
However, the subject matter of the proposal—and perhaps the persistence of the proponent in pursuing it—were apparently viewed as instances of the camel’s nose getting under the tent, and now, two public employee pension funds, CalPERS and Colorado PERA, have sought to intervene in the action and filed, separately from J&J, a motion to dismiss the complaint. What do they have do with it, you ask? In this post on The Harvard Law School Forum on Corporate Governance and Financial Regulation, they contend that they were compelled to intervene because “neither the plaintiff nor J&J share the interests of institutional investors like CalPERS and Colorado PERA….That CalPERS and Colorado PERA would move to protect shareholders’ right to sue should come as no surprise. CalPERS is the nation’s largest public pension fund, and holds over eight million shares of J&J stock; Colorado PERA is the twenty-fourth largest pension plan in the United States and holds over 1.9 million shares of J&J stock. Both funds participate in securities fraud class action lawsuits and have been appointed as class representative in such suits to defend their and other shareholders’ interests.” In addition, both pension funds have previously advocated against mandatory shareholder arbitration.
According to the post, “while the J&J case may be the first test of the legality of mandatory shareholder arbitration, neither party to the case represents the interests of institutional investors.” In support of their motion to intervene, the funds argue that “[t]his case comes before the Court in a strange posture… [A]s things stand, this litigation presents a truly anomalous scenario: Johnson & Johnson is the only party defending shareholders’ right to bring a class action against Johnson & Johnson. Meanwhile, the only shareholder party—a trust that owns 1,050 Johnson & Johnson shares—has chosen to advocate a position that is contrary to other shareholders’ interests.” It makes no sense, they say, “to leave J&J as the only party tasked with protecting shareholders’ interest in policing J&J’s conduct through class-action litigation against J&J. And what if the district court rules against J&J? If institutional investors like CalPERS and Colorado PERA aren’t parties to the case, they couldn’t appeal such a decision if J&J chose not to.”
But there is more to it than just the “strange posture” of the parties in the case—the funds signal that they want to use the opportunity to make their case against bylaws of this nature. In support of their motion to intervene, the funds observe that “the complaint advances the theory that a corporation’s bylaws should be “interpreted as a contract between the corporation and its stockholders” as a justification for why arbitration could govern shareholder disputes…. Colorado PERA and CalPERS believe that this theory is wrong and are eager to explain why.”
Both J&J and the pension funds have filed motions to dismiss the complaint. In support of its motion, J&J observed that the plaintiff had long waged “an academic crusade” to test the viability of bylaws that would “require not only mandatory arbitration of all federal securities law claims, but also waivers of class-action rights, rights to appeal and rights to challenge any arbitration award….Plaintiff’s trustee’s crusade should end here.” First, J&J contends that the proposal exceeds the permissible scope of bylaws under NJ law because mandatory arbitration bylaws do not relate to the company’s “internal affairs, or those affairs relating to the rights and duties of the corporation, its officers and directors, and its shareholders inter se.” Although the plaintiff claimed that state law was preempted by the FAA, J&J disputes that contention
“because the FAA applies only to binding agreements to arbitrate, and then only with respect to disputes ‘arising out of’ such agreements…. Contrary to Plaintiff’s argument, shareholders cannot be bound to bylaw provisions that exceed the limits imposed by New Jersey law. Moreover, disputes under the federal securities laws do not ‘arise out of’ a New Jersey corporation’s bylaws that, as a matter of law, may concern only internal corporate affairs. In any event, there can be no FAA preemption here because New Jersey law does not discriminate against arbitration; it merely provides that a company’s bylaws are not the appropriate place for provisions—like those in Plaintiff’s Proposal—that purport to regulate matters external to the corporation….”
Second, J&J contends, the proposal would violate federal law, which prohibits “agreements waiving the protections of these acts. The Supreme Court recognizes the need to inquire whether an arbitration agreement weakens shareholders’ ability to recover on statutory claims” and has limited the circumstances under which arbitration of federal securities claims is permissible, which are not applicable here.
In support of their motion to dismiss, the pension funds also contest the preemption argument, calling the plaintiff’s reliance on the FAA “a category error,” and making many of the same arguments offered by J&J on this issue. But they also contend that the FAA is inapplicable because
“it applies only to true contracts formed under the ‘law of contracts,’ under which a ‘mutual manifestation of intent to be bound’ and ‘explicit Agreement’ are ‘essential to the formation of an enforceable arbitration contract.’ It is therefore insufficient to resort to ‘corporate law principles’ that ‘impute to members of the corporation knowledge and acceptance of corporate bylaws.’ This is the ‘first principle’ of the FAA: ‘Arbitration is strictly a matter of consent.’ While the FAA thus has no bearing here, later enactments of Congress do. Congress has consistently encouraged securities class actions and discouraged waivers of shareholder rights, and the SEC has never allowed companies to mandate arbitration of shareholder securities claims. This Court should not lightly depart from that long-settled approach.’” [citations omitted]
More specifically, the funds contend that the FAA,“applies only when (1) a ‘contract evidencing a transaction involving commerce’ includes a written arbitration agreement and (2) the ‘controversy’ to be arbitrated ‘aris[es] out of such contract.’… To be sure, some courts have described corporate bylaws as contractual or quasi-contractual and have applied contract-law principles by way of analogy—even though… bylaws obviously would not satisfy the traditional Anglo-American requirements for the formation of a contract.” That is, the FAA “applies only to private bilateral ‘contract[s] evidencing a transaction involving commerce,’… and a corporation’s bylaws, absent a manifestation of assent, do not constitute such a contract.”
Citing a 2009 Third Circuit case, Kirleis v. Dickie, McCamey & Chilcote, the funds argue that, to be enforceable, arbitration bylaw provisions require “mutual manifestation of assent.” The constructive notice and presumption of assent that is often invoked in the context of corporate bylaws “may be sufficient to bind shareholders as a matter of corporate law, but it is insufficient as a matter of contract law—and it is plainly insufficient under the FAA. That fundamental distinction between corporate law and contract law is dispositive here. It is undoubtedly true that as a matter of corporate law, courts often treat a corporation’s bylaws, by analogy, as if they were a contract between the corporation and its shareholders…. But the fact that courts have found it useful to analogize bylaws to contracts for purposes of corporate law is not enough to make these bylaws subject to the FAA.” Under contract law, they argue, “mutual assent is critical to contract formation generally and the adoption of an arbitration agreement in particular.” We’ll have to wait to see whether the Court agrees.