Market Regulation

Mandatory Shareholder Arbitration is Contrary to the Law and Bad Public Policy

Statement of CFA Director of Investor Protection Barbara Roper

Earlier today, CFA submitted a White Paper to SEC Chairman Jay Clayton and the rest of the SEC Commissioners in which we detail why it would be both contrary to the securities laws and bad public policy to permit public companies to adopt forced arbitration agreements.

In it, we walk through in detail:

  • How forced arbitration clauses violate anti-waiver provisions of the securities laws;
  • That corporate charters and bylaws do not constitute contracts that are subject to the Federal Arbitration Act; and
  • Why, even if they were, subsequent congressional action preserving private actions and identifying federal courts as the appropriate venue for such actions would override the FAA.

The White Paper was written in response to Chairman Clayton’s statement last April, in a letter to Representative Carolyn Maloney, in which he “encouraged those with strong views to support their position with robust, legal and data driven analysis.” Chairman Clayton noted then, as he has before, that he does not entirely control whether the issue comes before the Commission. A company could force the issue onto the Commission’s agenda in one of several ways – including by attempting to go public with a forced arbitration clause in its offering documents or by changing its bylaws to incorporate such a clause.

If that happens, this White Paper is intended to help persuade the Commission to reaffirm the position the SEC has maintained for many decades – under Democratic and Republican leadership alike – that private lawsuits serve as an essential supplement to the SEC’s own enforcement efforts and that efforts to deprive investors of their right to bring such actions are illegal under the securities laws and bad public policy.

So far, although he has pledged to adopt a deliberative process should the issue arise in the context of a registered IPO of a U.S. company, Chairman Clayton has not provided the broader assurances needed to put the issue to rest. And Commissioner Peirce recently revived the issue with her suggestion that companies “absolutely” should have that right.

In order to understand why this issue is such a hot button issue for investors, I think it helps to put the legal and technical jargon aside and explain, in plain English, just what’s at stake here.

First, this is not about a mutual agreement between companies and their investors to resolve disputes through arbitration. The question being debated here is whether managers of public companies should be able to strip the owners of those companies of their right to hold the managers accountable in a court of law when they commit securities fraud.

Second, the question is not whether investors’ fraud claims should be heard in court or in arbitration. The question is whether these claims will be allowed to proceed at all. If you eliminate investors’ ability to band together to bring their claims in class actions, you will make it unaffordable for any but the largest investors to bring a claim. And even for large investors, claims will often not be economically viable.

That’s because securities fraud claims are expensive to bring. It can cost millions to hire the experts and compile the evidence necessary to prevail in court. If investors have to bring such actions individually in arbitration instead of as a class in court, small investors will be shut out entirely.

Third, advocates of forced arbitration would have you believe that their goal is to reduce the risk of frivolous litigation that they claim makes companies reluctant to go public in the United States. But this is wrong on several counts.

  • Forced arbitration doesn’t target frivolous claims, which Congress already addressed back in the 1990s through the Private Securities Litigation Reform Act. Forced arbitration eliminates meritorious claims, with the potential to seriously erode public confidence in the integrity of our markets.
  • While it is certainly true that companies don’t like to be sued, and will eliminate that risk if they can, there’s no evidence – and supporters of forced arbitration have offered none – that the threat of litigation undermines capital formation. On the contrary, companies enjoy a lower cost of capital, and foreign companies choose to list here as a result, precisely because U.S. markets are perceived to be the best policed in the world.
  • Through their deterrent effect, private lawsuits contribute to our markets’ reputation for transparency and integrity. Many of you will remember, for example, how the massive frauds at Enron and Worldcom and the wave of accounting scandals that followed roiled the markets, and how stocks in companies without a whiff of scandal were affected. Imagine how much worse the public’s reaction would have been if part of the Enron/Worldcom story was that investors who were victims of those frauds had no ability to recover even a portion of their losses because the companies in question had adopted mandatory arbitration clauses.

Finally, when it comes to compensating the victims of fraud, the SEC has neither the resources nor, in some areas, the authority to fill this gap. That is presumably why SEC leaders from both parties have long affirmed the essential role that private lawsuits play, not only in compensating the victims of securities fraud, but in promoting the integrity of the securities markets on which the health of our economy depends.

We hope the SEC’s commitment to this long-held policy will remain untested. But it would be foolish to assume that will be the case. Should the issue arise, in whatever context, we expect the Commission to respond as it has repeatedly done in the past: that measures that deprive defrauded investors of their right to pursue private claims in court violate the securities laws, are bad for investors, and are bad for the markets.

Contact: Barbara Roper, (719) 543-9468