For many years, the staff of the Securities and Exchange Commission (SEC) has maintained an informal policy of refusing to permit registration of public stock offerings if the underlying company instruments require arbitration of disputes between shareholders and the company rather than court litigation. There have been several attempts over the years by business interests to change that informal policy, but those efforts have been unsuccessful in the face of strong political pushback. Here is one online article about the controversy written by an opponent of changing the SEC’s informal policy. There are numerous other articles on the topic that are readily available online.
The U.S. Supreme Court’s recent decision in EPIC Systems v. Lewis, 584 U.S. ___ (2019), rejecting federal agency efforts to limit arbitration by regulation unless the regulatory effort is expressly authorized by the agency’s statutes, has reinvigorated proponents of changing the SEC’s informal policy. Those voices have argued that there is no express statutory authority for the SEC staff’s informal anti-arbitration policy and thus the policy is contrary to the Federal Arbitration Act (FAA). The chair of the SEC, however, has been reluctant to move on the issue, which excites great political emotions because of inter alia its possible impact on securities class actions.
Last year, Prof. Hal Scott, emeritus law professor at Harvard and trustee of the Doris Behr 2012 Irrevocable Trust, sought on behalf of the trust as shareholder to require Johnson & Johnson, Inc. (J&J) to solicit proxy voting on the trust’s proposal to amend J&J’s bylaws to require arbitration of shareholder disputes and to waive shareholder class proceedings whether in court or in arbitration. J&J, which is organized under New Jersey law, rejected the proxy proposal, asserting after receiving guidance from the New Jersey Attorney General’s Office that amending the bylaws to include a choice of forum rule would be contrary to New Jersey State corporation law. The company also relied on the SEC’s informal policy as a ground for denying the request. Scott then pursued the issue within the SEC, but the commission declined to become involved.
Notably, the SEC looked to the New Jersey State legal position as their ultimate basis for rejecting the trust’s petition to compel J&J to put the proposal to the shareholders. The SEC’s decision rested on the opinion of the New Jersey State Attorney General that the New Jersey Business Corporation Act (NJBCA) limits the proper subjects of corporate bylaws to matters of internal corporate concern and that federal securities law claims, “by their very nature, fall outside the scope of a corporation’s bylaw-making power.” The New Jersey Attorney General noted inter alia that the Delaware Court of Chancery reached the same conclusion in applying a Delaware statute that the relevant New Jersey provision tracks nearly verbatim. See Sciabacucchi v. Salzberg, C.A. No. 2017-0931-JTL, 2018 Del. Ch. LEXIS 578 (Del. Ch. Dec. 19, 2018), currently on appeal to the Delaware Supreme Court. The SEC staff remained silent regarding the relationship between the FAA and federal securities law, perhaps a safe position in light of the U.S. Supreme Court’s opinion in Epic Systems.
In March of this year, the trust filed suit in the U.S. District Court for the District of New Jersey, seeking to compel J&J to submit the proposal in its proxy information for a shareholder vote. The Doris Behr 2012 Irrevocable Trust v. Johnson & Johnson, D. N.J., No. 3:19-cv-08828-MAS-LHG (Judge Michael A. Shipp, presiding). Essentially, the trust argues that the FAA overrides both the SEC’s informal policy (due to the principles underlying Epic Systems) and New Jersey’s contrary state laws (due to the Supreme Court’s numerous decisions on FAA preemption of inconsistent state law and its decisions upholding the effectiveness of waiver of class proceedings in favor of individual arbitrations). J&J opposes, two state-controlled institutional J&J shareholders (the California Public Employees' Retirement System and the Colorado Employee Retirement Program) intervened to oppose, and the New Jersey Attorney General’s Office has made amicus submissions opposing. Neither the SEC nor the U.S. Department of Justice has appeared formally in the case.
The Colorado Employee Retirement Program has filed a Motion to Dismiss the trust’s action, arguing among other positions that (1) bylaws are not a “contract” for purposes of FAA coverage, and thus the FAA does not apply; and (2) New Jersey State law prohibits all choice of forum provisions in bylaws, not just arbitration agreements, and therefore is in any event not an anti-arbitration measure preempted by the FAA. Briefing on the dismissal motion concluded on August 27, 2019. The parties have been awaiting a decision by District Court Judge Shipp for several months now. It is hard to predict exactly when Judge Shipp will rule, but it is not unlikely he will issue an opinion before this year ends. Regardless of how he rules, the matter will surely move up the appellate chain to the U.S. Court of Appeals for the Third Circuit once ripe for appeal. So, Judge Shipp’s views will be only the first judicial statement in what will be an extended judicial, and likely regulatory, process.
If the trust’s argument prevails in this litigation, or if other efforts to get the SEC to change its informal policy ever succeed, the effect would be to allow public companies to block shareholder class actions by introducing individual arbitrations as the required alternative, coupled with a waiver of class proceedings. The political, legal, and economic ramifications would be very significant. This issue is certainly well-known among insiders and interested observers. A decision by the court to require J&J to present the proposal to its shareholders will trigger intense regulatory and legislative activity in Washington, D.C. A decision either way will increase the pressure on the SEC commissioners (especially the current Republican chair) to address the issue at the commission level.
If the Motion to Dismiss is granted, then we can anticipate a prompt appeal to the Third Circuit Court of Appeals. If the motion is denied, then complex rules come into play regarding whether that denial would be appealable immediately or only after conclusion of the full District Court proceedings.
In addition to the federal judicial proceedings, we can anticipate additional pressure by interested parties on the SEC commissioners and on SEC staff. Indeed, in the end the U.S. Congress may also play a role in mediating between the two statutory schemes by means of new legislation. In such circumstances, SEC action or inaction and congressional action or inaction may depend on the eventual composition of those bodies after the November 2020 general elections for the presidency and congressional seats.
It is also worth speculating that, if the eventual resolution of these issues is that the New Jersey State law is not preempted by the FAA (for the reasons put forward by the New Jersey State Attorney General and others), but the SEC’s informal anti-arbitration policy is preempted (by operation of the FAA and EPIC Systems), then public companies desiring to prevent securities class actions by their shareholders might be motivated to change their jurisdiction of incorporation from states like Delaware (if the Chancery Court is upheld by the Delaware Supreme Court) or New Jersey, which restrict choice of forum clauses in bylaws, to a state with a more flexible corporations law framework on the subject.
Mark Kantor is a member of the College of Commercial Arbitrators in Washington, D.C.
Copyright © 2019, American Bar Association. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. The views expressed in this article are those of the author(s) and do not necessarily reflect the positions or policies of the American Bar Association, the Section of Litigation, this committee, or the employer(s) of the author(s).