For decades, the Securities and Exchange Commission (SEC) effectively prohibited companies going through IPOs from using mandatory arbitration provisions as a tool to avoid class-action litigation. Recently, the commission announced a new policy that reverses its long-standing practice of declining to accelerate the effectiveness of registration statements of organizations whose corporate charters or bylaws contained such a provision.
While the new approach may hinder investors’ ability to pursue certain securities class-action claims in court, it will not eliminate all class-action risks for public companies.
The SEC’s policy shift
On Sept. 17, the SEC announced that mandatory arbitration provisions in corporate formation documents will not affect its decision to accelerate the effectiveness of registration statements (opens a new window) filed under the Securities Act of 1933. Instead, the SEC will now focus on the adequacy of “disclosures, including disclosure regarding issuer-investor mandatory arbitration provisions.” SEC Chairman Paul Atkins said that the commission’s role in the debate over mandatory arbitration provisions is “to provide clarity that such provisions are not inconsistent with the federal securities laws.”
The notion that public companies could avoid securities class-action litigation through mandatory arbitration provisions is not new. Issuers have, from time to time, sought to include such provisions in their bylaws or corporate charters, and there has been a long-running debate among securities practitioners about whether these provisions were at odds with the anti-waiver provisions of federal securities laws.
A key question was whether federal securities statutes were “inconsistent” with the Federal Arbitration Act, particularly as the FAA relates to the “public interest/investor protection” standard in section 8(a) of the Securities Act. The SEC, however, had never publicly weighed in on this topic — until now.
It is important to note that the laws of the state or non-U.S. jurisdiction where a company is organized typically control whether a company can adopt a mandatory arbitration provision in the first instance. The new SEC policy does not alter or even take a position regarding the application of state laws.
Crucially, Delaware — where many prospective public companies elect to be formed — has effectively banned mandatory arbitration clauses. Given this, more companies may seek to incorporate (or reincorporate) in other jurisdictions following the SEC’s announcements. States that are more hospitable to mandatory arbitration clauses include Texas and Nevada, both of which have recently amended their corporation statutes in an effort to become the preferred corporate domicile over Delaware.
Class actions vs. arbitration
In class-action litigation, plaintiffs who have suffered similar harm can pursue their common claims on a collective basis, rather than bringing multiple, individual lawsuits. For businesses, defending class-action litigation is time-consuming and expensive, requiring significant resources. In addition, class-action litigation can be highly publicized. To proceed, a class action must be certified by a court through a hearing process akin to a mini-trial.
Arbitration is a form of alternative dispute resolution (ADR) that enables parties to quickly and confidentially resolve legal disputes outside the traditional court system. Arbitration proceedings are more streamlined than class-action suits, with a neutral third-party — an arbitrator — hearing the case. Arbitration is generally considered to be faster, less expensive, and more predictable than class-action litigation.
Detractors, however, often point to three potential downsides of arbitration:
There is no public record of the proceedings.
Parties have extremely limited appeal options.
There is significantly less oversight than in litigation.
Although multiple other factors have a bearing on IPO activity, the aggressive securities class-action environment of recent years has not been particularly inviting to companies seeking to raise capital in public markets. The ability for prospective IPOs to now rely on arbitration provisions may attract more public listings. Any newly public companies that have adopted similar arbitration provisions will likely face fewer shareholder class actions as a result of the SEC’s policy change.
Mature public companies may also elect to amend their charters and bylaws to steer more disputes toward arbitration. “Our conclusion that the Federal securities statutes do not override the FAA in the context of issuer-investor mandatory arbitration provisions is not limited to” the context of IPOs, the SEC noted in its policy statement. “This same conclusion also applies, for example, if an Exchange Act reporting issuer were to amend its bylaws or corporate charter to adopt an issuer-investor mandatory arbitration provision.”
Both newly formed and mature public companies, however, still face class-action risk. Companies adopting arbitration provisions will likely face legal challenges as to the efficacy of the provision itself, and there is no guarantee that courts will enforce them. The adoption of an arbitration provision may also give rise to breach of fiduciary duty claims by shareholders, premised on directors receiving a personal benefit through avoidance of litigation.
In addition, even if arbitration may deter some individual shareholders from bringing claims, IPOs could still face the prospect — and cost — of a myriad of separate arbitrations that would have to be defended, with the risk of inconsistent results and the proverbial “death by a thousand cuts.” In the long run, plaintiff shareholders and corporate defendants alike may also find a lack of court opinions issued in shareholder litigation to be problematic, as case law helps to provide more consistent and predictable outcomes for all parties.
Insurance and risk considerations
Even with the prospect of less litigation for companies seeking to go public, it’s important that senior leaders do not ignore the risks that remain (opens a new window). As they go through the IPO process, companies should take steps to address the following:
Regulatory and disclosure risks. Companies going public must avoid errors and omissions in registration statements, and also meet various compliance requirements under the Sarbanes-Oxley Act of 2002.
Valuation risks. Companies can draw the ire of shareholders by overpricing or underpricing the value of shares offered to the public.
Board composition. Securities exchanges often have specific requirements that boards must meet. The New York Stock Exchange, for example, requires that the majority of listed companies’ directors and all members of audit, compensation, and corporate governance committees be independent.
Directors and officers liability (D&O) insurance can provide protection to companies and senior leaders for risks related to the many challenges businesses may face as they go public, regardless of the form the claim may take. Well-written D&O policies should include “arbitration or other dispute resolution proceeding” in their definitions of “claim.” This should allow coverage to respond to arbitration proceedings as it would to lawsuits, including by providing reimbursement for legal defense costs, as well as settlements or amounts awarded by arbitrators, subject to the particulars of any claim.
Moreover, effective D&O insurance programs will evolve as companies transition from private to public. Public companies face a host of potential risks that private organizations do not. As such, policies that may have served private companies well for many years may no longer be suitable for companies listed on public exchanges.
Any organization preparing for or considering an IPO should engage early with outside legal counsel assisting them in drafting registration statements to specifically discuss the advantages and disadvantages of an issuer-investor mandatory arbitration provision.
Well in advance of filing a registration statement, a company should also partner with an insurance broker that has experience designing and placing post-IPO D&O coverage. This can help ensure that its program will respond to the new risk landscape it and its leadership will encounter as a public company.
For more information, visit our D&O insurance page here (opens a new window), or contact a member of your Lockton Professional and Executive Risk team.
