(Reuters) - On Monday, Securities and Exchange Commission Chairman Jay Clayton announced that the SEC will not countenance the latest attempt to curtail securities class action litigation via mandatory shareholder arbitration. But for shareholder arbitration advocates, the news wasn’t all bad: The SEC seems to have backed away from its longstanding position that shareholder arbitration runs afoul of federal securities laws, leaving open an avenue for future investor arbitration proposals.
Technically, Clayton simply announced his support for a recommendation from the SEC’s Division of Corporate Finance that the SEC decline to bring an enforcement action against Johnson & Johnson if the company refuses to allow shareholders to vote on a mandatory arbitration proposal by a J&J investor. Harvard emeritus law professor Hal Scott, who serves as trustee of the Doris Behr 2012 Irrevocable Trust, notified J&J in November of the trust’s proposal that the company allow shareholders to vote at their annual meeting in April to amend J&J’s bylaws to require investors to arbitrate any disputes with the company as individuals. (Yes, it may seem counterintuitive that a shareholder wants to force a corporation to allow fellow shareholders to vote to give up their right to sue, but such is the nature of shareholder proposals.)
Johnson & Johnson, represented by Skadden Arps Slate Meagher & Flom, sent a letter to the SEC in December, asking for the SEC’s blessing to exclude the trust’s proposal from shareholder proxy materials. J&J’s argument in that December letter was that mandatory shareholder arbitration violates the anti-waiver provisions of federal securities laws, which preclude delegation of enforcement to arbitrators. Skadden pointed out that in 2012, when the SEC was reviewing mandatory arbitration proposals pushed by Michigan law professor Adam Pritchard on behalf of
shareholders at Pfizer and Gannett, SEC staff agreed that such proposals could “cause the company to violate the federal securities laws.” In those cases, the SEC allowed Pfizer and Gannett to exclude the shareholder proposals from a vote based on the potential federal securities law conflict, so, according to Skadden, it should do the same for J&J.
Scott replied that since 2012, the U.S. Supreme Court has repeatedly endorsed arbitration as an alternative forum for the vindication of rights conferred by federal law, most recently in 2018’s Epic Systems v. Lewis (138 S.Ct. 1612). The Epic decision, Scott argued, stands for the proposition that oversight by federal agencies, whether the SEC in the case of mandatory shareholder arbitration or the National Labor Relations Board in the Epic case, is no bar to resolving disputes by arbitration.
In January, the back-and-forth between Scott and J&J in letters to the SEC shifted from federal securities law to state corporate law. (The letters are included in Monday’s public filing by the SEC’s Division of Corporate Finance.) Last December, as you may recall, Vice-Chancellor Travis Laster of Delaware Chancery Court ruled, in a case considered a harbinger of a prospective test of the legality of mandatory arbitration, that Delaware corporate law does not allow companies to select the forum for the resolution of external claims by shareholders, including claims under federal securities law. After Laster’s decision in Sciabacucchi v. Salzberg, Johnson & Johnson, which is incorporated in New Jersey, obtained an opinion from counsel at Lowenstein Sandler that New Jersey law would also preclude mandatory shareholder arbitration.
The attorney general of New Jersey, Gurbir Grewal, subsequently sent the SEC a Jan. 29 letter advising that the J&J shareholder proposal would violate state law. The New Jersey AG cited Delaware’s Sciabacucchi ruling, explaining that New Jersey courts often look to Delaware for guidance. “The proposal’s provisions on mandatory arbitration of federal securities law claims are not ones which New Jersey law permits to be set forth in the bylaws of a business corporation,” the AG letter said. “These provisions would not address the internal concerns of Johnson & Johnson, but rather would seek to regulate external relationships of the company that are governed by federal law. Accordingly, the proposed bylaw amendment would violate New Jersey corporate law.”
The New Jersey AG’s opinion carried the day for the SEC’s corporate finance staff. The SEC’s no-action letter to Johnson & Johnson said it regarded the AG’s letter as “a legally authoritative statement that we are not in a position to question,” and that, in light of the AG’s position, the SEC would not recommend an enforcement action if J&J excluded the mandatory arbitration proposal from a shareholder vote.
The SEC said it was not expressing a view on whether the New Jersey AG was right or wrong, suggesting that if J&J or Hal Scott wanted a definitive determination on the legality of mandatory shareholder arbitration under New Jersey law, they should go to court.
The SEC letter ducked the federal-law question that had dominated early arguments by both Scott and J&J. “We are also not expressing a view as to whether the proposal, if implemented, would cause the company to violate federal law,” the letter said. “Chairman Clayton has stated that questions regarding the federal legality or regulatory implications of mandatory arbitration provisions relating to claims arising under the federal securities laws should be addressed by the Commission in a measured and deliberative manner.”
Clayton’s announcement emphasized that the Corporate Finance division’s no-action recommendation was based on the New Jersey AG’s interpretation of state law – and also warned, once again, that no one should expect quick answers from the SEC on the legality of mandatory shareholder arbitration under federal securities laws. “Since 2012, when this issue was last presented to staff in the Division of Corporation Finance in the context of a shareholder proposal, federal case law regarding mandatory arbitration has continued to evolve,” the SEC chair wrote. “Further, I am not aware of any circumstances where the Commission has weighed in on the legality of mandatory shareholder arbitration in the context of federal securities law. In light of the unsettled and complex nature of this issue, as well as its importance, I agree with the approach taken by the staff to not address the legality of mandatory shareholder arbitration in the context of federal securities laws in this matter, and would expect our staff to take a similar approach if the issue were to arise again.”
So why do Hal Scott and Adam Pritchard say the SEC’s handling of the J&J case represents some progress for shareholder arbitration proponents?
Because the SEC did not contend mandatory shareholder arbitration is illegal as a matter of federal law, which was the basis of the 2012 no-action letters to Pfizer and Gannett. “The SEC has reversed its position,” Scott told me in an interview Wednesday. “The most significant thing about this letter is that the SEC didn’t say the proposal would be illegal under federal law.”
Added Pritchard: “They’ve backed away from an obviously frivolous position.”
Scott said he plans to appeal the SEC staff’s recommendation to the commissioners. He said he doesn’t expect to win, but believes that the SEC’s framing of its recommendation as a matter of state law leaves room for him to argue that the commission must confront the federal law issue because federal securities laws preempt state law. In the past, Scott said, the SEC has said it would not issue no-action letters based on ambiguous state law – a rule, he said, that should certainly apply in these circumstances.
At the very least, Scott said, the SEC’s no-action letter leaves open the prospect of mandatory shareholder arbitration for corporations based in states whose corporate codes would permit it. (I should point out that Vice-Chancellor Laster’s Sciabacucchi ruling is on appeal to the Delaware Supreme Court so we can’t be sure even what Delaware’s final word will be on corporations picking a forum for federal securities claims.) I asked Scott whether he’s working on more shareholder proposals calling for mandatory arbitration, perhaps in a state with an AG who won’t put up a fight. He declined to say.
The SEC declined to provide a statement responding to comments from Scott and Pritchard, and J&J counsel Marc Gerber of Skadden declined to comment through a firm spokeswoman.
But I did talk to Paul Bland of Public Justice, whose group has been a stalwart opponent of shareholder arbitration, about whether we should read the SEC’s handling of the J&J case as a sign that the commission will no longer rely on its previous view of mandatory arbitration and federal securities law.
“I don’t see anything in the staff letter or the chairman’s statement that says the Federal Arbitration Act overrides federal securities law,” Bland told me. He said it makes sense that the SEC didn’t address that question because it didn’t need to. The New Jersey AG’s letter made the case an easy call for the SEC, Bland said: “The SEC dodged a thorny legal issue and went with an answer that was much more straightforward.”
I asked Bland whether he’s frustrated that the SEC has assiduously avoided reaching a conclusion, as the debate over mandatory shareholder arbitration has intensified, about whether the FAA trumps federal securities laws. Arbitration proponent Pritchard told me, for instance, that he thinks SEC Chair Clayton is putting off a reckoning on that question because he doesn’t want to face Congressional criticism. (In fairness, Clayton has said repeatedly that when the issue is ripe, the entire commission will reach a decision on shareholder arbitration as a matter of federal law, rather than leaving the matter in the hands of Corporate Finance staffers; his implication in the J&J case was that the New Jersey AG’s opinion obviated the need for a final decision as a matter of federal securities law.)
Bland told me he can’t criticize Clayton at all. “I feel like the chairman did investors a huge service,” he said. “This is a huge victory for shareholders.”