(Reuters) - Groundbreaking litigation can make for strange alliances.
The latest example of that truism came Friday in litigation in federal court in Trenton, where a trust led by retired Harvard law professor Hal Scott is trying to establish for the first time that corporate bylaws can impose mandatory arbitration on shareholders. The litigation, as I’ve told you before, has been counterintuitive from its beginning in March. Scott’s trust is a shareholder of Johnson & Johnson, yet the trust is suing to force J&J to allow it to propose a mandatory arbitration provision to cut off all shareholders’ rights to sue for securities law violations.
J&J, meanwhile, contends that mandatory shareholder arbitration is illegal under state and federal law so it has assumed the weird posture of defending shareholders’ right to file securities class actions. Noting that anomaly, two big state pension funds, the California Public Employees’ Retirement System and the Colorado Public Employees’ Retirement Association, moved last month to intervene in the litigation to assure that U.S. District Judge Michael Shipp of Trenton isn’t depending on J&J alone to represent shareholders’ interests.
On Friday, Johnson & Johnson and the pension funds filed separate motions to dismiss the suit by Scott’s client, the Doris Behr 2012 Irrevocable Trust. The two briefs assert overlapping but not identical arguments for why Judge Shipp should end the case now. Judge Shipp has not yet ruled on the funds’ motion to intervene, which may still be opposed by the trust. But the dismissal briefs show, if nothing else, that the pension funds, which own a combined 10 millions shares of J&J, deserve to be heard in a critical test of their right to sue for securities violations.
Harvard professor Scott said in an email that he is not commenting on the litigation.
The crux of arguments by both J&J and the pension funds is that corporate bylaws govern only a corporation’s internal affairs and cannot be used to restrict shareholders’ external rights under federal securities laws. Both briefs reminded Judge Shipp that the Attorney General of New Jersey, where J&J is headquartered, already made that very point to the Securities and Exchange Commission last January, when the SEC was weighing J&J’s request for permission to exclude the Behr trust’s mandatory arbitration proposal from the proxy materials sent to J&J shareholders.
The New Jersey AG, as the briefs explained, sent the SEC a letter opining that the proposal would be illegal under New Jersey’s corporate law because corporate bylaws cover only internal corporate affairs. The state AG, Gurbir Grewal, cited, among other precedent, a December 2018 opinion from Vice-Chancellor Travis Laster of Delaware Chancery court in Sciabacucchi v. Salzberg (2018 WL 6719718), which examined the distinction between internal corporate affairs governed by bylaws and external affairs outside of their case in a case challenging the legality of forum selection clauses. The SEC considered the New Jersey AG’s opinion sufficiently weighty to make it the basis of the commission’s decision in February to bless J&J’s exclusion of the trust’s mandatory arbitration proposal.
The company and the pension fund argued in Friday’s filing that there’s no doubt AG Grewal correctly interpreted the scope of corporate bylaws, citing case law and commentary dating all the back to Sir William Blackstone. “Bylaws are expressly limited to those matters that relate to a … corporation’s internal affairs, or those affairs relating to the rights and duties of the corporation, its officers and directors and its shareholders,” wrote J&J’s lawyers at Skadden Arps Slate Meagher & Flom. Moreover, both briefs pointed out, when New Jersey’s legislature recently amended state corporate law to allow corporations to amend their bylaws to select a forum for certain internal affairs suits by shareholders, lawmakers left federal securities litigation off of the list.
The trust, represented by Walter Zimolong of the Zimolong firm, has argued that under U.S. Supreme Court precedent on the Federal Arbitration Act, most recently in 2018’s Epic Systems v. Lewis (138 S.Ct. 1612), the FAA preempts state laws barring arbitration. Both the J&J and pension fund briefs refuted that assertion. I’m summarizing nuanced and multifaceted arguments, but, in essence, the briefs contend that the FAA preempts only state laws that disfavor arbitration provisions. Because New Jersey corporate law applies generally and doesn’t even mention arbitration, state law does not disfavor arbitration and therefore, according to J&J and the pension funds, is not preempted by the FAA.
The company and the pension funds also argued that corporate bylaws are not a contract between a company and its shareholders – but the contention received considerably more weight in the funds’ brief than in the company’s. I mentioned above that the dismissal briefs underscore the importance of giving the pension funds a say in litigation that could have deep repercussions for shareholders’ rights. The funds’ analysis of whether bylaws should be considered an enforceable contract shows why.
The funds’ lawyers from Gupta Wessler, Pomerantz and Bernstein Litowitz Berger & Grossman acknowledged that courts have construed bylaws to imply shareholder assent to their terms, notably in 2013’s Boilermakers v. Chevron (A.3d 934), in which Delaware Chancery Court okayed forum selection clauses for shareholder litigation against corporate board members. Such decisions have been based on the premise that when shareholders buy stock, they’re on notice that the company’s board has unilateral power to change the bylaws, and that those bylaws are binding.
But that precedent, according to the pension funds, has looked at the compact between shareholders and corporations as a matter of corporate law – not contract law. As the Supreme Court has interpreted the FAA, arbitration provisions are governed by contract, which means, according to the pension funds, that both companies and shareholders must agree to mandatory arbitration. Under that reasoning, the funds said, shareholder arbitration cannot be imposed by a unilateral corporate bylaw. Shareholder might not even know if a corporation decides to amend its bylaws to impose arbitration of securities claims. “This falls well short of the consent required to manifest agreement to an arbitration agreement,” the pension funds said.
In the J&J case, of course, the Behr trust isn’t asking for J&J unilaterally to change its bylaws to impose arbitration but for the company to allow shareholders to vote on the trusts’ proposal to mandate arbitration. In fact, as I’ve explained, J&J explicitly opposes changing its bylaws, arguing that it would be illegal for the company to require shareholders to arbitrate.
But the pension funds have an interest beyond the J&J case in establishing principles that will shut down shareholder arbitration proposals by companies that, unlike J&J, want to preclude securities class actions. J&J doesn’t have to worry that some other corporation might try to impose mandatory shareholder arbitration by changing its bylaws. CalPERS and the Colorado pension fund do.
It’s going to be interesting to see how the Behr trust responds to the tag-team attack on its pro-arbitration arguments. Its brief is due on June 28.