An August 21 blog post, “Shareholders Deserve Right to Choose Mandatory Arbitration,” by Professor Hal S. Scott, argues that the introduction of mandatory arbitration clauses into corporate charters would be good for stockholders. Nothing could be further from the truth.
Professor Scott argues that the current system of federal oversight is sufficient to inhibit and remedy corporate fraud. He states that he is in favor of “shareholders’ right to opt out of the costly and ineffective system of securities class action litigation…” and that mandatory arbitration will be more effective to redress corporate fraud. The facts contradict all of these sentiments.
First, Professor Scott contends that oversight by the SEC and Department of Justice obviates the need for class action securities lawsuits. He makes this statement in the same sentence that he mentions the 2008 financial crisis, a global financial meltdown largely caused by unchecked corporate fraud and greed that the SEC and DOJ failed to prevent. Moreover, the Supreme Court held, as far back as 1964, that private enforcement of the federal securities laws is a necessary supplement to the enforcement powers of the SEC. As former SEC Commissioner Luis Aguilar stated in 2012: “In light of the limited resources available to the SEC, private enforcement of the federal securities laws is a necessary tool to combat securities fraud.”
Second, contrary to Professor Scott’s argument that this is all about shareholder choice, as should be clear from the term “mandatory arbitration,” such charter provisions would leave shareholders with no choice. Shareholders already have the ability to arbitrate individual securities claims (assuming the company consents) and to opt out of class action lawsuits. But mandatory arbitration would force them to arbitrate, leaving them with no option to (a) commence a class action, (b) participate as a member of a class action, or (c) bring their own claims in court. Moreover, while Professor Scott suggests that stockholders would vote to include mandatory arbitration provisions in corporate charters and bylaws, he neglects to mention that, if the SEC allows it, charters could include such provisions pre-public offering (i.e., before investing stockholders would have a vote) and that, at least under Delaware law, a board of directors could unilaterally amend a corporation’s bylaws to include mandatory arbitration without any stockholder input. The only bar to such provisions is the SEC or possibly a stock exchange, not shareholders.
Third, Professor Scott’s argument that arbitration is an effective redress for individual stockholders disregards the facts. Just this week, Richard Cordray, director of the Consumer Financial Protection Bureau, penned a New York Times op-ed detailing the results of a seven-year CFPB study into arbitration:
Our study contained revealing data on the results of group lawsuits and individual actions. We found that group lawsuits get more money back to more people. In five years of group lawsuits, we tallied an average of $220 million paid to 6.8 million consumers per year. Yet in the arbitration cases we studied, on average, 16 people per year recovered less than $100,000 total.
It is true that the average payouts are higher in individual suits. But that is because very few people go through arbitration, and they generally do so only when thousands of dollars are at stake, whereas the typical group lawsuit seeks to recover small amounts for many people. Almost nobody spends time or money fighting a small fee on their own. As one judge noted, “only a lunatic or a fanatic sues for $30.”
While the CFPB’s study involved consumer arbitration, there is every reason to expect the same for investor arbitration. Indeed, the need to prove fraud in arbitrations – without the discovery tools available in court – would doom most cases and, except for very large individual losses, would not be financially feasible. In essence, mandatory arbitration would mean that investors would have zero redress for corporate fraud.
Finally, contrary to Professor Scott’s statement that the filing of securities class actions have caused up to 10 percent stock drops, the typical securities class case is brought after a company (or some other market participant or commentator) discloses new information to the market that causes the stock price to fall.
The truth is that securities class actions are uniquely suited to provide relief for thousands of investors where individual actions – in court or in arbitration – would not be financially feasible. The enactment of the Private Securities Litigation Reform Act in 1995 created a presumption that securities class actions should be led by the investors with the largest financial interest in the action. As a result, most federal securities class actions, and virtually all large securities class actions, are led by sophisticated institutional investors. As we pointed out in a recent article published in Law360 (the article is reprinted with Law360’s permission on the Barrack, Rodos & Bacine website): “The results achieved by these institutional investors are nothing short of stellar. Indeed, . . . 91 settlements [which were led by institutional investors within the 100 largest settlements reached since the PSLRA was enacted] collectively recovered approximately $60 billion for investors.” These settlements include recoveries arising from notorious examples of corporate fraud including Enron, WorldCom, Tyco International, and Cendant. The benefits of these recoveries flowed not just to the institutional investors who led the suits, but also to countless other institutional and individual investors whose losses, while often in the thousands or tens of thousands of dollars, would not have been sufficient to warrant an individual action. Professor Scott contends that such victories for investors have devalued companies.
Professor Scott’s real beef is that the investor recoveries do not come without cost: attorneys’ fees. The only result of securities class actions, he argues, is to reduce the value of companies sued by the amount of fees paid to the lawyers. Professor Scott’s argument is flawed. To begin with, the so-called stock-drop suits are not brought on behalf of investors as holders of stock. They are brought on behalf of investors who, when they purchased their stock, paid an artificially inflated price. Those investors may or may not be current holders. So it is inaccurate to say that securities class action settlements merely shift money from one pocket to the other of the same investors, less the fees paid to the lawyers. Indeed, in the WorldCom class action, for which our firm served as a co-lead counsel, none of the $6.19 billion recovered for the investor class came from the company, which had declared bankruptcy. Rather, payments were made by the company’s former senior executives and directors, its outside auditor, an outside financial advisor, and the underwriters of massive offerings that had become virtually worthless.
More importantly, Professor Scott’s solution – mandatory arbitration – would not provide redress for investors because it is not practical to prevail in arbitrations without the ability to obtain internal corporate records, non-party records, and sworn testimony, as allowed in court cases. Thus, while mandatory arbitration might prevent the payment of fees to lawyers, it would more significantly prevent any recovery for investors. Tell that to the hundreds of thousands, and perhaps millions of investors who received a recovery in the 91 settlements mentioned above.
Corporations should not be permitted to commit fraud with impunity. Investors who purchase stock at prices inflated by a company’s materially false or misleading statements about its financial, business, or operating conditions should have the right to pursue claims in court, where discovery of the facts and the evidence supporting their claims is permitted. The results of those lawsuits are public while in contrast, arbitration is conducted behind closed doors and is not an effective vehicle to provide redress for investors.
In the end, as its name suggests, mandatory arbitration is not about shareholder choice. It is about depriving shareholders of their only viable method of banding together to redress corporate fraud. Mandatory arbitration will only embolden corporations to engage in fraud and deception while leaving investors out in the cold, thereby weakening rather than strengthening investor faith in our capital markets.
This post comes to us from Samuel M. Ward and Michael A. Toomey at the law firm of Barrack Rodos & Bacine. Mr. Ward is a partner in the firm’s San Diego office and regularly participates in the prosecution of securities class action cases. Mr. Toomey is an associate in the firm’s New York City office and concentrates his practice on actions involving corporate governance as well as on securities class actions. The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients, or any of its or their respective affiliates.