Today [February 24, 2018] is a special day for the [Securities and Exchange Commission’s] Office of the Investor Advocate.[1] I started this job four years ago today, and because I am the first Investor Advocate that is also the day the Office of the Investor Advocate came into existence. During the past four years, through the efforts of the talented and dedicated individuals who have joined my Office and work so hard to advocate for investors, we have helped to elevate the Commission’s thinking about the needs of today’s investors. And we continue to make progress in some important areas. For example, the SEC Ombudsman, Tracey McNeil, has recently launched an electronic Ombudsman Matter Management System (OMMS) to make it easier for investors to let us know of any concerns about the SEC or a self-regulatory organization. An electronic OMMS form is available at the Ombudsman’s website, www.sec.gov/ombudsman, and we encourage investors to check it out.

This morning, I would like to share some of my views on the issue of mandatory arbitration and, more specifically, on efforts to force public company shareholders to forego class action lawsuits and seek recovery individually through arbitration. This has been a matter of concern to investors recently,[2] after commentators have suggested that U.S. IPO issuers should consider including arbitration provisions in their articles or bylaws.[3]

The idea of forced arbitration has been promoted as a way to reduce costs of securities litigation for public companies and thereby remove a perceived disincentive for companies to be public. Reportedly, it is too easy for plaintiffs’ firms to bring dubious cases and win settlements,[4] and some have argued that class action lawsuits, even meritorious ones, fail to compensate harmed investors in any meaningful way.[5]

There may be some validity to these concerns. But stripping away the right of shareholders to bring a class action lawsuit seems to me draconian and, with respect to promoting capital formation, counterproductive. Let me explain why.

If we take a step back and look at the big picture, there are some very good reasons why shareholders have been given private causes of action. In the United States, the government has traditionally played a limited role in policing our markets, as evidenced by the fact that only 4,600 SEC employees oversee approximately $72 trillion in securities trading each year, as well as the disclosures of more than 8,100 public companies and the activities of more than 26,000 registered entities.[6] Because of the limited scope of the SEC’s resources, investors themselves have typically borne a large share of the responsibility for policing the markets and rooting out misconduct. Over the years, Congress,[7] the Supreme Court,[8] and former SEC Commissioners[9] have recognized the importance of private suits in helping to protect investors and deter wrongdoing.

The SEC, itself, continually reminds investors of its constraints in advocating for their individual interests. Consider how many times every day an investor is told by the SEC staff that we cannot give them legal advice or represent their individual interests. For good reasons, nearly every SEC Investor Alert and hotline phone call includes a disclaimer to the effect that the reader or caller should consult with an attorney who specializes in securities law.[10] In fact, I have personally communicated this to investors many times over the course of my career. When I was a state regulator, I frequently cautioned investors that they should retain private counsel, because even though the interests of victims were generally aligned with the interests of the State of Kansas, those interests could diverge—for example, it might be in the best interest of the state to take away a license, which may decrease the likelihood that a victim would be repaid.

In addition, investors have remedies that may not be available to regulators, the most important of which is the ability to seek full restitution of their losses instead of merely disgorging the bad actor’s ill-gotten gains. Resource constraints can also make regulators pick and choose among cases, which means that the government may decline to pursue many viable cases. In short, our regulatory framework assumes that investors themselves will serve an important role in policing the markets.

Advocates for mandatory arbitration suggest that arbitration provides a sufficient way for investors to seek redress, even if investors are denied the right to pursue class action lawsuits. But, as a practical matter, unless a class-wide remedy is available there is often no other recourse for investors with small holdings.[11] Cases involving accounting irregularities or other corporate misdeeds are usually far more complex than the typical dispute involving a consumer contract, or even a dispute against a broker or investment adviser that involves the investor’s personal account. For individual investors who suffer losses in a widespread fraud, the costs of bringing claims individually in arbitration may well exceed the amount of the likely recovery. And, unless their losses are sizable, victims will struggle to find attorneys to represent them, much less experts to establish elements such as materiality, reliance, loss causation, and damages. This can lead to a collective action problem, where each investor lacks the economic incentive to bring an individual case, even though the collective losses of multiple investors would justify the costs of the litigation.[12]

Some have observed that class actions generally result in “institutional shareholders effectively suing themselves,” paying high costs for the defense while giving plaintiffs’ attorneys a large share of any settlement.[13] But institutional investors, who presumably have the economic incentives and resources to pursue individual arbitration, have been vocal in their opposition to forced arbitration. In a recent letter to the SEC, the Council of Institutional Investors expressed its view that these clauses represent a potential threat to principles of sound corporate governance that balance the rights of shareholders against the responsibility of corporate managers to run the business.[14] In my view, there is considerable value in seeing companies held accountable for wrongdoing, even if the compensatory mechanism is imperfect.

There are other downsides to relying upon individual arbitration as the sole means of recourse. For example, disputes that go to arbitration rather than the court system generally do not become part of the public record, which diminishes their deterrent effect.[15] And, while arbitration is often touted as an efficient means for resolving disputes, it seems terribly inefficient to require multiple plaintiffs to prove up the same claims in separate proceedings.[16] Arbitration also lacks procedural rules that require written opinions or decisions explaining the reasoning for an award, and the grounds for appeal tend to be extremely narrow.[17] As a result, the evolution of case law can be hindered.

Consider, for a moment, how different the federal securities laws would be in the absence of civil litigation. How would we define an investment contract in various fact-specific contexts without the cases that have become our guideposts? Would investors even be able to pursue claims under Rule 10b-5?

As a legal matter, I believe the Commission has been on solid footing when objecting to companies forcing shareholders into arbitration. Securities Act Section 8(a) allows the Commission to refuse to accelerate the effective date of an issuer’s registration statement upon considering, among other things, the facility with which the rights of the issuer’s securities holders can be understood, the public interest, and the protection of investors. If an issuer chooses to file a registration statement with a forced arbitration provision, I would urge the Commission and staff to make use of Section 8(a).

More broadly, Securities Act Section 14 and Exchange Act Section 29(a) state that any condition that would bind a person to waive compliance with those laws is void. The Supreme Court has upheld the validity of arbitration clauses in brokerage customer agreements, but, for the reasons I’ve already stated, I would suggest that arbitration is not a viable option for investors—particularly small investors—in cases involving fraud on the market or other corporate misconduct. In my view, if private remedies are an important part of the enforcement mechanisms for the ‘33 and ‘34 Acts, and forced arbitration provisions would render those remedies illusory for public company shareholders, then those arbitration provisions are void because they would undermine the enforcement of substantive provisions of the Acts.

Admittedly, there are legal arguments to be made on the other side. The law in this area is messy, particularly in the context of an offering that is reviewed by the SEC, and this specific issue has not been addressed by the Court. But, before public companies push this issue and try to go down this road, it’s worth considering where it may ultimately lead. For instance, if investors are blocked from seeking redress in an egregious case, it is not difficult to imagine calls for the SEC to receive greater resources and expanded enforcement powers (such as the ability to seek full restitution) to make up for the loss of private causes of action.

Or, perhaps more likely, investors may pursue other avenues to deter the use of forced arbitration. Not long ago, investors were outraged when a company went public with non-voting shares, and they turned to the index providers for a market solution that would prevent passive investors from being forced to buy the shares. If a company strips away the ability of investors to seek class actions, investors could go down that same road and ask the index providers to keep the company off the index. Before long, if the SEC fails to act, the index providers could step into that vacuum and become the de facto regulators of corporate governance in this country.

Let me close by saying that I hope the Commission does not actually have to confront this issue again in the near future. In my view, the Commission’s time would be better spent on matters that address more urgent needs of issuers and their investors. Chairman Clayton, to his credit, has indicated that he is not anxious to expend Commission resources on this issue,[18] and I hope companies are not anxious to push it. For those of you who advise companies that may be curious about adopting mandatory arbitration clauses, I encourage you to talk to them about the downsides and the likely resistance they would encounter from investors and their advocates, including me.

Thank you.

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