SEC may permit arbitration of shareholder disputes

Corporations may be allowed to amend their bylaws to permit arbitration of shareholder disputes – a move that could diminish costly shareholder class actions.
The Securities and Exchange Commission is currently studying the issue, prompted by a recommendation of a blue-ribbon committee led by Harvard Law Professor Hal Scott. The committee said the SEC should permit public companies to contract with investors that securities disputes be handled outside of the court system.
The bipartisan group, officially the Committee on Capital Markets Regulation, released an interim report in November about the competitiveness of U.S. financial markets.
“The [SEC] should not force shareholders to accept the costs that go with class action securities litigation,” the committee wrote, “particularly the substantial and unpredictable risk of large jury verdicts that effectively force settlement of what may well be non-meritorious claims, where those shareholders choose to forgo these rights.”
Last year, U.S. companies paid $17.6 billion to settle 95 shareholder class actions involving allegations of securities fraud and accounting irregularities, according to Cornerstone Research.
However, any move to arbitrating securities cases will undoubtedly spark sharp opposition from plaintiffs’ lawyers and shareholder rights groups, which could torpedo the initiative.
The SEC is expected to invite public comment on the controversial policy proposal.

Advantage, arbitration?
“The SEC is not trying to say, ‘Hey, we think companies should be winning more often.’ What they’re trying to do is limit a little bit the shareholder litigation that is completely meritless,” explained Andrew Merken of Burns & Levinson in Boston. “You have plenty of lawyers filing class actions on claims that have completely no merit. They do it because they feel they can get some money out of the company who can pay to make it go away.
“The SEC,” Merken continued, “is trying to take some of those claims out of the [court] system. If a plaintiffs’ lawyer knows the claim is tenuous or doesn’t exist at all, and you don’t have the benefit of a potential jury trial, with the presumptions of sympathy,” the lawyer won’t file the suit.
Arbitration isn’t a panacea or a get-out-of-jail-free card, however. Companies need to weigh its advantages and disadvantages, should the SEC allow it in shareholder disputes.
Experts suggest in-house counsel use this period before a formal proposal is filed to determine whether management and directors would be comfortable with arbitration.
“If I were in-house counsel, I would be asking my clients, ‘How comfortable would you be in some sort of alternative forum?’” said Craig Bradley of Stites & Harbison in Louisville, Ky.
In-house lawyers need to also consider what the differences would be for their companies in arbitration and litigation, and when one approach might be more advantageous than the other.
Chris Howard of Pierce Atwood in Portland, Maine encourages in-house counsel to develop an informed position so they can comment on the SEC proposal. They will be directly affected by these provisions, he pointed out, not the academics, pundits and politicians whose voices normally dominate policy debates.
Proponents of arbitration laud its confidentiality and more predictable outcomes. They say arbitrations are quicker and less expensive than court cases for the most part.
However, critics say some arbitration matters can drag on and be just as, if not more, expensive than cases litigated in court.
Robert Sentner, head of the arbitration group at Nixon Peabody in New York City, has noticed some corporate clients expressing a preference for litigation. If they’re going to spend as much money and time, at least in federal court the hurdles a plaintiff must clear to reach a jury are higher because a federal judge looks carefully at each step in the process, Sentner explained.
Brokerage firms in recent years turned to arbitration for a host of reasons, one of which is that it tends to favor industry over individual claimants, Merken said. “They don’t want the sympathy of the judge and the jury to weigh toward the individual aggrieved person. In arbitration you don’t have that. Whether it’s a single arbitrator or a panel, these are experienced, industry people,” he said.
But for every panel that favors industry, there’s a panel that “splits the baby,” which is another assumption practitioners make about arbitration.
Nonetheless, “if you talk to most business lawyers, as opposed to litigators, and asked if they would rather initially go through arbitration or litigation, the vast majority of business practitioners would tell you the arbitration process is more efficient, and over the long haul is probably going to bring more predictable results,” said Howard. “Efficiency and predictability – this is what a business needs to move forward.”
Tom Vaughn, of Dilemma in Detroit, said his clients’ affinity for arbitration varies widely. Some swear by it, others would never set foot in front of a panel, he said.
Foreign clients, though, who are often concerned about the litigious nature of U.S. society and large jury verdicts in the headlines, seem particularly enamored of arbitration. Vaughn said allowing arbitration of shareholder disputes could encourage more foreign companies to list on U.S. exchanges.

Potential impact
Shareholder class actions are a significant financial burden on small and mid-sized companies.
“Everyone who works with the class action system has been frustrated by the expense to corporations, and seeing situations where just sending notices to class members in small, basic class actions costs upwards of $1 million. That’s a conservative estimate,” said Frances Cohen of Bingham McCutchen in Boston.
“What we see in the class action realm,” Cohen said, “are settlements where individual class members may have suffered an injury of less than $10 or even less than $5 or $1, or may not have suffered any monetary injury at all, which are settled for amounts involving the payment of large legal fees because of the class nature of these actions.”
Proponents of the possible SEC policy change say that would change if compulsory arbitration removed the possibility of getting to a jury trial. “Rather than actions brought on behalf of millions of shareholders, you would see individual arbitrations in which there’s probably greater opportunity to assess the circumstances relating to the damages a particular investor would suffer,” Cohen said.
However, when a company writes an arbitration clause into its bylaws, it gives up its ability to seek a meaningful appeal. That, warned Sentner, is not a matter to be taken lightly.
“In a securities case, where it’s very significant and it matters a lot to companies how it comes out, the right to appeal is something which ought not to be lightly given up,” he said. “You can still appeal [an arbitration decision], but the grounds for reversing [are] much more limited than the grounds for reversing a trial decision.”
The SEC may permit arbitration rules that provide a limited appeal, perhaps on just the legal issues involved in the dispute, Vaughn said.