Carlyle Curbing Shareholder Rights Irritates Lawmakers Who See Precedent
Carlyle Group (CG) LP’s plan to protect itself from class-action lawsuits may set a precedent that undermines shareholder rights and encourages more companies to follow suit, lawyers, investors and government officials said.
The buyout firm this month amended a regulatory filing to require future shareholders to resolve claims against it through arbitration. The U.S. Securities and Exchange Commission, which blocked an initial public offering with a less-restrictive arbitration clause more than 20 years ago, must decide whether to allow Washington-based Carlyle’s offering to proceed.
Preventing the share sale could lead to a showdown between the agency and the Supreme Court, which has issued a series of pro-arbitration decisions in recent years. Allowing the IPO would rile congressional Democrats and pave the way for other buyout firms, hedge-fund managers and traditional corporations to go public with similar restrictions.
“The SEC should reject this effort to circumvent shareholder rights because it will be an extraordinary and enduring precedent,” U.S. Senator Richard Blumenthal, a Democrat from Connecticut who serves on the judiciary committee, said in telephone interview. “It will open the door to arbitration clauses in all IPOs, and thereby eviscerate shareholder rights.”
Florence Harmon, a spokeswoman for the SEC in Washington, declined to comment, as did Chris Ullman, a Carlyle spokesman.
Arbitrations differ from court proceedings in several ways: they are generally confidential, permit less discovery by plaintiffs and have fewer avenues for appeal.
Previous IPO Blocked
The SEC has held that companies can’t go public with a clause in their governing documents that limits the ability of shareholders to seek remedies under federal securities law. The agency blocked a stock sale more than two decades ago by a Philadelphia-based savings and loan that had also included a mandatory-arbitration provision in its corporate charter, according to Carl Schneider, a former securities attorney who represented the thrift. Mary Schapiro, chairman of the SEC, served as one of the agency’s five commissioners at the time.
Since then, securities class-action suits have become a big industry in the U.S., with 3,415 filings in federal court between Jan. 1, 1996, and the end of 2011, according to San Francisco-based Cornerstone Research. Settlements totaled $52.7 billion from 2001 and 2010, Cornerstone estimates, including $6.2 billion in the case of WorldCom Inc.
Lynn Turner, the SEC’s chief accountant from July 1998 to August 2001, said he sees “no reason” for the SEC to change its earlier position, given the agency’s mandate to protect investors. Allowing companies to bar shareholder class actions would remove a “significant process” by which corporate executives are held accountable, Turner said.
“The majority of the enforcement of the U.S. securities laws is not done by the SEC but by attorneys for investors,” Turner said in a telephone interview. “This Carlyle proposal destroys that enforcement mechanism, much to the detriment of 100 million Americans.”
The U.S. Supreme Court (1000L) has been moving in the other direction since Republican appointee John Roberts became chief justice in 2005, issuing a series of decisions that promote arbitration as the preferred method for resolving disputes. On Jan. 10, the day Carlyle amended its IPO filing to disclose the lawsuit ban, the court made a pro-arbitration ruling in a case involving CompuCredit Corp. that could also apply to federal securities laws, according to Cyril Moscow, a professor at the University of Michigan Law School in Ann Arbor.
The U.S. Supreme Court held in the late 1980s that brokerages could require arbitration of customer disputes. The justices have never ruled on whether public companies can extend the concept to shareholders, said Stephen Bainbridge, a corporate and securities law professor at the UCLA School of Law in Los Angeles. That could change should Carlyle meet opposition from the SEC and respond by suing the agency, Bainbridge said.
The high court would be “almost certain” to strike down SEC policy if Carlyle were to push the issue, Bainbridge said. “Carlyle is admittedly taking an extremely aggressive position, but it’s a position I believe is fully consistent” with U.S. and Delaware law, he said.
Carlyle’s structure as a limited partnership, rather than a corporation, is critical to the legality of its arbitration provision, Bainbridge said. That’s because Delaware, the state in which most companies are incorporated, gives partnerships more leeway than corporations to restrict their fiduciary duties to shareholders.
Many closely held firms that manage hedge and buyout funds are also structured as limited partnerships, meaning they too could go public with mandatory-arbitration clauses if Carlyle succeeds, Bainbridge said. Technology and industrial firms that are set up as corporations might consider converting into limited partnerships, weighing the huge tax liabilities they would incur, the UCLA professor said.
“If Carlyle can get away with this, you are going to have a bunch of CEOs telling their tax accountants, ‘Price out what it would cost me’” to convert from a corporation to a partnership, Bainbridge said in a telephone interview.
Carlyle has built political connections by employing high- ranking former government officials on its advisory boards. The list includes ex-President George H.W. Bush and former Defense and Treasury secretaries Frank Carlucci and James Baker. David Rubenstein, before co-founding Carlyle, served as deputy domestic policy adviser to former President Jimmy Carter.
Having debated whether to go public since 2007, Carlyle filed for an IPO in September amid a weak market for stocks issued by other private-equity firms, including Blackstone Group LP (BX) and KKR & Co.
Blackstone was named in six 2008 lawsuits that were later consolidated into a class-action complaint alleging that the prospectus for the company’s IPO was false and misleading, in part because it overstated the value of the firm’s private- equity and real estate investments. The plaintiffs seek damages and costs, as well as other relief, Blackstone said in its latest quarterly report, adding that the case is “totally without merit” and that the firm intends to “vigorously” defend itself. Blackstone shares trade at about half the company’s June 2007 IPO price of $31 each.
Carlyle revised its filing Jan. 10, in part to say that future shareholders who seek damages under U.S. securities laws would have to resolve the claims through arbitration. The same provision would bar Carlyle shareholders from filing individual and class-action suits.
“You give up your rights immediately under this construct,” said U.S. Representative Gary Ackerman, a Democrat from New York. “It should not be allowed to happen,” said Ackerman, a senior member of the House Financial Services Committee, which shares oversight responsibility for the SEC.
Arbitration “clearly” takes away certain rights from investors, Arthur Levitt, who served as SEC chairman under former President Bill Clinton from 1993 to 2001, said in a Jan. 19 interview on Bloomberg Radio’s “Bloomberg Surveillance.” That could diminish the public appetite for Carlyle stock, Levitt added in a telephone interview. Levitt is a Bloomberg LP board member.
“Companies that consider going down this road take a perceptual risk which, in terms of an IPO, is probably not a risk worth taking,” said Levitt, a senior adviser to Carlyle since 2001.
The Council of Institutional Investors, a Washington-based association of pension funds, endowments and foundations with combined assets exceeding $3 trillion, has been developing a policy to oppose corporations that limit shareholder rights by mandating legal claims be filed in Delaware, according to Gregory Smith, a board member.
Carlyle’s move would probably receive scrutiny from the institutional shareholder group, Smith said in a telephone interview.
“This reflects a company and management team that fears accountability to the very people” that will own the organization, said Smith, who is also general counsel for the Public Employees’ Retirement Association of Colorado, which manages about $40 billion in pension funds. “You have to ask what they are hiding or what are they preparing to hide?”
Joseph Dear, the investor council’s chairman, is also the chief investment officer of the California Public Employees’ Retirement System, the largest U.S. public pension fund with $229 billion in assets. As part of a larger agreement to invest in Carlyle funds, Calpers paid $175 million in 2001 to acquire what was then a 5.5 percent stake in the private-equity firm, according to people familiar with the situation at the time.
The fund is restricted from commenting on the arbitration issue at Carlyle, said Brad Pacheco, a spokesman for Calpers. Calpers, an advocate for corporate governance and shareholder rights, has a policy for monitoring securities litigation and determining when it should pursue “a lead plaintiff role,” according to the pension fund’s website.
Mandatory arbitration, by eliminating the threat posed by class-action suits, could encourage more private domestic and foreign companies to sell stock in the U.S., according to a November 2006 report by the independent Committee on Capital Markets Regulation prepared for Henry Paulson, the U.S. Treasury Secretary at the time.
The amounts paid out to small investors in class actions are often so minimal, after lawyers fees are deducted, that they don’t bother to collect the awards, Hal Scott, a Harvard law professor and the committee’s director, said in an interview.
Shareholders would benefit from the reduced threat that companies they have invested in would get stuck with large legal bills, said William Chandler, an attorney in the Georgetown, Delaware, office of law firm Wilson Sonsini Goodrich (1173L) & Rosati.
“To the extent you can reduce the costs of litigation, that benefits all shareholders,” said Chandler, who previously served as chief judge for the Chancery Court of Delaware. “Not just the ones” who sue, Chandler said.
Spiraling class-action costs prompted a pair of investors at Gannett Co. (GCI) and Pfizer Inc. (PFE) to propose that each of the companies require shareholders to resolve disputes involving $3 million or less through arbitration rather than in court. Gannett, the McLean, Virginia-based publisher of USA Today, and Pfizer, the New York drug manufacturer, are seeking permission from the SEC to forgo holding votes on the arbitration proposals at their annual shareholder meetings this year.
“Although sympathetic to the principal concerns espoused” by the shareholder proposal, Gannett believes “the implementation of the proposal would cause it to violate the federal securities laws,” its law firm, Hogan Lovells, wrote in a Dec. 27 letter to the SEC. “Rather than having the company’s proxy statement serve as a test case for investor sentiment on the issue, the appropriate course of action is for the issue to be debated and decided by Congress,” or by the SEC through its rule-making process, the firm wrote.
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