U.S. regulators have never allowed a company to go public if it planned to ban shareholders from seeking financial damages through class-action lawsuits. The Securities and Exchange Commission has always maintained that private litigation and enforcement of securities laws must work hand-in-hand to protect investors against fraud. Now, the SEC may be warming up to the idea of forced arbitration, say people familiar with the matter, upending decades of legal precedent and setting up a possible clash with investor advocates.
1. What is forced arbitration?
As the name suggests, it requires shareholders to work out grievances individually through a formalized conciliation process rather than by banding together under a class-action lawsuit in federal court. Such lawsuits can be costly to publicly traded companies, not to mention embarrassing. Arbitration is usually confidential, meaning existing shareholders and potential investors might not know about a case or how it ended.
2. What’s good about forced arbitration?
Business groups say it’s a faster, more economical way of resolving shareholder complaints. They say other stockholders end up paying the price for class-action suits, which really only benefit the plaintiffs’ lawyers who file them. Companies say it’s costly to defend themselves against class actions, some of which are frivolous.
3. What’s wrong with forced arbitration?
It removes the threat of a class action, which can act as a deterrent against companies’ putting out, for example, misleading or inaccurate financial statements. It would also reduce the chances of shareholders winning large financial damages, which are also seen as a deterrent. What’s more, the SEC’s own investor advocate has said the cost of bringing claims individually could create a “collective action problem” where stockholders decide not to move forward or have trouble finding attorneys because of the relatively small amount of money they can claim. He also expressed concern in a February speech over the difficulty plaintiffs can have in trying to appeal an arbitration decision. A majority of the money returned in corporate-fraud cases in 2016 was recovered through private lawsuits, not SEC action, according to Democratic SEC Commissioner Robert Jackson Jr., who opposes forced arbitration.
4. Why would the SEC make this change?
Chairman Jay Clayton, an appointee of President Donald Trump, has said one of his top priorities is turning around the two-decade-long decline in initial public offerings and the overall drop in the number of U.S. public companies. Mandatory-arbitration supporters say the possibility of class-action lawsuits are a big reason that many companies stay private.
5. What has the SEC chairman said?
Not much. Bloomberg News reported in January that SEC officials had privately signaled it is open to reconsidering its ban on mandatory arbitration clauses. Since then, Clayton has sought to tamp down speculation. He has said he’s “not anxious” to reconsider the ban and called the prospect of arbitration clauses in IPOs a “very complex question.” He has also told lawmakers that if the issue came before the agency -- a company wishing to go public could, for example, file a test case with the SEC in its registration statement -- it would provoke "a great deal of debate.” It also would likely require a vote by the five-member commission made up of Clayton, two Republican commissioners and two Democrats.
6. What do people outside the SEC say?
It depends whom you ask. In October, Treasury Secretary Steven Mnuchin co-authored a report recommending that the SEC weigh a change to its policy because it may “reduce costs of securities litigation for issuers in a way that protects investors’ rights and interests.” On the other hand, U.S. Senator Elizabeth Warren told Clayton in a February hearing that she couldn’t “think of anything that would do more harm to investors.”
7. Has the SEC ever dealt with this?
The commission last considered the issue in 2012 when private-equity giant Carlyle Group LP tried to include a forced arbitration clause in its IPO documents. Pushback came from some lawmakers, such as Democratic Senators Robert Menendez of New Jersey and Richard Blumenthal, and shareholder rights’ advocates, such as the Council of Institutional Investors. Ultimately, the SEC told the firm it wouldn’t sign off if the clause was included. Carlyle ultimately dropped it and raised $671 million that May.
The Reference Shelf
- The SEC’s investor advocate explains why he opposes mandatory arbitration.
- An explanation by one group, Better Markets, which favors tougher regulation of Wall Street, of why it thinks mandatory arbitration is unfair.
- This law professor writes that mandatory arbitration for shareholders "is an idea whose time has come."
- The Consumer Financial Protection Bureaulost its fight to ban mandatory arbitration in financial services.
- Bloomberg QuickTake explainers on the now-recalled CFPB rule barring mandatory arbitration by financial companies and on the drop in the number of companies going public.
- A news story on Carlyle Group’s ill-fated attempt to go public with bylaws banning class-action suits by shareholders.