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In a comprehensive letter to Congresswoman Carolyn Maloney (D-NY) obtained by Yahoo Finance, SEC Chair Jay Clayton gave shareholder advocates causes for both relief and concern about whether the agency will make it harder for investors to sue public companies.
Clayton clarified how the agency would handle whether corporations would be allowed to IPO with arbitration clauses preventing shareholders from suing the company in court — long considered a standard part of shareholder rights.
In the letter, Clayton notes that both he and the SEC’s Division of Corporate Finance believe that the decision about whether a public company can prevent its shareholders from suing in the case of fraud should be decided by the full Commission “in a measured and deliberative manner,” instead of just by the Division of Corporate Finance or another party.
Clayton stressed multiple times that “this issue is not a priority for me,” but laid out how the issue would come up.
“If we are presented with this issue in the context of a registered IPO of a US company, I would expect that any decision would involve Commission action (and not be made through delegated authority) and that the Commission would give the issue full consideration in a measured and deliberative manner. Such a review would take into account various considerations, including developments in applicable law and any other relevant considerations.”
In July, SEC Commissioner Michael Piwowar encouraged companies to “ask us for relief to put in mandatory arbitration into their charter,” as it would prompt a review.
In her letter to Clayton, Rep. Maloney had echoed the concerns of shareholder and consumer advocates that the decision would be made by delegated officials in a less-than-public and open forum, and that a decision to allow forced arbitration would be bad.
Maloney told Yahoo Finance she was pleased that Clayton wrote a detailed response, but was still “very disappointed that he has not committed to opposing the use of forced arbitration should it come up for a Commission vote.”
“Allowing companies to use forced arbitration clauses would devastate investor confidence in our markets, and would prevent shareholders from holding the next Enron or WorldCom accountable in court,” she told Yahoo Finance in a statement.
Some consumer and shareholder advocates, however, see a silver lining in Clayton’s comments.
“From the process perspective, it’s extremely good news,” said F. Paul Bland, executive director at Public Justice. Shareholder and consumer advocates, Bland said, had been concerned the issue may have been decided by “staff in the night.”
“After getting the Maloney letter he has committed to a public process. I think that is really good news,” he said.
Despite the commitment to the public process, Clayton offered no further insight into his views on allowing forced arbitration clauses for IPOs, reiterating that it’s up for debate.
“I have not formed a definitive view on whether or not mandatory arbitration for shareholder disputes is appropriate in the context of an IPO for a U.S. company,” Clayton wrote.
Traditionally, the SEC has not permitted forced arbitration clauses in IPOs, citing the Securities and Exchange Act of 1934. When the Carlyle group attempted to put one in 2012, the company found itself faced with a public relations battle and a questioning SEC and decided to drop the clause.
Attempts have also been made to enact forced arbitration clauses for shareholders after IPOs. In 2012, the SEC told Gannett Co. that there is “some basis” that its forced arbitration proposal violates securities laws, and to remove the proposal.
Still, nothing has explicitly barred forced arbitration provisions from IPOs, Clayton wrote.
“State laws generally provide the parameters for companies to establish their corporate governance through their organizational documents,” he wrote.
Many experts agree with him, even ones who do not like forced arbitration for shareholders.
“It’s a question of state law,” said Edward Rock, the director of NYU Law School’s Institute for Corporate Governance and Finance. “The SEC should not get involved and it’s not an appropriate issue for them to get involved with.”
In Rock’s view, the SEC’s mode of regulation is disclosure, not making substantive regulations. Those should be done by states like Delaware, where many large corporations are domiciled, to make laws.
Dual-class stock and SNAP
Shareholder rights have been a contested area over the past few years due to multi-class stocks, often from tech companies, designed to insulate corporations from the short-term minds of shareholders. The issue hit a head in 2017 when Snap (SNAP) IPOed without offering voting stock, which led to outcry from investors and hurt the company’s chances of being listed on indexes.
“With Snap, there was huge pushback, and it hasn’t done very well, which will make subsequent unicorns cautious about adopting that extreme dual-class structure,” Rock said. “Now the debate has shifted away from dual-class to whether we should prohibit them to list on exchanges or what sorts of limits on dual structures both allow founders and insiders a period of time.”
Rock noted that in the past there’s been pressure from the Council of Institutional Investors to exclude dual-class stocks from indexes but even that has moderated, with BlackRock saying last week to let them in so investors aren’t left out.
But this could be different when the right to sue in a court is on the table, not just the right to vote on company matters.
Institutional investors will be a factor
In a recent letter from the Council of Institutional Investors to the SEC, the Council’s general counsel denounced forced arbitration for shareholders: “our membership strongly opposes the introduction of forced arbitration clauses between U.S. public companies and investors.”
The Council’s letter highlights the headwinds that a company would face should it move forward with an arbitration agreement. But the question of why could come up too, as Bland noted.
“I believe any corporation who is considering an IPO or other securities document that would ban investors from bringing class action runs an enormous reputational risk,” he said. “If a company takes that step, what their communicating with investors is: ‘we think we can take away your rights if we lie or defraud you.’ And I suspect that if investors understand that’s what companies are saying, that will harm the company substantially.”