Many corporations’ bylaws mention arbitration in one or more ways.
Most commonly, they include arbitrations in the definition or category of the personal-liability-generating “proceedings” that might entitle directors or officers to indemnification.
Second, some bylaws offer directors and officers the option of arbitration to determine their eligibility for indemnification in certain circumstances.
Third, directors and officers contesting the board’s denial of indemnification might be allowed to arbitrate their claim.
Fourth, some bylaws allow, or require, disputes over the value of the stock held a by departing shareholder to be submitted to arbitration.
But there is little caselaw on whether bylaws can require shareholders to submit to arbitration claims or other complaints against the company (and/or against one or more of its agents), instead of filing an action in a state or federal court. Nor does this issue appear to have been addressed specifically by the policies published by many leading institutional investors and proxy advisors.
The Model Business Corporation Act’s 2.08(c), added in 2016, states that “No provision of the articles of incorporation or the bylaws may prohibit bringing an internal corporate claim in the courts of this state or require such claims to be determined by arbitration.” But no similar prohibition exists in the Delaware General Corporation Law (DGCL).
Although both CalPERs’ Governance & Sustainability Principles (Sept. 2019) and the Council of Institutional Investors’ Corporate Governance Policies (Sept. 22, 2020) advise companies not to “attempt to bar shareholders from the courts through the introduction of forced arbitration clauses,” such policies, unlike forum selection or fee-shifting provisions, are not mostly installed unilaterally by, or at the recommendation of, or even championed by, directors.
In fact, shareholder-initiated proposals for such bylaw provisions have been the subject of SEC No-Action Letters; the few state and federal court decisions appear to address, usually in specialized situations, director-initiated bylaws.
● The SEC’s Stance on Exclusion of Shareholder Proposals of Arbitration
At least as far back as 2013, pro-shareholder commentators suggested that “courts would uphold a by-law amendment that requires individual arbitration in place of securities class actions[, which] provide little meaningful compensation to institutional or individual stockholders, and instead primarily benefit plaintiffs’ attorneys who recover up to 35% of a settlement value in contingency fees; they do little to deter wrongdoing, as the actual wrongdoers are rarely held personally responsible for losses; and finally, . . . have a major negative impact on the competitiveness of the U.S. capital markets.” Hal S. Scott & Leslie N. Silverman, Stockholder Adoption of Mandatory Individual Arbitration for Stockholder Disputes, 36 Harv. J.L. & Pub. Pol’y 1187, 1226 (2013).
However, in 2012, the Securities and Exchange Commission’s Division of Corporation Finance permitted the board of Pfizer, under Rule 14a-8(i)(2) (17 C.F.R. § 240.14a-8(i)(2)), to exclude from proxy materials a shareholder proposal for a bylaw provision requiring most direct and derivative claims against the company or its agents to be submitted for arbitration in New York.
The SEC agreed with the company that the proposal would violate existing securities laws, namely, Section 29 of the Securities Exchange Act of 1934, which invalidates “[a]ny condition, stipulation, or provision binding any person to waive compliance with any provision of this title or of any rule or regulation thereunder, or of any rule of an exchange required thereby shall be void.” SEC No-Action Letter, Pfizer, Inc., 2012 WL 587597 (Feb. 22, 2012).
Pfizer had argued that the bylaw’s restriction that “No controversy or claim subject to arbitration under this Article may be brought in a representative capacity on behalf of a class of stockholders or former stockholders” would impermissibly waive shareholders’ right to bring claims under the Act’s Section 10(b) and Rule 10b-5.
Seven years later, the SEC declined to opine on whether Rule 14a-8(i)(2) would exclude from New Jersey-incorporated Johnson & Johnson’s proxy materials a shareholder proposal to require arbitration of claims under federal securities laws: the agency noted that “the Attorney General of the State of New Jersey has indicated that taking the actions requested by the Proposal would be illegal as a matter of New Jersey law.” SEC, No-Action Letter, Johnson & Johnson, 2019 WL 4306292 (Feb. 18, 2019).
Concurrently, SEC Chairman Jay Clayton issued a “Statement on Shareholder Proposals Seeking to Require Mandatory Arbitration Bylaw Provisions,” characterizing attempts to compel arbitration of securities claims as “a complex matter that requires careful consideration.” Without naming Johnson & Johnson, but clearly referring to the agency’s disposition of its request, he observed that:
“The staff of the Division of Corporation Finance explicitly noted that it was not expressing a view as to whether the proposal, if implemented, would cause the company to violate federal law. Since 2012, when this issue was last presented to staff in the Division of Corporation Finance in the context of a shareholder proposal, federal case law regarding mandatory arbitration has continued to evolve.
“Further, I am not aware of any circumstances where the Commission has weighed in on the legality of mandatory shareholder arbitration in the context of federal securities law.
“In light of the unsettled and complex nature of this issue, as well as its importance, I agree with the approach taken by the staff to not address the legality of mandatory shareholder arbitration in the context of federal securities laws in this matter, and would expect our staff to take a similar approach if the issue were to arise again. I continue to believe that any SEC policy decision on this subject should be made by the Commission in a measured and deliberative manner.”
● State Court Decisions
In Elf Atochem North America, Inc. v. Jaffari, 727 A.2d 286, 288 (Del. 1999), the Delaware Supreme Court found enforceable an LLC’s operating agreement provision that “any controversy or dispute arising out of this Agreement, the interpretation of any of the provisions hereof, or the action or inaction of any Member or Manager hereunder shall be submitted to arbitration in San Francisco, California….”
The Court rejected the argument that the Delaware Limited Liability Company Act “affords the Court of Chancery ‘special’ jurisdiction to adjudicate its claims, notwithstanding a clear contractual agreement to the contrary,” especially “because the policy of the Act is to give the maximum effect to the principle of freedom of contract and to the enforceability of LLC agreements,” and also because of “the fact that Delaware recognizes a strong public policy in favor of arbitration.” Id. at 295.
Arbitration bylaws were similarly upheld in In Corvex Management L.P. v. Commonwealth REIT, 2013 WL 1915769 (Md.Cir.Ct.), after the court observed that “both state and federal law cast a favorable light on arbitration” and that “Plaintiffs clearly had constructive knowledge — and, in fact, actual knowledge — that they were party to the arbitration agreement written into [the] Bylaws.”
Not only was the provision’s language “straightforward and unambiguous,” but each share certificate bore a legend indicating that it was “subject to all of the provisions of the Declaration of Trust and Bylaws of the Trust and any amendments thereto. The holder of this Certificate and every transferee or assignee hereof by accepting or holding the same agrees to be bound by all of the provisions of the Declaration of Trust and Bylaws of the Trust, as amended from time to time.”
Finally, the relevant Maryland statute allowed a real estate investment trust “to … [m]ake and alter bylaws not inconsistent with law or with its declaration of trust to regulate the government of the real estate investment trust and the administration of its affairs.”
● Federal Court Decisions
Although the District Court for the Southern District of New York did not directly address corporate bylaws, in In re Salomon Inc. Shareholders’ Derivative Litigation, 1994 WL 533595 (S.D.N.Y.) at *5, it held that derivative lawsuits against Salomon Brothers and individual defendants were properly arbitrable, because the company, as member of the NYSE, and its executives were bound by the NYSE Constitution’s arbitration requirement:
“Although the Court harbors considerable doubt as to the suitability of arbitration for the claims in shareholders’ derivative actions, . . . it is bound by the decisions of the Supreme Court and must heed its words: “[A]ny doubt concerning the scope of arbitrable issues should be resolved in favor of arbitration.” Id. at *8, citing Moses H. Cone Memorial Hosp. v. Mercury Constr. Corp., 460 U.S. 1, 24-25 (1983).
The Third Circuit, in Kirleis v. Dickie, McCamey & Chilcote, P.C., 560 F.3d 156, 158 (3rd Cir. 2009), decided “a question of first impression under Pennsylvania law: whether a shareholder/director may be compelled to arbitrate her civil rights claims pursuant to corporate bylaws to which she has not explicitly assented.”
The defendant law firm did not dispute that one of its lawyers, Alyson J. Kirleis, had not seen its bylaws before she sued the firm in federal court for alleged sex discrimination, retaliation, and a hostile work environment, or that she had never signed any document that had referred to or incorporated the arbitration provision.
However, the firm argued that, by accepting compensation and other benefits governed by its bylaws, and by holding “various management positions” at the firm, she had had “constructive knowledge” of this restriction. Id. at 159-160.
Acknowledging “the tension between corporate law principles—which generally impute to members of the corporation knowledge and acceptance of corporate bylaws—and the law of contracts, which requires consent to be bound,” id. at 162-163, the court, applying Pennsylvania state precedent, rejected the implicit agreement argument. “Pennsylvania law requires arbitration agreements to be expliclt,” id. at 164; but “Kirleis never received a copy of the only document containing the firm’s arbitration provision. Without this document, Kirleis could not have explicitly agreed to arbitrate her claims.” Id. at 165.
However, five years later, the District Court for the District of Massachusetts, in Delaware County Employees Retirement Fund v. Portnoy, 2014 WL 1271528 (D. Mass.) at *11, found that “whatever persuasive value Kirleis may have had is certainly curtailed by the Third Circuit’s subsequent recognition in Century Indemnity Co. v. Lloyd’s, 584 F.3d 513, 531-32 (3d Cir. 2009), that, under the [Federal Arbitration Act, 9 U.S.C. §§1 et seq.] and Supreme Court precedent, it could not require arbitration agreements to be ‘express’ and ‘unequivocal’ to be enforced because to do so would ‘impermissibly … require more of arbitration agreements than of contracts generally to be enforced whenever the standard differed from the applicable state-law principles of contract law.’”
The Portnoy court held that where “the stock certificates specifically notify shareholders that they would be bound by the provisions of the Declaration and Bylaws, including Bylaw amendments, . . . and the bylaws were publicly available,” id. at *12, even shareholders who had purchased shares before the board had added the arbitration provision to the bylaws were constructively bound by it.