SEC Reverses Stance, Allows Companies To Mandate Arbitration For Investor Claims

Last week, the Securities and Exchange Commission (SEC) issued a new policy statement allowing companies to include in their organizational documents arbitration provisions that would require investor claims arising under the federal securities laws to be resolved in arbitration rather than in court. Under the new policy statement, the SEC stated that the inclusion of such provisions will not impede a request by an issuer to accelerate the effective date of its registration statement. The policy statement reversed the SEC's previous position that it would not accelerate the effectiveness of a company's registration statement if it contained such a mandatory arbitration provision. The SEC's green light for companies to mandate arbitration of fraud and other investor claims could potentially eliminate many investor class actions.

Overview of the Policy Statement

The SEC explained that a registration statement for a newly issued security must be declared effective before an issuer may sell the securities covered by the registration statement, and the SEC will accelerate the effectiveness of a registration statement if it meets certain criteria. In particular, the SEC focuses on whether the registration statement completely and adequately discloses material information and considers the "public interest and the protection of investors."

Previously, the SEC had taken the view that the Federal Arbitration Act (FAA) was inconsistent with the federal securities statutes for the following two reasons: (i) mandatory arbitration provisions could violate the anti-waiver provisions of the federal securities statutes by foreclosing a judicial forum; and (ii) mandatory arbitration provisions would foreclose class action litigation in courts, and therefore impede investors' ability to bring private actions. For these reasons, the SEC had followed an unwritten policy of not accelerating effectiveness of registration statements for companies with mandatory arbitration provisions.

In announcing the new policy, SEC Chairman Paul Atkins said that the purpose of the new policy statement was to correct "the Commission's lack of a recent public position on this important topic" to promote "disclosure and transparency." Chairman Atkins continued that "based on the U.S. Supreme Court's current interpretation and application of the FAA, the existence of such [mandatory arbitration] provision[s] will not impact determinations whether to accelerate the effective date of a registration statement."

Specifically, the SEC concluded that "the Federal securities statutes do not override the Arbitration Act's policy favoring enforcement of agreements." It found that there was no basis to conclude that either the anti-waiver provisions or any other provision of the federal securities statutes displace the FAA in the context of mandatory arbitration agreements. The SEC cited two U.S. Supreme Court decisions from the 1980s that found arbitration provisions in cases involving the federal securities statutes enforceable, overruling precedent. In Shearson/American Express, Inc. v. McMahon, 482 U.S. 220 (1987), the Court concluded that the anti-waiver provision in the Securities Exchange Act of 1934 did not preclude enforcement of an arbitration agreement between a broker-dealer and its customer. The Court reached the same conclusion in Rodriguez de Quijas v. Shearson/American Express, Inc., 490 U.S. 477 (1989) with respect to anti-waiver provisions in the Securities Act of 1933. And more recently, in Epic Systems Corp. v. Lewis, 584 U.S. 497, 508 (2018), the Court held that for any federal statute enacted after the FAA, there must be a "clearly expressed congressional intention" to override the act. In other words, there is a "strong presumption" that the FAA applies exclusively to the enforceability of an arbitration agreement when Congress does not displace the FAA using unambiguous statutory language. As such, the SEC stated, "we can discern nothing in the Federal securities statutes that demonstrates a clear and manifest congressional intention to displace the FAA in the context of issuer-investor mandatory arbitration agreements."

Further, the SEC stated that although mandatory arbitration provisions "could unduly impede the ability of investors to bring private actions to enforce Federal securities laws," this was not a basis to override the FAA. The SEC concluded that "no provision in the Federal securities statutes 'guarantee[s] an affordable procedural path to the vindication of every claim.'" Citing American Express Co. v. Italian Colors Restaurant, 570 U.S. 228 (2013).

Potential Implications

The SEC's policy statement may threaten investor class actions, the most common way that investors pursue claims under the federal securities statutes. The U.S. Supreme Court has held on multiple occasions that arbitration provisions requiring individual (non-class) resolution of disputes are valid and enforceable under the FAA and preempt inconsistent state law. See Lamps Plus v. Varela, 139 S. Ct. 1407 (2019); AT&T Mobility LLC v. Concepcion, 563 U.S. 333 (2011). Investors who cannot proceed as a class will face new considerations in deciding whether to bring a claim. As the SEC recognized in its policy statement, mandatory arbitration provisions "would likely impact the cost of resolving future investor claims."

Although the new policy statement provides significant potential upside for companies pursuing Initial Public Offerings (IPOs), there also are practical considerations and risks associated with embracing a mandatory arbitration provision. The SEC cautioned that "we do not consider it within the Commission's purview to conclude whether any particular issuer-investor mandatory arbitration provision is enforceable for purposes of the FAA." Instead, the SEC will focus on whether there has been a "complete and adequate disclosure of material information" about the arbitration provision in the registration statement. Issuers that include mandatory arbitration provisions in their charters should expect SEC comments on the registration statement disclosure. Moreover, it is unknown whether large underwriters and institutional investors will accept the inclusion of an arbitration provision. Underwriters and institutional investors play a large role in shaping the governance of an IPO company to ensure that the company is attractive in the public markets. These institutional investors are the companies that often serve as named plaintiffs in securities class actions, and they may be less likely to make a substantial investment in a company that requires mandatory arbitration. Likewise, it remains to be seen whether the stock exchanges or proxy advisory firms will take positions on mandatory arbitration provisions that will impact their potential adoption.

State law also plays an important role in this analysis and creates further uncertainty. As the SEC acknowledged in its statement, Delaware recently amended Section 115(c) of its General Corporation Law in a way that may prohibit certificates of incorporation or bylaws from including an issuer-investor mandatory arbitration provision. It is an open question whether the FAA might preempt Delaware's law, or similar laws that other states may adopt, and the SEC declined to weigh in on the questions regarding the FAA's preemption of state law. The corporate laws of other states–such as Nevada Revised Statutes section 78.046 and Texas Business Organizations Code sections 2.115 and 1.002(36-a)–do not expressly address the validity of mandatory arbitration provisions for securities laws or other "non-internal" claims. This uncertainty leaves companies that incorporate mandatory arbitration clauses in their organizational documents vulnerable to challenges under state law.

The SEC noted that the new policy statement may not be limited to registration statements filed under the Securities Act. For companies whose stock is already trading, it might be possible for a company to amend its bylaws or corporate charter through a shareholder vote to adopt an issuer-investor mandatory arbitration provision. This remains an open question based on state law and constitutional considerations.

There are many unanswered questions about what the new SEC policy statement will mean for IPO companies, existing public companies, and investors. It may be that Special Purpose Acquisition Companies (SPACs) or de-SPAC companies and companies involved in crypto offerings will be among the first to take advantage of this new guidance and provide a test case for how investors will respond. And if they are successful, we may see larger companies adopt mandatory arbitration provisions in registration statements or even established public companies attempt to amend their organizational documents.

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