SEC Investor Advocate Objects to Mandatory Arbitration of Shareholder Class Actions

SEC Investor Advocate Rick Fleming expressed disapproval of mandatory arbitration provisions that prohibit shareholders from pursuing class actions. These provisions generally require shareholders to pursue claims on an individual basis through arbitration.

In an SEC Speaks program sponsored by the Practising Law Institute, Mr. Fleming responded to several commentators who recommended that U.S. public companies adopt mandatory arbitration provisions in their articles of incorporation or bylaws to avoid the high costs of class action litigation. Mr. Fleming argued that such a view neglects the negative side effects of limiting shareholders’ class actions.

Mr. Fleming asserted that the class action mechanism serves a number of beneficial purposes. These include (i) encouraging private enforcement of the securities laws where the SEC’s resources are limited, (ii) providing a means of redress for all investors, regardless of their holding size, (iii) avoiding collective action problems resulting from the high costs of pursuing securities claims, and (iv) serving as the basis for an extensive body of case law interpreting the federal securities laws. Mr. Fleming stated that arbitration does not offer comparable benefits because it does not effectively handle multiple plaintiffs, avoids public disclosure, does not require written decisions or opinions, renders appeals difficult to pursue, and does not incentivize investors with small holdings.

Mr. Fleming urged the SEC to continue its objection to U.S. IPO issuers that impose mandatory arbitration provisions on the basis of Securities Act Section 14, and Exchange Act Section 29(a), which provide that any condition that forces a person to waive compliance with those laws is void. Mr. Fleming also urged public companies to consider the downside risks of mandatory arbitration provisions.

Lofchie Comment: Notwithstanding Mr. Fleming’s arguments that the market would disfavor mandatory arbitration clauses, it seems quite plausible that the reverse would be true. In any case, academics can see how the stock markets react to the adoption of such provisions by individual companies. The hard question, then, becomes whether there is any public policy reason to disfavor such clauses even if securities holders as a group prefer them.

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