The SEC’s Arbitration Pivot: A Win for Whom?

On September 30, many of you likely read the Wall Street Journal Editorial Board’s opinion piece entitled The SEC’s Class Act on Class Actions.  In it, the Board praised the SEC’s new policy: to not block the effectiveness of proposed registration statements for companies with mandatory arbitration clauses in their bylaws, charters, and/or contractual agreements.  Without an effective registration statement, companies cannot sell their securities in an IPO or secondary offering.

In doing so, the Board took a swipe at securities class actions, characterizing them as leftist efforts to enforce progressive orthodoxy on climate and culture.  It even suggested these suits are partly to blame for the decline in new offerings. Contrary to the opinion piece, most suits don’t involve IPOs or social issues. They allege false financials and other fraudulent acts by companies whose shares have publicly traded for years. We and our clients know, each year US securities class actions recover several billion dollars for defrauded investors. Securities suits are subject to more stringent pleading standards than any others, ensuring frivolous ones don’t proceed. If IPOs are down, it’s for other reasons.

The Board praised the new SEC position for its apparent neutrality on the means for resolving shareholder disputes.  The agency said it would limit review to whether related disclosures were accurate.  However, as billionaire Steth Klarman has observed: “[t]he way to maximize outcome is to focus on the process.”  Mandatory arbitration precludes relief for those who can’t afford this process, primarily small investors who need agency protection the most.

Need proof?  Consider Petróleo Brasileiro S.A., a Brazilian majority state owned multinational corporation whose bylaws mandated arbitration.  In 2014, investors lost billions following a massive corruption scandal.  In 2018, the US class action recovered $3 billion for investors in US traded securities, including those sold in company offerings.  For those who bought common shares, only the largest investors could avail themselves of mandatory arbitration in Brazil.  More than a decade later, they have little prospect for meaningful compensation.

Having read the entire SEC position paper, the agency doesn’t seem fully persuaded by its own legal arguments, which is likely why it truncated the creation and implementation processes and stripped commissioners of their ability to delay effectiveness on these grounds.  At a minimum, the agency recognized there are significant legal questions surrounding the enforceability of these clauses under federal and state laws.  Years of litigation will be needed to resolve them.

In short, this SEC policy change is a very preliminary step in the direction of arbitration.  It remains to be seen whether companies will attempt them, whether market forces will override them, whether clauses can be enforced against federal and state law challenges, whether Congress steps in, and whether there will be policy reversals by subsequent administrations.

In the end, the SEC policy may prove more of a bust than the boon hoped for by the Board.