SEC Takes Neutral Stance Towards Mandatory Arbitration Provisions

As part of its campaign to “make IPOs great again,” the U.S. Securities and Exchange Commission (the “SEC” or the “Commission”) has issued a formal policy that adopts a neutral stance on mandatory arbitration provisions for investor claims arising under the federal securities laws (an “issuer-investor mandatory arbitration provision”). The policy states that the presence of such a provision will not affect the SEC staff’s decision as to whether to accelerate the effectiveness of a registration statement under the U.S. Securities Act of 1933 (the “Securities Act”). 

Prior to the adoption of this policy, the SEC staff took a strict “anti-waiver” stance, generally viewing any provision in a contract or agreement that attempted to waive the substantive protections of the federal securities laws as void and unenforceable as a matter of public policy. It was expected that the SEC staff would refuse to accelerate the effectiveness of a registration statement – which would in practice mean the transaction could not proceed – if the issuer had an issuer-investor mandatory arbitration provision in, for example, its articles or certificate of incorporation or bylaws. In one well-publicized 2012 case, an issuer removed the mandatory arbitration clause in its partnership agreement after consultation with the SEC staff, who had made it clear that it would not accelerate the effectiveness of the issuer’s registration statement as long as the mandatory arbitration provision remained in the agreement. 

The new policy notes that in the past, issuer-investor mandatory arbitration were viewed as inconsistent with the federal securities statutes in at least two respects: (1) these provisions could violate the anti-waiver provisions of the federal securities statutes by foreclosing a judicial forum; and (2) they could unduly impede the ability of investors to bring private actions to vindicate their rights under the federal securities laws by foreclosing class action litigation in courts. 

After analyzing recent U.S. court decisions involving the intersection of the Federal Arbitration Act of 1925 (the “FAA”) and other federal statutes, the policy concludes that considerations relating to the federal securities statutes do not override the FAA’s policy favoring enforcement of arbitration agreements, and accordingly the presence of an issuer-investor mandatory arbitration provision should not affect decisions regarding whether to accelerate the effectiveness of a registration statement pursuant to the Securities Act, or even under the U.S. Securities Exchange Act of 1934.

Key to this conclusion is a 2013 Supreme Court case holding that the FAA requires the enforcement of a mandatory arbitration agreement for bilateral arbitration even though the plaintiff’s cost of individually arbitrating the antitrust claims would exceed the potential recovery. This decision, the policy says, has now effectively foreclosed any argument that an arbitration agreement should not be enforced if, by precluding class-action relief, it would eliminate the economic incentive for many victims to seek relief for their private securities law claims. Consequently, as a matter of policy, the potential for an issuer-investor mandatory arbitration provision to diminish or eliminate the economic incentive for bringing private claims under the federal securities laws is not a sufficient basis to conclude that the federal securities statutes displace the FAA’s mandate to enforce arbitration agreements. The SEC staff will still be reviewing, however, whether an issuer has made appropriate disclosure with respect to any issuer-investor mandatory arbitration provisions.

In a separate but related matter, the SEC also voted to amend its rules of practices so that a challenge to the SEC’s staff decision to declare a registration statement effective would not automatically stay the staff’s decision. Prior to this rule change, if a third party requested Commission review of an SEC staff action made pursuant to delegated authority (such as a declaration of effectiveness), the action would be automatically stayed pending Commission consideration. The new amendment to Rule 431 of the SEC’s Rules of Practice adds declarations of effectiveness of registration statements to the list of exceptions to the automatic stay requirement.

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The policy is a major departure from the SEC’s prior enforcement of its “anti-waiver” position and has the potential to significantly disrupt securities class action litigation. 

However, the change does not necessarily mean that many issuers will rush to include issuer-investor mandatory arbitration provisions in their charter documents. First, there may be other legal obstacles to doing so. As the policy notes, Delaware recently amended its General Corporation Law in a way that may prohibit Delaware certificates of incorporation or bylaws from including an issuer-investor mandatory arbitration provision. Second, issuers may choose not to adopt such provisions due to potential negative market reaction. 

We will continue to monitor developments in this area and welcome any queries you may have.