Mandatory arbitration's next battleground: Delaware

A Freshfields US LLP partner is challenging the widespread view that a Delaware law passed last year bars mandatory arbitration of securities law claims.

Doru Gavril argued in an article published last week in the Harvard Law School Forum on Corporate Governance that SB 95 does not prohibit arbitration, despite a broad consensus among corporate lawyers, regulators and academics that it does so.

Since the Securities and Exchange Commission said last September that companies may include mandatory arbitration clauses in registration statements, no Delaware corporation has attempted it.

The only company that has done so, Dallas-based Zion Oil and Gas Inc., reincorporated from Delaware to Texas last year, then added a mandatory arbitration provision covering shareholder claims under federal and state securities laws in December.

Space Exploration Corp., which also reincorporated from Delaware to Texas and is gearing up for a major initial public offering next month, is planning to include mandatory arbitration along with a host of other provisions in its offering, according to a report in Reuters.

Gavril, a Redwood City-based securities lawyer, said it is not necessary to reincorporate because the Delaware law is silent on mandatory arbitration.

"There has never been a test of such a provision in federal courts and state courts," he said. "I have a high degree of confidence that [mandatory arbitration] provisions would be upheld."

Securities and Exchange Commission Chair Paul S. Atkins, who voted for a policy statement last September permitting such clauses in corporate registration statements, says the Delaware law prevents companies incorporated there from including them.

"Unfortunately, for public companies that consider mandatory arbitration to be a vital aspect of their dispute resolution strategy, SB 95 has effectively eliminated Delaware as an option for incorporation," he said in a speech last fall.

Gavril's argument is that SB 95 never mentions mandatory arbitration in its amendment of Delaware General Corporation Law, and that any textualist interpretation of the amended statute precludes a prohibition.

"Usually, if you're going to ban something, you're going to call it by name," he added.

He described the prevailing interpretation as self-reinforcing. "Companies were simply giving up because somebody had told them that Delaware prohibits mandatory arbitration," Gavril said.

Alan S. Kaplinsky, senior counsel with Ballard Spahr LLP, wrote in an article that "a strong argument can be made" that the Federal Arbitration Act preempts incompatible laws like Delaware's statutes that preclude contracting parties from controlling which claims are subject to arbitration.

Other legal experts disagree

Atkins and several legal scholars aren't persuaded.

Mohsen Manesh, a professor at the University of Oregon School of Law, said Gavril's argument is "hyper-textual."

He said the law "is a forum-selection statute, and it requires that shareholders be able to bring claims in at least one Delaware court. An exclusive arbitration provision shuts the courthouse doors."

Jill E. Fisch, a professor at the University of Pennsylvania Carey Law School, agreed that most commentary about the amended statute suggests the revised law does not permit mandatory arbitration of securities claims.

Private companies can require mandatory arbitration agreements in a shareholder agreement as a condition of buying stock. "But you can't really do that with a public company," she said.

"Delaware amended its statute specifically to expand its scope to claims that are not defined as internal corporate claims," she said. "The Legislature broadened it to include non-internal claims, which presumably means federal securities claims."

"I think the intent of the statute was to require the plaintiff to sue in a Delaware court," Fisch added.

Carlyle's test, SEC switch

The fight traces back to 2012, when The Carlyle Group Inc. -- then preparing for its IPO -- proposed forcing shareholder disputes into arbitration.

SEC staff objected, signaling the offering could be delayed if the provision remained. Carlyle backed down, effectively establishing an unwritten SEC policy against mandatory arbitration clauses in public-company offerings.

When the SEC changed the policy in September, Atkins - an appointee of President Donald Trump -- said the commission had never made a public statement about mandatory arbitration and concluded that disclosure of the provision is an adequate protection for investors.

Commissioner Caroline A. Crenshaw - the lone Democrat - objected, saying the policy statement was "another way to stack the deck against investors," especially small shareholders in public companies who won't be able to afford expensive legal fights.

"This will, correspondingly, supercharge our descent into a world where investors are unable to effectively vindicate the rights Congress promised them in our nation's securities laws," she added.

A test for Delaware?

Attorneys on both sides of the debate agree that Gavril's view has never been tested in court, and he hopes that a company will include a mandatory arbitration clause in its registration statement - to trigger a legal challenge to settle the issue.

Atkins and other attorneys say companies that want to add arbitration clauses can do so, but only by moving out of Delaware. In his October speech, the Trump appointee said he hopes the Delaware Legislature revisits SB 95.

Delaware legislators, concerned about the trend -- known as DExit -- of companies reincorporating from the state to Texas and Nevada, passed a law limiting access to corporate books and records in support of potential litigation as well as narrowing the definition of who qualifies as a controlling shareholder.

The Delaware Supreme Court upheld the corporate-governance reforms in February and also reversed several Court of Chancery opinions that displeased corporate executives.

Manesh, noting that only Zion Oil and Gas (and possibly SpaceX) have added a mandatory arbitration clause, said actions by Texas corporations don't prove anything about whether Delaware's law permits the provision.

"It's evidence that companies that want arbitration have to leave Delaware to get it," he said.

That's the last thing Delaware, which is dependent on franchise tax revenues as the dominant state where companies incorporate, wants.

Gavril, for his part, does not believe companies need to leave Delaware because he doesn't think SB 95 forbids mandatory arbitration.

But attorneys agreed that one easy fix would be for Delaware legislators to pass a bill clarifying that mandatory arbitration of securities claims is permitted, although such a move would run into opposition from the plaintiff's bar and other shareholder advocates.

While Gavril conceded that his opinion is a minority one, the attorney said his article has prompted plenty of interest.

"You will find people who agree with me six months from now," he said with a chuckle. "That's the thing about being first."

DOJ, SEC focus shift

U.S. Attorney Craig H. Missakian of the Northern District of California and other Trump administration officials in the Justice Department and SEC emphasized in speeches at a Federal Bar Association event in San Francisco last week that their focus will be on pursuing individuals, not corporations.

"This administration came in and took the approach that corporations, as corporations, are not necessarily something to be worried about and shifted the focus away from the entity toward the individual actors in the corporations," he said.

Jason Lee, associate director for enforcement in the SEC's San Francisco regional office, agreed. "The focus is on individual accountability and liability as opposed to just corporate," he said.