Longstanding decisions of the U.S. Supreme Court coupled with more recent developments in the corporate law of Delaware have sparked renewed concerns that publicly traded corporations may adopt arbitration provisions precluding shareholder lawsuits, particularly securities fraud class actions. In particular, in a line of decisions spanning decades, the U.S. Supreme Court has steadily expanded the reach of the Federal Arbitration Act (“FAA”). Section 2 of that statute mandates
“[a] written provision in any … contract evidencing a transaction involving commerce to settle by arbitration a controversy thereafter arising out of such contract or transaction . . . shall be valid, irrevocable, and enforceable…..”
Applying the FAA, the Court has upheld contractual agreements compelling arbitration of claims made under both the Securities Act of 1933 and the Securities Exchange Act of 1934. Indeed, the Court has gone further, ruling that an agreement to arbitrate is enforceable even when made as part of an unnegotiated contract of adhesion, even if pursuing claims through individualized, bilateral arbitration (rather than in a class proceeding) would make it uneconomical to vindicate those claims, and even if applicable state law would otherwise hold the agreement to arbitrate to be unconscionable.
Meanwhile, at the state level, a pair of recent court decisions in Delaware, the state in which most publicly traded companies are incorporated, have expressly invoked contract law precepts to uphold the use in corporate charters and bylaws of forum selection provisions governing all shareholder litigation. First, in Boilermakers Local 154 Retirement Fund v. Chevron Corp., the Delaware Chancery Court ruled that a forum selection bylaw may validly restrict the forum in which shareholders can bring state corporate law claims. Building on that decision, the Delaware Supreme Court in Salzberg v. Sciabacucchi upheld a corporate charter provision restricting the forum in which shareholders may bring federal securities law claims. Thus, with Boilermakers and Salzberg, Delaware law today provides that the “corporate contract”—comprised of a corporation’s charter and bylaws—may stipulate the forum for all manner of shareholder lawsuits, whether those lawsuits arise under state corporate law or federal securities law.
Taken together, these twin Delaware precedents coupled with the U.S. Supreme Court’s FAA jurisprudence appear to lay the doctrinal foundation to using the corporate contract to waive shareholders’ right to bring class actions by imposing mandatory arbitration for all shareholder claims. After all, as the Court has explained, an arbitration provision is simply “a specialized kind of forum selection clause” and, thus, readily akin to the provisions that Boilermakers and Salzberg validated. And if a corporate charter and bylaws are a “contract” between the corporation and its shareholders, as Boilermakers and Salzberg insist, then the corporate contract, like all contracts, is subject to the federal policy espoused by the FAA.
The widespread use of arbitration provisions in the governing documents of public corporations would have profound implications for shareholder rights. Despite its flaws, representative shareholder litigation can serve vital deterrence and remedial functions in both corporate governance and capital markets. Channeling this litigation into private arbitration that shareholders could only pursue on an individualized basis would largely neuter these functions and, thus, reshape the manner in which public corporations and securities markets operate.
In a forthcoming article, we allay these concerns, explaining that it should be trivially easy for courts to conclude that an arbitration provision set forth in the charter or bylaws of a public corporation is unenforceable against shareholders. This conclusion is true, notwithstanding Salzberg, notwithstanding Boilermakers, and notwithstanding the FAA. Simply put, it is a matter of equity and the integral role that a state plays in chartering corporations.
At root, every corporation is a creation of state law. A corporation’s attributes and, indeed, its very existence are dependent on the corporation law of the state that has chartered it. Thus, over two centuries of American jurisprudence has recognized that where a state grants a corporate charter, the state is a party to the corporate contract that governs the legal relationships between the corporation, its directors, and its shareholders. The state is a party to the corporate contract precisely because the state’s assent was required to bring the corporation into existence. As a party to the corporate contract, the chartering state defines the terms of its assent through the corporate law under which a charter is granted. Consequently, where a chartering state, through its corporate law, has barred the enforcement of an arbitration provision in the governing documents of the state’s corporate creations, there is no agreement to arbitrate. There is no agreement to arbitrate because the chartering state has, through its corporate law, withheld its assent to arbitration.
Applying this analysis to the corporate law of Delaware, a mandatory arbitration provision would be unenforceable in any situation involving public company shareholders. Such a provision would be unenforceable because, under Delaware corporate law, all charter and bylaw provisions must be “twice tested:” once by law and again in equity. Applying this “twice-tested” framework, an arbitration provision precluding securities fraud class actions would be inequitable, even if it were lawful. Such a provision would be inequitable because, among other reasons, it would deny the vast majority of shareholders a remedy for violations of federal law; transfer wealth from smaller shareholders to the largest; insulate managements and boards from accountability in a manner inconsistent with established Delaware precedent; and rupture the balance between federal and state regulation of public corporations. And because Delaware’s assent is necessary for the validity of every provision in every charter or bylaw of every corporation that the state charters, the governing documents of a Delaware corporation cannot compel any form of shareholder arbitration that Delaware law prohibits. The governing documents cannot compel arbitration because Delaware, as a party to the corporate contract, has through its corporate law withheld its consent to arbitration.
Significantly, this analysis applies notwithstanding the preemptive effect of the FAA. As made clear by the U.S. Supreme Court’s arbitration decisions, the FAA preempts any conflicting state laws that would preclude or limit the enforceability of an arbitration agreement. Mindful of these decisions, prior scholarship has attempted to place state corporate law outside of the preemptive reach of the FAA by reasoning that a corporation’s governing documents are fundamentally different than an ordinary commercial agreement and, therefore, a corporation’s charter and bylaws are not a “contract” within the meaning of the FAA. Such reasoning, however, has been substantially undercut by decisions like Salzberg and Boilermakers.
By contrast, the analysis laid out in our Article is fundamentally different than prior scholarship. Rather than denying the contractual nature of a corporation’s governing documents, we accept what the corporate case law has unequivocally said: A corporation’s charter and bylaws are a binding contract between the corporation and its shareholders. Yet, by broadening the aperture to reveal the integral role of the chartering state, we demonstrate that a state corporate law rule barring shareholder arbitration is not preempted by the FAA.
Such a state law rule would not run afoul of the FAA because the FAA applies only where there is an agreement to arbitrate. Where there is no such agreement—where an integral contract party has withheld its consent to arbitration—the FAA never enters the picture. As applied to the corporate contract, where the chartering state has through its corporate law withheld its consent to arbitration, there is no agreement to arbitrate. To interpret the FAA any differently would be to coerce state assent to shareholder arbitration where the state has in fact objected to it. It would compel a state to grant corporate charters on terms to which the state has not consented. “Arbitration … is a matter of consent, not coercion,” and in the context of the corporate contract that principle is no different.
We elaborate on all of these points in the full Article, which is available here.