Mandatory Arbitration and State Competition for Corporate Charters
Mandatory arbitration of shareholder claims is on the horizon. SEC Chair Paul Atkins has led the SEC to change its long-standing policy against mandatory arbitration. Space Exploration Technologies Corp. (“Space X”), a Texas corporation, recently went public with bylaws that conditionally provide for mandatory arbitration of a broad set of shareholder claims. Silicon Valley companies and their lawyers have long sought the ability to mandate arbitration and have been emboldened by their recent success in pressuring Delaware to change its law. We expect that there will be a renewed push to amend the Delaware General Corporation Law and the laws of other states to permit mandatory arbitration of shareholder claims. What are the present opportunities for companies to subject shareholder claims to mandatory arbitration? How will mandatory arbitration affect state competition for corporate charters? How should Delaware respond?
Under the law as it currently stands, no state clearly permits charter or bylaw provisions mandating arbitration and Delaware law clearly prohibits them. This, however, does not mean that corporate claims cannot be subjected to mandatory arbitration. For one, there are strong legal arguments that state laws that permit bylaw provisions that designate the state’s own courts as exclusive fora but do not permit mandatory arbitration provisions violate the Federal Arbitration Act (FAA). Moreover, companies can use contracts to mandate arbitration. In particular, a company can generally contract for mandatory arbitration of claims by the company (including derivative claims by shareholders acting on its behalf). Delaware case law that has interpreted such contractual clauses narrowly or even held them invalid is likely inconsistent with the FAA. In any case, newly enacted DGCL §122(18) likely validates such contracts. Using contracts to subject shareholders’ direct claims to mandatory arbitration, in contrast, is logistically difficult for publicly-traded companies because shareholders who acquire shares in secondary markets are not in privity of contract with the corporation. As a result, the inability to bind shareholders via a bylaw or charter provision imposes a severe constraint for those who want to mandate arbitration of direct claims. With the SEC abandoning its policy against mandatory arbitration and with companies showing interest in such provisions, we think it is only a question of time before some state will clarify its law to permit mandatory arbitration bylaw provisions.
If mandatory arbitration provisions are permitted, will companies embrace them? For corporate decision-makers, mandatory arbitration has advantages as well as disadvantages. The advantages are most pronounced for direct fiduciary duty and securities claims which are typically brought as class actions. Because mandatory arbitration provisions can eliminate class actions and because many direct fiduciary duty and securities claims are not viable without class wide aggregation, mandatory arbitration can undermine the financial viability of such shareholder litigation. In addition, discovery is typically more limited in arbitration, which also tends to disadvantage plaintiffs in fiduciary duty and securities suits. On the other hand, investors may oppose mandatory arbitration and punish companies that adopt it; mandatory arbitration may complicate the comprehensive resolution of disputes; and requiring shareholders to pursue claims individually could increase companies’ litigation costs if shareholder lawyers succeed in bringing direct claims on behalf of multiple individual plaintiffs.
How these considerations will play out is, at this point, unclear. But assuming that, over time, a significant fraction of public companies will be interested in mandatory arbitration, it will have significant effects on state competition. For one, even if other states do not change the manner in which they compete with Delaware (beyond permitting mandatory arbitration), mandatory arbitration will have two effects. First, for companies interested in mandatory arbitration, the comparative attractiveness of Delaware will decline. One of the advantages of incorporating in Delaware is having corporate disputes adjudicated in the highly-regarded Delaware Chancery Court. But for companies that choose to have their disputes resolved through arbitration, this advantage disappears. Second, mandatory arbitration will likely reduce the amount of litigation activity in Delaware and correspondingly the amount of business that Delaware lawyers derive from such activity.
But more concerning for Delaware, mandatory arbitration may affect how other states compete. In particular, mandatory arbitration makes a new competitive strategy viable for other states: offering a similar “product” as Delaware’s for a lower price. As long as this “product” included the Delaware Chancery Court, other states have had a hard time cloning it. But when the product consists mostly of the corporate statute and administrative services, cloning becomes much easier. In other words, the Delaware Chancery Court, with its highly-regarded, expert judges who promptly resolve disputes without juries, constitutes the steepest entry barrier protecting the enormous profits that Delaware derives from incorporations.
Not all states, however, would be well-positioned to compete with Delaware. By incorporating in a state, a company subjects itself to general jurisdiction—it can be sued in the state for any claim, regardless of whether the claim has any relation to the state. The only other state with general jurisdiction is the state in which the company’s principal place of business is located. Being subject to general jurisdiction in more states gives potential plaintiffs more opportunities to engage in forum shopping. Companies should thus think twice before incorporating in a state other than their principal-place-of-business state, especially if that other state offers plaintiff-friendly venues. From this perspective, Delaware is reasonably attractive: it is a small state with comparatively little variation across state judicial districts that can be exploited by plaintiffs and ranks high in legal climate surveys conducted by the Chamber of Commerce. In contrast, Texas, a state that is arguably trying to compete for corporations, is unattractive. Whatever its general pro-business attitude, Texas has districts that are regarded as plaintiff-friendly, ranks in the bottom quintile of the states in the Chamber of Commerce surveys, and is known for Texas-size jury verdicts. Indeed, companies that recently went public as Texas corporations are mostly Texas headquartered and thus already subject to its general jurisdiction. Other small states with high rankings, such as Connecticut and Vermont, would make more formidable competitors for Delaware were they decide to enter the game.
For Delaware, it would have been preferable had the issue of mandatory arbitration of internal corporate claims never gained any traction. Delaware stands to lose a lot if mandatory arbitration becomes common. But for better or worse, the mandatory arbitration genie is out of the bottle. We think Delaware should be pro-active, rather than wait until companies start migrating out or take the risk that DGCL §115, which permits exclusive forum provisions only as long as they include a Delaware forum, is held to be preempted by the FAA. As to the arbitration of securities law claims, Delaware has little to gain from requiring that these disputes be litigated rather than arbitrated and the legal and policy considerations, including whether a bylaw or charter provision is sufficient to bind plaintiffs in these suits, are for Congress and federal courts to decide.
Delaware should go further and permit companies to adopt mandatory arbitration provisions for fiduciary duty claims. But because mandatory arbitration constitutes a fundamental change in shareholder protection, companies should not be able to mandate arbitration without shareholder consent. Mandatory arbitration, after all, was not on the table when most companies incorporated in Delaware. If mandatory arbitration can be adopted by bylaw, directors, the targets of breach of duty claims, could opt into mandatory arbitration without shareholder approval, a substantial unilateral ex post change in shareholder rights. We therefore suggest that, going forward, any type of exclusive forum provision—be it mandatory arbitration or a requirement to sue in Delaware courts—should have to be contained in the charter. We view exclusive Delaware forum provisions as largely beneficial and predict that companies will have little difficulty in obtaining the requisite shareholder consent. As to mandatory arbitration provisions, they should stand or fall based on their ability to obtain shareholder approval. Shareholder approval, of course, will be easy to obtain in companies with controlling shareholders, and our scheme exposes minority shareholders in those companies to the risk of losing effective protection. While true, those shareholders are already at the mercy of their controllers who can easily cause the company to incorporate to a different state with lesser protections, including (soon) to a state that permits mandatory arbitration bylaws.
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