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Mar 06, 2018

SEC’s Jackson warns about mandatory arb in IPOs

Issue must be debated and decided openly, commissioner argues

A top securities regular has warned against allowing companies that are going public to use the process to force shareholders to resolve any complaints they have outside the courts.

SEC member Robert Jackson in a recent speech responded to a report that the securities industry is looking to include mandatory arbitration clauses in an initial public offering (IPO). ‘The idea is that our division of corporation finance will be forced to approve the IPO, stripping shareholders of their right to their day in court – and radically altering the balance between shareholders and corporate insiders,’ he says in prepared remarks.

‘I’ve expressed a great deal of skepticism about proposals like these in the past; as I told the Senate in October, I do not have the sense that what we have in corporate America today is too much accountability,’ he says.

‘I think we can all agree that the way to decide this isn’t through a clandestine effort by corporate lobbyists,’ Jackson adds. ‘Whatever the SEC decides, we should do it only through a careful, public rulemaking process. In short: if we’re going to take away investors’ right to their day in court, I hope my colleagues on the commission can agree that we should, at least, do so in the light of day.’

Financial institutions and public companies in other industries have long supported the use of mandatory arbitration clauses in their contracts with clients. They argue that resolving disputes without going to court is cheaper, more efficient and avoids what they see as frivolous lawsuits.

Critics counter that forcing clients to pursue claims via a non-public forum deprives clients of certain legal rights – such as to band together with other clients (or shareholders, in a post-IPO scenario) – and is fundamentally less fair.

In his remarks, Jackson argues that it is necessary to allow clients to bring lawsuits because the US Supreme Court holds that ‘policing corporate wrongdoing is a team effort – the government and investors working together to make sure insiders who betray investors are held to account.’

This is apparent in the area of shareholder recovery of losses from fraud where, in 2016, roughly 60 cents of every dollar returned to investors in corporate fraud cases came through private rather than SEC settlements, according to Jackson.

‘Shareholder suits also help us at the SEC identify and address corporate wrongdoing,’ he says. ‘In fact, in important empirical work scholars have observed that investor lawsuits are as good, if not better, than the government in targeting certain securities-law violations.’

Jackson adds that the role of lawsuits is particularly important at a time when ‘[o]ur enforcement efforts are straining against the limits of the SEC’s resources’, and recent judicial developments have made ‘the job of our enforcement staff harder than ever before.’

A time when SEC enforcement is ‘hamstrung by budgetary and legal limits is hardly the time to be thinking about depriving shareholders of their day in court,’ he says, adding that a public hearing enables judges to tell corporate insiders what is expected of them under the law.

Jackson spoke days after SEC investor advocate Rick Fleming raised similar concerns. In comments at an SEC-focused conference, Fleming also notes suggestions that IPO issuers should consider including arbitration provisions in their articles or bylaws. He acknowledges the criticisms of class action lawsuits but argues that ‘stripping away the right of shareholders to bring a class action lawsuit seems to me draconian and, with respect to promoting capital formation, counterproductive.’

In practice, investors with small holdings are unlikely to be able to bring a complaint unless they can do so as part of a class, he notes. ‘Cases involving accounting irregularities or other corporate misdeeds are usually far more complex than the typical dispute involving a consumer contract, or even a dispute against a broker or investment adviser that involves the investor’s personal account,’ he says.

‘For individual investors who suffer losses in a widespread fraud, the costs of bringing claims individually in arbitration may well exceed the amount of the likely recovery. And, unless their losses are sizable, victims will struggle to find attorneys to represent them, much less experts to establish elements such as materiality, reliance, loss causation and damages.’

Fleming notes that investors have urged index providers to drop from their coverage companies that go public with non-voting shares. ‘If a company strips away the ability of investors to seek class actions, investors could go down that same road and ask the index providers to keep the company off the index,’ he says. ‘Before long, if the SEC fails to act, the index providers could step into that vacuum and become the de facto regulators of corporate governance in this country.’