Mandating Arbitration of Securities Class Action Lawsuits: Commonwealth Reit v. Portnoy
Recent decisions out of Delaware have given broad license to companies to adopt bylaws that directly interfere with actions brought by shareholders and other investors. Delaware courts have upheld bylaws that require actions to be filed in that state. The Supreme Court has upheld a bylaw used by a non-stock company that allows a company to shift fees to shareholders in the event the case is dismissed.
Not all of the unfavorable case law, however, has come out of Delaware. Some companies have put in place provisions designed to prohbit class action lawsuits. One method of accomplishing the approach is to require that legal issues be arbitrated on an individual basis. The legality of this type of provision came up in Commonwealth Reit v. Portnoy, Civil Action No. 13-10405-DJC (D. Mass. March 24, 2014).
In that case, plaintiffs challenged the following bylaw:
- Procedures for Arbitration of Disputes. Any disputes, claims or controversies brought by or on behalf of any shareholder of the Trust (which, for purposes of this ARTICLE XVI, shall mean any shareholder of record or any beneficial owner of shares of the Trust, or any former shareholder of record or beneficial owner of shares of the Trust), either on his, her or its own behalf, on behalf of the Trust or on behalf of any series or class of shares of the Trust or shareholders of the Trust against the Trust or any Trustee, officer, manager (including Reit Management & Research LLC or its successor), agent or employee of the Trust, including disputes, claims or controversies relating to the meaning, interpretation, effect, validity, performance or enforcement of the Declaration of Trust or these Bylaws (all of which are referred to as “Disputes”) or relating in any way to such a Dispute or Disputes shall, on the demand of any party to such Dispute, be resolved through binding and final arbitration in accordance with the Commercial Arbitration Rules (the “Rules”) of the American Arbitration Association (“AAA”) then in effect, except as those Rules may be modified in this ARTICLE XVI. For the avoidance of doubt, and not as a limitation, Disputes are intended to include derivative actions against Trustees, officers or managers of the Trust and class actions by shareholders against those individuals or entities and the Trust. For the avoidance of doubt, a Dispute shall include a Dispute made derivatively on behalf of one party against another party.
The provision, therefore, required the arbitration of both derivative suits and class actions. The court found that plaintiffs were barred by res judicata from challenging the provision (courts in Maryland had held that the provision was valid).
Nonetheless, the opinion went on to examine the validity of the ban. The court dismissed the contention that the arbitration bylaw was not "approved" by investors. It was enough that the Trustees had the authority to amend the bylaws. The court likewise found that the plaintiffs had not established that the obligation to arbitrate would "essentially foreclose" the "ability to bring a derivative suit" by making the actions "cost-prohibitive" because of the unavailability of attorneys’ fees.
The court also dismissed a challenge based upon the "policies" of the SEC.
- The Plaintiffs next argue that the Arbitration Bylaw is “contrary to the SEC’s policies underlying federal securities laws,” particularly the anti-waiver provision of Section 29(a) of the Securities Exchange Act, and “frustrates shareholders’ statutory rights to attorneys’ fees and expenses pursuant to the Private Securities Litigation Reform Act of 1995 , 15 U.S.C. § 78u-4(a)(6)” (“PSLRA”). D. 41 at 26. First, the Supreme Court has held that the anti-waiver provision of the Exchange Act does not apply to “procedural provisions,” including compulsory arbitration. Rodriguez de Quijas v. Shearson/Am. Exp., Inc., 490 U.S. 477, 482 (1989). Second, 15 U.S.C. § 78u-4(a)(6) states only that “[t]otal attorneys’ fees and expenses awarded by the court to counsel for the plaintiff class shall not exceed a reasonable percentage of the amount of any damages and prejudgment interest actually paid to the class.” The cited portion of the statute merely caps the amount of attorneys’ fees to which plaintiffs are entitled and does not require that plaintiffs recover attorneys’ fees.
For the most part, these provisions are a matter of state law. Reversing them may require some type of preemption (or, perhaps like broker-dealer arbitration, a grant of authority to the SEC to act if it so decides). In at least one instances, however, the SEC acted, in the context of an IPO, to block this type of provision. See SEC Comment Letter, Carlyle S-1, 2012; see also Carlyle S-1, 2012.
At a minimum, the Commission should not throw up any roadblocks to shareholder proposals in this area. What ever management institutes in an effort to restrict shareholder rights with respect to litigation, shareholders should have equal right to undo it.