SEC Shift on Arbitration Sparks Strategies to Counter Its Effect

An SEC policy change enabling companies going public to shunt securities fraud claims into binding arbitration before they’re ever filed in court is already prompting ideas about how to turn the tables to the advantage of investors and their attorneys.

Securities and Exchange Chairman Paul Atkins announced the shift last week, touting it as “eliminating compliance requirements that yield no meaningful investor protections.” Critics promptly decried the potential loss of class actions, calling them a common, cost-effective, and public way to recoup losses and fight fraud.

If there’s a change in access to court, it wouldn’t do away with securities litigation entirely, said investors’ class action lawyer Thomas Laughlin of Scott & Scott Attorneys at Law. Instead, “it would lead to a very messy, very expensive, and very fractured landscape.”

“Large institutional investors who really feel they were victims of securities fraud are probably well positioned to pursue those claims and get redress, even under a mandatory arbitration regime,” said Matthew Close of O’Melveny & Myers LLP.

Initially, plaintiffs’ lawyers will at least be fighting the legality of the provisions, Close said. “In the short term, it’s going to lead to more work” for securities lawyers, “not less.”

And even if courts accept the provisions, those attorneys and their clients may be able to use the new arrangement to their advantage, some attorneys say. One such stratagem could fairly be called flood-the-zone: using mass arbitration to try to create leverage through the volume of arbitrations.

Filing by the Thousands

“There have been plaintiffs’ attorneys who have adopted these really interesting business models to file tens, if not hundreds or thousands, of arbitration cases all at once,” said University of Southern California law professor Adam Zimmerman.

That doesn’t happen more broadly because “the dollar value of an individual claim might not be worth it in certain circumstances,” he said. “But in securities cases, you can imagine that if we started going down the path of arbitration, we might see plaintiffs adopting a mass arbitration approach where they just file thousands of arbitration cases against the same defendant.”

Some arbitration provisions allocate some costs to the defendant, according to Zimmerman and Laughlin.

“The arbitration provisions and rules of the applicable arbitration forum specify who pays for costs and fees,” said Laughlin. Some arbitration provisions provide that the companies pay for the costs because it would otherwise be held unconscionable and therefore unenforceable, he said.

“Now, if a plaintiffs’ attorney files a lot of lawsuits on behalf of smaller investors, simply the cost of paying for all of those individual arbitrations might be so expensive that that itself might be a form of leverage that could be used to extract settlements,” Zimmerman said.

Reputations at Risk

The issue isn’t limited to newly public companies, said Ann Lipton, a professor at University of Colorado Law School. “Nothing stopped any company once they were already publicly traded from adopting that kind of provision, but the SEC wasn’t going to let you go public with it.”

Companies that were already public didn’t bother adopting the provisions because the fraud claims they faced under the Securities Exchange Act were more difficult for plaintiffs to prove than IPO-related claims, so the clauses “weren’t worth the fight” over their legality, she said.

Now there are “two trends to watch,” said Jonathan Polkes of White & Case LLP. One is whether companies just going public will take the SEC up on this new ability, he said. “And if it does become a thing, what about all the legacy companies? Are they going to start trying to take advantage of it? Those are two huge issues that we’re now going to see unfold.”

“I’m going to be looking carefully to see if any companies are really adopting the arbitration provision,” Laughlin said, noting companies will have their reputations to consider.

“You want to be seen as an honest and good company that investors want to buy in,” he said. “That lowers your capital costs, and also potentially leads people to buy your stock.”

‘The Holy Grail’

Still, being able to prevent investors from proceeding as a class could prove a powerful incentive for startups looking to go public.

That’s “the Holy Grail,” Lipton said. The individualized aspect “will kill most claims entirely,” she said.

For plaintiffs’ attorneys who “depend on a rich portfolio of different kinds of class actions, sometimes to cross-subsidize other kinds of class actions, then the loss of the ability to bring securities class actions could be very meaningful,” USC’s Zimmerman said.

The long-term result will depend on legal challenges, said O’Melveny’s Close. If the provisions withstand those challenges and proliferate, “it will shift the relative balance between companies, executives, and directors and officers insurers on the one hand, and the retail investor and plaintiffs’ class action bar on the other.”

But the consequences for plaintiffs’ attorneys depend, in part, on how many companies decide to write in those provisions. Reputational considerations, the need to attract investors, legal hurdles, and potential costs may all weigh against such clauses.