Mediation and the SEC

The SEC had to do a bit of fire-fighting in late spring as a Wall Street Journal story smoked out the topic of arbitration as a possible alternative to what now is often very expensive litigation – the strike suit, or class action lawsuit – usually brought claiming fraud on the market.

SEC chairman Christopher Cox confirmed his staff are looking at the possibility of allowing companies to seek shareholder agreement to the alternative settlement process. But he subsequently said this was only in the context of looking at everything that is suggested in terms of improving markets.

The Journal story had implied a higher level of interest in the idea, which was first bruited by the Committee on Capital Markets Regulation, co-chaired by former White House economic adviser Glenn Hubbard and former Goldman Sachs president John Thornton. One of three groups that looked at US competitiveness in the past year, the committee urged the SEC in a November 2006 report to let companies have the opportunity to give investors alternatives to litigation. Arbitration is one of the possible alternatives put forward.

By the end of April, the topic was receiving much wider media attention. Critics and supporters reacted quickly after the press noticed the concept was on the commission’s study list for the coming months. The most vociferous response came from Barney Frank, the Democratic congressman from Massachusetts who is also chairman of the House Financial Services Committee. His committee has responsibility for overseeing the work of the SEC and Frank has not been shy about saying he thinks there has been too much SEC deference to corporations.

On April 25, he launched a broadside on the matter of arbitration. In a letter addressed to Cox, Frank said he is completely against any mandatory arbitration being approved for companies’ dealings with shareholders. And, he said, ‘even voluntary adoption should not be permitted without vigorous open consideration and debate on the impact of such a change on our public securities market.’ He went on to say that Congress should be part of that debate.

Frank subsequently made good on that contention by announcing two weeks later that hearings would be held in June to look into a variety of SEC actions which imply that the commission may be favoring companies over investors. A Bloomberg report said Frank cited complaints that the enforcement division was being muzzled and – in apparent reference to the arbitration issue – that the commission may make it harder for investors to sue companies.

Cox responds to Frank’s concerns by highlighting that any new rules adopted by the SEC will not be mandatory. Rather, if discussion were to lead to action, the idea of arbitration would merely be an option. And, at that, subject to shareholder vote.

The idea of arbitration is generating considerable interest on all sides of business. In May, state attorneys general Marc Dann of Ohio and Mark Shurtleff of Utah, issued a joint letter, addressed to Frank and senators Christopher Dodd (D-Conn) and Richard Shelby (R-Alabama), commending the House decision to hold a hearing and asked that the Senate do the same. The letter cites the arbitration idea as one of several troubling aspects of planned SEC activities. The joint letter urges the Senate to hold hearings similar to those Frank is planning. They say proposals for regulatory and legislative reforms would bring sweeping changes.

Alleged anti-shareholder bias

The letter states: ‘While the SEC has not endorsed all of those proposals, the Commission’s actions and inactions regarding the way that (the Sarbanes-Oxley Act) and other securities laws are implemented is cause for alarm.’

By the middle of May, Cox was forced to give more assurances. Called to testify during a hearing in the Senate which was reviewing SEC budgetary matters, the chairman took a question on the arbitration matter from Senator Richard Durbin (D-Illinois), who questioned Cox about the commission’s intention in relation to limiting the rights of shareholders to seek legal redress in court.

‘There is no pending rule or proposal before the SEC to allow corporations to mandate arbitration of shareholder claims,’ Cox replied. Strictly speaking, that was true. However, talking with reporters after the hearing about the various competitiveness panels’ recommendations, he expanded: ‘We will undoubtedly become interested in some of them and not interested in others. But it is our responsibility to consider all of them.’

That of course meant the arbitration idea, part of what one SEC source says was a laundry list from the competitiveness groups, was still alive.

Proxy access – a catch-all solution

One reason the topic is attracting so much interest is because it has come up in the context of new proxy access rules. Washington observers say there is some hope at the SEC that a large number of matters can be dealt with under the proxy access discussion umbrella, hopefully balancing the competing interests of those who want less regulation with those who don’t want to see a weakening of oversight authority.

A series of proxy access roundtables – three in all – were scheduled by the commission to take place in May and June, with agenda items listed ahead of time. As the arbitration matter created its flurry of interest, the last of the agendas appeared. Arbitration was noticeably absent from the topic list.

There are some strong pro-ponents of arbitration. At the Manhattan Institute, Jim Copland who heads its Center for Legal Policy, has called the idea one that makes complete sense and one which may very well endow companies offering arbitration a premium in their stock price. Copland says the problem of securities litigation in the US is often cited by executives who would prefer an offshore listing. Equally, a number of non-US companies see so-called ‘strike’ suits as a reason not to list their shares in this country.

At one Fortune 50 company, where the legal expert consulted did not want to be quoted by name, the issue was seen as a bit obscure and not really on the radar for most corporations. ‘I can’t imagine this could happen,’ he says, adding ‘obviously corporations are more than happy to enter into a process that can save on costs.’

A more flexible solution

‘You need to note that at least in theory, the architecture of arbitration is totally negotiable,’ he observes. ‘You can negotiate or not. Often times you can have a very detailed arbitration provision which can be finely crafted. That makes arbitration very different from litigation, which can be a real runaway train.’

Margaret (Peggy) Foran, corporate secretary and vice president for governance at Pfizer and a lawyer herself, says that litigation is not always the most attractive solution. ‘I tend to be in favor of arbitration. You know shareholder suits can get very costly,’ Foran says. ‘At the end of the day shareholders don’t get much and I don’t think that’s fair. I always think arbitration is a good thing.’

A number of legal scholars see the matter in a larger context, that of how laws in America are defined by the courts. Their complaint is that the system of case law, where courts make decisions which help define the law, is slowly ebbing. In its place, out- of-court settlements and arbitration are among a growing number of non-jury means for settlement that increasingly are seen as a corrosive factor.

Many, if not most of these alternative dispute resolutions, as they are called, are not publicized. Indeed, the parties usually require silence on the outcomes. Without wide disclosure of what comprises the best course of action under the law, the scholars contend, there is an erosion of common law.

Part of the reason this issue is attracting so much attention is the extent of the impact it could have. It goes beyond the place of the SEC in disputes between shareholders and companies. Literally billions of dollars are at stake for corporate America, as any company hit by a so-called strike suit can attest. In 2006, there were eight settlements of shareholder lawsuits which exceeded $10 billion each. Obviously it follows that litigation and outside defense lawyers stand to lose millions if arbitration becomes standard practice.

A shrinking problem?

Oddly, all this focus on arbitration has come just as the total number of class action securities lawsuits has taken a sharp turn downward. In 2006, according to Cornerstone Research, the number of suits filed dropped to 110 from 178 the year before and were 43 percent below the ten-year average rate.

Still, the impact of shareholder disputes on corporate America is huge. The loss in market capitalization for companies hit with this type of litigation in 2006, according to Cornerstone, was $42 billion, excluding those firms involved in the options backdating scandal.

While larger organizations will usually have the resources to handle the costs of these actions, the bill can cripple a smaller company – one of the reasons overall securities regulatory reform is such a hot button in the marketplace and in Congress, where lobbying to ease the burden of regulation has been at its strongest in recent years.

This also part of the reason the SEC is considering alternatives to damaging shareholder lawsuits. The reduction to share price and therefore shareholder value, is one of the primary things the SEC is designed to minimize.

No overnight fix

Copland thinks the arbitration alternative may be the answer to many prayers, but cautions it could take awhile. ‘The market test might take some time to work itself out. Securities class-action lawsuits are such high-stakes and unpredictable affairs that they nearly always settle,’ he writes. ‘Even though professional arbitrators are likely to be more predictable and reasonable than lay jurors, it would take actual arbitrated disputes before anyone would know the exposure through the new system.’

What he likes most about it is that – in spite of the queries thrown up by Congress – the SEC could actually open the door to arbitration without the need for new laws to be passed by the legislators – something Copland believes makes the idea all that much more attractive.

‘If the reform goes through, it won’t be a panacea, as companies listed in America still face far higher regulatory burdens and prosecutorial threats than those listed abroad,’ concludes Copland. ‘Still, it’s exciting to see the SEC talking about this salutary reform.’