By removing the threat of regulatory delay, the SEC’s revised stance may encourage more companies—particularly those preparing for an IPO—to include mandatory arbitration provisions. From an issuer’s perspective, arbitration might enable faster and less expensive dispute resolution than court, and arbitration generally is confidential, while court generally is not. Issuers might be particularly interested in an arbitration provision that includes a class action waiver. If enforceable, such a provision would require each shareholder to arbitrate its own respective claims on an individualized basis, while preventing shareholders from using the class action mechanism available in court to litigate claims alleging class-wide damages on behalf of potentially hundreds of thousands of investors.

On the flipside, mandatory arbitration also presents significant potential challenges for shareholder plaintiffs and their attorneys. Chief among them, and as a corollary to the paragraph above, is the reduced financial incentive of litigating on an individualized basis, as the inability to aggregate small investor claims through class actions diminishes the economic viability of bringing individual cases. To put a finer point on it, a shareholder and/or its lawyers might conclude that the shareholders’ alleged losses do not justify, and possibly are even outweighed by, the time and expense of prosecuting the shareholder’s claims.

Shareholders and their lawyers might also be concerned about other aspects of mandatory arbitration, including the fact that arbitration generally offers less robust discovery than court litigation, which could impede plaintiffs' ability to develop strong evidentiary records. Moreover, the private nature of arbitration limits public scrutiny and media exposure, which plaintiffs often leverage to advance their litigation positions.

Although the Policy Statement removes one impediment to companies looking to impose mandatory arbitration on investors, other impediments remain, and other potential pitfalls warrant serious consideration.

• Potential Legal Challenges Under the Federal Securities Laws
  
  

  In the Policy Statement, the SEC explained why it believes that its new position concerning mandatory arbitration provisions is consistent with U.S. Supreme Court precedent (i) upholding provisions requiring arbitration of certain federal securities claims and (ii) reaffirming the liberal Federal policy favoring arbitration agreements under the Federal Arbitration Act of 1925 (FAA).

  Even so, the SEC acknowledged in the Policy Statement that the U.S. Supreme Court has not addressed “the precise issue of issuer-investor mandatory arbitration provisions.” Particularly given the existential threat that mandatory arbitration presents for securities class actions, companies should expect that the plaintiffs’ bar will challenge mandatory arbitration as violating provisions in the federal securities laws requiring that at least certain types of federal securities claims must be brought exclusively in court, and further providing that agreements to waive requirements under the federal securities laws are void.

• Due Process Concerns
  
  

  Even if not prohibited by federal securities laws, companies can reasonably anticipate that investors will seek to challenge mandatory arbitration provisions on due process grounds. For example, in a written statement, SEC Commissioner Caroline Crenshaw, who cast the lone dissenting vote opposing the Policy Statement, alluded to various due process challenges plaintiffs might make.

  Among other things, Commissioner Crenshaw opined that mandatory arbitration provisions might be crafted in such a way that they encroach upon substantive rights and implicate due process concerns, such as by eliminating certain legal remedies, or shortening applicable statutes of limitations. She also insinuated that the preclusion of collective action among shareholders (i.e., class actions) might constitute a due process violation. Although the precise contours of the due process challenges that plaintiffs might make remain to be seen, suffice it to say that such challenges are expected.

• State Law Challenges: Delaware as a Case Study
  
  

  State corporate laws might prohibit companies from adopting mandatory arbitration provisions. For example, Delaware, home to a large proportion of U.S. public companies, permits Delaware corporations to adopt forum-selection clauses, but, as the SEC acknowledged in the Policy Statement, “Delaware recent amended its General Corporation Law in a way that may prohibit certificates of incorporation or bylaws from including an issuer-investor mandatory arbitration.”

  To the extent that Delaware actually does prohibit mandatory investor arbitration, this might further accelerate the trend of companies leaving Delaware (dubbed “DExit”). Key concerns driving this migration away from Delaware include:

  • A perceived erosion of the “business judgment rule,” the judicially developed doctrine shielding corporate directors from liability for informed decisions made in good faith;
  • Recent judicial decisions perceived as unfavorable for the defense bar;
  • A rise in shareholder litigation and exposure to substantial damages;
  • Broader stockholder inspection rights than in certain other jurisdictions.
  
  

  Other states, such as Texas and Nevada—arguably the two biggest beneficiaries of DExit—do not expressly prohibit mandatory arbitration. The extent that these states actually permit mandatory arbitration would be yet another way for these states to differentiate themselves and bolster their status as attractive Delaware alternatives for companies considering going public or reincorporating elsewhere.

• Cost and Other Implications of Mandatory Arbitration
  
  

  While arbitration might ultimately be preferable to court, or at least less expensive for companies and their D&Os, that is not necessarily going to be true in all cases.

  • Mass arbitration: If multiple investors file separate arbitrations, the arbitration filing fees, defense costs, settlements, and other financial losses tied to each case will add up: filing fees alone can be thousands of dollars, and if thousands of individual investors bring separate arbitrations, the company could be liable to pay millions in arbitration fees alone.
    
    
  • Motion practice and discovery: In court, motions to dismiss and other pretrial motions are common and often a means of disposing of investor claims. For context, motions to dismiss are filed in nearly 100% of federal securities class actions, and when courts rule on those motions, they grant them (with or without prejudice) most of the time. By contrast, dispositive pretrial motion practice is not necessarily even available in arbitration. Even when it is, pretrial motions might not lead to early dismissals with the same frequency as in court.
    
    Relatedly, in federal court (and in at least some state courts), defendants in federal securities class actions have the benefit of an automatic stay of discovery during the pendency of any motion to dismiss, meaning defendants do not have to devote the often substantial time and money inherent in producing documents, sitting for depositions, and responding to other discovery requests, unless and until a securities class action survives a motion to dismiss. Such a stay of discovery is not generally required in arbitration and, to the extent that companies seek to mandate such a discovery stay in their arbitration provisions, companies can reasonably anticipate that claimants will challenge those provisions.
    
    
  • Arbitration hearings, appeals, and related insurance implications: As a corollary to fact that dispositive pretrial motion practices might be unavailable or less effective in arbitration, companies and their directors and officers might find that their best – or only – chance of defeating claims in arbitration is by prevailing at an arbitration hearing, the arbitration version of a trial. The risk of an adverse judgment after an arbitration hearing, including one that could trigger various coverage exclusions in a D&O insurance policy, would be particularly acute if appeals from adverse arbitration outcomes are precluded or significantly limited, as is often the case. Indeed, the risk of a non-appealable adjudication that jeopardizes the companies’ and its D&Os’ insurance coverage could be so severe that defendants/respondents are effectively coerced into unfavorable settlements before an arbitration hearing takes place. This fact, coupled with arbitration’s confidential nature making it difficult to ascertain pertinent information about arbitrations, such as pre-hearing dismissal rates, might well make D&O insurers hesitant to offer premium discounts for companies that adopt mandatory arbitration provisions.
    
    

  In addition to risks inherent in arbitration, there are other noteworthy risks that companies would be wise to consider before adopting a mandatory arbitration provision.

  One risk is that imposing mandatory arbitration on investors might create unfavorable optics or downright reputational harm, and it could even dissuade or preclude investors (e.g., large institutions) from buying company stock. Another risk is that a future change in SEC leadership could result in a reversal of the SEC’s new policy, and whether a reinstatement of the SEC’s prior disapproval of such provisions might have adverse consequences for companies that go public with mandatory arbitration provisions now, including with respect to post-IPO fundraising.