Allowing Shareholders to Customize Their Protections Through Arbitration of Shareholder Disputes

Abstract

This article proposes allowing corporations to require arbitration of shareholder disputes by adopting an arbitration provision into their bylaws or charter. I outline the benefits, drawbacks, and legal challenges these provisions will face. There are two errors in the current view of shareholder litigation. First, it isn’t about management. Managers and directors may have their name on the complaint, but at the end of the day, the shareholders write the check, and the managers keep their yachts. Studies show that shareholder litigation has little effect on a manager or director’s wallet or reputation. So when evaluating remedies, the balance is not between the needs of shareholders and management. It is about allowing shareholders to determine the scope of their remedies against themselves. Second, this isn’t about litigation. Shareholder suits settle at extremely high levels. These suits are about settlement, not judgment. So when evaluating the benefits and drawbacks of reform proposals, such as arbitration, we err by comparing them to litigation. With this perception corrected, most of the disadvantages of arbitration melt away. I propose allowing shareholders to decide what level of protection they want through shareholder litigation. I propose doing this by allowing firms to include mandatory arbitration provisions in their charters or bylaws. This doesn't require a change in the law — instead it requires the SEC to reverse its position that arbitration violates the Securities and Exchange Act of 1934, bringing the commission back in line with current Supreme Court precedent. Under my proposal some firms may choose to retain the current regime. Others might opt for binding arbitration of all claims. Others would be free to explore a mix of arbitration and litigation, customized to their needs. For example, acquisitive firms may push claims regarding mergers into arbitration, but allow more typical fraud claims to continue through the courts. This proposal adds flexibility, lowers the cost to taxpayers, and customizes solutions on a company-by-company basis. To invoke Smith, Wright and Hintze’s seminal theory, it leverages corporations as “laboratories of corporate governance.” Further, because I am not proposing imposing arbitration on any company, but instead allowing each company the freedom to adopt arbitration as it sees fit, it’s not clear why we should care whether it offers benefits to the company. Because managers are rationally apathetic to shareholder litigation, there’s little reason to suspect they will spend political capital pushing through arbitration against the shareholders’ will. And if it is the shareholders’ will to limit their own remedy, why should the government stop them?