Pomerantz LLP

Dept. Of Treasury Promotes Forced Arbitration For IPO Claims

Attorney: Leigh Handelman Smollar
Pomerantz Monitor March/April 2018

When a company goes public, it seeks to raise money from investors by selling securities through an initial pub­lic offering (“IPO”). To effectuate an IPO, the company must file several documents with the SEC, including a registration statement and a prospectus. In these docu­ments, the company relays its financial statements and other important information about its business, opera­tions and strategy. Investors rely on these documents in determining whether to purchase the company’s securi­ties in the IPO.

Under the securities laws, investors can much more eas­ily recover for misrepresentations in IPO offering docu­ments than misrepresentations in non-IPO public disclo­sures. Section 11 of the Securities Act makes companies automatically liable for any material misstatements or omissions in their registration statements; and all officers and directors who sign the registration statement are also presumptively liable. In order to escape liability, these of­ficers and directors carry the burden of establishing that they did not know, and could not reasonably have known, about the misrepresentations. Investor reliance on these misrepresentations or omissions is also presumed, un­less the company can disprove it.

Of course, most investors cannot practically avail them­ selves of these rights unless they can pursue them in a class action. Except for large institutional investors, which may have large-scale individual damages, most investors’ losses are not great enough to justify bringing an individual securities action. The very threat of class action securities suits helps to keep companies honest, especially in their public filings. Investors are able to seek the full amount of damages from the fraud, whereas a government action typically only seeks disgorgement. Class action securities suits based on false or mislead­ing IPO documents have allowed investors to recover billions of dollars over the years. These investors range from an average citizen holding the security in his/her retirement account, to large pension funds. Private class action securities suits on behalf of investors have been a driving force in holding bad actors accountable. It is well-known that SEC resources are limited and that private enforcement has been more effective in not only holding bad actors accountable, but in deterring wrong­doing as well.

The very effectiveness of these Section 11 remedies has made them a prime target of pro-business groups; and the Trump administration is showing signs that it may well be listening to them, in the guise of promoting more IPOs. The U.S. Dept. of Treasury recently issued a report on ways to reduce the cost of securities litigation, including forced arbitration. Bloomberg News has report­ed that the SEC, under its new chair, Jay Clayton, might be looking for ways to effectively ban securities class actions based on misstatements in IPO documents, in favor of forcing arbitration. Often, class actions are impossible to arbitrate; therefore, requiring arbitration could effectively present an insurmountable barrier to any recovery for all but the minority of investors whose losses are large enough to make an individual action practicable.

While this move may promote more IPOs in the United States, taking away real investor rights has serious implications in the United States securities markets. In general, the SEC has been less successful in recover­ing monies for defrauded investors than private lawsuits. Further, as the Wall Street Journal recently reported, foreign investors purchased over $66 billion in U.S. stocks in 2017, which number is predicted to grow. One of the main reasons foreign investors like to invest in U.S. stocks is that the protections of the U.S. securities laws are stronger than those of other countries. The Petrobras case is a great example. There, investors in a class action who purchased pursuant to U.S. trans-actions were able to recover $3 billion (despite Petrobras bylaws requiring arbitration). However, investors who purchased securities through the Brazilian stock ex­change were required to arbitrate their claims rather than bring a private enforcement action. Those investors recovered nothing.

Aside from individual investors not being able to recover in an arbitration, there is another negative side effect: arbitrations are not matters of public record and, therefore, the deterrent effect is negated. Newly-appointed SEC Commissioner Robert J. Jackson, Jr. has recently stated similar concerns, displaying his skepti­cism for mandatory arbitration of these claims.

While SEC Commissioner Michael S. Piwowar indicat­ed he would be willing to consider such a drastic policy change, SEC Chairman Jay Clayton has told a Senate panel that he is “not anxious” to allow investors to be barred from filing securities class action claims after an IPO. Senator Elizabeth Warren has been vocal about refusing to dilute investor rights in this regard. She told Clayton, “The SEC’s mission is to protect investors, not throw them under the bus.” Further, former SEC Chair­man Harvey Pitt urged Clayton to put this issue on the “back burners,” citing the very limited resources that the SEC is already encountering. Jackson, Jr. also voiced concerns with respect to the limited budget of the SEC. Another critic of the proposed policy change, Rick Flem­ing, Investor Advocate at the SEC, has stated his opinion about mandatory arbitration of shareholder claims this way: “stripping away the right of a shareholder to bring a class action lawsuit seems to me to be draconian, and, with respect to promoting capital formation, counterpro­ductive.”

Chairman Clayton recognizes that the issue is complex, with investor rights pitted against public company rights, each with their own strong advocates. He confirmed that any policy change in this regard would be subject to great debate, reiterating his desire to delay decision on this is­sue: “[This] is not an area that is on my list for where we can do better[.]” In other words, Chairman Clayton does not appear to want to decide this issue anytime soon.