The Corporate Contract and Shareholder Arbitration

Abstract

Longstanding U.S. Supreme Court precedents interpreting the Federal Arbitration Act (FAA) coupled with more recent corporate law decisions in Delaware have sparked concerns that publicly traded corporations may adopt arbitration provisions precluding shareholder lawsuits, particularly securities fraud class actions. These concerns are misplaced. Delaware law, which governs the majority of publicly traded corporations, requires that charter and bylaw provisions be "twice tested:" they must be both legal and equitable to be enforceable. Arbitration provisions precluding securities fraud class actions are inequitable because, among other considerations, they would deny the vast majority of shareholders a remedy for violations of federal law; transfer wealth from smaller shareholders to the largest; insulate managements and boards from accountability in a manner inconsistent with established Delaware precedent; and rupture the balance between federal and state regulation of public corporations.

More than two centuries ago, the Supreme Court in Dartmouth College explained that the state is a party to the corporate contract along with the corporation and its shareholders. This principle has since been reaffirmed in a long line of cases. As a party to the contract, the state’s assent is a prerequisite to corporate formation. Because state assent is necessary, the state may, through its corporate law, dictate the terms of the corporate contract, including the terms of corporate existence and intra-corporate relationships. When the state withholds its assent to a provision in the corporate contract, because, for example, the provision is inequitable, the offending provision never comes into existence: it is void ab initio for lack of assent.

This feature of corporate law distinguishes the corporate contract from other contracts governed by the FAA. The FAA presumes the existence of an agreement to arbitrate, even in contracts of adhesion. But even contracts of adhesion require assent to be enforceable, and no assent can exist with respect to a corporate charter or bylaw provision that is rejected as inequitable by the chartering state. A long line of Supreme Court precedents emphasizing federal law’s deference to state law in the regulation of state-created corporations buttresses this conclusion.

This analysis differs substantially from arguments that charters and bylaws are not contracts and, therefore, not subject to the FAA. This Article instead embraces what the courts have repeatedly stated, that charters and bylaws are contracts, but broadens the analysis to emphasize the need for state assent as a precondition to contract formation. Because that assent is not forthcoming in Delaware with respect to mandatory arbitration provisions that would preclude or unreasonably burden securities fraud class actions, there can be no agreement to adopt those inequitable provisions in the corporate charter or bylaws, and absent the assent necessary for contract formation, the plain text of the FAA makes clear that the FAA cannot apply.

Keywords: Corporate Law, Securities Law, Contract Law, Arbitration Law, Delaware, Federal Arbitration Act, Securities Regulation, Securities Litigation

JEL Classification: K12, K22