Although the Green Bay Packers have been called the worst stock in America from a shareholder perspective, it looks like the Carlyle Group is going to take a run at the title. Steven Davidoff reports that:
It is quite possible that the Carlyle Group, the private equity firm that is preparing to go public, is proposing the most shareholder-unfriendly corporate governance structure in modern history.
It starts with the fact that Carlyle is providing its soon-to-be public shareholders with no power over the company. Carlyle shareholders will have no ability to elect directors. Instead, Carlyle intends for the company to be controlled by its management ....
Carlyle has eliminated the fiduciary duties applicable to most corporate directors. Instead, shareholders’ rights will be governed by Carlyle’s partnership agreement, which provides that the board can act in its sole discretion without good faith. If a conflict of interest arises between the shareholders and Carlyle, the managing general partner can obtain approval from a conflicts committee that will be conclusive. The conflicts committee will comprise the independent directors who are appointed by Carlyle. ...
Carlyle is requiring that public shareholders arbitrate all claims against the company. The arbitration must be confidential, meaning no one would ever even know about it unless it was required to be disclosed by another law. Class-action lawsuits are specifically barred.
Technically, of course, Carlyle is a limited partnership not a corporation. According to Carlyle's draft registration statement, Carlyle is going public as a Delaware limited partnership. As i discuss below, Delaware law allows a limited partnership agreement to limit--even eviscerate--fiduciary duties and litigation rights even if the partnership is publicly held. As a legal matter, the analogy to the corporate law rights of shareholders thus is inapt.
Setting aside the issues relating to litigation rights and mandatory arbitration, I'm not especially bothered by the governance provisions of Carlyle's set up. The de jure restrictions on Carlyle investors are analogous to the de facto limits on the powers of outside investors in a company that has a dual class capital structure. Indeed, a perceptive commenter at Davidoff's NY Times blog wrote that:
How is the Carlyle proposal significantly different from the arrangement at the NY Times, which leaves control of the company in the hands of the Sulzberger family even though they no longer own a majority of the stock?
It's not, IMHO.
As I explained in a blog post commenting on Manchester United's decision to go public with a structure in which the insiders retained control by holding a class of stock having greater voting rights than the class of stock sold to outsiders:
I wrote about dual class stock in my article The Short Life and Resurrection of SEC Rule 19c-4, in which I explained that dual class stock structures established in an IPO (as is the case here) pose few concerns:
Public investors who do not want lesser voting rights stock simply will not buy it. Those who are willing to purchase it presumably will be compensated by a lower per share price than full voting rights stock would command and/or by a higher dividend rate. In any event, assuming full disclosure, they become shareholders knowing that they will have lower voting rights than the insiders and having accepted as adequate whatever trade-off the firm offered in recompense.
Man U public investors will buy their shares knowing that the Glazers are in charge and will remain so by virtue of the dual class stock structure. They will know or should know that dual class stock presents a serious agency cost problem because incumbents who cannot be voted out of office are almost impossible to discipline. Public Man U investors thus implicitly will have accepted whatever trade-offs the deal entailed as appropriate compensation for that risk.
Put another way, the market will price the risk posed by dual class stock, providing investors who buy the lesser voting rights stock with a discount from the price they would have had to pay if they had had full voting rights. Those who buy the stock thus are paying the right price and are fully protected.
I don't see why the same analysis would not apply here.
But what about the mandatory arbitration provision? It's been a while since I taught Securities Regulation, but my recollection is that the SEC takes the position that shareholder rights under the securities laws cannot be subject to mandatory arbitration. Jennifer Johnson and Edward Brunet sharply criticized proposals to change that rule in their article Arbitration of Shareholder Claims: Why Change is Not Always a Measure of Progress:
Two Blue Ribbon business advisory panels have recently proposed arbitration to remedy the problems endemic to shareholder class action litigation. Critics have long assailed shareholder litigation as harmful to firms without conferring a corresponding benefit upon shareholders or the public. Contemporary criticism has focused on the circularity of the remedy in shareholder suits and the charge that even the potential for shareholder litigation harms the competitive edge of the U.S. financial markets. We contend that even accepting these criticisms at face value, arbitration is not the solution. The lure of arbitration as a panacea to cure the ills of litigation is based upon myths concerning modern arbitral realities. First, arbitrators apply substantive and undefined principles of fairness and equity rather than legal rules. Such decisions, once made, are virtually insulated from judicial review. While historically such a system constituted an efficient dispute resolution system between homogenous members of trade groups, modern consumer arbitration rarely takes place between those with any common understanding of applicable norms other than the law. Second, there is a hidden societal cost to moving to an arbitration system to redress securities law claims. Experience teaches us that mandatory arbitration causes the law to atrophy. This trend would be exacerbated in shareholder litigation, which is often based upon implied causes of action, that by their nature depend upon transparent judicial interpretation. Third, modern arbitration will not cure the ills of class action litigation. Arbitration today is no longer particularly quick or efficient in that it has incorporated many of the procedural appendages such as discovery that are common in litigation. However, the procedural protections against the most vexatious lawsuits against corporations would not operate in the world of arbitration. This danger would be intensified if class action arbitrations were allowed. This essay will critique the proposals calling for arbitration of shareholder claims and conclude that arbitration is not an attractive alternative to litigation.
As Lawrence Cunningham has argued, however, the US Supreme Court increasingly "administers a self-declared national policy favoring arbitration." The conflict between those precedents and the SEC's longstanding policy of refusing to allow a registration statement to become effective if the issuer seeks to compel mandatory arbitration of shareholder claims will be brought to a head by Carlyle. If the SEC refuses to let Carlyle's registration statement become effective, presumably Carlyle will seek some form of judicial review. But how would/ should such a claim come out? Let's defer that for a minute.
A separate question is whether state courts would enforce a mandatory arbitration provision insofar as state law-based claims involving such matters as breach of fiduciary duty are concerned. As noted, Carlyle's draft registration statement specifies that Carlyle is going public as a Delaware limited partnership. In an unpublished opinion, Aris Multi-Strategy Fund, LP v. Southridge Partners, LP, 2010 WL 2173839 (Del. Ch. 2010), former Chancellor Chandler enforced a mandatory arbitration clause in a limited partnership agreement and stated that:
... permitting limited partners to contractually agree to arbitrate their statutory rights-rather than assert those rights in court-is consistent with the manner in which Delaware has treated this issue in other contexts. In the corporate context, for example, parties can agree to submit advancement actions under 8 Del. C. § 145 to arbitration, notwithstanding the Court of Chancery's exclusive jurisdiction over section 145 actions.FN4 And in the limited liability company context, parties can agree to submit derivative actions against company management under 6 Del. C. § 18-110(a) and related statutes to arbitration, notwithstanding the Court of Chancery's jurisdiction over such matters.
Does Carlyle being publicly held change that result? I doubt it. In another unpublished opinion, Gerber v. Enterprise Products Holdings, LLC, 2012 WL 34442 (Del. Ch. 2012), VC Noble wrote that:
Our General Assembly, however, has determined that, with a very limited exception, a limited partnership agreement may eliminate the duties that any person may owe to the limited partnership or the holders of the partnership's LP units. See 6 Del. C. § 17–1101(d). That means that a limited partnership agreement may, with the imprimatur of Delaware law, permit self-dealing transactions between a limited partnership and its controller with almost no oversight by this Court. This raises the issue of just what protection Delaware law affords the public investors of limited partnerships that take full advantage of 6 Del. C. § 17–1101(d). If the protection provided by Delaware law is scant, then the LP units of these partnerships might trade at a discount or another governmental entity might step in and provide more protection to the public investors in these partnerships. Those issues, however, are not ones that this Court need or should address. The General Assembly has decided that this Court has only a limited role in protecting the investors of publicly traded limited partnerships that take full advantage of 6 Del. C. § 17–1101(d), and that is a role this Court must accept.
See also Miller v. Am. Real Estate Partners, L.P., 2001 WL 1045643, at *8 (Del. Ch. Sept. 6, 2001) (citing Sonet v. Timber Co., L.P., 772 A.2d 319, 322 (Del. Ch.1998)) (“But just as investors must use due care, so must the drafter of a partnership agreement who wishes to supplant the operation of traditional fiduciary duties. In view of the great freedom afforded to such drafters and the reality that most publicly traded limited partnerships are governed by agreements drafted exclusively by the original general partner, it is fair to expect that restrictions on fiduciary duties be set forth clearly and unambiguously.”).
If you can limit fiduciary duties by contract in the case of a public limited partnership, why wouldn't a mandatory arbitration clause be enforceable as well? And, if you can do that with respect to state law claims, why shouldn't you be able to do it with respect to federal claims?
In sum, FREEDOM OF CONTRACT + SUPREME COURT POLICY FAVORING ARBITRATION + MARKET WILL PRICE TERMS = the SEC policy is wrong. Mandatory arbitration clauses ought to be enforced as to both state and federal claims.
But what if Carlyle were a corporation? This post is already too long. So the short answer is: I think the result should be the same. And I bet Delaware will move in that direction. See Charles Nathan's post on the analogous issue of the enforceability of exclusive jurisdiction provisions:
In a recent decision, In re Revlon, Inc. Shareholders Litig., newly-appointed Vice Chancellor Laster suggested a solution. In dicta, he endorsed a Delaware entity’s right to mandate in its governance documents a chosen forum for the resolution of state law-based shareholder class actions, derivative suits and other intra-corporate disputes. Vice Chancellor Laster stated that “if boards of directors and stockholders believe that a particular forum would provide an efficient and value-promoting locus for dispute resolution, then corporations are free to respond with charter provisions selecting an exclusive forum for intra-entity disputes.” Presumably, the Vice Chancellor had Delaware in mind.
Nathan goes on to discuss the legal issues at some length. In any case, assuming Laster wasn't simply trying to build up business for Delaware courts, there's no immediately obvious policy reason why the same result would not apply to mandatory arbitration provisions.
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