By: Bhavya Solanki (Maharashtra National Law University, Mumbai)
After the Companies Act, 2013 (“CA, 2013”), the Indian shareholders became able to initiate class action suits by themselves on behalf of other aggrieved shareholders. Aspirations were high but the practicality of the proposal, questionable. Factors like a lack of funding mechanism have stymied its usage. The need to venture into an alternate forum like arbitration has become apparent now. As is shown in the post, arbitration is not immaculate, but so isn’t litigation. The question then becomes, which mechanism balances out as a net positive.
SHAREHOLDER LITIGATION AND CLASS ACTION
In shareholder litigation, the need to sue arises from the “agency problem”. In a company, the owner group i.e. the shareholders, is separated from the controller group i.e. the board of directors and the managers. This separation may give rise to varying interests between these two groups, and this is essentially the agency problem. The management may even try to sabotage the company’s operations or work against the interests of the shareholders. Specific to India, this agency problem also greatly operates between the majority and the minority shareholders (as India has many state-controlled or family-owned businesses).
For this reason, as is explained by Valian A. Afshar, the right to sue purports to serve two purposes: firstly, it acts as deterrence to companies and the management, and, secondly, it compensates the aggrieved shareholders for the harm suffered by them. Essentially, the management is kept in check by the looming threat of shareholder claims. Further, the compensatory function of suing helps diminish agency costs as the aggrieved shareholders become entitled to damages.
Only subsequent to Satyam wherein remediless Indian investors emerged uncompensated unlike their American counterparts, was “class action” made available as a legal recourse to shareholders under section 245 , through the CA, 2013. Class actions are the suits in which one or several persons jointly sue on behalf of a larger group of people. Section 245 lets the shareholders bring a class action suit before the Tribunal if they feel that the management or conduct of the affairs of the company are being conducted in a manner prejudicial to the interest of the company or its shareholders. It aims at several targets like empowering individual claimants with lack of resources to aggregate claims, allaying the burden of judiciary, et cetera. However, what was exalted as an impetus for growth and transparency has remained severely underused. To the best of my knowledge, the provision hasn’t been properly invoked even once till now. This is despite the existence of thousands of public companies and rampant frauds, but understandably so.
As is argued by commentators like John C. Coffee, George A. Fowler and Valian A. Afshar, they fail to achieve both of the purposes of litigation: deterrence and compensation. Deterrence is not significant because, as per them, recoveries often do not exceed litigation expenses. Sometimes, there may not be any net benefit accruing out of litigation for the shareholders. Further, owing to the unhurriedness of courts, shareholders may become hesitant to file actions. For this reason, many potential claims may remain unclaimed.
With regard to its compensatory role, securities class actions are inflicted by the “circularity problem“. The circularity problem refers to the fact that because of the “separate legal entity” characteristic of companies, the company itself ends up compensating the shareholders for the wrongdoings, and not the individual defaulters. Therefore, in the end, it is the investors’ money itself which gets utilized for compensating the aggrieved investors.
In jurisdictions like the U.S.A., class action suits are immensely popular. This is because they get easily financed through contingency fees and third-party funding. Contingency fees lets the lawyers have a percentage in the recovery. Lawyers become the propelling force behind class actions as they get entitled to a generous share in the bumper compensation granted by the courts. In return, the aggrieved shareholders are able to get legal assistance minus the upfront charges. Further, the impetus to recover costs incentivizes lawyers towards winning the case.
However, levying contingency fees is banned in India and third-party funding remains unregulated. Under the CA, 2013, Investor Education and Protection Fund can fund the legal expenses incurred in class actions. However, the viability of a government-controlled fund mechanism has been routinely doubted.
Without these, shareholders themselves have to finance the action, with their only chance of recovery being under the loser-pays rule in case they succeed. On the other hand, if the shareholders emerge unsuccessful, financing the defendant’s litigation costs becomes difficult if shareholders are dispersed, which is usually the case in public listed companies.
MANDATORY SHAREHOLDER ARBITRATION
The insertion of “Mandatory Shareholder Arbitration” [“MSA”] provisions in the Articles of Association (AoA) of companies could be a way to resolve some of the above stated issues. It could require all shareholder claims to be arbitrated and even entirely eliminate class action suits or class arbitration by requiring individual arbitration.
ARBITRATION VERSUS CLASS ACTION
In India, the courts seem to have a favorable and positive disposition towards arbitration. It offers several advantages over litigation like leaving room for flexibility which makes the resolution process much more seamless. As the parties can choose their own arbitrator, it becomes particularly apropos for resolving complex matters like securities and company law as an arbitrator with the requisite expertise can be appointed. Further, confidentiality is a major concern for corporate disputes which is maintained here. Also, with companies going international, corporate disputes can span across jurisdictions which becomes problematic in litigation. Arbitration allows divorcing such disputes from the national court system and gives them an international forum. Arbitration awards are also easier to enforce and are often complied voluntarily.
The arguments in favor of and against choosing arbitration over class action have been examined below:
- Benefits of Choosing Arbitration over Class Action
Firstly, arbitration would avert frivolous shareholder claims from even being brought in the first place as individual shareholders wouldn’t be able to hide behind class action. After frivolous claims are sieved out, what would be left out are the claims by important institutional shareholders with higher shareholdings in the company, who would be able to financially shoulder the process. So, only the best and the most meritorious claims will be brought forth which would increase their effectiveness. When bigger shareholders bring claims against the company, it would prove to be a bigger statement and will inadvertently dent the company’s reputation. These big shareholders are anyways the ones who would have served as lead plaintiffs in a class action suit, except for now they will go for arbitration. This will have the intended deterrent effect.
Secondly, it would be particularly beneficial for the shareholders from a compensatory point of view as arbitration will lead to faster resolution and therefore, faster compensation. In contrast, resolution through NCLT remains unhurried.
Also, in a class action, the lead applicant fights the case on behalf of several. Therefore, he becomes the chief decision maker and the non-lead applicants tend to become detached from the process. Au contraire, individual arbitration would welcome more assertive claims. It will increase the engagement of shareholders with the process which could have a greater deterrent effect on the companies.
Further, because of the “circularity issue”, limiting the number of claims against the company would work to the benefit of the big institutional investors as they provide the most financial support to the company. So, they are indirectly funding all the litigation costs and compensation paid by the company in any action. In the end, it is the shareholders who stand to lose the most in any action. Since any action against the company would impose costs, they would in effect be reducing the company’s profits. In this regard, each “marginal dollar of profit or loss falls on them”. If they are the ones bringing the claim, they are, additionally, directly funding their own litigation expenses. Realizing this, the claims brought by these investors has to be of such great merit that it justifies incurring all these direct and indirect expenses. So, it has bound to create a huge stir in the industry and garner much more publicity.
- Downsides of Choosing Arbitration over Class Action
Firstly, individual arbitration over class action would mean that multiple arbitrations will have to be conducted instead of a single class action. It may discourage shareholders from bringing claims as a single shareholder will have to bear all the cost. However, a counter argument can be made based on the “circularity issue” previously discussed, that though it seems that the small shareholders are left unprotected, their protection comes indirectly from the profits the company makes which would have otherwise been squandered on unnecessary litigation.
In a U.S. case, the plaintiff’s opposition to MSA was backed by a group of securities law professors who argued that without the transparency and visibility of legal proceedings held in an open courtroom, and the possibility of getting rebuked by a judge, the fiduciaries would be much less deterred from violating their duties to shareholders.
Arbitration is private and ensures confidentiality, which is also the principal reason behind companies preferring it over litigation. An indication of internal disputes within a company could impact the value of shares or prompt attempts at a hostile take-over. However, whether shareholder suits should be left private is in itself debatable as it would result in the loss of their deterrent effect through negative publicity. Jennifer Arlen has stated that the very reasons why some companies would desire arbitration of fraud claims are the reasons why it would be bad public policy to permit them.
To allay these concerns, class arbitration has been suggested by some commentators. This would ensure that resources like costs, witnesses, et cetera, are shared. Maintaining confidentiality also becomes difficult in class arbitrations. Disclosures could also happen by the way of internal and media whistleblowing.
- Balancing the Above
MSA is certainly not an immaculate conception. The debate surrounding its desirability over litigation is fresh across jurisdictions. In the Indian context, it could resolve some issues currently plaguing the court system like excessive delays, deficiency of specialized judges, et cetera. Individual arbitrations could reduce the number of vexatious claims, ensuring only the meritorious ones are followed through. These would be easily financed. However, deterrence to claiming is a concern for many which could be solved through class arbitration. In this case, however, the problem of the ban on contingency fees persists. A lack of confidentiality in class arbitration is also an issue which could disincentive companies from opting for it. So, companies should not be empowered to completely eliminate class arbitration by mandating individual arbitration in their clauses. In any case, India can at least explore the legal viability of mandatory shareholder arbitration, and try it out for itself once.
(The author is a student at Maharashtra National Law University (MNLU), Mumbai. with a keen interest in arbitration)