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Minority Shareholder Freeze Outs

Issues surrounding arbitration are now front and center in the business and legal worlds. In January 2012, news concerning Carlyle Group’s initial public offering surfaced when it proposed “the most shareholder-unfriendly corporate governance structure in modern history.” [1] In its proposal, Carlyle required that public shareholders arbitrate all claims against the company. Moreover, the arbitration must be confidential and precludes class-action lawsuits.[2] With the Supreme Court practically removing all barriers to arbitration in cases like AT&T Mobility v. Concepcion[3] or CompuCredit v. Greenwood, [4] Carlyle’s proposed governance structure seems poised to withstand legal challenge.

But Carlyle goes beyond merely requiring disputes to be arbitrated. Additionally, many Carlyle shareholders will have no ability to elect directors. If public shareholders hold less than ten percent of the company, Carlyle reserves the right to summarily repurchase all of those shares. [5] Perhaps most interestingly, Carlyle has supplanted fiduciary duties with a partnership agreement that grants the board to act in its sole discretion without good faith. A committee of independent directors appointed by Carlyle deals with conflicts of interest.

However, minority shareholder freeze out is not an entirely new concept in the private equity sphere. Other public private equity firms including Apollo Global Management, the Blackstone Group, and Kohlberg Kravis Roberts contain similar corporate governance structures. [6] Some commentators view these provisions as designed to “eliminate any ability of shareholders to sue the board for even the most egregious acts.” [7]

The first challenge the Carlyle Group will face is the approval from the Securities and Exchange Commission. The question will likely center on whether a public company can force arbitration in cases involving federal securities law. In support of its proposed corporate governance structure, Carlyle will find solace in recent Supreme Court decisions like AT&T Mobility and CompuCredit.

Arguments favoring the arbitration clause focus on the division between the company and shareholder interest. Some commentators believe that shareholder interests and incentives tend to be short term, while companies should be run by boards of directors who are incentivized to focus on the company’s long-term interests.[8] By limiting shareholder rights, the board of directors can avoid the pitfall of focusing on short-term profits.

Another advantage is that arbitration clauses reduce transaction costs. When private equity firms primarily operate through acquiring companies, shareholder litigation significantly increases the cost of doing business. According to a report released by Cornerstone Research in cooperation with Stanford Law School, 91% of acquisitions valued over $100 million in 2011 were subject to shareholder litigation. [9] According to the same study, the number of lawsuits per deal averaged 5.1. [10] Of the 565 legal challenges to acquisitions in 2010-2011, 27% were voluntarily dismissed, 4% were dismissed by the court with prejudice, and 69% settled. [11] With the cost of legal representation on the rise, the increase of lawsuits per deal becomes increasingly burdensome for publicly traded private equity firms.

While it is unclear whether firms can require arbitration for claims of federal security violations, the Supreme Court’s decision in CompuCredit seems to support the use of arbitration in any setting not directly prohibiting it. Further, the use of arbitration clauses may be necessary to support the central business model of publicly traded private equity firms. Finally, the market is the best place to regulate corporate governance structures: if investors are not satisfied with shareholder rights, they can simply choose not to invest. As long as adequate disclosure is provided to potential shareholders, arbitration provisions like that proposed by Carlyle Group should be held valid.

[1] Steven Davidoff, Carlyle Readies an Unfriendly I.P.O. for Shareholders, DealBook (Jan. 18, 2012), http://dealbook.nytimes.com/2012/01/18/carlyle-readies-an-unfriendly-i-p-o-for-shareholders/

[2] Id.

[3] AT&T Mobility LLC., v. Concepcion, 131 S.Ct. 1740 (2012) (Under Federal Arbitration Act, California must enforce mandatory arbitration clause that precludes class-action arbitration)

[4] Compucredit Co. v. Greenwood, 132 S.Ct. 665 (2012) (holding where federal statute is silent on arbitration, Federal Arbitration Act requires arbitration agreement to be enforced according to terms)

[5] Id.

[6] Id.

[7] Steven Davidoff, Carlyle Readies an Unfriendly I.P.O. for Shareholders, DealBook (Jan. 18, 2012), http://dealbook.nytimes.com/2012/01/18/carlyle-readies-an-unfriendly-i-p-o-for-shareholders/

[8] Id.

[9] John Gould, Developments in M&A Shareholder Litigation, Harvard Law School Forum on Corporate Governance and Financial Regulation (Mar. 4, 2012), http://blogs.law.harvard.edu/corpgov/2012/03/04/developments-in-ma-shareholder-litigation/

[10] Id.

[11] Id.

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Aaron Schneff

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