Private Equity Firm’s Attempt to Impose Arbitration on Investors Fails

Near the beginning of the year the private equity firm, Carlyle Group LP, caused a stir when the company amended its registration statement for its $1 billion initial public offering to include a condition requiring stockholders to forego their right to sue individually or as a class and instead participate in arbitration. The provision came atop of the elimination of other traditional shareholder rights, and many wondered whether the Securities and Exchange Commission would approve a corporate governance structure so unfriendly to shareholders.

The arbitration requirement proved to be too much. After consulting with the SEC, avoiding civil litigation and maybe fearing the controversy that would surround its initial public offering, Carlyle Group dropped the requirement one month later.

Shareholder Rights

Private equity firms that go public usually offer few rights to investors, limiting their voting rights and denying them the ability to remove the general and managing partners. The structure allows for greater capitalization while the direction of the firm remains under the control of the managerial regime before the public offering.

Carlyle specifically limited shareholder rights by limiting the influence of shareholders on management, reducing the fiduciary duties of the general partner to shareholders, and allowing the unfavorable repurchase of stock on demand. Significantly, Carlyle also wanted to require all public shareholders to submit any legal claims against the company to private arbitration, and to require that any dispute aired through arbitration would remain confidential. The total effect of the shareholder provisions was that investors would not be able to sue the company to enforce their limited rights or for any federal and state securities law violations.

While the limited rights of shareholders is not uncommon among other private equity firms traded publicly, no other firm has attempted to eliminate the ability of shareholders to sue in court. The cost to individual shareholders to litigate disputes is extremely high and therefore shareholders normally turn to a class-action lawsuit to exercise their rights by pooling resources. However, Carlyle’s arbitration requirement also prohibited class-action lawsuits, so the strategy of cost sharing among shareholders to bring a suit was eliminated.

Arbitration Clauses

The law regarding arbitration requirements is indefinite as it applies to federal securities law. Some federal courts have ruled that arbitration clauses are illegal under federal securities law, but more recently the U.S. Supreme Court in CompuCredit Corp. v. Greenwood and AT&T Mobility v. Concepcion upheld arbitration clauses in consumer credit cases. Based on these Supreme Court decisions, Carlyle hoped to extend the legality of the arbitration requirements to public shareholders.

Carlyle may have also hoped that traditional federal securities concerns would not apply because it is a partnership. Instead of offering corporate shares, Carlyle offered common units in its partnership and investors who bought common units would be subject to its partnership agreement that severely limited their rights as discussed above.

Perhaps not recognizing a difference between a partnership’s common units and a corporation’s shares offered to the public, and perhaps not wanting to set a precedent, the SEC advised Carlyle that it would not approve the filing with the arbitration requirement. As a result Carlyle Group dropped the shareholder arbitration provision in its registration.

An experienced transactional lawyer and commercial litigator can help a business plan around potential legal potholes and help guide a firm out of legal issues when they strike.