Evolving Threats to Recovering Losses from Investments on Foreign Exchanges

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Editor’s Note: The Campbell Law Observer has partnered with Judge Paul C.  Ridgeway, Resident Superior Court Judge of the 10th Judicial District, to provide students from his International Business Litigation and Arbitration seminar the opportunity to have their research papers published with the CLO.   The following article is one of many guest contributions from Campbell Law students to be published in the Spring 2016 semester.

There are numerous benefits to investing in foreign securities exchanges.  Some companies exclusively sell their shares on foreign exchanges.  Investing in foreign companies could yield substantial monetary gains in various areas of the world experiencing rapid economic growth.  Foreign Investments lead to a diversified portfolio and thus limit the overall risk of loss.  While benefits like a diversified portfolio may seduce an American into investing on a foreign exchange, mandatory arbitration clauses within a company’s bylaws and shifts in the judicial system’s application of the Securities Act of 1933 pose serious threats to an investor’s potential to recover losses.  In light of the recent developments in In re Petrobras Securities Litigation, investors should be aware of the risks posed by purchasing securities on a foreign exchange and know how to identify them before engaging in foreign transactions.

Earlier this year, a scandal emerged where the Brazilian energy corporation, Petroleo Brasiliero SA (“Petrobras”), was engaged in a corruption scheme by inflating the price of its actual assets as well as the costs of contracts to help conceal money being funneled to corporate heads and politicians.  After information concerning the scandal went public, a corporate audit was conducted and revealed the true value of the company’s assets.  As expected, the company’s assets were much less ($98 billion less) than reported to the public and its investors via regularly issued financial statements.  Following the news of the company’s true value, the price of the stock plummeted as faith in the company’s structure and competency came under intense scrutiny.  It wasn’t long before purchasers of the company’s securities brought lawsuits against the company alleging fraud and misrepresentation that violated Brazilian Corporate Law as well as the regulations set forth in the Securities and Exchange Commission of Brazil or “Comissão de Valores Mobiliarios” (“CVM”).

Plaintiffs who bought their shares on the São Paolo Stock Exchange argued that they were entitled to a remedy from the United States judicial system under Brazilian law

The plaintiffs brought a class action lawsuit in the Southern District of New York presided by Judge Jed Rakoff.  The lead plaintiff of the class is Universities Superannuation Scheme Ltd (USS), a British pension fund.  USS is a U.K. based pension fund primarily composed of academic related personnel.  As lead plaintiff, the trustee of the pension is representing other investors who bought Petrobras securities as well.  An opinion was issued July 30, 2015 in which Judge Rakoff addressed the claims and defenses of both parties.  Amidst Rakoff’s opinion, legal scholars have taken notice of his ruling in regards to the Brazilian arbitration clause and Securities Act claims.

Plaintiffs asserted that Petrobras violated various provisions of Brazilian law by conducting the bribery scheme.  Among the numerous complaints, the plaintiffs who bought their shares on the São Paolo Stock Exchange (BOVESPA) argued that they were entitled to a remedy from the United States judicial system under Brazilian law.  The defendants argued that any Brazilian law claims were subject to mandatory arbitration in Brazil due to the company’s bylaws.

In 2001, Brazilian authorities amended Article 109 of Brazilian Corporate Law to expressly permit companies to implement mandatory arbitration clauses into their bylaws.  Arbitration would be conducted according to the rules of arbitration laid out in the Brazilian Arbitration Act (BAA).  The legislation was drafted by a commission of judges, arbitration experts, and government officials, which was later approved by the Brazilian National Congress.  Not only was there legitimate legislation in support of an arbitration clause, but also Petrobras had to incorporate the provision into their bylaws in order to be listed on the “Novo Mercado.”  The Novo Mercado is a special listing segment on the BOVESPA.  Before a company may be listed on the Novo Mercado, it must adopt a mandatory arbitration provision into the company’s bylaws.  In 2002, Petrobras adopted the arbitration provision in dispute.

The arbitration clause reads, “disputes involving the Corporation, its shareholders, managers and members of the Audit Board” regarding “the rules issued by the Brazilian Securities and Exchange Commission as well as in all further rules applicable to the operation of the capital market in general,” “shall be resolved according to the rules of the Market Arbitration Chamber (MAC).”

The arbitration clause was valid and if the plaintiff class wanted to pursue their Brazilian claims, they must submit to the MAC

Judge Rakoff heard arguments from both sides, in addition to multiple experts on Brazilian law, and concluded that all of the claims arising under Brazilian law as a result of the purchases of securities on the BOVESPA were subject to the mandatory arbitration clause.  The arbitration clause was valid and if the plaintiff class wanted to pursue their Brazilian claims, they must submit to the MAC.

The plaintiff’s contested the defendant’s arbitration argument by asserting four different defenses.  First, plaintiffs argued that the provision of the BOVESPA transaction that provides for mandatory Brazilian Arbitration was invalid because it was a contract of adhesion, thus arbitration would only be appropriate when the consumer initiates arbitration or the consumer has consented to arbitration in writing.  Second, the arbitration provision was not unanimously approved by all shareholders therefore it was void.  Third, plaintiffs should not be bound by this provision since they did not give consent at the shareholders meeting.  Finally, the inclusion of the arbitration provision was void due to lack of notice to the shareholders.

Judge Rakoff dispensed with the plaintiff’s first defense that buying Petrobras subject to the arbitration clause constituted a contract of adhesion because both the relevant statute and case law are contrary to plaintiff’s application of the law.  Petrobras’ expert, Luiz Cantidiano, explained that past precedent and authority establish that the “provisions of the Brazilian Arbitration Act regarding adhesion contracts apply to contracts of unequal bargaining power, such as consumer contracts, and not arbitration provisions contained in corporate bylaws.”  Rakoff found that no unequal bargaining power was present under these facts and that past Brazilian cases suggest that arbitration clauses are not intended to be analyzed as a contract of adhesion under the BAA.

The plaintiff’s next contention that the arbitration provision was invalid since the shareholders did not unanimously approve it was unpersuasive as well. Defendant’s expert explained that Brazilian Corporate Laws provide that lacking unanimous agreement by shareholders on specific provisions does not in itself make that provision void per se.  Cantidiano conceded that there were certain situations where unanimous shareholder approval was needed in order to enact corporate changes but that adoption of an arbitration clause was not one of them.  Article 136 of Brazilian Corporate Law (BCL) provides that a simple majority is sufficient to change a given provision.  In addition, the expert presented past cases where shareholders had either withdrawn or voted against a company’s arbitration agreement and those shareholders were still bound to arbitration.

Judge Rakoff ruled that consent to arbitration was given simply when the plaintiffs purchased securities on the BOVESPA

After ruling that the arbitration clause was legally approved, Judge Rakoff ruled that consent to arbitration was given simply when the plaintiffs purchased securities on the BOVESPA.  The arbitration clause was adopted into the company’s bylaws in 2002.  In order to be certified into the plaintiff class of the litigation, plaintiffs had to have bought stock in or after 2010.  By buying stock eight years after the incorporation of the arbitration clause, which was a requirement of the BOVESPA, purchasers of Petrobras securities on the BOVESPA are deemed to have consented to the arbitration.  Rakoff found this interpretation to be consistent with case law and the intent of the drafters.

Lastly, Judge Rakoff ruled that Petrobras gave sufficient notice as to the shareholders meeting which elected to adopt the arbitration provision.  Plaintiff’s expert, Erica Gorga, argued that, the arbitration clause was not legally adopted because the meeting agenda published in advance of the shareholders’ meeting did not provide adequate notice of the proposed amendment.  Cantidiano refuted this claim by asserting that the agenda for the proposed 2002 amendment was published to the then current shareholders directly and prospective owners via the annual listings on the Securities Exchange Commission.  The notification alerted investors that a vote would be held on the reform of the Company’s bylaws to promote “changes to enhance corporative governance practices and to move toward fulfillment of requirements for listing in Level two of the BOVESPA.”  Among the requirements was the adoption of the mandatory arbitration clause.  Because the members of the putative class by definition purchased their shares in or after 2010, the arbitration clause is binding to purchasers.  The proof that reasonable efforts were made to alert both current and prospective shareholders as the arbitration amendment led Judge Rakoff to conclude that sufficient notice was given to the shareholders meeting.

the Judge also noted that invalidating the arbitration clause would cause unwanted consequences that contradict public policy

Some scholars have questioned the ruling arguing that recent amendments to Brazilian Corporate Law and established interpretations of the Brazilian Constitution provide dissenting investors a vehicle to avoid arbitration.  One argument against the ruling claims that Law 13,129 of the BCL was amended May 26, 2015 to give dissenting shareholders the right to withdraw from a company in case a shareholders general meeting approves the adoption of an arbitration clause into its bylaws.  A corollary to this argument is that having shareholders be bound to the arbitration clause in the absence of express consent violates article 5, XXXVI of the Brazilian Constitution, which states, “The law shall not exclude any injury or threat to a right from the consideration of the Judiciary.”  Therefore, binding shareholders to arbitration without their express consent unconstitutionally blocks potential plaintiffs from bringing claims into court.    While the argument makes sense, the Brazilian court has found that the BAA does not violate the Brazilian Constitution since shareholders may choose to sell their shares if they do not want to consent to the proposed arbitration clause.  Basically, once a simple majority approves the adoption of an arbitration provision, a shareholder also consents to arbitration by holding onto the shares of the company instead of selling it.

In addition to interpreting the BAA and past precedent, the Judge also noted that invalidating the arbitration clause would cause unwanted consequences that contradict public policy.  In the same year that Petrobras adopted the arbitration provision, 160 other companies took similar measures.  By invalidating Petrobras arbitration provision the court would invalidate all other arbitration provisions made pursuant to the BAA.  This undoubtedly weighed in favor of interpreting the arbitration clause in favor of the defendants.

Defendant’s not only argued that claims brought by parties who bought stock on the BOVESPA were subject to mandatory arbitration but the plaintiffs who purchased Petrobras securities in U.S. transactions must also arbitrate their Securities Act claims.  In support of their argument, defendants asserted that the arbitration provision applies to claims arising from “rules applicable to the operation of the capital market in general,” which includes U.S. federal securities laws.

Rakoff did not find this argument persuasive as he held that different rules of law applied to plaintiffs who bought their shares straight from the BOVESPA and those who purchased securities in the United States.  Nonetheless, Judge Rakoff proceeded to dismiss the securities claims by reasoning that the plaintiffs lacked standing to assert such claims.

Investing in foreign companies by engaging in trade on foreign exchanges is evolving into a landscape where the United States judicial system has limited authority to help American investors

Rakoff not only dismissed plaintiffs’ claims pertaining to Brazilian law, but also applied a relatively new standard from Morrison v. National Bank of Australia when he dismissed the Securities Act Claims.  Before Morrison, United States case law supported securities act claims brought both by foreign and domestic plaintiffs to recover losses incurred on foreign exchanges.  Morrison held that Securities Act claims exclusively apply to securities purchased on U.S. exchanges.  Even though the plaintiffs in the Petrobras litigation were citizens of the United States, they lacked standing to bring claims under the Securities Act since they purchased their securities on a foreign exchange.

Investing in foreign companies by engaging in trade on foreign exchanges is evolving into a landscape where the United States judicial system has limited authority to help American investors.  In addition to the previously known hurdles that result in dismissal like forum selection clauses and forum non-conveniens, mandatory arbitration provisions in companies’ bylaws and recent changes to the application of the Securities Act of 1933 are the new impediments that prevent the recovery of losses from purchases made on foreign exchanges.  While there is little an individual can do to change a court’s application of Securities claims, investors can take measures to ensure that they do not fall victim to the arbitration trap.  As mandatory arbitration provisions become increasingly common in a company’s bylaws, investors should conduct due diligence by researching the corporate laws pertaining to arbitration in a given country and sifting through the bylaws of the company of interest.

Researching the corporate laws of a country seems like a lot of work but most securities regulatory agencies post a country’s relevant corporate and transactional laws on their website.  The United States Securities and Exchange Commission has listings of all market regulations.  The Securities and Exchange Commission of Brazil has a section on its website that directs the reader to relevant laws and the latest regulatory notices.  Resources like these can be a helpful starting point in getting acclimated with a foreign country’s market regulations.

Locating a company’s bylaws is a similar process.  If an investor has targeted a particular company whose shares are being publicly traded, that company’s bylaws must be made public in the corresponding regulatory agency.  For instance, an individual may look up the bylaws to any publicly traded company on a United States exchange by searching the Securities Exchange Commission’s database, Edgar.  Similar databases can be found on many country’s regulatory agency websites.  Conducting this type of due diligence is nothing short of a tedious nuisance, but it is necessary if you want to protect yourself from mandatory arbitration.

Judge Rakoff’s opinion is illustrative of the dangers that an investor exposes him or herself to on foreign exchanges.  For future investors, it is important to note that the United States courts no longer apply Security Act claims to purchases of securities exchanges abroad.  In addition, if things go badly with a foreign investment, your best chance of a remedy may be mandatory arbitration according to the company’s bylaws.

A lower risk solution is to purchase securities on United States exchanges.  By doing so, an individual preserves their right to bring Security Act claims and likely doesn’t bind him or herself to arbitration.  However, if an individual is determined to purchase securities on a foreign exchange yet remain unbound by an arbitration clause, that person should take steps in the form of diligent research to ensure that result.