November/December 2016

ADR and Governance News from Jim Reiman

November –  December, 2016

Friends and colleagues

Thanksgiving has come and gone, and the year-end and new year holidays are upon us.  Best wishes to all for a relaxing and joyous holiday season, and a healthy and fulfilling new year.

As regular readers of this Newsletter know, each issue I present a summary of recent research reports, legal decisions and news articles that I hope my readers will find of interest and worthy of their time to peruse and perhaps download and read in their entirety.  I focus on two areas:  corporate governance and alternative dispute resolution (“ADR”).  Additionally, I almost always include a matter of general interest in an “Interesting Case/Article of the Month” section.  Previously I had also included an article concerning discovery and e-discovery in particular given the 2015 amendments to the Federal Rules of Civil Procedure.  Now that the new rules are in force and being employed, I’ve been told by several readers such cases are of less interest hence I will no longer include a discovery case unless one of particular interest crosses my desk.

Regrettably, this issue does not include an “Interesting Case/Article of the Month.”  Quite candidly, since the November election my non-legal reading has been monopolized by election related issues and the Trump transition, and I have not come across an article of general interest that is not election focused.  Assuming that my readers, like me, are overloaded by election reporting, I’ve decided to forego an Interesting Article this month and take a vacation from the election and transition.

For my governance readers, I present two studies:  one just published documenting the decline in the number of public companies, the concomitant increase in the size and market-share of the remaining companies, and the general state of the American corporation.  Additionally, I present three related articles which seemed uniquely appropriate given the current news regarding the hacking of the US political parties’ servers.  They concern cybersecurity and the question:  who is responsible (and accountable) for cybersecurity?  At issue:  the “widespread lack of personal and organizational accountability for the protection of a company’s most sensitive data.”

For my arbitrator readers, I present two cases.  The first is a decision issued by the Supreme Court of Switzerland addressing the independence of arbitrators who are lawyers in large international firms.  The second is a Third Circuit decision compelling arbitration and reversing a District Court decision holding that the Courts, and not an arbitrator, were to adjudicate the parties’ dispute.  The case also addresses a narrow “reverse-preemption” statute which permits states to preclude arbitration of certain disputes notwithstanding the Federal Arbitration Act’s general preemption of State law.

This Month’s Articles

Corporate Governance

  • The Accountability Gap:  Cybersecurity & Building a Culture of Responsibility:  Tanium, a Silicon Valley tech and cybersecurity company, and Nasdaq “teamed up to investigate how business leaders assess their own cybersecurity vulnerability.”  Their report, “The Accountability Gap: Cybersecurity & Building a Culture of Responsibility”, researched by Goldsmiths, University of London, “found a worrying gap between presumed and actual corporate readiness for data security incidents and a widespread lack of accountability at the top levels of organizations.”  While there have been may such reports and studies recently, I present this one because it addresses the issue of personal accountability within an organization and the relationship between corporate cultural and cybersecurity.  As the authors put it in their Executive Summary:  “[There is a] widespread lack of personal and organizational accountability for the protection of a company’s most sensitive data.”  The problem is not merely a technological problem, it is also a problem of culture.
  • Is The American Public Corporation In Trouble?: The National Bureau of Economic Research published a report at the end of November on the state of the American public corporation:  “Is the American Public Corporation in Trouble?”  Their findings:  “There are fewer public corporations now than forty years ago, but they are much older and larger. They invest differently, . . . have record high cash holdings, . . . are less profitable . . . and profits are more concentrated.”  The study examines the differences between public companies today and those of 40 years ago, and several of the reasons for such differences.

Alternative Dispute Resolution

  • Independence Of Arbitrators In Large International Law Firms:  The Supreme Court of Switzerland recently addressed the question of whether the failure of a sole arbitrator (a lawyer in the Swiss office of law firm X) to disclose that that the German office of his firm represented one of the parties in an unrelated matter required the granting of a request for revision.  A corollary issue was the effect of the International Bar Association (IBA) Guidelines on Conflicts of Interest in International Arbitration, which the moving party argued mandated that the arbitrator recuse himself.  Based upon an analysis of the specific facts of the case, the Swiss Supreme Court upheld the arbitration award and the propriety of the arbitrator’s service.
  • Compelling Arbitration/Reverse-Preemption:  The case, decided by the Third Circuit Court of Appeals, reversed and remanded a District Court’s decision denying a motion to compel arbitration.  At issue was whether the appellant’s challenge was to the contract as a whole or just the arbitration clause of the contract.  Also at issue was the enforceability of a Nebraska law prohibiting the arbitration of insurance disputes – a “reverse-preemption” statute.

I hope you find one or more of the below articles of interest and worthy of your inbox’s space.

Warm regards,

Jim Reiman

Articles / Corporate Governance

The Accountability Gap:  Cybersecurity & Building a Culture of Responsibility 

Given the current news cycle’s focus on the computer hacks of the Democratic and Republican parties’ servers and the renewed focus on cybersecurity, I thought it appropriate to present three related articles I’ve seen over the months regarding cybersecurity.  Like most in the corporate governance world, I’ve sat through multiple presentations on cybersecurity and cyber-risk, and have read dozens of articles.  While I’m certainly no expert, my take-away is that achieving cybersecurity is as much about changing corporate culture – both in the boardroom and in the trenches – as it is about technology.

The principal article presented (a report of a study commissioned by Tanium, Inc. and Nasdaq) reviews the issue from the board perspective and squarely addresses the need for individual directors to assume responsibility for cybersecurity just as they assume responsibility for financial and other issues that impact the company as a whole.  The second article in the group of pieces presented (“Aligning Cybersecurity with Corporate Culture,” appearing in the Wall Street Journal) discusses cybersecurity and corporate culture.  Both address the “lack of personal and organizational accountability for the protection of a company’s most sensitive data.”

Consider:  In the December 14 issue of the New York Times it was reported that the FBI contacted the Democratic National Committee (“D.N.C.”) in September, 2015 and advised them that “[a]t least one computer system belonging to the D.N.C. had been compromised by hackers [that a FBI] . . . cyberespionage team [had] linked to the Russian government.”  The call was taken by Yared Tamene, a tech-support contractor for the D.N.C.  Mr. Tamene’s response:  he essentially he ignored the call.  “By his own account, he did not look too hard even after [the FBI] called back repeatedly over the next several weeks — in part because he wasn’t certain the caller was a real F.B.I. agent and not an impostor.”  Did it not occur to Mr. Tamene to ask for the FBI agent’s ID number and then call the Bureau in Washington to confirm his identity?  Assuming that Mr. Tamene advised those at the D.N.C. to whom he reported that the FBI had called, did they not believe it their job to do something?

The identification and assumption of responsibility for cybersecurity is the principal message of both articles presented.  As noted, the Tanium and Nasdaq piece focuses on the Board.  Recognizing that most directors are not technologists and that addressing and over-seeing cybersecurity is in part a technology issue, the Tanium/Nasdaq piece asserts that directors don’t need to be technologists, but they do need to have a sensitivity to the issues, the confidence to “speak up,” and the knowledge to know what questions to ask.

“Our findings revealed a hesitance in [directors], who did not consider themselves knowledgeable about cybersecurity, to speak up.  To a large extent, cyber is still delegated entirely to those “techies,” but board members are beginning to recognize their role in understanding the language and the issues around cybersecurity. 

*     *     *

Even when an organization has the best technology in the world, if the people who are safeguarding that organization’s most trusted information don’t know how to be accountable and responsible, the company is still at great risk. “It’s knowing which questions to ask, but it’s also knowing what evidence looks like. And not even being able to interpret it, because a lot of that would be technical, but being able to demand proof that somebody can stand by their answers,” 

The Tanium/Nasdaq piece defined seven inherent challenges that make up cybersecurity vulnerability: Cyber Literacy, Risk Appetite, Threat Intelligence, Legislation & Regulation, Network Resilience, Response, and Behavior.  It then developed a statistical model for determining “readiness, awareness and vulnerability for these challenges and assessed [such] through a survey of 1,530 non-executive directors (NED), C-level executives, Chief Information Officers (CIO), and Chief Information Security Officers (CISO) across the United States, United Kingdom, Germany, Japan, and Denmark, Norway, Sweden, and Finland (Nordics).”  The study’s goal:  “understand where the gaps exist across all organizational levels around cybersecurity vulnerability from a people, process, and technology perspective.”

The findings:

“Our study findings illustrate the daily realities of low awareness and low readiness: 91% of NEDs at the highly vulnerable companies cannot read a cybersecurity report, preventing them from asking the right questions and validating the data that technical leadership provides. On the readiness side, 98% of highly vulnerable companies do not track devices on their network, leaving them unable to secure what they cannot manage. Combined with the 2 out of 5 respondents across NED, C-level, and CIO/CISO-level respondents who admitted they don’t feel responsible for the repercussions of a cyberattack, it’s easy to see why the Accountability Gap is growing.”

  Tanium Inc. and Nasdaq, Inc, The Accountability Gap:  Cybersecurity & Building a Culture of Responsibility

 JR Reagan, “Aligning Cybersecurity with Corporate Culture,” The Wall Street Journal, April 25, 2016

 Eric Lipton, David E. Sanger, Scott Shane, “The Perfect Weapon: How Russian Cyberpower Invaded the U.S.,” New York Times, December 13, 2016


Is The American Public Corporation In Trouble?  

Authors Kathleen Kahle (University of Arizona) and René Stulz (Ohio State University, Fisher College of Business) examine and document changes in American public companies over the past 40 years and the 1989 prediction by Michael Jensen of “the demise of the public corporation.”  They find that unlike the rest of the world, the number of American public companies has declined. . . significantly.

There are today roughly one half the number of public corporations (3,776) than at the peak in 1997 (7,507), and 22% fewer than 40 years ago (1975).

“Not only are there fewer public corporations today than forty years ago, but these corporations are very different. They are much older and bigger. They are in different industries. Their assets are composed differently. They invest less in physical assets but more in R&D. They finance themselves differently. They are less profitable, especially if they are small. Their payouts to shareholders are higher, but in contrast to forty years ago, more payouts take the form of repurchases than of dividends. Their shareholders are very different, as institutions now typically hold more than half the shares of corporations large enough to be suitable investments for such investors.”

In terms of economic impact, public companies today have far greater wealth than 40 years ago.

“[T]he average market value of equity of public corporations [is] significantly larger [today than 40 years ago.]  In fact, we find that the average market value of the equity of a public corporation (in constant 2015 dollars) in 2015 is almost ten times the market value in 1975. The median market value increases by a factor of ten as well. Hence, we have fewer public corporations, but they are much larger. This increase in size is accompanied by a striking increase in the concentration of performance and assets. In 2015, 35 corporations account for half the assets of public corporations and 30 account for half the net income. In contrast, in 1975, these numbers were, respectively, 94 and 109.”

Not only has the wealth of American public companies changed significantly over the past 40 years, but their ownership has as well.

“The first year in which we can obtain institutional ownership . . . is 1980.  In 1980, institutional ownership averages 17.7%.  In 2015, average institutional ownership is 50.4%.  Shareholders’ payouts from corporations also differ now compared to 1975.  Average dividends per dollar of assets are lower today than in 1975, in spite of the fact that average dividends per dollar of assets have increased by a factor of almost three since 2000.  Repurchases of shares are much higher now than either twenty or forty years ago.  Since the late 1990s, public corporations as a whole spend more on repurchases than on dividends, and repurchases per dollar of assets are more than six times what they were forty years ago.  Because of the increase in repurchases, the highest share of net income paid out during our sample period is in 2015.  Another important implication of repurchases is that, when we use an asset-weighted average, American public firms have negative net issuance of equity, meaning that large firms repurchase more shares than they issue for most years since the late 1990s.”

So, conclusions?  Is the American public corporation in trouble?  Is Jensen’s prediction of the demise of the public corporation being proven correct?

The authors don’t expressly answer these questions.  However, they conclude:  “As a whole, public firms appear to lack ambition, proper incentives, or opportunities. They are returning capital to investors and hoarding cash rather than raising funds to invest more.”  Not exactly a ringing endorsement of vigor and future strength.

 Kathleen Kahle, René Stulz, Is The American Public Corporation In Trouble?, National Bureau of Economic Research, November, 2016

 Mark Fahey, The Other 1%:  Fewer And Fewer Public Companies Are Getting More And More Of The Pie, CNBC LLC, November 30, 2016

Articles / Alternative Dispute Resolution

Independence Of Arbitrators In Large International Law Firms 

Swiss lawyers Frank Spoorenberg and Daniela Franchini, of the Genevia law firm Tavernier Tschanz, report a recent decision by the Swiss Supreme Court addressing the independence of arbitrators who are lawyers in large international firms.  The case concerned an arbitration arising out of a contract for the construction and installation of a boat lift in Italy.  The parties were a Dutch affiliate of a German Group (Y) and an Italian company (X).  The lift cables failed, and X filed a request for arbitration before the ICC seeking damages from Y.  The ICC appointed a Swiss lawyer from the Swiss office of law firm A as sole arbitrator.  The arbitration proceeded, and the arbitrator found for Y.

Following the entry of the award, X learned that the German office of law firm A had advised a company belonging to the same group as Y.  According to X, “the connection between the law firm A and a company belonging to the same group as Y would have constituted a ground to challenge the arbitrator or the award had it been known during the proceedings,” and that such a challenge would have resulted in the removal of the arbitrator.  Specifically, X argued that under the International Bar Association (IBA) Guidelines on Conflicts of Interest in International Arbitration, recusal was mandated.

While the specific IBA Guideline is not referenced in the Spoorenberg/Franchini report, this author assumes that the reference is to IBA Guideline 1.4, which identifies as a relationship which results in a non-waivable conflict of interest those situations wherein “The arbitrator or his or her firm regularly advises the party, or an affiliate of the party, and the arbitrator or his or her firm derives significant financial income therefrom.”

The Swiss Supreme Court held that “the different lawyers working with A had to be considered members of one and the same law firm”.  The arbitrator submitted that “A was not an integrated law firm, the members of which would share the fees, but a mere network of independent law firms.”  The Court, relying upon this fact, confirmed the arbitral award and determined the arbitrator to have acted properly in serving as an arbitrator in the proceeding.  In so finding, the Supreme Court “emphasized that the member firms of the network were independent legal entities with no financial integration.”  Additionally, it noted that “the party to the arbitration and the affiliate had no specific relationship and were members of a group composed of more than 300 legal entities.”

Based on these conclusions, the Supreme Court found that the IBA Guidelines “had no relevance in this case.”  Additionally, the Supreme Court found that “the circumstances of the case were not of such gravity as to render the award ‘incompatible with the sense of justice and equity’ because there was no indication of any bias against X during the proceedings (subjective impartiality) and the connection between the arbitrator and Y’s affiliate was very tenuous (objective impartiality).”


 Frank Spoorenberg and Daniela Franchini, Independence Of Arbitrators In Large International Law Firms, International Law Office, December 1, 2016


Compelling Arbitration/Reverse-Preemption:  

In South Jersey Sanitation Company, Inc. v. Applied Underwriters Captive Risk Assurance Company, Inc., the United States Court of Appeals for the Third Circuit reversed a lower court’s denial of a motion by Applied Underwriters Captive Risk Assurance Company, Inc (“Applied Underwriters”) to compel the arbitration of its dispute with South Jersey Sanitation Company, Inc. (“South Jersey”).  At issue was an agreement know as the Reinsurance Participation Agreement (“RPA”), which South Jersey sought to have rescinded based upon fraud, intentional misrepresentation, illegality, and negligent misrepresentation.

The District Court ruled in favor of South Jersey, finding that (1) Nebraska law governed the dispute pursuant to the RPA’s choice-of-law clause; (2) Nebraska law provides that “all arbitration provisions ‘concerning or relating to an insurance policy,’ except those ‘between insurance companies,’ are unenforceable”; (3) “the RPA is not a contract between insurance companies”; (4) the Nebraska Statute prohibiting enforcement of arbitration agreements concerning or relating to insurance policies preempts the Federal Arbitration Act (“FAA”), through the McCarran–Ferguson Act (“M–FA”), and (5) the arbitration provision is therefore unenforceable.

The Court of Appeals reviewed the issues de novo, determined that the District Court had erred in failing to compel arbitration, and reversed and remanded.

Two principal issues were addressed:  First, given the clear and unambiguous existence of a “controlling arbitration agreement” within the RPA, did the District Court err by not enforcing such agreement?  Second, is the Nebraska “reverse-preemeption” statute applicable, and enforceable?

Beginning with the first issue, the right of a court to ignore a clear and “controlling” arbitration agreement when the contract containing the arbitration clause is alleged to have been procured by fraud, the Appellate Court held:

“Congress enacted the [FAA] ‘to reverse the longstanding judicial hostility to arbitration agreements ․ . . and to place arbitration agreements upon the same footing as other contracts.’  [citation omitted]  Although the FAA favors arbitration and limits the involvement of the court system in contracts that provide for arbitration, “[l]ike other contracts, (arbitration agreements) may be invalidated by ‘generally applicable contract defenses, such as fraud, duress, or unconscionability.’ ” Rent–A–Ctr., W., Inc. v. Jackson, 561 U.S. 63, 68 [remaining citation omitted]). Accordingly, where a party challenges the validity of an otherwise controlling arbitration clause, courts hear that challenge. [citation omitted] (“If a party challenges the validity under [FAA] § 2 of the precise agreement to arbitrate at issue, the federal court must consider the challenge before ordering compliance with that agreement under [FAA] § 4.”).

The challenge, however, must focus exclusively on the arbitration provision, rather on than the contract as a whole. As the Supreme Court stressed in Rent–A–Center, “only (an arbitration provision-specific) challenge is relevant to a court’s determination whether the arbitration agreement at issue is enforceable.” [citation omitted]. If the challenge encompasses the contract as a whole, the validity of that contract, like all other disputes arising under the contract, is a matter for the arbitrator to decide. [citation omitted].

*     *     *

[U]nless South Jersey specifically challenges the legal validity of the RPA’s arbitration provision, the parties’ present dispute, which arises out of the RPA, is subject to arbitration.”

With respect to South Jersey’s claim that the arbitration clause of the RPA was void under Nebraska law, the Appellate Court rejected South Jersey’s claims that the courts, and not an arbitration tribunal, must determine the applicability of the Nebraska reverse-preemption statute for similar reasons.

“On its face, South Jersey’s contention that the RPA’s arbitration provision is rendered unenforceable by the Nebraska Statute appears to target the arbitration provision alone, rather than the contract as a whole. This argument, however, suffers from the same defect as South Jersey’s fraud argument because regardless of whether the Nebraska Statute reverse-preempts the FAA that statute must first be shown to apply to the arbitration provision at issue. We determine that it is not clear that the short but obscure RPA falls within the ambit of the Nebraska Statute.”

The Appellate Court clarifies is decision regarding the reverse-preemption provision in a footnote:

“We do not decide here whether the Nebraska Statute reverse-preempts the FAA because South Jersey has not persuaded us that the Nebraska Statute is applicable to the contract at issue. To determine its applicability, the precise function and contours of the RPA must be elucidated, and that is a matter for the arbitrator under the parties’ clear and expansive arbitration agreement.”

Even though expressly declaring that it was not ruling upon the enforceability of the Nebraska reverse-preemption statute, the Appellate Court further examined that issue.  First, it set forth the applicable section of the McCarran–Ferguson Act (“M–FA”) relied upon to underpin the Nebraska statute.

“The M–FA provides in relevant part that ‘[n]o Act of Congress shall be construed to invalidate, impair, or supersede any law enacted by any State for the purpose of regulating the business of insurance, or which imposes a fee or tax upon such business, unless such Act specifically relates to the business of insurance[.]” 15 U.S.C. § 1012. 

Having reviewed the language of the M-FA, the Appellate Court concluded:  “[u]nder [the M–FA], state laws reverse-preempt federal laws if (1) the state statute was enacted ‘for the purpose of regulating the business of insurance,’ (2) the federal statute does not ‘specifically relate to the business of insurance,’ and (3) the federal statute would ‘invalidate, impair, or supersede’ the state statute.” [citation omitted]

Next, the Appellate Court looked to Nebraska’s interpretation of its statute:

“In Kremer v. Rural Community Insurance Co., [citation omitted] the Nebraska Supreme Court stated that, ‘under § 25–2602.01(f)(4), agreements to arbitrate future controversies concerning an insurance policy are invalid.’ Noting that ‘[e]very federal appellate court to address this issue has held that state laws restricting arbitration provisions in insurance contracts regulate the business of insurance and are not preempted by the FAA,’ (citations omitted), the Nebraska Supreme Court ‘conclude[d] that a statute precluding the parties to an insurance contract from including an arbitration agreement for future controversies regulates the insurer-insured contractual relationship’ [citation omitted]. In reaching this conclusion, the court noted that it did not consider dispositive ‘whether statutes restricting arbitration agreements in insurance policies affect the transfer of risk.’[citation omitted].  This language, while dicta, strongly suggests that Subsection (f)(4) of the Nebraska Statute applies only to insurance policies themselves, and that ‘any agreement’ must be read as an arbitration agreement or provision within such a policy, rather than a derivative investment contract.

Having reviewed the M-FA and the Nebraska Courts’ construction of its reverse-preemption statute, the Appellate Court applied its analysis to the facts of the case before it.  The Court’s conclusion:  it is not clear from the pleadings and documents whether the RPA is an “agreement concerning or relating to an insurance policy” within the meaning of the Nebraska Statute.  An argument that it does is a challenge to the entire agreement and not just the arbitration clause of the RPA, hence for the same reasons that an arbitrator must decide the issue of fraud, an arbitrator must decide the construction of the RPA and the concomitant applicability of the Nebraska statute.

 The full decision:  South Jersey Sanitation Company, Inc. v. Applied Underwriters Captive Risk Assurance Company, Inc., Case No. 14-4010 (3d Cir. Oct. 25, 2016)