United States: Arbitration: The Plaintiffs’ Bar Strikes Back

I. Introduction

Arbitration provisions in consumer finance contracts came into widespread use in the mid-to-late 1990s as an effective industry antidote to the plague of class actions raging during that decade. Consumer finance companies and retailers saw the U.S. Supreme Court’s broad view of the reach of the Federal Arbitration Act (the FAA) in 1995’s Allied-Bruce Terminix Cos. v. Dobson ¹ as a means not only to preclude runaway punitive damage verdicts in state courts but also to prevent class actions, the conventional wisdom then being that class arbitrations were not permitted under the FAA. In the ensuing years, arbitration provisions in consumer contracts became a kind of wonder drug, defeating or deterring the filing of many putative class actions.

Particularly in the past year, however, judicial reluctance to cede jurisdiction to private arbitration in consumer cases has found momentum to the point that arbitration provisions are now under full-fledged counterattack, principally under the flag of the doctrine of unconscionability. And the U.S. Supreme Court dealt another blow to the use of arbitration, in its 2003 decision in Green Tree Financial Corp. v. Bazzle,² by determining that an arbitrator could order class arbitration where the contract did not expressly forbid it. Whether or not the

Green Tree Financial Corp. v. Bazzle involved two companion cases in the South Carolina Supreme Court against Green Tree. In each case, the South Carolina Supreme Court affirmed a class award of about $10 million, plus attorneys’ fees. In one case, the trial court had certified a class and then ordered arbitration. In the other case, no class was certified prior to arbitration, but the parties chose the same arbitrator selected in the first case.

The arbitration provisions at issue in Green Tree did not expressly address class actions. The U.S. Supreme Court thus faced three options:

• Let the arbitrator decide whether the contract permitted class arbitration;

• agree with the South Carolina Supreme Court that the arbitration provision did not prohibit class arbitration and affirm; or

• reverse the South Carolina Supreme Court and hold that the FAA preempted South Carolina law to the extent it permitted class arbitrations.

In the U.S. Supreme Court’s Green Tree decision, four Justices held that the contract interpretation question should have been decided by the arbitrator. The Court’s decision held that it was not one of the "gateway" matters concerning an arbitration agreement that courts decide, such as whether there is a contract at all. The question involved what kind of arbitration the parties agreed to, not whether they agreed to arbitrate. Thus, according to Justice Breyer’s plurality opinion, because the trial court certified a class first, and the arbitrator likely thought he was bound by that decision in both cases, remand was warranted to give the arbitrator a chance to do the job for which the parties contracted.

Justice Thomas opined separately that he would never enforce the FAA in state court proceedings, period. Justice Stevens also wrote separately, stating that he would prefer to affirm contract permitted class proceedings, the Court held, was for the arbitrator to decide. These developments are the subject of this article. the South Carolina Supreme Court’s ruling, but concurred in the plurality opinion so there would be a controlling judgment.

Bazzle did not involve a provision, commonplace in many contracts, barring class arbitration. The enforcement of such a provision is the crucial issue in many pending cases. What does Bazzle suggest about the outcome of an appeal of a holding that a provision barring class arbitration is unconscionable?

First, whether or not a provision is unconscionable is likely to be seen as a "gateway" matter to be decided by a court. Second, since unconscionability was not an issue in Bazzle, little seems certain about the Justices’ reactions to unconscionability arguments. It seems likely, though, that the three dissenting Justices would uphold a class action ban as permitted under the FAA and preempting contrary state law.³ Third, if the unconscionability case is a federal case, then a fourth vote might be coaxed from Justice Thomas, perhaps leaving Justice Scalia, who concurred in Justice Breyer’s opinion, in the infrequent role of potential swing vote.

What should a defendant do if its arbitration agreement is silent about a bar on class actions? Bazzle very likely means the arbitrator will decide whether the arbitration is a class arbitration or not. Obviously, a defendant should choose an arbitrator with the utmost care. A three-member panel, though somewhat more costly, is usually preferable to a single arbitrator where the risk of a large award is a concern; collegial interaction may have a tempering effect on an award. Ultimately, because an arbitrator’s decision is very difficult to overturn in the courts, in some states defendants may even prefer to waive arbitration and take their chances in state court, with full appellate review.

In recent years, the defense of unconscionability has gained strength as an argument to avoid certain types of arbitration provisions. Arbitration provisions, of course, are enforced as a matter of contract, so traditional contract defenses may be available as a means to defeat the arbitration provision. Indeed, it is not unusual for plaintiffs relying on unconscionability to raise other contract defenses as well, including fraud in the inducement, duress, or other similar theories.

In evaluating unconscionability claims, most courts distinguish between "procedural" unconscionability and "substantive" unconscionability. Procedural unconscionability refers to the process by which an agreement is reached and the agreement’s form, including the use of fine print, boilerplate, or inconspicuous language, or the use of convoluted or unclear wording. Substantive unconscionability, on the other hand, refers to contractual terms that are unreasonably or grossly favorable to one side (so that no reasonable consumer with knowledge of such terms would have assented). The courts are split on whether a party must show both procedural and substantive unconscionability in order to establish a valid defense to the attempted enforcement of an arbitration agreement.⁴ Nevertheless, a gross disparity in the contract terms (even absent evidence of procedural unconscionability) may support a finding of unconscionability.

The factors most often cited by courts in finding actionable unconscionability include: (1) lack of adequate notice (e.g., the use of fine print or inconspicuous language; not requiring the consumer to read or initial the arbitration provision prior to signing the contract; unclear or confusing language in the arbitration clause; not providing a copy of the agreement for months after transaction; etc.); (2) deprivation of adequate remedies (e.g., prohibiting class actions; prohibiting injunctive or declaratory relief; limiting the amount recoverable; capping punitive damages; etc.⁵ ); (3) a lack of "mutuality" (allowing the lender, but not the borrower, to seek judicial review of the arbitration award; or a provision applicable only to claims traditionally brought by an employee but not to those brought by employers; or allowing one party to unilaterally alter terms; etc.); (4) a biased arbitrator or arbitration process (e.g., the employer selects the arbitrator; use of a panel of arbitrators connected to the industry or paid by an industry group; requiring the consumer to make his or her claim within a shortened time period; etc.); (5) an unreasonable location which denies the claimant effective access (e.g., requiring the consumer to travel 1,000 miles to arbitrate the claim); (6) unreasonably high costs or excessive fees (e.g., requiring arbitration in compliance with rules that impose high filing fees; cost-sharing provisions that inure to the benefit of one party; etc.); and (7) procedural unfairness (e.g., real or implied threats should the employee not sign the agreement; shortening the otherwise applicable statute of limitations; limiting discovery; etc.).

Although many unconscionability cases feature consideration of multi-pronged attacks on arbitration provisions, often one concern predominates over others. The recent cases discussed below are grouped by what seems to be the principal issue addressed by each court.

In East Ford, Inc. v. Taylor,⁶ the Mississippi Supreme Court found an arbitration agreement signed by an automobile purchaser to be procedurally unconscionable because the contract did not sufficiently highlight the arbitration provision. The language was not in boldface type, and was one-third the size of many of the other (highlighted) terms in the document, in what the court termed "very fine print." The court did not address the issue of substantive unconscionability, and did not explicitly address FAA-state law discrimination and preemption issues⁷ that seem evident where a state court adopts special presentation requirements for arbitration provisions. The East Ford case is potentially significant because of the widespread use of arbitration in Mississippi consumer contracts, but seems limited to the facts relating to the specific agreement described by the court. In fact, in a case decided shortly afterward by the same court, Russell v. Performance Toyota, Inc.,⁸ an arbitration agreement between a dealership and a truck buyer was held not to be unconscionable, although the buyer claimed he lacked knowledge of the contract as a whole and of the arbitration agreement in particular. The court concluded the buyer was not coerced into signing the agreement, and the arbitration provision in the purchase agreement was preceded by boldface and capitalized headings and was almost immediately succeeded by the signature line.

In much the same vein as East Ford is the Nevada Supreme Court’s decision in Burch v. Second Judicial District Court.⁹ In Burch, an arbitration clause in a warranty booklet was found to be procedurally and substantively unconscionable. The court concluded that the buyers were not sophisticated consumers and did not understand warranty terms, and that some of the builder’s representations were misleading. Also, the arbitration provision was provided in a non-conspicuous manner (located on page six of a thirty-one-page warranty booklet, after five pages of material relevant only to persons residing outside of Nevada). The provision also granted the builder’s insurer the unilateral and exclusive right to decide the rules governing arbitration and to select the arbitrators. Under these circumstances, the court concluded, the provision was unconscionable and would not be enforced.

Numerous recent California decisions find arbitration provisions that prohibit class actions to be unconscionable. In Ingle v. Circuit City Stores, Inc.,¹⁰ the Ninth Circuit U.S. Court of Appeals refused to enforce an employment contract’s arbitration provision that applied only to claims by the employee and barred class actions. The Ninth Circuit also focused on: the one-year limitations period; a $75 filing fee payable to the employer; a splitting of costs coupled with possible shifting of all costs to the employee; and the $5,000 limit on punitive damages. The court refused to sever the invalid provisions and enforce the agreement. (Circuit City’s employment agreement fared somewhat better in the Sixth Circuit, which held the limitation of remedies and cost-splitting provisions were unconscionable, but severed them and compelled arbitration.)¹¹

Similarly, in Ting v. AT&T,¹² the Ninth Circuit deemed a long distance telephone company’s unilateral imposition of a new subscriber contract that imposed binding arbitration to be procedurally and substantively unconscionable. The Ting contract: eliminated class actions; curtailed damages in cases of misrepresentation, fraud, and other intentional torts; and imposed a fee-splitting provision that placed significant financial hurdles in the potential litigant’s path. The contract also barred consumers from disclosing the existence, content, or results of an arbitration or award (except as required by law or to confirm and enforce the award).

In Circuit City Stores, Inc. v. Mantor,¹³ the Ninth Circuit deemed a later, revised version of Circuit City’s arbitration provision to be unconscionable under California law, because it retained anti-class action limitation period and cost-splitting provisions, and because the employee was unduly pressured to sign the agreement (or potentially risk his position). The provision also required employee payment of a waivable $75 filing fee.

A California district court, in Acorn v. Household International, Inc.,¹⁴ refused to enforce, as unconscionable, an arbitration agreement executed in the course of buying and financing a home. The agreement prohibited class actions, provided that the eventual arbitration award should remain confidential, and contained an arbitration fee structure that split costs between the parties. The offending provisions were also held not severable.

The California Supreme Court has agreed to review the class action bar/ unconscionability issue to resolve a split in the state’s lower appellate courts. In Szetela v. Discover Bank,¹⁵ a California Court of Appeals panel held that a credit card agreement’s arbitration provision (sent by notice in billing statement) was procedurally and substantively unconscionable in prohibiting class actions for small individual claims. In the court’s view, the provision was not only unfair to credit card customers, who might be owed relatively small sums of money, but also served as a disincentive for the card issuer to avoid the type of conduct that might lead to class actions. The same court later reaffirmed that holding in another case,¹⁶ applying Nevada law. Another California appellate panel, however, held that the FAA preempted state law to the extent that state law would not enforce the card agreement with the class action ban.¹⁷ The California Supreme Court agreed on April 9, 2003 to hear the cases.¹⁸

Cases finding anti-class action arbitration provisions to be unconscionable are not confined to California-based courts. In Luna v. Household Finance Corp. III,¹⁹ a federal district court held, under Washington law, that an arbitration agreement was not procedurally unconscionable but was substantively unconscionable. Borrowers who consolidated their debts signed an arbitration agreement with the lender that: prohibited class actions; provided the lender with the ability to seek judicial review; required that arbitration awards be kept confidential; and included a cost-splitting schedule that would require the borrowers to pay much more than they would have if pursuing their claims in court. The court refused to compel arbitration.

The Alabama Supreme Court, in Leonard v. Terminix International Co., L.P.,²⁰ held that an arbitration clause in a pest control agreement was unconscionable because it expressly precluded a class action. The court reasoned that underlying claims for less than $500 could not be feasibly prosecuted under the American Arbitration Association’s Commercial Arbitration Rules, so that the effect of the class action bar was immunity for the defendant. The court distinguished cases rejecting arguments that arbitration provisions were unconscionable because of the impecunious circumstances of the plaintiff. The court reasoned that those cases involved personal circumstances while the economic infeasibility point was applicable to anyone, rich or poor. The court also explained that it would hold a provision prohibiting class actions to be unconscionable even if arbitration were not required. On rehearing, the court declined to consider the effect of the applicability of the AAA’s consumer arbitration rules on its ruling.

In State ex rel. Dunlap v. Berger,²¹ the West Virginia court found an arbitration provision in a retail purchase and financing agreement that prohibited punitive damages and class action relief to be unconscionable. These limitations were found not to be severable. Although not denominating the issue as one of severability, the court refused to "sanitize" the unconscionable contract.

A recent Illinois case, however, Hutcherson v. Sears Roebuck & Co.,²² demonstrates that arbitration provisions precluding class relief still will be enforced in many, if not most, jurisdictions. Applying Arizona law but citing no Arizona cases and discussing general case law, the Hutcherson court held that an arbitration provision with a class action prohibition was enforceable. The court rejected the California court’s decision in Szetela, and stated that the importance of class actions as a consumer protection tool was overriden by the strong federal policy favoring enforcement of arbitration agreements. The court also cited other cases so holding.²³

Where an arbitration provision includes special provisions for selection of an arbitrator or for the arbitration procedure, rather than relying on the rules of an established arbitration organization, the provision may be vulnerable to attack.

In Harold Allen’s Mobile Home Factory Outlet, Inc. v. Butler,²⁴ a provision in an arbitration agreement that authorized the seller of a mobile home to select the arbitrator unilaterally was held to be unconscionable. The only limitation on the arbitrator selection provision was that the arbitrator could not have performed legal services for seller. The court deemed this to offend "fundamental notions of fairness."

Murray v. United Food & Commercial Workers International Union,²⁵ an employment discrimination case, involved an arbitration agreement, signed as a condition of employment, that gave the union the power to choose the arbitrator, and allowed the union, but not the employee, to disregard the arbitration result (to the extent that the arbitrator’s decision purported to alter the union’s bylaws). Under such circumstances, the court concluded that the agreement was "utterly lacking in the rudiments of even-handedness" and refused to enforce the arbitration provision.

In Little v. Auto Stiegler, Inc.,²⁶ the provision in a mandatory employment arbitration agreement permitted either party to "appeal" an arbitration award of more than $50,000 to a second arbitrator. The California Supreme Court held the provision to be unconscionable because it inordinately benefitted the defendants by authorizing a post-arbitration proceeding, either judicial or arbitral, wholly or largely at the expense of the party on which the arbitration was imposed. The court also noted that an agreement may be held unconscionable if it lacks a "modicum of bilaterality," wherein the employee’s claims against the employer, but not the employer’s claims against the employee, are subject to arbitration. The unconscionable provision was severed from the remainder of the valid arbitration agreement.

Provisions in arbitration agreements that limit damages or remedies available to consumers or employees continue to encounter legal difficulty. Where found invalid, these limitations are sometimes deemed severable, so arbitration still is compelled, but recourse to arbitration may be jeopardized if limitations on remedies are coupled with other issues, such as costs.

The U.S. Supreme Court had an opportunity this term to address this issue in PacifiCare Health Systems, Inc. v. Book.²⁷ The arbitration provision in Book barred an award of punitive damages. The district court refused to compel arbitration of the plaintiffs’ federal RICO claims, on the ground that the punitive damage bar precluded the plaintiffs from obtaining meaningful relief, and the Eleventh Circuit U.S. Court of Appeals affirmed. The Supreme Court held that it was unclear whether the punitive damages bar precluded treble damages under RICO, so it compelled arbitration to allow the arbitrator to decide the question.

In Ex Parte Thicklin,²⁸ the Alabama Supreme Court held that a provision in the arbitration agreement prohibiting the arbitrator from awarding punitive damages was unconscionable and void as a matter of public policy. The plaintiff, a mobile home purchaser, was therefore entitled to seek punitive damages, notwithstanding the arbitration agreement to the contrary. The prohibition was deemed severable.

In BellSouth Mobility LLC v. Christopher,²⁹ the Florida court held that the arbitration agreement was at least substantively unconscionable. The agreement was in a preprinted contract for wireless telephone services. It provided that: the arbitrator could not award punitive damages; limited recovery to actual damages; and precluded class action relief. The agreement also gave the telecommunications company an unfair advantage, the court reasoned, since customers were bound to arbitration but the company retained the option of pursuing court action in some instances, including collection of debts. The Bell South court concluded that the substance of the arbitration provision was unconscionable, but remanded for an evidentiary hearing regarding procedural unconscionability.

In Simpson v. Grimes,³⁰ the Louisiana Court of Appeals held that an arbitration agreement contained in a contract for brokerage services was unconscionable for lack of mutuality. The court found that although the investment company did not explicitly retain the right to seek non-arbitral relief, it achieved the same result through "clever subterfuge." As a result, the court concluded that the agreement was unconscionable because it allowed the investment company alone to modify the terms of the arbitration agreement.

The "no mutuality" argument, though rejected by most courts as a contract law argument, was successful in Cash in a Flash Check Advance of Arkansas, L.L.C. v. Spencer,³¹ in which the Arkansas Supreme Court held that an agreement requiring only the consumer to submit disputes to arbitration would not be enforced. The arbitration provision was in a loan contract issued by a check-cashing company. It allowed the merchants to resort to court action, but did not allow the consumer the same option. The court held that the agreement was void for lack of mutuality as a matter of contract law. The court did not rely on the doctrine of unconscionability.

The Supreme Court held in Green Tree Financial Corp.-Alabama v. Randolph ³² that an agreement to arbitrate in a retail installment contract was not unenforceable simply because it did not address arbitration costs. The Court concluded that the record did not show that the consumer in fact would bear prohibitively large arbitration costs if the arbitration proceeded. The agreement’s silence alone was insufficient, in other words, to preclude enforcement of the arbitration provision. The Court did not suggest how detailed a showing of the burdensomeness of costs would be required to preclude enforcement of an arbitration agreement.

In Livingston v. Associates Finance, Inc.,³³ the agreement provided that the lender "may" pay arbitration costs if the borrowers requested it and were unable to do so themselves. In seeking to compel arbitration, the lender offered to pay costs exceeding what the borrowers would incur in federal court. The district court refused to compel arbitration, finding the cost offer to be vague and the risk of a discretionary fee award being made by the arbitrator to the lender to create such uncertainty that the borrowers’ exercise of their Truth-in-Lending Act rights was impeded. The Seventh Circuit U.S. Court of Appeals reversed, finding that the borrowers bore the burden of showing that costs would be prohibitive, under the standard Green Tree-Alabama, and had failed to meet that burden. The Seventh Circuit stated in Livingston that the lender’s ultimate offer to pay all costs foreclosed the possibility that costs would be prohibitive. The court directed the parties to arbitration.

A provision in an arbitration agreement requiring a mobile home purchaser to pay a AAA filing fee of more than $2,000 was held to be unconscionable in Mendez v. Palm Harbor Homes, Inc.³⁴ The potential dispute was worth only $1,500, and the court concluded that requiring arbitration would be oppressive and against public policy. The Washington court took note of Green Tree-Alabama, but couched its analysis in terms of unconscionability.

In Faber v. Menard, Inc.,³⁵ an Iowa district court considered whether an arbitration provision in an employment contract was unconscionable. The provision compelled the employee to pay half of the arbitrator’s fees and to bear the employee’s own costs in the arbitration. Relying heavily on Ninth Circuit precedent from California, the Iowa court held that the agreement was both procedurally and substantively unconscionable and refused to compel arbitration of the employee’s claims.

Arbitration provisions are still enforced by many courts, but a right to compel arbitration can no longer be taken as a given. In order to realize the benefits of arbitration provisions, parties will need to be vigilant for case law changes that could jeopardize enforcement, and update their agreements accordingly. Thus, a regular "maintenance schedule" for arbitration provisions is advisable. Companies operating in more than one state should do so on a state-by-state basis. In seeking to compel arbitration, vehicle dealers have an advantage over employers: customers ordinarily have a choice where to shop. Demonstrating that the buyer had a meaningful choice and did not avail himself or herself of it has been useful for companies seeking to compel arbitration. In drafting, the parties should avoid limitations on remedies and focus on the main economic objectives: avoiding the costs of litigation, and the risk of runaway jury verdicts and class actions. Similarly, arbitration is not a profit center; creditors should forget about filing fees, and be sure the costs for the consumer are comparable to what they would be in court. If self-help or provisional remedies in court must be reserved as a practical matter, then creditors should be sure that at least some issues of interest to both sides are subject to arbitration. A stand-alone arbitration agreement can eliminate arguments concerning presentation, formatting, and formation issues. Finally, parties to potential litigation should think strategically about particular cases that could set precedents. A company does not have to seek arbitration in every case that it could do so. Merely having an arbitration provision in a consumer contract is a deterrent to some cases. And, if an arbitration provision has been held to be unenforceable by a trial court, consider whether appealing and creating a published precedent is really worth the risk and is better than the alternatives.

Sutherland articles are intended to provide clients with information on recent legal developments, not to render legal advice.