Wallace & Graham - Articles - The Dangers of Mandatory Arbitration Clauses

The Dangers of Mandatory Arbitration Clauses

By Mona Lisa Wallace, Esq.

One of the most important consumer law issues that has emerged in recent years is the ever-more-frequent use by companies of consumer arbitration clauses in form consumer contracts. These arbitration clauses are increasingly found in everything from cellphone contracts to credit card terms to consumer goods contracts and warranties. Furthermore, there has been a general trend to include special provisions in these arbitration clauses that purport to ban class actions and classwide relief.

The evil this causes can be evinced by a simple hypothetical. Imagine a consumer who buys a DVD player that turns out to have a defect that would cost $100 to fix. It would be impractical in this situation to require the consumer to initiate an individual arbitration claim in this situation against the DVD manufacturer. No lawyer may be willing or able to take the individual case on anything but a pro bono basis. Nor could one expect the typical consumer to negotiate the procedural maze of arbitration on his or her own without help of counsel. The result is that the presence of the arbitration clause with its ban on class actions leaves the consumer without any legal recourse.

Indeed, it is precisely this kind of claim that justifies the existence of the class action remedy – when each individual victim’s claim is monetarily too modest to make practical an individual lawsuit (or arbitration), but where a classwide proceeding could efficiently secure justice and a remedy to thousands of identically affected victims.

Overview of Law on Arbitration

The public policy favors settling disputes by means of arbitration. Prime South Homes, Inc. v. Byrd, 102 N.C.App. 255, 401 S.E.2d 822 (1991). However, in some cases, the North Carolina courts will refuse to give effect to a clause, typically where the facts are very sympathetic. See Milon v. Duke University, 145 N.C.App. 609, 551 S.E.2d 561 (2001), rev’d, 355 N.C. 263, 559 S.E.2d 789 (NC Supreme Court adopted Court of Appeals dissenting judge’s opinion that medmal arbitration clause should not apply).

The North Carolina Court of Appeals has suggested that an agreement to arbitrate, if contained in a contract covering other topics, must be independently negotiated, and that the court should closely scrutinize an arbitration clause in a contract of adhesion. Blow v. Shaughnessy, 68 N.C.App. 1, 16, 313 S.E.2d 868, 876-877, rev. denied, 311 N.C. 751, 321 S.E.2d 127 (1984); Routh v. Snap-On Tools Corp., 108 N.C.App. 268, 423 S.E.2d 791, 796 (1992) (“The fact that an arbitration agreement was attempted in a contract of adhesion at the close of the relationship further indicates a lack of mutuality of interest between these parties.”).

Is an Arbitration Clause that Bans Class Actions Void?

The better view is that arbitration clauses which purport to ban the legal remedy of a class action are void because they deprive consumers of what may be the only practical legal remedy they have. Courts that have reached this conclusion include:

Dunlap v. Berger, 567 S.E.2d 265 (W.Va. 2002) (arbitration clause void);
American Gen. Fin., Inc. v. Branch, 793 So.2d 738 (Ala.2000) (arbitration clause in a loan agreement was unconscionable where all the loan companies used such a clause);
Leonard v. Terminix International Co., 854 So.2d 529 (Ala. 2002) (arbitration clause which barred class actions was unconscionable);
Patterson v. ITT Consumer Fin. Corp., 14 Cal.App.4th 1659, 18 Cal.Rptr.2d 563 (1993) (arbitration clause unenforceable);
Williams v. Aetna Fin. Co., 700 N.E.2d 859, 866-67 (Ohio 1998) (same);
Lozada v. Dale Baker Oldsmobile, Inc., 91 F.Supp.2d 1087, 1100-03, (W.D.Mich. 2000) (enforcement of arbitration agreement under Michigan's consumer fraud act would be procedurally and substantively unconscionable);
Powertel, Inc. v. Bexley, 743 So.2d 570, 574-77 (Fla. Ct. App. 1999), rev. denied, 763 So.2d 1044 (Fla. 2000) (arbitration provision barring a class action under the Florida Deceptive and Unfair Trade Practices Act was both procedurally and substantively unconscionable);
Acorn v. Household Intern., Inc., 211 F.Supp.2d 1160 (N.D.Cal. 2002) (arbitration clause including ban on class actions unconscionable);
Mercuro v. Superior Court, 96 Cal.App.4th 167, 179, 116 Cal.Rptr.2d 671 (2002) (arbitration forum, though equally applicable to both parties, relevant to finding of unconscionability because "repeat player effect" rendered provision disadvantageous to weaker party);
Ting v. AT&T, 319 F.3d 1126 (9th Cir. 2003) (class action bar in arbitration clause was unconscionable);
Luna v. Household Fin. Corp. III, 2002 WL 31487425, *9 (W.D.Wash. Nov. 4, 2002) (same);
Mandel v. Household Bank, 105 Cal.App.4th 75, 129 Cal.Rptr.2d 380, 2003 WL 57282, at *4 (2003) (applying Nevada law);
Bellsouth Mobility LLC v. Christopher, 819 So.2d 171 (Fla. Ct. App. 2002) (same);
Hayes v. County Bank, 713 NYS2d 267 (Sup. Ct. Queens County 2000) (arbitration clause struck where it would prevent class relief).

The public policy rationale behind these decisions is stated in Knepp v. Credit Acceptance Corp., 229 B.R. 821, 842 (Bankr.N.D.Ala.1999):

If this approach [no class-wide arbitration] prevails, the pervasive use of arbitration agreements in consumer contracts could have the effect of eliminating class actions as an option available to aggrieved consumers. If class actions are no longer an option, the vast majority of consumer claims involving relatively small sums of money on an individual basis will be left without a remedy.

Likwise the court noted in Keating v. Superior Court of Alameda County, 31 Cal.3d 584, 609-10, 645 P.2d 1192, 1207, 183 Cal.Rptr. 360, 375 (1982), rev'd in part and appeal dismissed in part on other grounds, 465 U.S. 1, 104 S.Ct. 852, 79 L.Ed.2d 1 (1984);:

If the right to a classwide proceeding could be automatically eliminated in relationships governed by adhesion contracts through the inclusion of a provision for arbitration, the potential for undercutting these class action principles, and for chilling the effective protection of interests common to a group, would be substantial.... If, however, an arbitration clause may be used to insulate the drafter of an adhesive contract from any form of class proceeding, effectively foreclosing many individual claims, it may well be oppressive and may defeat the expectations of the nondrafting party.

Other cases have ruled negatively. Bess v. Check Express, 294 F.3d 1298 (11th Cir. 2002) (upholding arbitration clause in payday loan case); Burden v. Check Into cash of Kentucky, LLC, 267 F.3d 483 (6th Cir. 2001) (noting that argument against arbitration clause was difficult to win); Randolph v. Green Tree Financial Corp., 244 F.3d 814 (11th Cir. 2001) (provision to arbitrate TILA claims is enforceable even if it precludes class action); Gras v. Associates First Capital Corp., 786 A.2d 886 (N.J. Super. 2001) (arbitration clause enforceable); Sagal v. First USA Bank, 69 F.Supp.2d 627, 632 (D.Del.1999), aff'd, 254 F.3d 1078 (3d Cir.2001) (court compelled plaintiff to arbitrate TILA claim even though arbitration would preclude class action); Johnson v. West Suburban Bank, 225 F.3d 366, 368 (3d Cir.2000), cert. denied, 531 U.S. 1145, 121 S.Ct. 1081, 148 L.Ed.2d 957 (2001) (claims under TILA and the Electronic Fund Transfer Act may be arbitrated despite class action bar).

Thus, this is clearly an issue which is still being developed in the law.

Impact of the Federal Arbitration Act

An increasing number of consumer arbitration clauses recite that the Federal Arbitration Act (FAA) controls. The FAA represents "a liberal federal policy favoring arbitration agreements," Moses H. Cone Mem'l Hosp. v. Mercury Constr. Corp., 460 U.S. 1, 24, 103 S.Ct. 927, 74 L.Ed.2d 765 (1983), in order " 'to reverse the longstanding judicial hostility to arbitration agreements ... and to place arbitration agreements upon the same footing as other contracts,' " Green Tree Fin. Corp.-Alabama v. Randolph, 531 U.S. 79, 89, 121 S.Ct. 513, 148 L.Ed.2d 373 (2000) (quoting Gilmer v. Interstate/Johnson Lane Corp., 500 U.S. 20, 24, 111 S.Ct. 1647, 114 L.Ed.2d 26 (1991)).

"Pursuant to th[is] liberal policy, 'any doubts concerning the scope of arbitral issues should be resolved in favor of arbitration, whether the problem at hand is the construction of the contract language itself or an allegation of waiver, delay, or a like defense to arbitrability.' " O'Neil v. Hilton Head Hosp., 115 F.3d 272, 273-74 (4th Cir.1997) (quoting Moses H. Cone, 460 U.S. at 24-25, 103 S.Ct. 927).

When parties have entered into a valid and enforceable agreement to arbitrate their disputes and the dispute at issue falls within the scope of that agreement, the FAA requires federal courts to stay judicial proceedings, see 9 U.S.C.A. § 3, and compel arbitration in accordance with the agreement's terms, see 9 U.S.C.A. § 4. If any party to the arbitration clause attempts to invalidate an FAA arbitration clause, the Court must determine the validity of the provision. Prima Paint Corp. v. Flood & Conklin Mfg. Co., 388 U.S. 395, 400, 87 S.Ct. 1801, 1804, 18 L.Ed.2d 1270 (1967).

The FAA has 3 key sections:

Section 2 of the Act provides that an agreement to arbitrate in a transaction involving commerce "shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract."
Section 3 compels "a federal court in which suit has been brought 'upon any issue referable to arbitration under an agreement in writing for such arbitration' to stay the court action pending arbitration once it is satisfied that the issue is arbitrable under the agreement."
Section 4 in pertinent part provides that "the court shall hear the parties, and upon being satisfied that the making of the agreement for arbitration or the failure to comply therewith is not in issue, the court shall make an order directing the parties to proceed to arbitration in accordance with the terms of the agreement ..."

In construing § 2, the US Supreme Court has held that “state law, whether of legislative or judicial origin, is applicable if that law arose to govern issues concerning the validity, revocability, and enforceability of contracts generally.” Perry v. Thomas, 482 U.S. 483, 492 (1987).

Under Fourth Circuit law, the courts are called upon to determine whether the particular dispute at issue is one to be resolved through arbitration. In doing so, the court must "engage in a limited review to ensure that the dispute is arbitrable -- i.e., that a valid agreement to arbitrate exists between the parties and that the specific dispute falls within the substantive scope of that agreement." Hooters of Am., Inc. v. Phillips, 173 F.3d 933, 938 (4th Cir.1999) (internal quote marks omitted). Although "highly circumscribed," the "judicial inquiry ... is not focused solely on an examination for contractual formation defects such as lack of mutual assent and want of consideration." Id.

Rather, parties may also seek revocation of an arbitration agreement "under 'such grounds as exist at law or in equity,' including fraud, duress, and unconscionability." Sydnor v. Conseco Fin. Servicing Corp., 252 F.3d 302, 305 (4th Cir.2001) (quoting 9 U.S.C. § 2).

Arbitration and Unconscionability

The Supreme Court has stated that the defense of unconscionability is available to a party challenging an arbitration agreement. Doctor’s Assocs., Inc. v. Casarotto, 517 U.S. 681, 687 (1996) ( “generally applicable contract defenses, such as fraud, duress or unconscionability, may be applied to invalidate arbitration agreements without contravening [the F.A.A.]”); Gilmer v. Interstate/Johnson Lane Corp., 500 US 20, 33 (1991) (“courts should remain attuned to well-supported claims that the agreement to arbitrate resulted from the sort of fraud or overwhelming economic power that would provide grounds ‘for the revocation of any contract’”) (citation omitted).

“In determining whether the parties executed a valid agreement to arbitrate, courts generally apply ordinary state-law principles that govern the formation of contracts.” Sydnor, 252 F.3d at 305. “Moreover, the FAA provides that a party may seek revocation of a contract under ‘such grounds as exist at law or in equity,’ including fraud, duress, and unconscionability.” Id.

Unconscionability is a doctrine whereby the challenged contract must be one which no reasonable person would enter into, and the “‘inequality must be so gross as to shock the conscience.’” L&E Corp. v. Days Inns of America, Inc., 992 F.2d 55, 59 (4th Cir.1993) (quoting Smyth Bros.-McCleary-McClellan Co. v. Beresford, 128 Va. 137, 104 S.E. 371, 382 (1920) (internal quotations omitted)).

The fact of a contract of adhesion is an important factor to consider, though not, of itself, dispositive. See Routh v. Snap-On Tools Corp., 108 N.C.App. 268, 423 S.E.2d 791, 796 (1992) (“The fact that an arbitration agreement was attempted in a contract of adhesion at the close of the relationship further indicates a lack of mutuality of interest between these parties.”).

Along these lines, it may be reasonable to argue that a contract containing a broad consumer arbitration clause which bans class relief is void as against the public policy as a contract of adhesion between unequal contracting parties – the one a large corporation, and the other quite often a consumer of limited education and weak financial position.