Enforceability of Arbitration Clauses in Consumer Financial Services Contracts

Agreements to arbitrate are commonly incorporated into consumer contracts, significantly impacting consumer financial services contracts. One study found that among all types of consumer contracts, 69.2% of agreements in the credit card, banking, investment, accounting, and tax consulting fields contained arbitration clauses, and 17 out of the 18 consumer contracts for homeowner’s insurance, renter’s insurance, auto insurance, and health insurance had arbitration clauses. Linda J. Demaine & Deborah R. Hensler, “Volunteering” to Arbitrate Through Predispute Arbitration Clauses: The Average Consumer’s Experience, 67 Law & Contemp. Probs. 55, 62 (2004). Thus, when faced with consumer litigation, financial services companies often seek to enforce these agreements through arbitration, which can be more financially advantageous and efficient than litigating in court.

In 1925, Congress originally enacted what was essentially the Federal Arbitration Act (“FAA”) to eliminate the traditional reluctance to enforce arbitration agreements. See H.R. Rep. No . 68-96 (1924). Although the FAA only applies to contracts involving interstate commerce and maritime transactions, courts have frequently stated that the broad goals of the FAA encourage arbitration. See e.g., Moses H. Cone Mem’l Hosp. v. Mercury Constr. Corp., 460 U.S. 1, 24, 25 (1983) (“The Arbitration Act establishes that, as a matter of federal law, any doubts concerning the scope of arbitrable issues should be resolved in favor of arbitration … .”). In 2010, the United States Supreme Court reaffirmed the benefits of arbitration: “lower costs, greater efficiency and speed, and the ability to choose expert adjudicators.” Stolt-Nielsen SA v. AnimalFeeds Int’l Corp., 130 S. Ct. 1758, 1776 (2010). Several states enacted their own legislation that encourages arbitration. See, e.g., Yvette Ostolaza, Overview of Arbitration Clauses in Consumer Financial Services Contracts, 40 Tex. Tech L. Rev. 37, 39 (2007).

However, the mere existence of a contractual arbitration provision in no way guarantees that the dispute will in fact result in arbitration. If a dispute arises, a court or arbitration panel may be asked to enforce the agreement. Courts in some states have been hesitant to enforce arbitration clauses in consumer disputes for a wide variety of reasons. Companies or individuals seeking to enforce such agreements need to be aware of the pitfalls that have caused courts not to enforce agreements to arbitrate. Of a timely note, the Supreme Court recently held that the FAA preempts state law that conditions the enforceability of arbitration agreements on the availability of class procedures. AT&T Mobility LLC v. Concepcion, No. 09-893, 2011 WL 1561956 at *13 (2011). Although such a ruling appears on its face to be quite favorable to consumer companies, drafters of such clauses need to be aware of the potential methods of circumventing this ruling.

Nonetheless, even under Concepcion, arbitration clauses likely can and will continue to be challenged using traditional contract defenses such as unconscionability, fraud, and duress. In fact, § 2 of the FAA contains a “savings clause” authorizing the invalidation of arbitration agreements “upon such grounds as exist at law or in equity for the revocation of any contract.” 9 U.S.C. § 2. The “savings clause” includes “generally applicable contract defenses, such as fraud, duress, or unconscionability, but not by defenses that apply only to arbitration or that derive their meaning from the fact that an agreement to arbitrate is at issue.” Concepcion, 2011 WL 1561956 at *5. Thus, even if an arbitration provision contains a class action waiver, it can still be invalidated if the arbitration agreement as a whole fails under contract law, so long as the common law right is not applied as a per se prohibition against arbitration. See Concepcion, 2011 WL 1561956 at *7 (“As we have said, a federal statute’s saving clause cannot in reason be construed as [allowing] a common law right, the continued existence of which would be absolutely inconsistent with the provisions of the act.”).

In light of the varying state-specific laws determining the legality of arbitration agreements, both in and outside of the class action context, litigators and their clients should remain cognizant of these developments to determine whether arbitration provisions in their consumer contracts will be enforceable. The broad overview provided in this article includes the main reasons why consumers have successfully challenged arbitration provisions, and guidance on how drafters can best formulate these provisions to make them enforceable.

Procedural Unconscionability
as Defense to Arbitration Provisions

Courts have refused to enforce arbitration provisions based on an unconscionability defense, likely because the doctrine is malleable. Most courts view unconscionability as having two components, procedural and substantive unconscionability. See James J. White & Robert S. Summers, Uniform Commercial Code §§ 4-7 (4th ed. 1995). Procedural unconscionability relates to the process by which an agreement to arbitrate is reached, and the form of the agreement, including the use of fine print or convoluted or unclear language. Substantive unconscionability arises from the inclusion of terms unreasonably favorable to one side and to which the other party does not assent. A majority of states hold that an agreement to arbitrate will not be enforced under the doctrine of unconscionability when only both procedural and substantive unconscionability are shown. See, e.g.,
Pokorny v. Quixtar Inc., 601 F.3d 987, 996 (9th Cir. 2010). Some courts require proof of either substantive or procedural unconscionability. See, e.g., Banc One Acceptance Corp. v. Hill, 367 F.3d 426, 433 n.4 (5th Cir. 2004). Finally, some states require only a holding of substantive unconscionability. See
Owner-Operator Indep. Drivers Ass’n v. C.R. Eng. Inc., 325 F. Supp. 2d 1252, 1263 (D. Utah 2004).

Being a Contract of Adhesion Should Not Alone
Make an Arbitration Agreement Unconscionable

Many consumer contracts do not have individually negotiated provisions, causing them to be considered “contracts of adhesion” or “take it or leave it” contracts. See Concepcion, 2011 WL 1561956 at *9 (“the times in which consumer contracts were anything other than adhesive are long past.”). Most courts have held that the adhesive nature of the contract does not lead to a finding of unconscionability per se; rather, there must be such a procedural gap as to imply that there was no meeting of the minds at all. See Johnson v. Tele-Cash Inc., 82 F. Supp. 2d 264, 278-79 (D. Del. 1999), rev’d in part, 225 F.3d 366 (3d. Cir. 2000); In re Palm Harbor Homes Inc., 195 S.W.3d 672, 678 (Tex. 2006).

In Carbajal v. H&R Block Tax Services Inc., Judge Easterbrook rejected the argument that an arbitration agreement in a “contract of adhesion” was inherently unconscionable, holding that “arbitration specified in a form contract must be treated like any other clause of the form. Unless Delaware (whose law applies) would refuse to enforce limited warranties, clauses curtailing the time available to file suit, and the like, then this arbitration clause must be enforced.” 372 F.3d 903, 906 (7th Cir. 2004). Consequently, cases such as Carbajal and Concepcion provide strong support for the notion that arbitration contracts cannot be found unconscionable merely because they are contracts of adhesion.

Additionally, under Supreme Court precedent, the question of whether a contract is unconscionable because it is adhesive is likely one for the arbitrator. In Prima Paint
v. Flood & Conklin Mfg.
Co., the Supreme Court stated that if a defense goes to the entire contract, rather than just to the arbitration provision, it should be decided by the arbitrator. 388 U.S. 395, 403-04 (1967).

Following this logic, the Eleventh Circuit, in Jenkins v. First Am. Cash Advance of Georgia LLC, found that “adhesion claims are for an arbitrator, not a federal court, to decide” because the “claims do not relate to the Arbitration Agreements themselves; rather, they allege the [contracts], in general, were adhesive.” 400 F.3d 868, 877 (11th Cir. 2005).

However, some courts take a different view and find the “take it or leave it” nature of certain arbitration clauses to be procedurally unconscionable. See Szetela v. Discover Bank, 97 Cal. App. 4th 1094, 1100 (Cal. Ct. App. 2002). In particular, courts have found such provisions to be unconscionable when the consumers did not have reasonable alternatives to entering the contract—for instance, if they would suffer other adverse effects, such as not closing on a house if they did not sign the agreement. See Doyle v. Fin Am. LLC, 918 A.2d 1266, 1276 (Md. Ct. Spec. App. 2007). Consumers’ ability to negotiate some terms in the contract may eliminate a procedural unconscionability argument and, depending on the state, could eliminate an unconscionability claim altogether.

Small Print/Lack of Prominence

The FAA prohibits states from passing statutes that require parties to display arbitration clauses with special prominence. See Doctor’s Assoc. Inc., 517 U.S. at 686-88. Similarly, courts may not use the doctrine of unconscionability to achieve that result. See Perry v. Thomas, 482 U.S. 483, 493 n.9 (1987). Additionally, “arbitration clauses need not be specially marked or singled out in some way from other provisions of the contract.” Rollins Inc. v. Foster, 991 F. Supp. 1426, 1434 (M.D. Ala. 1998). In fact, courts have even upheld arbitration agreements with respect to plaintiffs who were blind or illiterate. See Wash. Mut. Fin. Grp. v. Bailey, 364 F.3d 260, 264-65 (5th Cir.); Am. Gen. Fin. Servs. Inc. v. Griffin, 327 F. Supp. 2d 678, 683 (N.D. Miss. 2004).

However, the Concepcion Court noted that states are free to address issues surrounding contracts of adhesion, such as “requiring class action waiver provisions to be highlighted … .” Concepcion, 2011 WL 1561956 at *9 n.6. Also, at least one court in Illinois (although its precedence in light of Concepcion remains unclear) found that the type size and location of the arbitration provisions rendered them procedurally unconscionable. Kinkel v. Cingular Wireless LLC, 828 N.E.2d 812, 819 (Ill. App. Ct. 2005). Consequently, to address the potential concerns of courts and to defend against claims of procedural unconscionability, drafters of consumer arbitration provisions should consider making the provisions more conspicuous than other provisions in the contract through use of a more prominent font type, size, and location within the agreement.

Changes-in-Terms Notices

Even if the original agreement lacks an arbitration provision, courts will generally enforce arbitration agreements enacted through a change-in-terms notice. In one case, the court held that an arbitration agreement added to a contract pursuant to a change-in-terms notice that provided a 15-day period for the customer to opt out of the arbitration clause was not unconscionable. Bank One v. Coates, 125 F. Supp. 2d 819, 830-31 (S.D. Miss. 2001). In another case, the customer was deemed to accept the new terms simply by continuing to use the service. Iberia Credit Bureau
Inc. v. Cingular Wireless, 379 F.3d 159, 173-74 (5th Cir. 2004). Even if the consumer claims to have never received the change-in-terms provision, if it was mailed to the consumer with a return address and not returned, then the “mailbox rule” raises a rebuttable presumption that the document has been received by the addressee, precluding the consumer from claiming lack of receipt as grounds for avoiding arbitration. See Hoefs v. CACV of Colo., 365 F. Supp. 2d 69, 73 (D. Mass. 2005).

Notably, the California Court of Appeals in Badie v. Bank of America invalidated a change-in-terms notice that added an arbitration clause. 79 Cal. Rptr. 2d 273, 281 (Cal. Ct. App. 1998). The Badie court did not analyze the change-in-terms provision under the doctrine of unconscionability, but rather found that any modification to a credit card agreement must be anticipated by the original contract in order for those terms to become part of the contract. Id. The court invalidated the arbitration clause because unlike a modification of fees, grace periods, or annual percentage rates, the imposition of a completely new term, such as an arbitration provision, was not anticipated by the original cardholder agreement. Id. at 289. Drafters of consumer financial services contracts should research state-specific laws to determine whether parties can add arbitration clauses through change-in-terms notices.

While procedural unconscionability usually must be present to invalidate an arbitration clause, procedural unconscionability alone should not provide the sole justification for an unconscionability defense. As a result, courts typically focus on the substantive unconscionability of the provision.

Substantive Unconscionability
as Defense to Arbitration Provisions

Generally, the more an arbitration agreement merely selects the forum, but leaves the consumer with the same basic rights as a court proceeding, the greater the likelihood the clause will be upheld. Arbitration provisions sometimes provide for arbitration of the consumer’s claims while leaving the company free to litigate its claims in court. Plaintiffs often challenge this “lack of mutuality” as unconscionable. Some courts agree with such plaintiffs while other courts take the opposite view. See e.g., Iberia Credit Bureau Inc., 379 F.3d at 170-71 (holding a clause that requires consumers to arbitrate, but not a defendant company, is unconscionable as one-sided); but see Harris v. Green Tree Fin. Corp., 183 F.3d 173, 181 (3d Cir. 1999) (“It is of no legal consequence that the arbitration clause gives Green Tree the option to litigate … while requiring the Harrises to invoke arbitration.”).

Limitation of Remedies

A substantive limitation of remedies such as statutory damages or punitive damages may render an arbitration agreement unconscionable. See, e.g., Morrison v. Circuit City Stores Inc., 317 F.3d 646, 670 (6th Cir. 2003).

In order to draft a “bulletproof” arbitration clause, it may be important not to limit the remedies available to plaintiffs depending on the particular forum.

Fees Associated With Arbitration

Some courts hold that arbitration agreements that require the plaintiff to pay reasonable arbitration fees, even if more expensive than court fees, are not substantively unconscionable. See, e.g, Young v. Jim Walter Homes Inc., 110 F. Supp. 2d 1344, 1349-50 (M.D. Ala. 2000).

However, other courts have found arbitration agreements to be unconscionable when they require the plaintiff to pay costs of arbitration that are higher than the costs of going to court. See e.g., Ting, 319 F.3d at 1151. At least one court has stated that “[t]he fact that [plaintiffs] are required to pay any arbitrator’s fee is sufficient to render the obligation unconscionable.” Torrance v. Aames Funding Corp., 242 F. Supp. 2d 862, 874 (D. Or. 2002). To avoid this potential problem, many arbitration agreements provide that the business will pay all costs of arbitration.

Confidentiality Agreements

Some courts have found confidentiality agreements in arbitration clauses unconscionable, reasoning that such agreements create a “repeat player” advantage for companies because they will know the results of the arbitration despite the confidentiality agreement, whereas individual plaintiffs would not have access to this information. See, e.g., Ting
v. AT&T, 319 F.3d 1126, 1151-52 (9th Cir. 2003).

Some courts conclude that invalidating confidentiality clauses will help avoid giving the industry a superior legal posture, since the results of the arbitration and, in certain circumstances, the arbitrators’ reasoning would be available to the public. Id. In contrast, other courts have held that a term in an arbitration agreement requiring the parties to keep all future arbitration proceedings confidential is not unconscionable. See, e.g., Iberia Credit, 379 F.3d at 175-76.

Choice of Forum/Choice of Arbitrator

A plaintiff’s consent to the choice of arbitrator and forum is likely enough to avoid unconscionability. However, the choice must be fair, and consumer arbitration provisions should not provide for a location that is inconvenient for the consumer to attend the arbitration hearing. See Hollins v. Debt Relief of Am. 479 F. Supp. 2d 1099, 1107 (D. Neb. 2007).

Although consumers sometimes challenge the selection of certain arbitral forums on the grounds that the forum is biased in favor of corporations, courts generally find that these challenges have no merit, particularly in cases involving reputable forums such as the National Arbitration forum or the American Arbitration Association. See, e.g., Coates, 125 F. Supp. 2d at 836. However, such provisions are likely impermissible when one party actually selects the individual arbitrators. See, e.g., McMullen
v. Meijer Inc., 166 F. Appx. 164, 167-69 (6th Cir. 2006).

Parties to arbitration agreements can reduce the risk that courts will invalidate the agreement based on specific provisions by including an explicit severance clause. See, e.g., Yvette Ostolaza, Overview of Arbitration Clauses in Consumer Financial Services Contracts, 40 Tex. Tech L. Rev. 37, 55-56 (2007).

Class Action and Class Arbitration Waivers

In the consumer arbitration world, perhaps the most significant issue was whether such contracts could contain provisions requiring consumers to arbitrate on an individual, as opposed to a classwide basis.

In Discover Bank v. Superior Court, the California Supreme Court invalidated class waiver provisions found in consumer contracts of adhesion containing an agreement to arbitrate, where the parties had unequal bargaining power and it was alleged that the party with superior bargaining power had engaged in a scheme to cheat a large number of consumers out of small amounts of money. 113 P.3d 1100, 1108 (Cal. 2005). In AT&T Mobility LLC v. Concepcion, what is sure to be a landmark ruling, the Supreme Court, in a 5–4 decision, abrogated Discover Bank and upheld the enforceability of class action waivers, in essence, elevating the FAA over certain state consumer protection laws. 2011 WL 1561956 at *13 (2011).

The California plaintiffs unsuccessfully argued that the Discover Bank rule was not preempted by the FAA because its rule was grounded in the state’s unconscionability doctrine and policy against exculpation, and, thus, was a “ground as exists at law or in equity for the revocation of any contract” under § 2 of the FAA. Concepcion, 2011 WL 1561956 at *6. California’s argument was not unique—indeed a majority of recent state court decisions have struck down class arbitration prohibitions as against public policy. See, e.g., Tillman v. Commercial Credit Fla. Loans Inc., 655 S.E. 2d 362, 370-72 (N.C. 2008).

The Concepcion Court framed its opinion in light of its recent decision in Stolt-Nielsen, in which the Court held that if an arbitration agreement is silent on the issue of class procedures, it will not be construed to authorize class arbitration. Stolt-Nielsen, 130 S. Ct. at 1775 (“a party may not be compelled under the FAA to submit to class arbitration unless there is a contractual basis for concluding that the party agreed to do so.”) (emphasis in original).

The Court found that since class action must be based upon consent, to interpret an arbitration agreement that is silent on the issue of class procedure as authorization for class arbitration would ignore the significant differences between the structure, purposes and benefits of private, bilateral arbitration and class arbitration. Id. at 1773-76. Thus, under Stolt-Nielsen, if a class action wavier is sought, a company must explicitly include it in the contract. Furthering the Court’s desire to validate the enforcement of arbitration agreements according to their terms and not through silence or amorphous state law concepts, the Court invalidated the Discover Rule to accomplish the “overarching purpose of the FAA”—to ensure the enforcement of arbitration agreements according to their terms so as to facilitate streamlined proceedings. 2011 WL 1561956 at *8.

The reach of Concepcion is unclear. Since the Court found the Discover Rule preempted by the FAA, even though the Rule was a judicially created state law based on the doctrine of unconscionability, the question becomes what contract defense would not “create[] a scheme inconsistent with the FAA.” Concepcion, 2011 WL 1561956 at *8. Plausibly, attorneys could argue that as long as the state has not adopted blanket prohibitions against arbitration provisions that run afoul of the FAA, like California did in Discover, courts are free to analyze and apply common law defenses to class action waiver provisions on a scenario-by-scenario basis. Certainly application of the FAA and Concepcion cannot mean that companies are free to draft arbitration provisions that violate contract law. Thus, an understanding of why courts have invalidated class action provisions in the past can only aid professionals in the future in the formulation of enforceable clauses.

Even After Concepcion, Companies
Are Not Exempt From Liability

Even though class action arbitration waivers are now generally enforceable, parties seeking to enforce such waivers do not have free rein to commit small violations against large numbers of consumers without recourse or penalty. Rather, in the consumer financial services context, other vehicles exist to compensate consumers, such as the ability for consumers to recover statutory attorneys’ fees, treble damages or costs under the Truth in Lending Act (“TILA“), the Racketeer Influenced and Corrupt Organizations Act (“RICO”), the antitrust laws, or consumer protection laws.

Prior to Concepcion, courts often upheld class action waivers when such incentives were present. See Jenkins v. First Am. C
ash Advance of Ga., 400 F.3d 868, 878 (11th Cir. 2005). Additionally, Concepcion in no way limits the state attorney general or public enforcement agencies from prosecuting companies that harm consumers. See F
onte v. AT&T Wireless
Servs. Inc., 903 So. 2d 1019, 1025 (Fla. Dist. Ct. App. 2005); Tsadilas v. Providian Nat’l Bank, 13 A.D. 3d 190, 191 (N.Y. App. Div. 2004).

Court Could Refuse to Enforce Class Waiver
If It Defeats Statutory Remedy

In addition to unconscionability, class action waivers may be unenforceable if they preclude plaintiffs from enforcing their federal rights. In re Am. Express Merchants’ Litigation, 634 F.3d 187, 197-98 (2d Cir. 2011) (holding that despite Stolt-Nielsen, the arbitration clause was unenforceable where the cost of plaintiffs’ individually arbitrating their dispute with Amex would be prohibitive, effectively depriving plaintiffs of the statutory protections of the antitrust laws).

In addition, the First Circuit disregarded a contractual class action ban in an antitrust case reasoning that the goals of private enforcement of antitrust laws would be defeated if a class action was precluded. Kristian v. Comcast Corp., 446 F.3d 25, 58-59 (1st Cir. 2006). The court distinguished antitrust lawsuits from suits under other federal laws such as TILA, because the former were more complex and required substantially more time and resources to prosecute. Id. at 57-58. However, cases decided pre-Concepcion striking down class action waivers that preclude the ability to enforce statutory remedies under state laws are likely invalid as the Supreme Court clearly held that the FAA preempts state law. See e.g.
Wong v. T-Mobile USA Inc., No. 05-73922, 2006 WL 2042512, at *2, *9 (E.D. Mich. July 20, 2006) (finding class action waiver unenforceable when it would prevent the ability to enforce statutory remedies under the Michigan Consumer Protection Act, which specifically permitted class actions).

Legislative Developments

State legislatures can enact legislation that permits class action waivers and prevents the courts from finding such waivers unconscionable. For instance, Utah enacted changes to its Consumer Credit Code in 2006 that permit an open-end or closed-end creditor to contract with the consumer to preclude the consumer’s participation in a class action. Utah Code Ann. §§ 70C-3-104, 70C-4-105 (2001).

Nationally, although it never became law, the federal Arbitration Fairness Act would have amended several provisions of the FAA by invalidating arbitration agreements in employment, consumer, or franchise disputes, and in any “dispute arising under any statute intended to protect civil rights.” Arbitration Fairness Act of 2009, H.R. 1020, 111th Cong. § 2(b) (2009). In light of Concepcion, the Arbitration Fairness Act may be reintroduced. Currently, federal legislation targeted at curbing predatory lending against members of the armed forces exists, making it a misdemeanor punishable by a fine or imprisonment for creditors to extend consumer credit to members of the military if the agreement requires the members to submit to arbitration. 10 U.S.C. §§ 987(e)(3), (f) (2006).

Conclusion

Consumer arbitration provisions can provide an efficient method of resolving disputes with consumers, and in light of Concepcion, can provide a method to contract out of class action litigation. Although Concepcion appears to provide broad protection to drafters of consumer arbitration provisions, the legal requirements to enforce such provisions are evolving.

Even though a class action waiver may no longer be per se unconscionable, a court could easily strike down an arbitration agreement for other reasons. Thus, when drafting a consumer arbitration provision and evaluating whether it will be enforced, it is important for lawyers to understand the current judicial and legislative developments on this issue as applied in the particular jurisdiction where their client will seek to enforce the arbitration provision.