Commercial Disputes – Class Action Defense Alert March 2009 Authors: That’s Unconscionable: An Update Regarding the Enforceability of Arbitration Provisions in R. Bruce Allensworth bruce.allensworth@klgates.com Form Contracts +1.617.261.3119 Irene C. Freidel Introduction irene.freidel@klgates.com A current hot topic in the ever-growing field of consumer finance litigation is the +1.617.951.9154 enforceability of arbitration provisions in lending contracts. The enforceability of such provisions, however, has become a thorny issue, and one that is increasingly Phoebe S. Winder resolved in favor of the consumer. While the Federal Arbitration Act (“FAA”) phoebe.winder@klgates.com establishes a presumption in favor of the enforceability of arbitration agreements, the +1.617.261.3196 courts have raised several roadblocks to prevent what they consider to be abuses of the arbitral forum. An increasing number of courts have permitted consumers to William G. Potter escape arbitration where the operative arbitration provision would effectively william.potter@klgates.com eliminate the consumers’ ability to bring claims against the lender and where the +1.617.951.9127 consumers did not have a meaningful opportunity to negotiate or reject that provision of the contract. Robert W. Sparkes III robert.sparkes@klgates.com The importance and fluidity of the enforceability issues surrounding arbitration +1.617.951.9134 provisions in lending and other consumer finance contracts are highlighted by recent opinions out of the Third Circuit Court of Appeals (Homa v. American Express Co., ---F.3d---, 2009 WL 440912 (3d Cir. Feb. 24, 2009))1 and the United States District Court for the Central District of California (Guadagno v. E*Trade Bank, ---F. Supp. 2d ---, 2008 WL 5479062 (C.D. Cal. Dec. 29, 2008)).2 In Homa, the Third Circuit K&L Gates comprises approximately 1,900 lawyers in 32 offices located in panel decision appears to retreat from a prior panel’s rationale upholding the North America, Europe, and Asia, and enforceability of class action waivers in arbitration clauses (and FAA preemption) represents capital markets participants, and to bring the Third Circuit in line with other federal courts on the issue.3 In entrepreneurs, growth and middle Guadagno, the Central District of California court found an arbitration clause and market companies, leading FORTUNE class action waiver enforceable based, in part, upon the existence of an opt-out 100 and FTSE 100 global corporations, provision related to the mandatory arbitration clause.4 In short, these opinions and public sector entities. For more exhibit the constantly evolving nature of the debate surrounding the enforceability of information, please visit arbitration provisions in consumer finance related contracts discussed below. www.klgates.com. This client update discusses three of the most common roadblocks to the enforceability of arbitration provisions: 1. excessive or one-sided “carve-out” exceptions; 2. inconspicuous waivers of the right to a jury trial; and 3. class action waivers that effectively eliminate consumers’ rights to seek redress for damages.
Commerical Disputes – Class Action Defense Alert an arbitration provision by arguing that the The Federal Arbitration Act provision is unconscionable under applicable state law. For example, in Iberia Credit Bureau, Inc. v. The enforceability of any arbitration provision in the Cingular Wireless L.L.C. , 8 the Fifth Circuit Court of consumer finance context will usually flow from the Appeals upheld two arbitration clauses but struck FAA, 9 U.S.C. §§ 1 et seq. (2006). The FAA down a third, finding the arbitration provision requires courts to honor parties’ agreements to unconscionable under Louisiana law because it resolve disputes through arbitration rather than completely exempted the drafter from arbitration, through the courts. The FAA preempts any but did not similarly exempt the consumer. In so contradictory state law that specifically targets arbitration. 5 Accordingly, any state statute, or ruling, the Fifth Circuit found that Louisiana law concerning unconscionability applied with equal provision in a state statute, that purports to force to all contracts and therefore was not specifically govern arbitration agreements is preempted by the FAA. 9 preempted by the FAA. 6 For example, a state law prohibiting class action waivers in arbitration To understand when an arbitration agreement will agreements would run afoul of the FAA. To avoid be held unconscionable, it is important to first preemption by the FAA, state statutes (and common understand what courts look for to determine law) concerning the validity of contractual unconscionability. Before finding an agreement to agreements to arbitrate must apply to all types of contracts. 7 Consumers may escape from their be unconscionable, courts usually require that there be both “procedural” and “substantive” agreement to arbitrate only if they can show that unconscionability. 10 Procedural unconscionability they will be unable to vindicate their statutory rights focuses on the disparate bargaining power of the in an arbitral forum, or if they can convince a court parties, including whether one party was more (or an arbiter) that the arbitration provision should sophisticated than the other, and whether the be invalidated on the basis of some common law contract was one of adhesion 11 – i.e., a standard principle such as unconscionability, duress, fraud, or form contract drafted solely by one party and to be lack of consideration. Below, this client update signed by the party in the weaker position (typically discusses three of the most common roadblocks to the consumer). 12 Substantive unconscionability enforcement of arbitration provisions. These measures whether the provisions of the agreement obstacles survive preemption by the FAA because itself are unfair as to one party. 13 In the consumer they spring from common law principles of general finance context, the consumer is typically less applicability to contracts, rather than from sophisticated than the lender, and usually agrees to a arbitration-specific prohibitions. non-negotiable contract prepared by the lender. Once the courts have found substantive Carve-Outs unconscionability in the provisions of an agreement, One common pitfall that may render an arbitration they will typically find the agreements between provision void is the inclusion of excessive, one- lenders and unsophisticated consumers to be sided “carve-outs.” A carve-out is an exception to procedurally unconscionable as well. Thus, the an arbitration provision that limits the circumstances important question in most consumer finance cases in which the provision applies, usually to the will be whether the agreement itself is so unfair as detriment of the consumer. A number of courts to be substantively unconscionable – a question that have found arbitration provisions unconscionable turns on state law. because they contained carve-outs that allowed the drafter access to the courts, but restricted the There is no bright line that can be drawn between an consumer to arbitration. arbitration agreement that is merely unequal, but nevertheless valid, and one that is so one-sided it Because the doctrine of unconscionability is will be deemed unconscionable. Courts that have ordinarily a common law principle applicable to all considered this issue generally deem arbitration contracts, the FAA will not operate to preempt an provisions unconscionable where carve-outs exempt unconscionability argument made by a consumer in the drafter from the obligation to arbitrate, but bind opposition to an arbitration agreement. Thus, the non-drafting party (i.e., the consumer) to the consumers may be able to challenge the validity of March 2009 2
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