Arbitration Clauses as a Mechanism for Enforcing Unenforceable Contract Terms

In my article The Arbitration Bootstrap,[1] I explain how courts are misinterpreting the Federal Arbitration Act of 1925 (the FAA) in ways that allow firms to use arbitration clauses to render unenforceable contract terms enforceable. Arbitration clauses require consumers and employees to waive their rights to bring litigation in court.  Although arbitration is less protective of consumers and employees than litigation in public courts, arbitration clauses are unavoidable in many markets because firms impose contracts of adhesion that include mandatory arbitration clauses.

Arbitration bootstrapping describes situations where firms insert terms unrelated to arbitration into an arbitration clause because judges are more likely to enforce terms embedded in arbitration clauses.  For example, firms insert terms into their arbitration clauses to shorten statutes of limitations, to reduce damage awards, or to prevent injunctive relief.  These types of contract terms are considered unconscionable—and, thus, unenforceable—in many states.

In theory, legal doctrines exist to protect consumers and workers from arbitration clauses that are unconscionable or that eliminate an individual’s ability to seek redress for violations of the law.  Most notably, state contract law makes unconscionable contracts—and unconscionable contract terms—unenforceable.  With respect to federal statutory rights, the Effective Vindication Doctrine provides that the “arbitration of the claim will not be compelled if the prospective litigant cannot effectively vindicate his statutory rights in the arbitral forum.”[2]

The Supreme Court, however, has recently undermined both of these mechanisms—the unconscionability defense and the Effective Vindication Doctrine—in cases involving class action waivers in arbitration clauses.  A class action waiver is a contract term that requires consumers and workers to promise neither to bring nor to participate in class action litigation against the firm.  By eliminating the possibility of class actions, firms can essentially immunize themselves from judicial scrutiny because the cost of bringing an individual action often exceeds the maximum potential damage award.  Despite this, in 2011, in AT&T Mobility LLC v. Concepcion,[3] the Supreme Court held that the FAA preempted state laws that treated certain class action waivers embedded in arbitration clauses as unconscionable.  The ruling meant that firms could evade otherwise applicable state laws against an unconscionable class action waiver simply by inserting the waiver into an arbitration clause.  In 2013, the Supreme Court in American Express Co. v. Italian Colors Restaurant[4] considered a Second Circuit opinion that struck down a class action waiver for violating the Effective Vindication Doctrine because the cost of bringing an individual claim could exceed $1 million while the maximum possible recovery was less than $40,000.  The Supreme Court reversed, holding that “a contractual waiver of class arbitration is enforceable under the Federal Arbitration Act when the plaintiff’s cost of individually arbitrating a federal statutory claim exceeds the potential recovery.”[5]  The Italian Colors opinion substantially undermined the Effective Vindication Doctrine.[6] This provides a strong incentive for retailers and employers to use arbitration clauses as a vehicle for imposing anti-consumer terms that would otherwise be unenforceable.

The Arbitration Bootstrap

Firms now use arbitration clauses as a bootstrap, a mechanism to impose contract terms that would otherwise be unenforceable as a matter of contract law.  In addition to class action waivers, five examples stand out.

  1. Statutes of Limitations. Some courts have found contractual restrictions on limitations periods to be substantively unconscionable. Many businesses attempt to circumvent these rules by including shortened statutes of limitations in arbitration clauses. Attorneys advise their clients (and other attorneys) to use arbitration clauses as a mechanism for shortening the statute of limitations. Unlike judges, arbiters do not have to apply the same considerations of reasonableness and have more latitude to enforce business-imposed reductions of the statute of limitations.
  1. Damage Limitations. In response to laws that allow plaintiffs to recover noncompensatory damages, many firms use arbitration clauses to attempt to limit damages. Arbitration clauses commonly prohibit punitive damages, incidental damages, and any other type of damage beyond mere compensatory damages. Some arbitration clauses also claim to cap damage awards irrespective of actual damages.  While these terms may be unenforceable in a traditional contract interpreted by a judge, an arbiter gets to determine whether the damage-limitation provision in an arbitration clause is enforceable. Indeed, some courts have acknowledged that firms can limit damages in arbitration in ways that they cannot limit them in court.
  1. Fee-Shifting Provisions. Many statutes have pro-plaintiff attorney fee-shifting provisions to protect consumers. Firms cannot contractually forbid statute-directed fee shifting in many states. In contrast, some courts invoke the Supreme Court’s call for deference to arbitration clauses in order to accept firm-imposed interference with pro-plaintiff fee-shifting regimes in arbitration.
  1. Forum-Selection Clauses. State rules can limit judicial deference to forum-selection clauses.  And judges can decline to enforce a forum selection clause if they conclude that it is unconscionable or otherwise against public policy.  Firms can evade such rules by embedding their forum-selection clause in an arbitration provision.  Arbitration clauses often specify the site where any arbitration arising from the contract shall take place, locations that are sometimes thousands of miles away from the plaintiff.  Although some states would invalidate such provisions in nonarbitration contexts, state prohibitions on out-of-state arbitration may be considered preempted by the FAA in light of the Supreme Court’s pro-arbitration jurisprudence.
  1. Non-Coordination Clauses. Some arbitration clauses forbid not only class actions, but also any coordination among the victims of illegal conduct. Arbitration clauses commonly contain confidentiality requirements that prevent cost sharing or even information sharing among plaintiffs seeking to recover for their injuries. For example, the agreement at issue in Italian Colors precluded the plaintiffs from even informally arranging among themselves to pay for a common expert report that each could use in individual arbitration proceedings. Despite the proffered efficiency justifications for arbitration, this provision was designed to create inefficiency in order to make claims against the defendant cost-prohibitive.

In sum, by limiting the ability of courts to use the unconscionability defense and the Effective Vindication Doctrine as methods of constraining anti-plaintiff terms in an arbitration clause, Concepcion and Italian Colors encourage firms to load their arbitration agreements with otherwise unenforceable provisions.

State Efforts to Protect Consumers Thwarted

Many states have sought to protect their citizens from overreaching arbitration provisions.  States have tried three approaches.  First, some states made certain categories of disputes nonarbitrable.  Second, states sought to apply the contract doctrine of unconscionability to make certain anti-consumer terms in arbitration clauses unenforceable. Third, unable to cordon off areas of law from arbitration or to address specific anti-consumer terms, some states sought to insure that their citizens were at least informed that they were waiving their right to sue in court.  The Supreme Court has invalidated all of these avenues as inconsistent with the legislative intent behind the FAA.

Misinterpreting the Legislative History of the FAA

The Supreme Court has claimed three distinct intentions of the 1925 Congress that passed the FAA: an intent that the FAA apply to all federal and state claims unless explicitly exempted by Congress; an intent that the terms of arbitration clauses should be enforced as written; and an intent that states cannot do anything that would disfavor arbitration clauses or interfere with their enforcement.  The Court’s vision of the legislative history of the FAA is flawed.

The most important fact about the testimony, hearings, and reports leading up to congressional enactment of the FAA is that every witness, every Senator, and every Representative discussed one issue and one issue only: arbitration of contract disputes between merchants.  In particular, Congress did not intend the FAA to facilitate firms imposing arbitration clauses on consumers through contracts of adhesion.  Arbitration was not intended for complex legal issues, such as those involving statutory claims.

Courts have repeatedly upheld both arbitration clauses and anti-consumer terms within them—as well as striking down states’ efforts to protect consumers—based on a claimed fealty to legislative intent.  In over a dozen opinions, the Supreme Court has asserted—without evidence—that Congress enacted the FAA with the intent of compelling courts to enforce arbitration clauses “according to their terms” or “as written.”  This “according to their terms” language facilitates the arbitration bootstrap because firms can put anti-consumer terms in the arbitration clause and, judges reason, the FAA requires enforcement of those terms.  The Court has converted its judge-made presumption of arbitrability into a presumption of contract terms being enforceable as long as they are inserted into an arbitration clause.  When legislators in 1925 discussed the enforceability of arbitration agreements, they gave no thought to the possibility that decades later firms would load arbitration clauses with terms that were unconscionable, inequitable, or otherwise unenforceable under applicable state law. Although courts hold that Congress intended the FAA to prevent states from enacting laws to protect their citizens, Congress did not intend the FAA to preempt any state laws.

Conclusion

If a contract term would not be enforceable if it were outside of an arbitration clause, it should not become enforceable because it is inserted into an arbitration clause.  Unenforceable terms should remain unenforceable regardless of where they appear in a contract.  Courts must cut the arbitration bootstrap.  If a state contract rule applies to all contracts, that rule should apply equally to the contents of an arbitration clause.  If courts stopped treating arbitration clauses as a legitimate vehicle for anti-consumer terms, businesses would probably stop doing so as well. In order to implement the will of Congress, courts should either sever the unconscionable terms in an arbitration clause—or strike the arbitration clause altogether—so long as this is what the court would do when confronted with the same unconscionable terms in a contract without an arbitration clause.

ENDNOTES

[1] Christopher R. Leslie, The Arbitration Bootstrap, 94 Tex. L. Rev. 265 (2015).

[2] In re Cotton Yarn Antitrust Litig., 505 F.3d 274, 282 (4th Cir. 2007).

[3] 131 S. Ct. 1740 (2011).

[4] 133 S. Ct. 2304 (2013).

[5] Id. at 2307.

[6] Mark A. Lemley & Christopher R. Leslie, Antitrust Arbitration and Merger Approval, 110 Nw. U. L. Rev. 1 (2015).

The preceding post comes to us from Christopher R. Leslie, Chancellor’s Professor of Law, University of California Irvine School of Law.  The post is based on his article, The Arbitration Bootstrap, 94 Tex. L. Rev. 265 (2015), which is available here.

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