Insights

In April 2011, in AT&T v. Concepcion, the United States Supreme Court invalidated a California state law which had prohibited consumer contracts from including class action arbitration waivers.[1] The Supreme Court held that the Federal Arbitration Act (the “FAA”), which reflects a liberal federal policy favoring arbitration, preempted the California state law.

Despite this setback, California courts have continued to find ways to deny motions to compel arbitration in consumer finance litigation. Recent cases in California demonstrate that the current state of arbitration in California generally favors parties challenging arbitration clauses, but there is some hope that properly drafted and negotiated arbitration agreements will be enforced.

While California is clearly a leader in consumer-friendly law, it is unclear to what extent other states will follow California’s aggressive stance against compelling arbitration. Still, a few lessons can be learned from California’s cases as to how to draft arbitration clauses that may withstand attack, even in California.

The goal of the FAA is to encourage arbitration by requiring courts to honor arbitration agreements in accordance with the parties’ expectations. The federal law accomplishes this by partially preempting state law as happened when the Supreme Court invalidated California’s law. However, the FAA provides that arbitration clauses can still be invalidated by general state law contract defenses such as fraud, duress, and unconscionability.

Unconscionability, the main defense used to invalidate arbitration clauses, consists of two elements—procedural and substantive unconscionability. For a court to find a contract term unconscionable, a party must show that the term is both procedurally and substantively unconscionable. That test is a question of law for the judge.[2] The procedural element addresses how the contract was negotiated. The substantive element focuses on the actual terms of the agreement.

The determination of whether an arbitration clause is procedurally unconscionable hinges on whether a court finds the contract to be one of adhesion. A contract of adhesion is one which is standardized and is imposed and drafted by a party of superior bargaining strength (i.e., the dealer or finance company). The other party can only adhere to its terms or reject it completely. Courts consider two factors to make this determination: oppression and surprise.

Courts find oppression where there is inequality of bargaining power resulting in no real negotiation and no meaningful choice for the consumer. The surprise factor concerns the extent to which the terms of the contract are hidden or not easily readable to the consumer. We note that the Supreme Court in Concepcion recognized that all consumer contracts are contracts of adhesion.

California courts have identified various factors which, when considered together, can render an arbitration agreement procedurally unconscionable.[3] The courts have found procedural unconscionability where the actual arbitration clause is inconspicuously located in the agreement, for example, on the back of the last page. Courts also analyze the style and size of fonts to determine whether the buyer could adequately identify the clause.

Most important to courts is the buyer’s opportunity to negotiate terms of the contract, although the agreements are almost always boilerplate. Still, California courts are looking for some evidence of a meaningful opportunity for negotiation and absent that they are likely to find a clause procedurally unconscionable. Specifically, courts noted the seller’s failure to give a buyer adequate time to read the contract, failure to mention the arbitration clause to the buyer and state its importance, and failure to require that the buyer initial pages and certain provisions.

To determine whether the arbitration clause is substantively unconscionable, courts look for overly harsh and one-sided terms in the arbitration clause. If the arbitration clause lacks a “modicum of bilaterality,” courts are likely to find substantive unconscionability and refuse to enforce the arbitration clause. Generally, courts will sever unconscionable terms from an agreement and enforce the rest of the agreement. This might be possible, for example, if the only unconscionable term was one that required the plaintiff to advance the costs of arbitration. A court might strike this provision and otherwise compel arbitration subject to the remaining terms of the agreement.

However, a court will not always sever particular unconscionable terms and enforce the other conscionable provisions of an agreement. If a court finds that the arbitration clause contains so many invalid terms such that the agreement is “permeated with unconscionability,” the court will not sever the offending terms and will refuse to compel arbitration.

California courts have identified various factors which render an arbitration agreement substantively unconscionable.[4] The focus is on the effect of the terms of the agreement, not whether they appear fair on their face. Courts viewed a term which allowed the seller to retain its right to self-help repossession as a one-sided term because the buyer was still subject to arbitration for any conceivable claim. Thus the clause lacked “bilaterality.” Also substantively unconscionable were terms that put the burden of high arbitration costs on the buyer and procedures for appeal which provided the buyer with no meaningful opportunity to appeal and thus unjustly favored the seller.

Considering the facts of these cases, one wonders what arbitration clause would be enforceable in California. Even one finance company’s attempt to argue that an arbitration clause was not procedurally unconscionable because the consumer could have bought the car from another dealer under a contract that did not contain an arbitration term was rebuffed by a California state court. The court stated that it was not obligated to enforce procedurally unconscionable agreements just because there is a market affording a consumer choice, especially since no evidence was presented that arbitration clauses are not universal terms in car sales contracts.[5] The California courts have been clear that the procedural element focuses specifically on the negotiation of the sales contract in the dealer’s office and courts seem unlikely to consider other realities in the process of a consumer buying a car.

Still, a recent California case offers some hope for compelling arbitration. In a case decided in federal district court in California,[6] the court compelled arbitration where the agreement contained a delegation provision by which the parties had agreed to have the arbitrator decide the issue of arbitability. Although the arbitration clause in this case had the same terms as those declared unconscionable in the cases discussed above, the court did not find that it was permeated with unconscionability and therefore certain unconscionable provisions could not be severed. Importantly, however, the court noted that the buyer had acknowledged reading, understanding, and agreeing to the terms of the contract. Thus, there was no clear procedural unconscionability to the arbitration agreement. Had the court found more evidence of procedural unconscionability, it might not have been as quick to compel arbitration, but the importance of counsel’s reliance on the delegation provision cannot be ignored.

Besides adding a delegation provision stating that questions of arbitability will be determined by an arbitrator, there are other lessons to be learned from the recent decisions in California. To avoid a finding by the court that the contract contained the element of surprise, creditors would be advised to require that buyers initial all pages and even the specific arbitration clause.

Even when all pages are initialed by the buyer, courts have found procedural unconscionability because the buyer was essentially given the sales contract on a “take it or leave it” basis and so had no meaningful opportunity to understand and negotiate the terms of the contract. Considering the general acceptance of a preprinted contract in Concepcion, the focus shifts to a customer’s ability to understand the contract provisions. Thus, it is important to actually tell the buyer to take time to read the contract and it may also be necessary to explicitly tell the buyer that any disputes are subject to arbitration.

Nicole F. Munro is a partner of Hudson Cook, LLP, in the firm’s Hanover, Maryland office. Nicole can be reached at 410-865-5430 or email at nmunro@hudco.com.

Peter L. Cockrell is an associate of Hudson Cook, LLP, in the firm’s Hanover, Maryland office. Peter can be reached at 410-865-5418 or email at pcockrell@hudco.com.

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[1] AT&T Mobility v. Concepcion, 131 S. Ct. 1740 (2011).

[2] Sanchez v. Valencia Holding Co., 200 Cal. App. 4th 11, 19; 132 Cal. Rptr. 3d 517, 528; 2011 Cal. App. LEXIS 1327 (Cal. Ct. App. 2011).

[3] See Sanchez; Lau v. Mercedes-Benz USA, LLC, No. CV 11-1940 MEJ, 2012 U.S. Dist. LEXIS 11358 (N.D. Cal. Jan. 31, 2012); Buzenes v. Nuvell Financial Services, No. BC407366 (Cal Ct. App. Jan. 25, 2012) (unpublished).

[4] See id.

[5] Sanchez at 25.

[6] Hamby v. Power Toyota Irvine, Civ. No. 11cv0544-BTM (S.D. Cal. Mar. 22, 2012).