ABA Section of Business Law
ABA Section of Business Law
Business Law Today
May/June 1998
Excuse me, but who's the predator?
Banks can use arbitration clauses as a defense
By ALAN S. KAPLINSKY and MARK J. LEVIN
Kaplinsky is a senior partner and Levin a partner with Ballard Spahr Andrews & Ingersoll, LLP, in Philadelphia.
Consumers have been ganging up on banks. But now the institutions have found a way to defend themselves. During the past several years, financial services companies specializing in consumer lending have become prime targets for class action lawsuits by borrowers attacking virtually every aspect of their credit practices. Many of the newer, and more sophisticated, products and services offered by banks and other lenders — such as credit life, disability and unemployment insurance; private label credit cards; and tax refund anticipation loans — have been particularly susceptible to class litigation by consumers. This surge in consumer litigation has been fueled by the growing number of plaintiffs' lawyers who have turned from securities, antitrust and products liability litigation to consumer financial services litigation.
All of the dangers inherent in an individual consumer lawsuit — the threats of costly and drawn-out litigation, runaway juries, gargantuan punitive damages awards and adverse publicity — are magnified exponentially when a class of hundreds or thousands of consumers is certified. Faced with these threats, companies often feel pressured to pay substantial amounts in settlement for reasons having nothing to do with the actual merits of the dispute.
However, lenders have discovered that the potential for class action litigation is significantly reduced if the consumers have agreed to arbitrate their disputes with the lenders. Arbitration is a method of dispute resolution in which a neutral third party is chosen to hear both sides of a case and then resolve it by rendering an award. Arbitration is a powerful deterrent to class action lawsuits against lenders because the great weight of authority holds that arbitrations cannot be conducted on a class basis unless the parties have agreed to do so. In addition to the fact that arbitration can result in a substantial savings of time, energy and resources, these authorities have encouraged increasing numbers of lenders to implement arbitration programs in their financial services contracts. Stripped of the threat of a class action, plaintiffs' lawyers have much less incentive to sue.
To date, one federal court of appeals and three federal district courts have specifically considered whether an arbitration may proceed on a class-wide basis, and they have unanimously concluded that it may not absent a provision in the arbitration agreement or the applicable arbitration rules specifically authorizing class arbitration. Under Section 4 of the Federal Arbitration Act, 9 U.S.C. §4 (FAA), federal and state courts are authorized to direct to arbitration parties who have agreed to arbitrate "in accordance with the terms of the [arbitration] agreement." Section 4 provides in pertinent part:
A party aggrieved by the alleged failure, neglect or refusal of another to arbitrate under a written agreement for arbitration may petition ... for an order directing that such arbitration proceed in the manner provided for in such agreement .... 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. Therefore, the courts examine the parties' arbitration agreement and the applicable arbitration rules for evidence that the parties agreed to permit class actions. If the arbitration agreement or applicable procedural rules expressly state that class actions are not permitted, or even if the agreement and rules are merely silent on the question, the federal courts have not permitted plaintiffs to arbitrate their claims on a class-wide basis.
The first federal court to rule on class arbitration was Gammaro v. Thorp Consumer Discount Co., 828 F. Supp. 673 (D. Minn. 1993), appeal dismissed, 15 F.3d 93 (8th Cir. 1994). Plaintiff, who had obtained a consumer loan from Thorp, filed a putative class action under the Truth in Lending Act (TILA) and state UDAP statutes alleging that Thorp improperly refused to permit plaintiff to rescind the loan. After determining that plaintiff's individual claims were governed by an arbitration agreement between the parties, the court considered whether it had the authority to direct the arbitrator to adjudicate the dispute as a class action.
The court held that it did not have the authority to order class arbitration because, under Section 4 of the FAA, it was required to give effect to the parties' arbitration agreement, and the agreement between plaintiff and Thorp made no provision for class treatment of disputes. The court found persuasive analogous court decisions holding that district courts are without power to consolidate arbitration proceedings absent express authority in the arbitration agreement. (The overwhelming majority of federal courts now so hold, although some earlier decisions were to the contrary.)
The same result obtained in McCarthy v. Providential Corp., 1994 WL 387852 (N.D. Cal. July 19, 1994), appeal dismissed, 122 F.3d 1242 (1997). Plaintiffs, homeowners who had obtained reverse mortgage loans from Providential, filed a class action complaint alleging violations of the TILA and various state laws. Providential moved to compel arbitration of plaintiffs' claims pursuant to an arbitration clause in the reverse mortgage agreements and also sought an order that arbitration proceed on an individual, rather than a class, basis. The McCarthy court held that the arbitration could not proceed on a class-wide basis.
As in Gammaro, the McCarthy court found analogous support for its ruling in federal cases (the overwhelming majority view) holding that courts lack the power to consolidate arbitration proceedings unless the arbitration agreement authorizes consolidation. The same result should apply to class actions, the court reasoned, because "[c]onsolidation and class actions are both methods of adjudicating numerous individual actions involving common questions of law or fact." 1994 WL 387852, at *8. The court also found the reasoning in Gammaro to be persuasive. Examining the arbitration agreement between plaintiffs and Providential, the court found no provisions authorizing either arbitration or the consolidation of claims. Therefore, it dismissed the class action lawsuit and ordered plaintiffs to arbitrate their claims, holding that it had no authority to order that the arbitration proceed as a class action.
Very recently, Judge DeMent of the U.S. District Court for the Middle District of Alabama, in granting the defendant's motion to compel plaintiff to arbitrate her TILA and Equal Credit Opportunity Act claims, held that the court had no authority to certify those arbitrable claims as class action claims. Randolph v. Green Tree Financial Corp., No. 96-D-11-N, 1997 U.S. Dist. LEXIS 21721 (M.D. Ala. Nov. 26, 1997).
The court emphasized that it could only enforce the arbitration agreement as the parties wrote it, and the agreement made no provision for class action treatment or for consolidation of arbitration proceedings. In addition, the court relied on U.S. Supreme Court precedent holding that the policies favoring arbitration are so strong that arbitration agreements should be enforced even if piecemeal litigation (individual lawsuits as opposed to a class action) results. The court also relied on the overwhelming majority of federal cases holding that courts may not consolidate arbitration proceedings if the parties have not agreed to do so.
At the appellate level, in Champ v. Siegel Trading Co. Inc., 55 F.3d 269 (7th Cir. 1995), the U.S. Court of Appeals for the Seventh Circuit likewise held that "absent a provision in the parties' arbitration agreement providing for class treatment of disputes, a district court has no authority to certify class arbitration." Plaintiff in Champ brought a class action complaint against the defendants claiming violations of the Commodity Exchange Act, RICO and various state laws. Plaintiff contended that even if she had to arbitrate, the arbitration should be ordered to proceed as a class action.
Plaintiff relied on Rule 81(a)(3) of the Federal Rules of Civil Procedure, which provides that in proceedings under the FAA, the federal rules apply to the extent not provided for in the FAA. Because the FAA is silent on the issue of class arbitration, plaintiff asserted, Rule 81(a)(3) allows the federal courts to apply Federal Rule of Civil Procedure 23, governing class actions, and order arbitration to proceed on a class basis. The Seventh Circuit rejected plaintiff's argument, explaining that the FAA requires that arbitration agreements be enforced according to their express terms, whereas Rule 81 applies only to judicial proceedings:
First of all, Rule 81(a)(3) says that the Federal Rules fill in only those procedural gaps left open by the FAA. But as explained above, Section 4 of the FAA requires that we enforce an arbitration agreement according to its terms. Such terms conceivably could consist of consolidated or even class arbitration. The parties here did not include in their agreement an express term providing for class arbitration. Thus, one could say that through the proper application of 9 U.S.C. § 4, the FAA has already provided the type of procedure to be followed in this case, namely, nonclass-action arbitration. . . .
But more to the point, we still could not accept the [plaintiffs'] assertions because by its language Rule 81(a)(3) only applies to judicial proceedings under the FAA. . . . But nothing in the language of Rule 81(a)(3) purports to apply the Federal Rules of Procedure to the actual proceedings on the merits before the arbitrators .... Therefore, absent an express provision in the parties' arbitration agreement providing for class arbitration, Rule 81(a)(3) does not provide a district court with the authority to reform the parties' agreement and order the arbitration panel to hear these claims on a class basis pursuant to Rule 23. Id. at 226-77 (emphasis added; citations omitted). Accordingly, the Seventh Circuit held that "[s]ince the parties' arbitration agreement does not expressly provide for class arbitration, the district court correctly concluded that it was prohibited from reading such a procedure into these arbitration agreements." Id. at 277.
The federal authorities mentioned above are far more persuasive than the few older state court decisions that have ruled, without benefit of the analysis in the above cases, that arbitration may proceed on a class basis. See Dickler v. Shearson Lehman Hutton Inc., 408 Pa. Super. 286, 596 A.2d 860 (1991), alloc. denied, 532 Pa. 663, 616 A.2d 984 (1992); Keating v. Superior Court, 3 Cal. 3d 584, 645 P.2d 1192, 183 Cal. Rptr. 360 (1982), rev'd on other grounds, 465 U.S. 1 (1984). These courts did not rigorously analyze the issue under the FAA; instead, they attempted to evaluate whether a class action in arbitration would be a fair way of resolving the parties' disputes, concluding that if class members were required to arbitrate on an individual basis, the small amount of money potentially recoverable in each case might dissuade claimants from proceeding and thus detract from the policy favoring arbitration.
Both courts also envisioned a hybrid procedure in which the court would retain jurisdiction over the class certification process while the arbitrator would adjudicate the merits of the claim. Such a result seems totally inconsistent with Section 4 of the FAA, which requires that an arbitration agreement be enforced in accordance with its terms, as well as with interpretive decisions of the U.S. Supreme Court. See, for example, Volt Info. Sciences Inc. v. Board of Trustees, 489 U.S. 468, 479 (1989) ("private agreements to arbitrate are enforced according to their terms").
Moreover, as analogous support, the Keating court relied on an older Second Circuit case, Compania Espanola de Petroleos, S.A. v. Nereus Shipping, S.A., 527 F.2d 966 (2d Cir. 1975), cert. denied, 426 U.S. 936 (1976), for the proposition that courts have authority to "consolidate" arbitration proceedings. However, the Second Circuit itself has since declared Nereus Shipping to be inconsistent with the principles set forth in the FAA. See Government of the United Kingdom v. Boeing Co., 998 F.2d 68 (2d Cir. 1993) (holding that a district court cannot order consolidation of arbitration proceedings arising from separate agreements to arbitrate absent the parties' agreement to allow such consolidation).
In contrast to Dickler and Keating, at least one other state court, consistent with federal practice, has held that arbitrations cannot proceed on a class-wide basis since to order class arbitrations would rewrite the contract between the parties. Steinberg v. Prudential-Bache Securities Inc., 1986 WL 5024 (Del. Ch. Ct. 1986). See also the National Association of Securities Dealers Manual, Code of Arbitration Procedure ¶10300 (CCH July 1997) (a claim submitted as a class action is not eligible for arbitration under the NASD Code).
The cases discussed here have done much to encourage financial services companies to implement arbitration programs in their consumer contracts. It is anticipated that virtually all major banks and lending institutions will implement consumer arbitration procedures within the next five years. Lenders that have not yet implemented arbitration programs should promptly consider doing so, since each day that passes brings with it the risk of additional multimillion-dollar class action lawsuits that might have been avoided had arbitration procedures been in place.
