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What to Make of the Second Circuit Voiding a Class Action Waiver Under California’s Discover Bank Rule?

July 23rd, 2010 Arbitration Practice and Procedure, California State Courts, Class Action Arbitration, Class Action Waivers, Practice and Procedure, United States Court of Appeals for the Ninth Circuit, United States Court of Appeals for the Second Circuit, United States Supreme Court Comments Off on What to Make of the Second Circuit Voiding a Class Action Waiver Under California’s Discover Bank Rule? By Philip J. Loree Jr.

After deciding Stolt-Nielsen, S.A. v. AnimalFeeds, Inc. and Rent-A-Center West v. Jackson, the United States Supreme Court left federal arbitration law at a crossroads.  In both cases the Court adhered quite faithfully to its prior Federal Arbitration Act jurisprudence, under which it enforces arbitration agreements according to their terms, without regard to other considerations.  In Rent-A-Center the Court implicitly reaffirmed that these pro-enforcement rules apply equally to contracts of adhesion. 

We will find out whether the Court intends to continue down the same path when it decides AT&T Mobility v. Concepcion next term, a case that raises the question whether California’s Discover Bank  unconscionability rule is pre-empted by the Federal Arbitration Act.  That rule deems unconscionable under California law class-action or class-arbitration waivers where:  (a) “the waiver is found in a consumer contract of adhesion in a setting in which the disputes between the contracting parties predictably involve small amounts of damages”; and (b) “it is alleged that the party with the superior bargaining power has carried out a scheme to deliberately cheat large numbers of consumers out of individually small sums of money.  .  .  .”  Discover Bank v. Superior Court, 36 Cal. 4th 148, 162-63 (2005) (citing Cal. Civ. Code § 1668). 

The Discover Bank rule is grounded in a California-law principle – embodied in Cal. Civ. Code § 1668 – that “contracts which have for their object, directly or indirectly, to exempt anyone from responsibility for his own fraud.  .  .  are against the policy of the law.”   See Cal. Civ. Code § 1668.  If a company is allegedly engaging in fraudulent acts designed to cheat numerous consumers out of small amounts of money, a class action or class arbitration waiver may, if enforced, effectively act as an exculpatory provision that insulates the company from the consequences of its small scale, but widespread fraud, because the individual, allegedly defrauded consumers have little incentive to pursue separate actions or arbitrations to recoup trivial amounts of damages.  See Discover Bank, 36 Cal. 4th at 162-63.  Any contract that had that effect – whether it is a class action waiver in an arbitration clause, an exculpatory agreement or a contract that simply forbids class actions  — would be unconscionable under the rule.  

In Fensterstock v. Education Finance Partners, No. 09-1562-cv, slip op. (2d Cir. July 12, 2010), the United States Court of Appeals for the Second Circuit suggested one path that the United States Supreme Court might take on Discover Bank preemption.  In an interesting opinion, Senior Circuit Judge Amalya Lyle Kearse, joined by Circuit Judges José A. Cabranes and Chester J. Straub, held that the Discover Bank rule was not preempted by the Federal Arbitration Act.  According to the Second Circuit, California’s  Discover Bank rule “’places arbitration agreements on the exact same footing as contracts that bar class action litigation outside the context of arbitration,’” and for that reason the rule is not preempted by the Act.  Slip op. at 16-17 (quoting Shroyer v. New Cingular Wireless Serv., Inc., 498 F.3d 976, 990 (9th Cir. 2007) (emphasis in original)). 

On first blush the Second Circuit’s decision seems reasonable.  But there are some important issues lurking beneath the surface that the Supreme Court will need to address when it decides AT&T Mobility

In Stolt-Nielsen the Supreme Court, among other things, established certain Federal Arbitration Act “rules of fundamental importance,” which trump inconsistent state law.  (Blogged here.)   One of these is that parties may “specify with whom they chose to arbitrate.”  Stolt-Nielsen, slip op. at 19 (emphasis in original).   And another – the one that controlled the outcome of Stolt-Nielsen – is that  “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.”  Slip op. at 20 (emphasis in original).  The Court admonished that it “falls to courts and arbitrators to give effect to these [and other enumerated] contractual limitations, and when doing so, courts and arbitrators must not lose sight of the purpose of the exercise:  to give effect to the intent of the parties.”  Slip op. at 20. 

Application of these rules to an arbitration agreement containing a class-arbitration or class-action waiver would presumably result in enforcement of that waiver as a matter of federal law.  The rule that the parties can choose with whom they arbitrate necessarily preempts any state law or policy that would declare void or unenforceable such an express choice made by the parties to limit the universe of persons with whom they agreed to arbitrate.  And the Discover Bank  rule – for all its reasonableness and good intentions – is just such a rule.

Alternatively, the Stolt-Nielsen rule that affirmative consent — not mere silence — is required for a court or arbitration panel to compel class arbitration strongly suggests that class-arbitration or class-action waivers are irrelevant.  Even if one is excised from the arbitration clause, what is left is usually an arbitration clause that is silent on class arbitration.  But under Stolt-Nielsen courts and arbitrators cannot compel class arbitration in the face of silence.   So the net effect of including such a waiver in a contract that is otherwise silent on class arbitration is zero, which hardly makes the waiver a candidate for nonenforcement under the Discover Bank rule.  

The Supreme Court’s disposition of the American Express Merchants’ Litigation matter suggests that it believes Stolt-Nielsen is relevant to the question whether class arbitration waivers are enforceable or simply irrelevant.  Readers may recall that in May 2009 American Express filed a cert petition in the American Express Merchants’ Litigation.  The Second Circuit had held that an arbitration agreement provision forbidding class-action arbitration was invalid and unenforceable on federal public policy grounds under the circumstances of that case, which involved federal antitrust claims.  See Re American Express Merchants’ Litigation, 554 F.3d 300 (2d Cir. 2009), vacated and remanded sub nom., American Express Co. v. Italian Colors Restaurant, No. 08-1473 (May 3, 2010). 

On May 3, 2010 the Court issued a summary order in American Express Co. v. Italian Colors Restaurant, granting certiorari, summarily vacating the Second Circuit judgment, and remanding it “for further consideration in light of” Stolt-Nielsen.   Justice Sotomayor “took no part in the consideration or decision” of the petition.   See Italian Colors, No. 08-1473 (May 3, 2010) (summary disposition).  It is unclear whether the Court vacated the judgment because it believed the waiver was enforceable or irrelevant, or whether there was some other Stolt-Nielsen-related reason.  

In Fensterstock the Second Circuit apparently did not figure Stolt-Nielsen or Italian Colors into its preemption analysis.  Oddly enough it relied on Stolt-Nielsen for the proposition that the class-arbitration waiver could not be severed from the remainder of the arbitration agreement, because if the class arbitration waiver were removed, the arbitration clause would be silent on class arbitration, which in turn meant that the court could not compel class arbitration.  While that conclusion probably should have led the court to rethink its preemption analysis, instead it led the court to conclude further (and implausibly) that the entire arbitration clause could not be enforced, and that the claimant could pursue a class action in court.  But that reasoning makes little sense because it suggests that an arbitration clause that contains no class-arbitration waiver, and  is simply silent on class arbitration,  would violate the Discover Bank rule.        

The question that will likely arise in AT&T Mobility is whether Stolt-Nielsen’s “rules of fundamental importance” require enforcement of the waiver despite contrary state law governing contracts generally.  If the Court decides to follow the same path it was on this past term, then it might well find that the Stolt-Nielsen rules of “fundamental importance” trump the Discover Bank rule, or render irrelevant both the class waiver and the Discover Bank rule.  But if at least one member of the Stolt-Nielsen/Rent-A-Center majority decides to break ranks, then it could be that the Court adopts an analysis similar to that used in Fensterstock

The narrow nature of the Discover Bank rule, coupled with strong public policy considerations against allowing parties to effectively insulate themselves from liability for fraud, could cause such a break in the ranks.  If that turns out to be the case, perhaps the Court will say that the “rules of fundamental importance” are subject to state law defenses applicable to ordinary contracts, and that the Discover Bank  rule constitutes such a defense.  Or the Court might say that the “rules of fundamental importance” are different – or are to be applied differently – in cases involving adhesive contracts.   

Whatever position a majority of the Court may take, the stakes are fairly high.  There has already been a good deal of political fallout resulting from the Court’s arbitration decisions this term, and the practical implications of that fall-out are not entirely clear in terms of whether the Arbitration Fairness Act of 2009 is likely to be passed.  But even if Rent-A-Center does not precipitate legislative action on the Arbitration Fairness Act, a reversal in AT&T Mobility could well be the proverbial straw that broke the camel’s back.  On the other hand, an affirmance in AT&T Mobility — coupled with an adjustment of the “rules of fundamental importance” in the adhesive contract context — might well shift public attention from anti-arbitration legislation on to something more — for lack of a better phrase — fundamentally important.

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