October 29, 2014 Practice Points

What NOT to Do When Drafting an Arbitration Clause

By Amanda M. H. Wolfman

Merkin v. Vonage America Inc., No. 2:13-cv-08026-CAS (MRWx), 2014 WL 457942 (C.D. Cal. Feb. 3, 2014), shows that unconscionability is more than a theoretical threat to the enforceability of contractual arbitration clauses. While arbitration provisions are permissible in “take-it-or-leave-it” contracts of adhesion and, undoubtedly, there is a “liberal federal policy favoring arbitration agreements,” courts will not compel arbitration if a contract containing an arbitration provision is unconscionable.

In Merkin,the plaintiffs brought a putative class action in California state court, alleging that Vonage America Inc. (Vonage) billed customers for a monthly “Government Mandated” fee, despite the fact that no government agency mandated such a fee. Id. at *1. Vonage removed the case to the U.S. District Court for the Central District of California and subsequently moved to compel arbitration based on an arbitration clause (the Arbitration Clause) in the Vonage Terms of Service Agreement (the Agreement). Id. Based on the lack of “clear and unmistakable evidence” that the parties agreed to delegate questions of arbitrability, the court held that it—not an arbitrator—should determine the unconscionability of the Arbitration Clause. Id. at *5. The court then denied Vonage’s motion to compel arbitration, holding that although the plaintiffs had agreed to the Agreement, the Agreement and Arbitration Clause were nevertheless procedurally and substantively unconscionable. Id. at *11.

The court’s analysis regarding the details of, and circumstances surrounding, the Agreement and Arbitration Clause provides guidance as to what not to do when drafting and modifying contractual arbitration clauses. “Procedural unconscionability concerns the manner in which the contract was negotiated and the respective circumstances of the parties at that time, focusing on the level of oppression and surprise involved in the agreement.” Id. at *5 (citations and internal quotation marks omitted). “[T]he question of oppressiveness turns on the relative balance of bargaining power between the parties.” Id. at *7.

The court began this analysis by holding that the Agreement was per se oppressive because it was a “take-it-or-leave-it” contract of adhesion and, thus, gave the subscriber no opportunity to negotiate. Id. at *6–7. The court then highlighted Vonage’s authority to modify the Agreement at will—authority that Vonage exercised 36 separate times between 2004 and 2013. Id. at *2, 7. Particularly because of these actual and repeated modifications of the Agreement over the years, and the fact that subscribers were not notified of modifications so they would have to constantly check Vonage’s website to make sure they did not miss any new updates to the Agreement, the court found that surprise was present in the case. Id. at *8–9. Accordingly, the court found that the Arbitration Clause was “suffused with a high degree of procedural unconscionability.” Id. at *9.

Against this backdrop, the court stated that “only a moderate finding of substantive unconscionability [was] required to render the [Arbitration Clause] unconscionable.” Id. The “paramount consideration” when assessing substantive unconscionability is mutuality. Id. (citation and internal quotation marks omitted). In Merkin, the Arbitration Clause was “unfairly one-sided” because it “carve[d] out exceptions for the categories of claims likely to be brought by Vonage”—e.g., “collection disputes, intellectual property disputes and unauthorized use of service disputes.” Id. at *9–10. In its ruling, the court made clear that “[f]ederal law favoring arbitration is not a license to tilt the arbitration process in favor of the party with more bargaining power.” Id. at *11 (citations and internal quotation marks omitted).

The court, thus, denied Vonage’s motion to compel arbitration. The case is now on appeal, so the U.S. Court of Appeals for the Ninth Circuit will add to this story, one way or another. Regardless of the ultimate outcome of the case, however, the district court’s opinion offers a cautionary tale: “fairness” is ignored at the drafter’s peril.

Keywords: alternative dispute resolution, litigation, unconscionability, arbitrability, enforceability

Amanda M. H. Wolfman is with Novack and Macey LLP in Chicago, Illinois.

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