November 20, 2012 Articles

Post-Concepcion Push-Back: Challenges to Arbitration

Throughout the history of the Federal Arbitration Act, courts have struggled with scope of jurisdiction and discretion to determine the validity and enforceability of arbitration clauses.

By Peter J. Korneffel and Kathryn R. DeBord

Throughout the history of the Federal Arbitration Act (FAA), courts have struggled with the scope of their jurisdiction and discretion to determine the validity and enforceability of an arbitration clause. With the most recent edicts handed down by the Supreme Court in the 2010–2011 term, culminating in AT&T Mobility LLC v. Concepcion, 131 S. Ct. 1740 (2011), a court’s discretion is undoubtedly limited under the FAA. The analysis, which is cloaked in the presumption that the arbitration clause is valid, seems to boil down to three primary questions:

First, is the challenge directed specifically to the making of the arbitration clause, or does it relate to the underlying contract (the “container contract”), such that the challenge goes to the arbitrator, not to the court, pursuant to the so-called “separability doctrine”?

Second, if the challenge indeed is directed specifically to the making of the arbitration clause, are there any valid state law contract defenses to the formation of the arbitration agreement?

Third, if state law contract defenses are available, do those defenses discriminate against or have a disproportionate impact on arbitration clauses, such that they are nevertheless preempted by the FAA?

This analysis may seem clear cut, but its application remains nebulous. For example, when do challenges relate to the “making” of the arbitration agreement, as opposed to the container contract? And what types of state law contract defenses can be used to invalidate an FAA arbitration clause? In light of Concepcion’scurtailment of the use of state public policy as a mechanism to invalidate FAA clauses and Justice Thomas’s concurring decision that the FAA immunizes arbitration clauses from substantive unconscionability defenses, the relevancy of unconscionability law in modern FAA jurisprudence is up for debate.

As a result, many lawyers and courts are turning their attention to formation challenges—that is, defects in the making of the agreement to arbitrate. These defects include not only instances of fraud and duress, as Justice Thomas identified, but also whether, for example, the contracting parties received adequate notice of the arbitration agreement’s terms and whether adequate consideration was exchanged for the agreement to arbitrate. Most commonly, since Concepcion, some courts are turning to the contractual defense of illusory promises to invalidate arbitration clauses based on the argument that the clause is not supported by sufficient consideration.

The contractual defense of an illusory promise is not new. But since Concepcion, many courts are turning to it to try to invalidate arbitration clauses, based on the argument that the particular clause is not supported by sufficient consideration because it lacks mutuality. Recently, this defense has been appearing regularly in challenges to mass consumer contracts that include an arbitration clause and a “change-in-terms” provision. The argument is that the change-in-terms clauses in the container contract, permitting a service provider to change terms of the contract, renders the arbitration clause illusory and therefore unenforceable. These courts are reaching this decision regardless of whether the contract’s terms (including its arbitration clause) are otherwise supported by consideration under state law.

Whether this new defense to arbitration clauses can survive the Supreme Court’s FAA jurisprudence is a question that we expect will be resolved over time, but for now there is a circuit split forming over the issue. The defense appears to be another backdoor effort to get to the same result Concepcion foreclosed, however, and it likely violates the Supremacy Clause, the separability doctrine, or both.

Federal Substantive Law—Supremacy, Separability, and State
The FAA provides that an arbitration provision “shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract.” 9 U.S.C. § 2.

The act creates a body of “substantive law of arbitrability, applicable to any arbitration agreement within the coverage of the act.” Moses H. Cone Mem’l Hosp. v. Mercury Constr. Corp., 460 U.S. 1, 24 (1983). Because the FAA creates substantive federal contract law, it preempts state laws that interfere with it. Southland Corp. v. Keating, 465 U.S. 1, 12 (1984). Its reach extends to “ the limits of Congress’ Commerce Clause power”; therefore, state courts cannot apply state statutes that invalidate arbitration agreements. Allied-Bruce Terminix Cos. v. Dobson, 513 U.S. 265, 272 (1995). Moreover, all claims are arbitrable unless Congress provides otherwise, and absent contrary congressional intent, public policy cannot be used to create some sort of exception to arbitration, regardless of the claim involved. Mitsubishi Motors Corp. v. Soler Chrysler-Plymouth, 473 U.S. 614 (1985).

The Supreme Court’s rejection of public policy exceptions to the FAA did not, however, prevent courts and states from creating various types of state public policy exceptions to avoid the enforcement of agreements to arbitrate under certain circumstances. These state public policy exceptions presumably were crafted on the rationale that, under the FAA’s savings clause, arbitration agreements may be revoked on the same bases as any other contract under the applicable state’s law, and, therefore, state substantive unconscionability defenses and public policy may be used to revoke arbitration clauses.

California’s so-called Discover Bank ruleis one obvious example of the application of state public policy to invalidate arbitration clauses.The Discover Bank rule was a line of cases invalidating FAA arbitration clauses that contained class action waivers in consumer contracts based on state law public policy. In Concepcion, the Supreme Court held that this state public policy was preempted by the FAA. Concepcion rejected the heavily lobbied notion that arbitration clauses precluding class procedures are unconscionable where the claims involved are so low in value that they would not be pursued absent a class mechanism. Instead, said the Court, agreements to arbitrate are to be enforced according to their terms, and state public policy cannot be used to contravene the supremacy of the FAA. Justice Thomas went further in his concurrence and said that laws of substantive unconscionability could not be used to invalidate arbitration clauses at all. This is because, Justice Thomas reasoned, the FAA’s savings clause only allows for the use of state laws to “revoke” arbitration clauses. It does not allow courts to use state laws to “invalidate” those clauses or render them unenforceable. As a result, he reasoned, not all contract-based defenses are available under the FAA, only a subset relating to revocability. Thomas conceded that the “difference between revocability, on the one hand, and validity and enforceability, on the other, is not obvious,” but based on the language of the FAA and its broader statutory scheme and intent, he concluded that the “grounds . . . for the revocation” of an arbitration clause refers only to grounds related to the making of the agreement—that is, grounds related to formation, such as fraud, duress, and mutual mistake. Contract defenses unrelated to the making of the agreement—such as public policy—cannot be the basis for declining to enforce an arbitration clause, according to Thomas.

Four cases—Prima Paint Corp. v. Flood & Conklin Mfg. Co., 388 U.S. 395 (1967); Buckeye Check Cashing, Inc. v. Cardegna, 546 U.S. 440 (2006); Rent-A-Center, W., Inc. v. Jackson, 130 S. Ct. 2772 (2010); and Granite Rock Co. v. Int’l Bhd. of Teamsters, 130 S. Ct. 2847 (2010)—provide the Supreme Court’s articulation of the so-called “separability doctrine” (also known as the “severability doctrine”), which lies in tandem with Justice Thomas’s reasoning. Under the doctrine, the Supreme Court recognized that, as a matter of federal substantive law, arbitration clauses are separate from the contracts in which they are embedded; therefore, the court’s determination of whether the parties agreed to arbitrate must be made separately from the remainder of the contract. A party seeking to avoid an arbitration agreement on the grounds of a formation defect, such as insufficient consideration, fraud, or duress, must therefore “specifically” challenge the arbitration clause in order for the court to have jurisdiction over the challenge. Buckeye, 546 U.S. at 448–49. If the attack challenges the formation of the contract generally, then the challenge is for the arbitrator to decide in the first instance.

Justice Scalia explained in Buckeye that the separability doctrine is necessary to keep courts from determining ultimate issues in violation of the FAA:

It is true, as respondents assert, that the Prima Paint rule permits a court to enforce an arbitration agreement in a contract that the arbitrator later finds to be void. But it is equally true that respondents’ approach permits a court to deny effect to an arbitration clause in a contract that the court later finds to be perfectly enforceable. Prima Paint resolved this conundrum—and resolved it in favor of the separate enforceability of arbitration clauses. We reaffirm today that, regardless of whether the challenge is brought in federal or state court, a challenge to the validity of the contract as a whole, and not specifically to the arbitration clause, must go to the arbitrator.

Id.

Thus, it makes no difference whether, if successful, the challenge would nullify the contract in its entirety, including the arbitration clause. Because parties to an FAA arbitration agreement agreed to arbitrate all disputes related to the contract, they also agreed to arbitrate whether the contract was properly formed in the first place.

Attempts to Avoid Arbitration Clauses as Illusory Promises
Although it is arguable that challenges to arbitration agreements as illusory go to the “making” of the arbitration agreement and are therefore technically proper challenges under the FAA according to Justice Thomas’s analysis, the problem is that these challenges almost never are challenges directed “specifically” to the arbitration clause. Rather, most of these cases involve change-in-terms provisions that apply to all of the terms in the container contract, not just the arbitration clause.

As a result, the recent challenges to arbitration clauses as illusory promises create a conundrum under this FAA jurisprudence. Assuming no terms have actually been changed (and therefore assent to the changed terms is not at issue), the presence of the change-in-terms provision raises the issue of consideration; that is, whether the contracting parties were ever bound to a contract at all. Because it is a question of consideration, even if the change-in-terms provision renders the contract illusory as drafted, the contract may nevertheless be supported by adequate consideration and therefore enforceable. Most states, for example, recognize that a contract that lacks consideration as written can still later be enforceable and deemed supported by sufficient consideration when the parties exchange promises and then perform in accordance with those promises.

With this in mind, it appears that illusory challenges to arbitration clauses based on change-in-terms clauses in the underlying container contracts can lead to only one of two results under the FAA and the Supreme Court’s decisions.

The first result—the “Scylla”—is that the change-in-terms provision, if it invalidates anything at all, invalidates the entire contract as illusory under the applicable state’s law. This would be true in states that require mutuality of each obligation in the contract in order for the contract to be supported by sufficient consideration (a “mutuality state”), regardless of future performance by the parties. In a mutuality state, a court facing such a challenge likely does not have jurisdiction in the first instance to rule on the enforceability of the arbitration clause because the challenge necessarily attacks the entire contract. As Buckeye says, the arbitrator, not the court, has jurisdiction over this challenge even if the arbitration clause ultimately may be invalidated.

The alternative result—the “Charybdis”—is that the change-in-terms provision does not render the contract illusory, because, under that applicable state’s law, mutuality of each obligation is not required so long as the contract as a whole is supported by consideration (a “non-mutuality state”). Consideration can be achieved through, for example, exchanges of promises (such as to provide services to a customer in exchange for payment) or through performance under the contract. In other words, notwithstanding the change-in-terms clause, all of the terms are supported by consideration under that state’s contract laws. And importantly, for non-mutuality states, whether the contract is supported by sufficient consideration is determined based on the contract as a whole, and not based on any one clause within that contract.

As a result, to invalidate the arbitration clause—and only the arbitration clause—in a non-mutuality state based on a finding that the change-in-terms provision rendered the clause illusory, the court must hold that the arbitration clause requires mutuality of obligation even though the contract as a whole is otherwise valid under state law. This type of double standard is what the Supreme Court in Allied-Bruce Terminix Cos. v. Dobson held is impermissible and preempted by the FAA:

[W]hat States may not do is decide that a contract is fair enough to enforce all its basic terms (price, service, credit), but not fair enough to enforce its arbitration clause. The [Federal Arbitration] Act makes any such state policy unlawful, for that kind of policy would place arbitration clauses on an unequal “footing,” directly contrary to the Act’s language and Congress’ intent.

513 U.S. 265, 281 (1995).

In Grosvenor et al. v. Qwest, 854 F. Supp. 2d 1021 (D. Colo. 2012), the Colorado District Court refused to enforce an arbitration clause governed by Colorado law based on the plaintiffs’ defense that the agreement to arbitrate was an illusory promise. The arbitration clause was embedded in a larger consumer contract that contained, in addition to the arbitration clause and other contractual terms, a change-in-terms clause. Colorado is a non-mutuality state, but following Tenth Circuit precedent, the Grosvenor court held that, notwithstanding the governing state law of mutuality of obligation, arbitration clauses that allow one party the “unfettered right” to change their terms are illusory and unenforceable. This finding treats arbitration clauses differently than other contract terms and holds arbitration clauses to different standards than the other contract terms are held to, apparently contradicting the Supreme Court’s mandates that arbitration clauses must be on the same footing as all other contract terms.

Courts are beginning to identify this conundrum, and many have concluded, likely correctly, that these arguments lead to a trap between the proverbial Scylla and Charybdis and ultimately cannot be used to defeat arbitration clauses in court because doing so would violate either the separability doctrine—e.g., D-J Eng’g Inc. v. UBS Fin. Servs., No. 11-cv-1316-CM-DJW 2012 WL 171342, at *4 (D. Kan. Jan. 20, 2012) (holding that the issue of whether the contracts are illusory is to be resolved in arbitration, not this court)—or federal preemption—e.g., Soto v. State Indus. Prods., Inc., 642 F.3d 67, 76–77 (1st Cir. 2011) (holding to the extent Puerto Rico imposed mutuality requirement on arbitration clauses, FAA would preempt that requirement); S.E. Stud & Components, Inc. v. Am. Eagle Design Build Studios, LLC, 588 F.3d 963, 966–67 (8th Cir. 2009) (holding Arkansas law requiring mutuality of obligation within arbitration agreement, even if there was sufficient mutuality within the rest of the contract, was preempted by FAA; proper conclusion was that mutuality of obligation is not required for arbitration clauses so long as contract as a whole is supported by consideration).

Even in a mutuality state, it is unclear whether the FAA would preempt state law requiring mutuality of obligation for arbitration agreements. Several courts have rejected any requirement of mutuality of obligation in arbitration clauses. E.g., Bess v. Check Express, 294 F.3d 1298, 1308 (11th Cir. 2002) (holding that “lack of mutuality does not, in and of itself, render the arbitration agreement unconscionable”); Harris v. Green Tree Fin. Corp., 183 F.3d 173, 179–81 (3d Cir. 1999) (noting that most federal and state courts have held that mutuality is not a requirement of a valid arbitration clause, and summarizing state and federal cases so holding); Wilson Elec. Contractors, Inc. v. Minnotte Contracting Corp., 878 F.2d 167, 169 (6th Cir. 1989) (recognizing that Prima Paint “does not require separate consideration for an arbitration clause contained within a valid contract”).

This appears to be the correct analysis, but the courts will be defining the landscape over the coming year as more cases addressing this issue will go to appeal, including Grosvenor. In light of existing FAA jurisprudence, however, it appears that the only possible way for a court to properly “revoke” an arbitration agreement based on the defense that it was an illusory promise is to do so based on a change-in-terms provision that is within the arbitration clause itself, instead of the container contract, and to also find that the arbitration clause is not otherwise supported by consideration under the applicable state’s law. Anything less likely runs afoul of the FAA and Supreme Court precedent, and will be seen as another FAA loophole that needs to be plugged.

Keywords: litigation, class action, derivative suits, contract formation, consideration, unconscionability, mutuality, change-in-terms clause

Peter J. Korneffel and Kathryn R. DeBord – November 20, 2012


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