*Co-authored with Latif Zaman, associate, Hudson Cook, LLP

In April 2011, arbitration scored big when the United States Supreme Court, in AT&T v. Concepcion, held that the Federal Arbitration Act (the FAA) preempted a California state law that effectively considered any arbitration clause with a class action waiver unconscionable. After Concepcion, the California Courts and now the California legislature look to other ways to invalidate arbitration.

On April 30, the California legislature substantially rewrote SB 491, which now provides that any term in a contract of adhesion waiving the right to join or consolidate claims, or to bring a claim as a representative member of a class or in a private attorney general capacity lacks the necessary consent to waive that right, and is void. The bill would apply to contracts entered into on or after January 1, 2013. But the attack on arbitration (or class action waivers in general) is not restricted to the west coast.

Just a few weeks ago, the Consumer Financial Protection Bureau (the CFPB) began a public inquiry into how consumers and financial services companies are affected by arbitration and arbitration clauses. Congress mandated those studies through the Dodd-Frank Act and authorized the CFPB to issue regulations pursuant to the study. While proponents of arbitration, like us, assert that arbitration is a faster and cheaper alternative to litigation and protects dealers from unscrupulous plaintiff’s attorneys out to make millions, others believe that consumers often do not understand the rights they are giving up when agreeing to arbitrate.

In studying the effects of arbitration clauses, the CFPB will look into a number of issues, including the prevalence of arbitration clauses, the type of arbitration claims consumers bring, the effect of arbitration that actually occurs, and the effect of arbitration clauses that do not lead to actual arbitration. Once those studies are complete, the CFPB will decide if it is necessary to impose restrictions on arbitration clauses in order to protect consumers. More troubling is the fact that the CFPB has the authority to ban the use of arbitration clauses altogether.

While the CFPB studies arbitration clauses on a broad scale and explores whether to restrict or prohibit them, questions remain about the extent to which state law can restrict arbitration clauses in the wake of Concepcion. Concepcion dealt with a relatively consumer-friendly arbitration clause. In the clause, the company agreed to pay for the costs of arbitration, hold the arbitration in the consumer’s home county, and not seek attorney’s fees. If the consumer was awarded a greater sum in arbitration than the company’s final pre-arbitration offer, the company would pay double the consumer’s attorney’s fees and a minimum award of $7,500. Even though consumer-friendly, California courts applied the Discover Bank rule to invalidate the arbitration clause, which also contained a class action waiver.

The Supreme Court found that the FAA preempted the California common law’s Discover Bank rule. The FAA was designed to promote arbitration. State laws labeling arbitration clauses unconscionable solely because they bar class relief clearly undermine the intent of the federal legislation.

Courts, even outside of California, are finding ways to invalidate arbitration provisions. In Brewer v. Missouri Title Loans, the court dealt with the question of whether it follows from the Concepcion holding that the FAA preempts state unconscionability defenses when dealing with arbitration clauses in general. Brewer found that the Concepcion ruling was limited to California’s Discover Bank rule being preempted. The Supreme Court’s issue with the Discover Bank rule was that it made any arbitration clause unenforceable if it featured a class action waiver. The rule was focused solely on the arbitration clause, and was based on a general distrust of arbitration clauses.

The court in Brewer read Concepcion to stand for FAA preemption of state laws that declined to enforce arbitration clauses based on public policy concerns about arbitration. However, state law defenses, such as unconscionability, can still be used to potentially invalidate the formation of a contract and of an arbitration clause. Accordingly, if a state law does not single out arbitration clauses, explicitly or implicitly, the issue of preemption requires a case-by-case analysis of the arbitration clauses in question.

The court in Brewer applied the doctrine of unconscionability to find that the arbitration clause was clearly one-sided and unconscionable. The clause required arbitration to resolve disputes initiated by the consumer, at the consumer’s cost, while the company retained the right to repossess the collateral by force or through suit in court. The consumer waived the right to seek attorney’s fees, while the company retained that right. The clause was also a contract of adhesion and no consumer had ever successfully renegotiated any of the terms of the arbitration clause. Considering all these factors, the Brewer court found the arbitration clause unconscionable.

Cases such as Brewer will undoubtedly play into the CFPB’s decision on whether to further regulate, or even prohibit, arbitration clauses in consumer contracts. If other states follow Missouri’s reasoning and determine that federal law does not preempt states from applying the doctrine of unconscionability to contract formation, the specifics of arbitration clauses will be considered on a holistic level to determine their overall validity.

For the clauses to be valid, companies would do well to draft with a mind towards fairness and respecting the interests of both parties. Consumer contracts are generally contracts of adhesion, so there is necessarily an unequal bargaining position. Thus the onus will always be on companies to use terms that are fair to consumers. Self-regulation is crucial to the continued viability of arbitration clauses, and hopefully what happens in California, stays in California.

*Latif Zaman, an associate of Hudson Cook, LLP, in the firm’s Hanover, Maryland office, co-authored this piece. Latif can be reached at 410.782.2346 or lzaman@hudco.com.