The Proposed Arbitration Fairness Act: Still a Well-intended but Potentially Dangerous Overreaction to a Legitimate Concern

By George H. Friedman*

Introduction
The recent release of the Consumer Financial Protection Bureau’s Final Report to Congress on mandatory arbitration of consumer financial disputes has focused attention on the prevalent use of mandatory, predispute arbitration agreements (“PDAAs”) in consumer transactions. The Report, released March 10th was quite negative about arbitration, foreshadowing regulations to address the problem. Why? Dodd-Frank section 1028 directs the CFPB to study the use of PDAAs and later report to Congress. The statute also vests authority in CFPB to possibly develop regulations banning, limiting, or conditioning their use.

And, already there have been some results. Immediately after the CFPB’s Report was released, Senator Al Franken (D-MN) stated that he intends to breathe new life into the concept of a federal Arbitration Fairness Act (“AFA”). In a March 10th statement he states, “The findings of the [CFPB] report also highlight how important it is to pass into law a commonsense measure to ban these forced arbitration agreements. My legislation, the Arbitration Fairness Act, would ensure that American consumers, workers, and small businesses have the right to fight back when they aren’t treated fairly.”

On the House side, Representative Hank Johnson (D-GA) issued a press release on March 10th in which he said, “Furthermore, this study underscores the importance of creating arbitration fairness in all consumer agreements. I strongly believe that the comprehensive solution to this problem is the Arbitration Fairness Act, which would eliminate forced arbitration clauses in employment, consumer, civil rights, and antitrust cases, and would allow consumers and workers to freely choose arbitration after a dispute occurs. This simple fix would allow a voluntary system of arbitration.”

If past is prologue, the bills would amend the Federal Arbitration Act (“FAA”)1 by adding a new chapter invalidating PDAAs for consumer, investor, employment, or civil rights claims. The proposed legislation is similar to prior failed efforts to similarly amend the FAA going back at least to 2005,2 including the Arbitration Fairness Act of 2013, which expired with the close of the last Congress. Also introduced in February is the Investor Choice Act of 2015 (“ICA”) which would ban the use of mandatory pre-dispute agreements by broker-dealers and investment advisers and guarantee class action participation.

Two years ago, I wrote an article that appeared in the Securities Arbitration Commentator concluding that, while a well-intended effort to address a legitimate concern – PDAAs imposed via an adhesion contract by dominant parties on weaker parties like consumers and employees – the AFA of 2013 was in fact a potentially dangerous overreaction that would end up harming those it intended to protect. The presumably identical AFA of 2015 has not improved with age. Neither has the ICA. As a public service, I’ve dusted off and updated the key points made in my article, and a blog post I wrote last fall, Fixing arbitration of consumer disputes: What does this have to do with the Rolling Stones? in which I offered a compromise approach that might actually be enacted. I urge Congress and friends and foes of arbitration to read on.

Consumer Arbitration Clauses are Everywhere
Indeed, arbitration clauses abound in the consumer context, showing up in a vast array of contracts for consumer goods and services. Applied for a credit card? You’ve likely agreed to arbitrate disputes with your bank. Got a new cell phone? Payday loan? Rented a car? Opened a checking or stock brokerage account? Arbitration is likely right there in your contract.

Unfortunately, the supporters of mandatory or “forced” consumer arbitration – typically businesses – and those that hate it – typically consumer rights advocates – are locked in a polarized death embrace, with each side demanding that their view prevail. Opponents of consumer arbitration want mandatory predispute arbitration agreements banned outright. Supporters want PDAAs left alone. I suggest that by insisting that they get what they want – instead of what they need – they are both wrong. As the Rolling Stones song says, “You can’t always get what you want, but if you try sometimes, you just might find you get what you need.” I think I’ve identified that need.

The Current Landscape
In 1925, what’s now called the Federal Arbitration Act was enacted. It made PDAAs enforceable as a matter of federal law, and the Supreme Court in recent years has steadfastly supported the FAA. As already noted legislation will soon be introduced in Congress that would amend the FAA to ban PDAAs outright in all sorts of consumer and employment contracts.

Before we get too excited about either the Arbitration Fairness Act or the Investor Choice Act, bear in mind that there were several attempts over the years to amend the FAA to limit or ban use of mandatory arbitration in consumer contracts. These failed when the Republicans controlled the White House and Congress, and met a similar fate under Democratic control of these institutions as well. For example, in 2009 the Democrats regained the White House and control of both houses of Congress. The capital markets tanked, there were Madoff and other scandals, and the economy crashed. But the Arbitration Fairness Act didn’t make it out of the House Financial Services Committee, which at the time was chaired by Barney Frank, an avowed critic of PDAAs in consumer contracts. If it didn’t happen then, it’s not going to happen today with a Republican Congress. The same holds true for the Investor Choice Act.

Consumer Advocates: Be Careful What You Ask For
I also submit that before they jump on the anti-arbitration bandwagon and seek passage of the AFA, consumer advocates should be careful what they ask for. I see potential harm for consumers in the offing.

  • The bill would require both sides to agree to arbitration after a consumer dispute arises. First, assuming all sides will agree to arbitrate after a dispute arises is a fool’s paradise. Research shows clearly that, at that juncture, one side or the other has a strategic or tactical reason not to agree to arbitration. And assuming that it will always be the consumer that rejects arbitration is wrong. That door would swing both ways. A business could decide to go scorched-earth litigation on a case by case basis, dragging consumers through protracted and costly litigation.
  • The dispute resolution process would become unpredictable. A consumer would have no way of knowing which disputes would go to arbitration and which would end up in court.
  • Dispute resolution providers may not be there. With caseloads becoming unpredictable and sporadic, alternate dispute resolution providers might find it untenable to maintain their fora. This is not theoretical; it’s already been discussed.
  • Costs would rise. And who would bear the cost off all this uncertainty? The consumer.
  • And litigation stinks. Also, let’s think about where these disputes would end up if PDAAs are banned – in court. Going to court is terrible for all parties, especially consumers. Granted, in some parts of the country litigation is relatively quick and inexpensive, and a consumer occasionally gets a large jury verdict against the business,3 but in general it takes a long time, is very costly, and is subject to both extensive discovery and relatively liberal dismissal standards. If arbitration is eliminated, I stand by my belief that litigation would be a poor way for parties to resolve their differences.

Businesses: Be Careful Urging Preservation of the Status Quo
The problem with the status quo is that it generally doesn’t last forever. While the Supreme Court has been generally supportive of PDAAs, it has hinted several times that there may be limits. For example, the Court requires that the arbitration rules and program be fair, that the consumer be able to obtain essentially the same relief in arbitration as in court, and that the fees not be excessive. Also, it is folly in my opinion to think of arbitration as a Red State-Blue State issue. I think it is transitioning to becoming more of a populist issue, and it wouldn’t be shocking to see Republicans in states like the Dakotas or Alabama breaking ranks at some point. The CFPB’s Final Report has touched off a media firestorm, with the overwhelming bulk of the coverage being anti-arbitration. Also, on March 16th, the New York Times published an article describing how unscrupulous lenders were using arbitration to foreclose on property or repossess vehicles of active duty veterans. This, too, generated a media firestorm. In short, things could change in a hurry.

But something should be done to Protect Consumers
Having demonstrated why the AFA is problematic, I do believe there are legitimate concerns Congress needs to address. For example, I believe it is unfair to require a consumer to agree to arbitration when a contract is signed as a condition of the dominant party providing goods or services. Ditto for employees. It’s not that the arbitration process is unfair, assuming basic standards of procedural fairness are maintained. It’s that perceptions of fairness require a choice for the weaker party.4

But some of the arbitration systems imposed on consumers and employees –not those of the established ADR providers – have aspects that are not fair. For example, requiring consumers to travel hundreds of miles for a hearing involving relatively small amounts of money is not fair. Allowing the dominant party to select a captive ADR provider isn’t fair. Burying the arbitration agreement in the midst of a dense contract is not fair.5 There are better approaches, which: 1) address perceptions that it is not fair for a dominant party to force a consumer or employee to agree to a PDAA as a condition of obtaining goods or services or employment; and 2) ensure procedural fairness.6

Back to the Rolling Stones: the Friedman AFA
Instead of both sides digging in and demanding what they want, they should consider a compromise that gives both sides what they need. And what do they both need? A bill that might actually be enacted that would serve both sides. I suggest that Congress impose conditions on the use of PDAAs in consumer contracts – but not ban PDAAs outright. Here are the main aspects of this compromise:

a) in a contract involving a customer (including investors – we don’t need two laws addressing the same problem) any predispute arbitration agreement must be clearly identified, completely optional, and separately signed or clicked by the consumer;

b) a consumer cannot be denied goods or services if the consumer declines the arbitration option; and

c) clear procedural fairness guidelines such as already exist at the American Arbitration Association, FINRA, and Arbitration Resolution Services,7 must be followed in any arbitration system

I blogged recently on point c; the established alternative dispute resolution providers are not the problem, folks.

Let me elaborate on what such a statute should look like. Four simple provisions would make for a good law:

  1. Customer choice, but before a dispute arises: the consumer should have a choice about whether to submit disputes to arbitration, but this choice should be made when the contract is signed. Requiring all parties to agree to arbitration after a dispute arises, could actually harm customers because businesses offering services would sometimes decline to arbitrate, making the dispute resolution process unpredictable for the consumer;
  2. Clear, knowing, and voluntary agreement to arbitrate: to ensure that consumers knowingly and voluntarily agree to arbitrate, the AFA should require that the individual separately initial/click the arbitration agreement if they agree to arbitration;
  3. Establish procedural fairness criteria: the new AFA should also require that any consumer arbitration system adhere to basic standards of procedural fairness. As I’ve already stated, FINRA’s program is that model; and
  4. Promote web-based arbitration systems: an arbitration system that steers consumers to travel to a “brick and mortar” arbitration hearing to resolve disputes that typically involve modest amounts is not a good idea. It’s a particularly poor one when the consumer’s interactions with the business have been entirely online. Consumers should have the option of using an online ADR system.

To avoid Constitutional challenges, the law should be prospective; it should apply to contracts entered into or revised after the effective date.

Conclusion: Getting What You Need
This approach gives both sides what they need: a fair system that gives consumers the choice they want and businesses the predictability and risk management they crave. Or, somewhat like another song says, “all we are saying is give choice a chance.”


19 U.S.C §§ 1 et seq.

2Prior iterations were similar but not exactly the same. For example, the 2011 version would have covered franchise agreements.

3See, e.g., Barlyn, Suzanne, South Carolina jury awards $8.1 million to investor who was misled by BB&T (June 30, 2014), available at http://www.reuters.com/article/2014/07/01/us-adviser-verdict-exclusive-idUSKBN0F52RF20140701 .

4See Black, Barbara & Gross, Jill, When Perceptions Changes Reality: an Empirical Study of Investors’ Views on the Fairness of Securities Arbitration, 2008 J. DISPUTE RES. 349 (2009), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1118430## .

5For example, FINRA Rule 12800 presumes that cases involving less than $50,000 will be resolved on documents only unless the investor requests a hearing. See http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=4185 .

6Waiting for the CFPB to use its Dodd-Frank rule-writing authority is not the answer. The Bureau’s authority is limited to consumer-financial goods and services, not including brokerages and investment advisers. Any regulations banning, limiting, or imposing conditions on PDAA use would not address employment, franchise, securities, and non-consumer arbitration.

7Full disclosure. I’m chairman of the Board of ARS.

 


*George H. Friedman, an ADR consultant and Chairman of the Board of Directors of Arbitration Resolution Services, Inc., retired in 2013 as FINRA’s Executive Vice President and Director of Arbitration, a position he held from 1998. In his extensive career, he previously held a variety of positions of responsibility at the American Arbitration Association, most recently as Senior Vice President from 1994 to 1998. He is an Adjunct Professor of Law at Fordham Law School. Mr. Friedman serves on the Board of Editors of the Securities Arbitration Commentator. He is also a member of the AAA’s national roster of arbitrators. He holds a B.A. from Queens College, a J.D. from Rutgers Law School, and is a Certified Regulatory and Compliance Professional (Wharton-FINRA Institute).




CFPB Issues Final Report on Arbitration, Telegraphing a Ban or Limits on Arbitration. Should SEC follow Suit?

By George H. Friedman

[This was originally published in the author’s blog at the Securities Arbitration Commentator]

Short answer: no. For those who want a little more detail, read on.

I wrote recently on my blogs at both the Securities Arbitration Commentator and Arbitration Resolution Services about the Consumer Financial Protection Bureau’s (“CFPB”) study of mandatory predispute arbitration agreements (“PDAAs”) in consumer financial products and services. To again review, Dodd-Frank section 1414 bans outright PDAAs in residential mortgage contracts and section 1028 directs the CFPB to study the use of PDAAs in other consumer financial products and services and later report to Congress; the statute also vests authority in CFPB to possibly develop regulations banning, limiting, or conditioning their use. Turns out I predicted correctly that CFPB would unveil its Final Report to Congress at its March 10th “field hearing” in Newark.

Surprise! Arbitration is bad for consumers

To the shock of no one, the Bureau’s Final Report to Congress concludes that mandatory PDAAs are bad for consumers. The Report has several findings, including these major conclusions:

  • Three out of four consumers surveyed did not know if they were subject to an arbitration clause.
  • Arbitration clauses can act as a barrier to class actions.
  • Consumers filed roughly 600 arbitration cases and 1,200 individual federal lawsuits on average each year in the markets studied.
  • By contrast, on average, roughly 32 million consumers were eligible for relief through class action settlements in federal court each year. An average of at least $220 million per year was paid out to consumers from these settlements. For checking accounts alone, class action settlements over three years totaled over $600 million for at least 19 million consumers.
  • No evidence of arbitration clauses leading to lower prices for consumers.

Clear where CFPB is heading.

I have no quarrel with these findings. And it’s clear to me where CFPB is heading: I have no doubt whatsoever that CFPB will ultimately issue regs that ban or severely limit the use of predispute arbitration clauses in contracts governing consumer financial products and services. And you know what? It should! There are serious abuses that need to be addressed, as the Final Report indicates, and as I said in my previous blog posts.

Should SEC follow suit?

The ink was barely dry on the Final Report when reactions to the Report – including views on implications for securities and investment adviser arbitration – began to flow along party lines. PIABA – a bar association of attorneys who represent customers in arbitration – issued a press release supporting the Report and suggesting that the SEC get on with the business of addressing mandatory customer-broker arbitration. NASAA – the association of state securities administrators – also weighed in on March 10th in a statement adding, “We hope the CFPB’s findings will encourage the SEC to use the authority the agency was granted in the Dodd-Frank Act to investigate the impact of similar clauses used by broker dealers and investment advisers, and prohibit or restrict their use ‘in the public interest and for the protection of investors.” So, pressure is clearly building to compel SEC to follow what is sure to be CFPB’s lead. Should it? I suggest no.

FINRA arbitration is not the problem

Why do I suggest that SEC not follow lockstep behind CFPB?

1. Dodd-Frank treats securities arbitration differently. Although the operative language in Dodd-Frank provides similar guidance and direction to both the CFPB and SEC about what the agencies are to do about mandatory or forced use of PDAAs, there is a key difference: Dodd-Frank section 921 does not require the SEC to do anything about PDAAs in customer-broker contracts. This was not in my opinion a drafting oversight. Had Congress intended identical treatment, it would have either used identical language or vested rule-writing authority in a single federal agency.

2. Securities Arbitration is already regulated. The SEC for decades has regulated securities arbitration. It inspects FINRA’s arbitration program, investigates complaints, and – drumroll please – must approve any changes to the rules after a lengthy public comment process.

3. FINRA’s program is fair! In my opinion, FINRA’s arbitration program is the fairest consumer program there is. There, I said it. How so? As pointed out in an article I published last summer, What’s a Regulator to Do? Mandatory Consumer Arbitration, Dodd-Frank, and the Consumer Financial Protection Bureau, 20:4 ABA Dispute Resolution Magazine 4 (Summer 2014):[1]

  • Rule 2268 governs the content and placement of arbitration clauses. No hidden arbitration clauses are permitted.
  • FINRA serves the claim on the broker with whom the investor has a complaint. This rule saves the investor time and money. Typically, other dispute resolution providers do not serve the claim on the respondent.
  • The fee structure favors the investor.
  • The hearing is sited where the investor lived when the underlying events occurred.
  • There are hearing locations in all 50 states (at least one in each state).
  • The process includes a motion-to-dismiss rule that severely limits motions made prior to the claimant resting his/her case and provides sanctions for frivolous motions.
  • Parties have access to the FINRA discovery guidesand codified discovery provisions in the Code of Arbitration Procedure for Customer Disputes.
  • The customer has the option of an all-public panel.
  • In close calls, if the investor wants an arbitrator removed for bias, he or she is removed.
  • FINRA will enforce arbitration awards in the investor’s favor.
  • Awards are public, in a searchable database, and available free of charge on the web; statistical data on the program are available on the web.
  • FINRA’s Rule 12204 allows an investor to opt out of arbitration and instead participate in a class action.

In short, the program is the model of fairness. Don’t take my word for it. Even critics of consumer arbitration have spoken favorably about FINRA’s arbitration system. See http://www.indisputably.org/?p=4234 and http://www.investmentnews.com/article/20120905/FREE/120909978. Also, FINRA’s arbitration program got high marks when measured against the “arbitration fairness index” created by Professor Tom Stipanowich, a leading authority in the arbitration field.

4. The two main problems cited in the CFPB Report don’t exist at FINRA. It’s important that reviewers bear in mind the many differences between FINRA’s arbitration system and other consumer arbitration programs. Two of the major findings in the CFPB Report – class action waivers and hidden arbitration clauses – are not problems or issues for the securities customer in the FINRA arbitration forum (see FINRA Rules 12204 and 2268, respectively).

What’s your plan, Friedman?

I suggested in my ABA article that CFPB should write rules that impose conditions on the use of PDAAs in contracts for consumer financial products and services – but not ban PDAAs outright. I think SEC should do the same thing. Specifically, the rules should provide: a) in a contact between a customer and an investment adviser or broker, any predispute arbitration agreement must be clearly identified, optional, and separately signed or clicked by the customer; b) a customer cannot be denied goods or services if the customer declines the arbitration option; and 3) clear procedural fairness guidelines such as already exist at FINRA must be followed in any arbitration system. I then elaborated on what such a rule should look like, opining that four simple provisions would make for a good rule:

1. Customer choice, but before a dispute arises: the customer should have a choice about whether to submit disputes to arbitration, but this choice should be made when the contract is signed. Requiring all parties to agree to arbitration after a dispute arises – could actually harm customers because businesses offering services would sometimes decline to arbitrate, making the dispute resolution process unpredictable for the customer.

2. Clear, knowing, and voluntary agreement to arbitrate: To ensure that customers knowingly and voluntarily agree to arbitrate, SEC’s rule should require that the individual separately initial/click the arbitration agreement. Rule 2268 already governs the content and placement of arbitration clauses.

3. Promote web-based arbitration systems: an arbitration system that steers consumers to travel to a “brick and mortar” arbitration hearing to resolve disputes that typically involve modest amounts is not a good idea. It’s a particularly poor one when the consumer’s interactions with the business have been entirely online. Customers should have the option of using an online ADR system.

4. Establish procedural fairness criteria: the new rules should also require that any customer arbitration system adhere to basic standards of procedural fairness. As I’ve already stated, FINRA’s program is that model.

My advice for SEC

My parting advice to CFPB was to tread carefully and stay focused on its core mission of protecting consumers. I offer the same advice to the SEC. I think it will become politically untenable for the SEC to do absolutely nothing about PDAAs, especially in light of the pressure that’s been brought to bear on this issue by some in Congress, NASAA, PIABA, and others (for example the AFL-CIO). My view is that, at a minimum, the SEC will have to study the subject (it has since 2010 been accepting comments on mandatory arbitration), and eventually require some changes (impose limits or conditions). It should not, in my opinion, ban PDAAs outright. Think about it. To ban PDAAs in customer-broker contracts, the SEC would have to find that doing so is “in the public interest and for the protection of investors.” Essentially, the SEC would be saying: “We’ve been supervising customer-broker arbitration for decades. But, you know, we just realized it’s a terribly unfair system.”

On the other hand, a finding that says, “We’ve studied customer-broker arbitration and we’ve concluded that it’s a fair process. But, you know, these few changes will make it even better” is certainly feasible.

———

[1] See also The Arbitration Fairness Act: a Well-intentioned but Potentially Dangerous Overreaction to a Legitimate Concern, 2013:1 Securities Arbitration Commentator 1 (June 2013).


George H. Friedman, an ADR consultant and Chairman of the Board of Directors of Arbitration Resolution Services, Inc., retired in 2013 as FINRA’s Executive Vice President and Director of Arbitration, a position he held from 1998. In his extensive career, he previously held a variety of positions of responsibility at the American Arbitration Association, most recently as Senior Vice President from 1994 to 1998. He is an Adjunct Professor of Law at Fordham Law School. Mr. Friedman serves on the Board of Editors of the Securities Arbitration Commentator. He is also a member of the AAA’s nation roster of arbitrators. He holds a B.A. from Queens College, a J.D. from Rutgers Law School, and is a Certified Regulatory and Compliance Professional (Wharton-FINRA Institute).