Managing Your Class-Action Risk Through Arbitration Agreements

More companies are now using arbitration agreements to manage class-action risk. Several recent U.S. Supreme Court decisions have made it possible for companies to use arbitration to resolve disputes while managing class-related litigation, and the court granted certiorari in yet another case (DIRECTV, Inc. v. Imburgia, Docket No. 14-462) as recently as March 23, 2015. Most of the activity has been in the consumer financing[1], employment, retail and securities brokerage spaces. Construction industry participants, such as design professionals and contractors, traditionally have not been subject to class actions. But product suppliers and homebuilders may have material class-action exposure. To evaluate whether arbitration is an appropriate tool to manage your class-action risk, consider the following five points.

1. The party with whom you wish to arbitrate must consent to the arbitration agreement.

Arbitration is a consensual process. While the Federal Arbitration Act (FAA) does not require parties to sign an arbitration agreement for it to be valid and enforceable, you must be able to establish that an agreement exists and covers the dispute in question. Oral agreements to arbitrate are not enforceable under the FAA. Developing a process that results in a valid and enforceable arbitration agreement can be challenging, depending on the nature of the sales process. If you sell directly to customers, then the process is relatively straightforward because you control the contracting process — but sales directly through an online platform raise additional issues about securing necessary consent. If, however, you sell through a distribution network, then achieving consent with an end purchaser can be more challenging and will require more planning.

2. The arbitration agreement and process must be fair.

Arbitration has advantages and disadvantages compared to litigation. If the process is designed appropriately, it can be more efficient and cost-effective than litigation. Where you sell to consumers, many of the national arbitration providers, such as the American Arbitration Association (AAA) and JAMS, have instituted procedures and rules for consumer arbitrations. These rules are designed to make arbitration a favorable forum for consumers, and they should be consulted before adopting them as part of your agreements.

3. Be mindful of possible state law challenges to the enforceability of your arbitration agreement.

The FAA expressly states that an arbitration agreement is subject to challenge on state law grounds that apply to all contracts. State law generally prohibits the enforcement of unconscionable agreements. What constitutes unconscionability varies between states, but it is grounded in the concept of fairness. Both the process by which the agreement was reached and the agreement itself must be fair. It is important to review the relevant state law in addition to the FAA before finalizing your arbitration agreement.

4. Take care in choosing and crafting the specific rules that will govern your arbitration.

Most arbitrations are administered by a third party such as the AAA or JAMS. These organizations have published rules that govern arbitrations under their administration. Parties are generally free to amend the rules, but arbitrations involving consumers are more regulated. When administering, these organizations assist the parties in the arbitrator-selection process and other tasks. It is possible to adopt a non-administered arbitration process. One of the national providers that offers arbitration rules is the International Institute for Conflict Prevention & Resolution (CPR). It is important to carefully determine the appropriate provider and rules that will govern your arbitration.

5. Consider specific features to make your arbitration process fair and user-friendly.

If you anticipate that most of your arbitrations will involve consumers, then evaluate whether certain features should be built into your arbitration agreement. These features might include providing for an opt-out process whereby the consumer can unilaterally decide within a specified period of time to contact you to “opt out” of the arbitration process. After the “opt-out” period expires, the consumer no longer has that right. Another possible feature might be permitting the consumer to “opt out” any time before commencing the arbitration process if the dispute qualifies for small-claims court resolution. It also is important to state in your arbitration agreement that the arbitrator does not have the authority to conduct a class-wide arbitration. While many of the published rules indicate as much, where the agreement is silent on the issue, it is a good practice to make this clear. As for the arbitration process itself, consider what discovery might be appropriate, whether there will be a hearing, the nature and location of any hearing, and the type of award the arbitrator will be required to issue. Be mindful that more process usually means more cost. If your arbitrations involve consumers, it will be important to aggressively manage costs so consumers can freely exercise the right to use arbitration to resolve disputes.

[1] On March 1, 2015, Consumer Financial Protection Bureau issued a 728-page report on the use of arbitration clauses in consumer financial transactions.