Victory for Justice in Fensterstock

In a victory for access to justice, the Second Circuit held Monday that a student loan agreement forbidding a borrower to make claims on a class-wide basis in arbitration or litigation was unconscionable under California law and that California’s law was not preempted by the Federal Arbitration Act. It also said the agreement’s severability clause didn’t open the way to compellling class arbitration because, once the other clauses were out, the agreement was silent on dispute resolution, so it couldn’t order class  arbitration.

This is a big case as the first point addresses the issue SCOTUS will hear next term in AT&T v. Concepcion, where AT&T claims the FAA preempts California law because it discriminates against arbitration clauses compared to other kinds of contracts. The second point, on severability, takes up lessons SCOTUS articulated in last term’s Stolt-Nielsen case. It’s important as a broad and convincing contribution to intense national disputes over dispute resolution.

 The substantive objection in the case, Fensterstock v. Education Finance Partners, concerns how the lender allocated monthly loan repayments between interest and principal, using a squirrely provision allocating to interest all payments except those received exactly on the monthly payment due date. The borrower says that’s a hidden fee, stretching out loan amortization, and makes substantive claims for breach of contract and unfair trade practices. The agreement also contained a dispute resolution clause, limiting both sides to individual arbitration—not class arbitration or class litigation or any kind of litigation. It named California as governing law.

The lender wanted to compel arbitration, citing the FAA, requiring courts to do that for any arbitration clause in a contract involving interstate commerce, except those found invalid under general contract law principles. The borrower, a lawyer three years out of law school when he consolidated $52,000 in student loans, claimed the clause was unconscionable under California law and the court agreed, throwing out the clause and opening up a class action lawsuit.

The opinion is meticulous in extracting extensive block quotations from dozens of California cases on point, including the pivotal Discover Bank case. Drawing on a state statute making void contracts exculpating one from fraud, that case finds that some dispute resolution clauses in consumer contracts trip over it, being against law, public policy, and unconscionable. The statute and policy target enterprises who overcharge large numbers of ordinary people small amounts, then insulate themselves from liability using non-negotiable contracts preventing the small stakes from being accumulated to make a case worth pursuing.

Clauses doing that can be unconscionable both procedurally, because adhesive, prolix and peddled by one in a stronger bargaining position, and substantively, for facilitating such a scam. California statutory and common law unconscionabilty doctrine apply equally to clauses waiving rights to pursue class actions in litigation or class arbitration. They can be void whether part of an arbitration clause or otherwise. That equal application is important because the Federal Arbitration Act preempts any state law, statutory or judicial, that discriminates against arbitration clauses. The Second Circuit finds California law immune from preemptive attack under the FAA. That’s the broad issue facing SCOTUS in AT&T next term.

California law is also clear that not all class action waivers or class arbitration waivers are unconscionable, as not all are offered adhesively nor designed to insulate fraudulent conduct from proper review. But this clause was unconscionable, striking out in California’s three-part test: (1) a standardized consumer contract of adhesion drafted by a party with superior bargaining power; (2) the disputes about allocating payments between principal and interest involve small amounts of damages; and (3) the borrower alleged that the lender’s plan is to cheat large numbers of people out of small sums of money.

The lender thought the contract’s severability clause would enable compelling  class arbitration, but the court disagreed.  The clause claims to rescue all provisions not stricken when others are stricken as unconscionable. But after striking the clauses forbidding class actions in courts or arbitration, there was nothing valid on dispute resolution to enforce.  Striking a clause prohibiting class arbitration doesn’t authorize compelling it.  As the Supreme Court recently held in Stolt-Nielsen, the court’s job under the FAA is to enforce valid arbitration clauses, not promote arbitration. 

PS:  An annoying thing I’ve found amid proliferation of boilerplate in adhesion contracts lately is how they put vital clauses in ALL CAPITAL LETTERS. Drafters must think that will lead people, including judges after the fact, to think they were conspicuous and attracted requisite attention and understanding. In fact, PRINT WRITTEN IN ALL CAPITAL LETTERS IS MUCH MORE DIFFICULT FOR PEOPLE TO READ OR UNDERSTAND than words written in regular case, though putting them in bold may help. Just a thought.

Hat Tip: Ed Labaton

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3 Responses

  1. Nate Oman says:

    I haven’t read this case, but I am suspicious about the use of unconscionability in these cases. Suppose that I really do give up my right to pursue a small claim. The very fact that the claim is so small makes it difficult, I think, to claim with a straight face that the contract is unconscionable. For my money, these California unconscionability represent two issues. The first is an attempt to revive the old public-policy doctrine against binding arbitration notwithstanding the FAA by dressing the old public-policy argument up as an unconscionability claim. Second, I think that even if they can’t revive the old public-policy doctrine they still want to police particular arbitration practices on public policy grounds. It seems to me that that a contract where I give up a small claim is not unconscionable simply because in so doing, we reduce monitoring of the firms misbehavior by private parties. Rather, it seems to me that the cases are saying that regardless of whether it is unconscionable, we want to make the disclaimer of such small claims in valid as a way of harnessing private litigation to serve some public policy goal. Fair enough, but if this is so the California courts should just say so and quit mucking around with nonsense about procedural unconscionability, the size of the font in the contract, and the like. In particular, I think that these unconscionability cases in the context of arbitration potentially create an undesireablely broad unconscionability doctrine were the same principles to be applied to other cases.

  2. peter says:

    I am not quite sure if I follow the critique. The public policy goal that the California courts seem to want to allow private litigation to advance is the goal of not effectively insulating parties from liability altogether, by allowing those parties to engage in deliberately dishonest, penny-ante cheating of their customers, by insisting up front that if they ever rip you off for 25 cents a month, after you signed a boilerplate contract that afforded you no opportunity to negotiate, you have to arbitrate on a 1-on-1 basis, which it is pretty certain no one will do.

  3. Edward K. Lenci (ACS's counsel) says:

    On June 13, 2011, the US Supreme Court vacated the Second Circuit’s decision and remanded the case for further consideration in light of AT&T Mobility v. Concepcion.