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Arbitration: New Jersey's Supreme Court Tackles Two Unconscionability Cases (Web)

On Aug. 9, 2006, the New Jersey Supreme Court decided two arbitration unconscionability cases: Muhammad v. County Bank of Rehoboth Beach, Delaware, No. A-39-05, and Delta Funding Corp. v. Harris, No. A-44-05.

In Muhammad (also available at, plaintiff Jaliyah Muhammad obtained a short-term, single advance, unsecured $200 loan from defendant County Bank. Muhammad extended the loan twice, with a $60 finance charge each time, and subsequently obtained two similar County Bank loans in April and June 2003.

In order to receive the loan, Muhammad had to complete and sign three pages of standard form contracts, loan notes, and a disclosure form. The two-page loan application form contained an arbitration agreement stating that all disputes "shall be resolved by binding individual (and not class) arbitration" under the procedures of the National Arbitration Forum, a Minneapolis-based ADR provider.

Above the loan application’s signature line, as well as in the loan note and disclosure form, there was a section that stated by signing these documents the plaintiff would agree to the "Agreement to Arbitrate All Disputes" and the "Agreement Not to Bring, Join or Participate in Class Actions."

In February 2004, Muhammad filed a putative class-action suit alleging County Bank, Main Street Service Corp., a loan servicer for County Bank, and Easy Cash and Telecash, both County Bank affiliates, for charging and conspiring to charge illegal interest rates and violating the Consumer Fraud Act, the civil usury statute, and the New Jersey RICO statute. The plaintiff also alleged that County Bank aided and abetted the other defendants' unlawful conduct by renting out its name without actually funding the loans.

The plaintiff opposed the defendants' motion to compel arbitration, and filed a cross-motion concerning discovery. Muhammad argued that the arbitration agreement was unconscionable based on the class-action waiver, discovery limits in NAF's rules, the costs, and the bias inherent in NAF as an arbitration forum.

But the trial court granted the defendant's motion to compel arbitration pursuant to the Federal Arbitration Act. An appeals panel upheld the class-arbitration bar specifically and affirmed that the arbitration agreement was not unconscionable. Muhammad v. County Bank of Rehoboth Beach, 379 N.J. Super. 222 (App. Div. 2005).

The state Supreme Court granted Muhammad’s motion for leave to appeal. 185 N.J. 254 (2005). Seven amicus briefs were filed, with five parties, including the state attorney general, supporting Muhammad.

The main question of law before the Court was to determine whether an arbitration agreement found in a consumer loan contract is unconscionable, in whole or in part, under New Jersey contract law. On appeal, the defendant asserted that the plaintiff's challenge to the class-action waiver clause should be viewed as a challenge to the contract as a whole, and not as a specific challenge to the arbitration agreement, thus to be determined by an arbitrator, relying on Prima Paint Corp. v. Flood & Conklin Manufacturing Co., 388 U.S. 395 (1967), and Buckeye Check Cashing Inc. v. Cardegna, 126 S. Ct. 1204 (2006).

The Court observed that there are two distinct class-action waivers: the class-arbitration waivers, and the broad class-action waivers. The broad class-action waivers “could be considered distinct from the arbitration agreement in the contracts, and thus could be considered part of the ‘contract as a whole,’“ wrote Justice Jaynee LaVecchia for the majority 5-1 decision.

In such a circumstance, an arbitrator addresses the unconscionability of the broad class-action waivers.

But, LaVecchia noted, “[t]hat situation is not before us,” explaining that

there are 15 distinct class-arbitration waivers within the arbitration clauses of both the Loan Note and Disclosure form and the Application. Those class-arbitration waivers, based on their location and subject matter, are part of the arbitration agreements, and not part of the contracts as a whole.

This, the opinion states, allowed the Court to consider unconscionability.

In examining class arbitration for the first time, the New Jersey Supreme Court turned to its state law contract requirements to review whether the defendants’ waiver was unconscionable. To determine whether New Jersey contract law principles permitted enforcement of the agreements’ class-arbitration prohibitions, the Court applied Rudbart v. North Jersey Dist. Water Supply Comm’n, 127 N.J. 344 (1992). Rudbart requires a case-by-case, fact-sensitive examination into (1) the contract’s subject matter, (2) the parties' relative bargaining positions, (3) the degree of economic compulsion motivating the "adhering" party, and (4) the public interests affected by the contract.

The Court stated that the nature of the loan between plaintiff Muhammad and the defendant financial services companies showed “gross disparity in the relative bargaining positions of the parties.” That, along with the presence of elements of an adhesion contract, “indicate a degree of procedural unconscionability,” Justice LaVecchia wrote. The contract wouldn’t be enforced, the opinion states, because the level of unconscionability in the substantive contractual terms and conditions “impact ‘public interests’ adversely.”

Next, the Court analyzed whether the effect of the class-arbitration bar was to prevent Muhammad from pursuing her statutory consumer protection rights, and thus to shield the defendants from complying with the state laws.

The Court observed that the effect of the class-arbitration bar is to preclude a realistic challenge to the substance of the loan contract's terms in pursuit of statutory rights, because class-action waivers reduce the possibility of finding competent counsel to advance a cause of action. As a practical matter, the waiver can result in shielding the defendants from liability for failing to comply with the New Jersey laws.

The Court ruled that it was unconscionable for the defendants to deprive the plaintiff of the mechanism of a class-wide action, whether in arbitration or in court litigation under the general applicable state contract law.

The opinion states, “The public interest at stake in [Muhammad’s] ability and the ability of her fellow consumers effectively to pursue their statutory rights under this State's consumer protection laws overrides the defendants' right to seek enforcement of the class-arbitration bar in their agreement.”

Further, the New Jersey Court reflected on its public policy favoring arbitration, and stated that its policy “is not determinative of whether a specific class-arbitration waiver is unenforceable.” The arbitration process does not require that claims be brought only by individuals. But, the opinion notes, class-arbitration waivers do not make arbitration a more streamlined and efficient forum for adjudicating disputes–“unlike the limited discovery often found in arbitration agreements.”

Moreover, it stated that drafters of arbitration agreements and forum rules, as well as arbitrators themselves, may allow for the development of new procedures to address some of the perceived inadequacies with the current arbitration system as applied to class arbitration.

It is interesting to note that the Court in its analysis did not solely focus on the plaintiff's ability to individually vindicate her statutory rights, but also took into consideration broader aspects of how class-action waivers affect the various interests protected under the Consumer Fraud Act.

Finally, the Court reversed the Appellate Division’s judgment, remanding the matter to the trial court, holding that the provision in the consumer loan contract that forbids class-wide arbitration unconscionable and unenforceable, but finding the waiver severable. The Court enforced the remaining valid portion of the arbitration agreement.

* * *

In a companion case, Delta Funding Corp. v. Harris, No. A-44-05 (also available at ), the New Jersey Supreme Court also dealt with whether an arbitration agreement found in a consumer loan contract is unconscionable, in whole or in part, under the New Jersey contract law.

The Court got the case on a certification order from the Third U.S. Circuit Court of Appeals, after the plaintiff’s claim had been dismissed by both a federal district court and a New Jersey trial court. The Court granted certification on the following question: “Is the arbitration agreement at issue, or any provision thereof, unconscionable under New Jersey law, and, if so, should such provision or provisions be severed?”

The Court’s four-judge majority opinion sent the case to arbitration, but not before deciding that some of the arbitration provisions were unconscionable. Still, the Court backed severability, denying the plaintiff’s unconscionability about some of the arbitration agreement provisions, and leaving overall unconscionability determinations in the case to the arbitrator.

In December 1999, Alberta Harris, a 78-year-old woman with a sixth-grade education and whose only source of income was Social Security payments, entered into a mortgage loan contract with Delta Funding Corp. She secured a $37,700 loan with a mortgage on her home, which she owned outright. Delta later assigned the loan to Wells Fargo.

The loan contract contained an arbitration agreement that allowed either party to elect binding arbitration as the forum to resolve certain claims; actions for foreclosure and similar actions were excluded from arbitration.

The arbitration agreement provided that no claims would be arbitrated “on a class action or class-wide basis.” The agreement also contained clauses on cost, appeal procedure and severability.
Harris was unable to make the loan payments. Wells Fargo instituted a foreclosure action in New Jersey Superior Court. Harris filed a reply and counterclaim, as well as a third-party complaint against Delta alleging violations of the Truth in Lending Act, the Real Estate Settlement Procedures Act, or Respa, and the New Jersey Consumer Fraud Act. Delta filed a federal district court petition seeking to compel arbitration.

Harris filed motion for summary judgment contending that the arbitration agreement was unconscionable and unenforceable.

In March 2004, the district court denied Harris’s summary judgment motion, and granted Delta’s motion to compel arbitration. Delta Funding Corp. v. Harris, 396 F. Supp. 2d 512 (D.N.J. 2004). The state court then dismissed her third-party complaint against Delta.

Harris appealed to the Third Circuit, which sent the case to New Jersey’s top court.

The Supreme Court said that the claim should be decided based on the general principles of New Jersey contract law. The opinion, like Muhammad written by Justice Jaynee LaVecchia, states that since many of the agreement’s provisions are ambiguous, interpretation by an arbitrator would be necessary. It held that several parts of the arbitration agreement may be unenforceable if an arbitrator viewed them as unconscionable.

Harris alleged certain facts surrounding her contract signing that indicated a high level of procedural unconscionability. The Court relied on the Rudbart holding, see above, where a consumer contract’s procedural unconscionability was analyzed focusing on the fourth Rudbart factor, “public interests affected by the contract.”

Harris argued that it was unconscionable for an arbitration agreement to include a cost-shifting provision that allowed an arbitrator unfettered discretion to allocate the entire arbitration cost to a consumer, because those provisions limit consumers’ substantive statutory rights and remedies.
Appellee Delta claimed that “arbitrators rarely, if ever, shift costs to a consumer,” and offered to pay for the arbitration.

The Court found that the fee-shifting provisions could deter Harris, and similarly situated consumers, from pursuing statutory claims through mandatory arbitration. It further stated that although New Jersey public policy Jersey would permit an arbitration agreement to shift costs and attorneys’ fees to a consumer who brought “frivolous” or “bad faith” claims( see N.J.S.A. 2A:15-59.1), there was no limit in Delta’s contract provision.

The Court ruled that the agreement, as yet uninterpreted by an arbitrator, could force Harris to bear the risk that she would be required to pay all arbitration costs. That risk, the Court held, was unconscionable because it deterred her from vindicating her statutory rights.

Next, the Court addressed the arbitration agreement provision that required parties to bear their own fees and costs, no matter who prevailed, “[u]nless inconsistent with applicable law.” The Court stated that the arbitrator may not have the power to award attorney’s fees when that statutory remedy was merely discretionary. It held that Harris’s contract would prevent her from recovering discretionary attorney’s fees and costs, and thus was unconscionable.

The Court further held that the appeals provision was unconscionable to the extent that Harris would incur the entire costs of taking an appeal and would bar Harris from being awarded costs if she prevailed on her appeal.

The Court, however, did not back Harris’s claim that the class-arbitration waiver provision was unconscionable, since she wasn’t seeking to bring a class claim.

The Court drew a comparison with the Muhammad case above, which found a class-arbitration waiver unconscionable, based on the context of low-value consumer claims. Harris, on the other hand, was found to be seeking more than $100,000 in damages--not a low-value case which would not be litigated absent the availability of a class proceeding. Harris had adequate incentive to bring her claim as an individual action, because her home’s foreclosure was at stake--and the statutes under which she sought relief provided for attorney fees and costs to prevailing plaintiffs. The class-arbitration waiver in this case was held enforceable.

The Court also noted that foreclosure is a judicial process that proceeds in court, pursuant to the arbitration agreement. The arbitration agreement had excluded foreclosure actions against Harris, requiring her to use a second forum to arbitrate her third-party claims against Delta. The Court agreed that bifurcated claims resolution structure was burdensome, but it did not hold it unconscionable.

Moreover, Harris claimed that the arbitration agreement discovery and confidentiality provisions were unconscionable. She also contended that it was unconscionable for an arbitration agreement not to require a record of the proceedings, or a reasoned and publicly available award. The Court held that these arguments challenged arbitration as a dispute resolution system, and were “not persuasive.”

The Court noted that neither the arbitration agreement, nor the rules of the potential arbitration administrators–which included the American Arbitration Association, JAMS, or the National Arbitration Forum--prevented Harris from obtaining a record of the proceeding or a reasoned award. Similarly, the Court pointed out that there was nothing in either the arbitration clause or the administrators’ rules requiring that arbitration awards be kept confidential. It ruled that it was not unconscionable to require that the proceedings before the arbitrator be kept confidential when the arbitrator’s written award was not required to be kept confidential.

There were two other opinions in the case. Justice James R. Zazzali in a separate opinion, agreed with LaVecchia’s majority opinion where it struck down unconscionable provisions. But Zazzali disagreed with the majority’s view that some of the provisions were not unconscionable; he would have found the class action waiver and the bifurcated foreclosure structure requiring proceedings in two forums unconscionable.

He also would have declared the entire arbitration agreement unconscionable. Zazzali reached his conclusions, he writes at the end of his 19-page opinion , “[b]ecause I believe that this agreement exploits the individual and manipulates the process. . . .”

Justice Roberto A. Rivera-Soto dissented, noting he would not reach the merits of Harris’s unconscionability claims. He would have dismissed the certification of the Third Circuit’s question and sent the case to arbitration.

Justice Barry T. Albin didn’t participate in the case.

--Ongmu Tshering, CPR Intern