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Arbitration: Second Circuit Invalidates a Class Action Waiver (July 16).

The Second U.S. Circuit Court of Appeals held a class arbitration waiver in a law student loan contract was unconscionable under California law, and invalidated the arbitration agreement.

But in light of an April U.S. Supreme Court decision, the panel noted that it could not authorize the plaintiff, a practicing attorney who filed suit over misallocation of his student loan payments, to proceed with a class arbitration.

In Monday’s Fensterstock v. Education Finance Services, No. 09-1562-cv (2d Cir. July 12, 2010), plaintiff Joshua Fensterstock, now practicing in New York, filed suit against Education Finance Partners ("EFP"), a now-defunct California-based student loan company, and its loan servicer, Affiliated Computer Services, referred to here as ACS, for fraudulent and deceptive practices under California law.

Fensterstock consolidated his student debt with EFP in 2006, taking out a loan of nearly $53,000 at a fixed 9.32% interest rate. The loan was to be repaid over 29 years, with about $441 due on the 14th of each month.

After more than a year of paying on time or early, Fensterstock noticed that for payments sent before the 14th of the month, the companies diverted the entire payment to interest, rather than apportioning it to both interest and principal. He alleged that this allocation altered an agreed-upon amortization schedule.

He claimed that $263 from his payments had been misallocated thus far.

According to Fensterstock, this scheme “prevent[s] borrowers from paying off the principal of their loans” and will result in an “enormous lump-sum payment” due at the end of the loan period.

Fensterstock argued that a class action is required because the relatively small damage claims make individual suits impractical. The class-action waiver clause, he claimed, is unconscionable and against public policy because it is part of a non-negotiable adhesion contract.

The district court found the arbitration agreement to be unconscionable and unenforceable. The loan servicer, ACS, appealed.

ACS argued that Fensterstock should be compelled to arbitrate individually, per the arbitration agreement's terms. The contract was not adhesive, ACS contended, because Fensterstock was a practicing attorney who could choose not to accept, rather than a student whose education would be interrupted. Fenterstock was an “unusually sophisticated borrower,” according to ACS, because he was a contract and finance attorney.

The Second Circuit ruled that the waiver was unconscionable under California law, citing the California Supreme Court's important decision in Discover Bank v. Superior Court, 36 Cal. 4th 148 (2005), and the Ninth Circuit's discussion of that case in Shroyer v. New Cingular Wireless Services Inc., 498 F.3d 976 (9th Cir. 2007).

Under the Discover Bank rule as discussed in Shroyer, a class waiver is unconscionable if (a) it is a contract of adhesion, (b) the potential disputes are predictably ones involving small sums of money, and (c) the party with superior bargaining power was alleged to have “deliberately cheat[ed] large numbers of consumers out of individually small sums of money.”

Such a contract is procedurally and substantively unconscionable, because it is an adhesive contract that insulates a defendant from liability--a “'get out of jail free card' while  compromising important consumer rights,” according to Discover Bank.

California law, the Second Circuit panel opinion notes, does not hold as a per se rule that all class waivers are unconscionable. The company’s defense that the contract was not adhesive because Fensterstock was a sophisticated client was rejected by the court because there was “no showing here that plaintiff could have obtained a consolidation loan that did not contain a similar class action arbitration provision.” That is, he had no meaningful choice.

The panel reasons that California state law is not preempted because Federal Arbitration Act  Section 2 allows for challenges under general state contract law. The California consumer protection laws against unconscionable class action waivers apply equally to all contracts. The state laws do not “discriminate” against arbitration agreements, which could be grounds for preemption by the pro-arbitration federal law.  The FAA can be found at 9 U.S.C. 1 et seq.

The fact that Fensterstock was not “surprised” by the class waiver is not dispositive under California law, because he was unable to negotiate the “take it or leave it” terms. The same is true regarding his “sophistication.” The court writes that “we have seen nothing in his education, experience, or expertise to suggest that he had any meaningful opportunity to negotiate that clause out of the contract.”

The court also discusses the recent U.S Supreme Court case of Stolt-Nielsen S.A. v. AnimalFeeds International Corp., No. 08-1198 (April 27).  Loan service company ACS had asked the court to sever the unconscionable class waiver term from the remainder of the arbitration agreement, and to order individual arbitration.

The Fensterstock panel, in a unanimous opinion by Circuit Judge Amalya L. Kearse, who was joined by Circuit Judges Jose A. Cabranes and Chester J. Straub, notes that under Stolt-Nielsen, which overturned a Second Circuit decision finding an implied agreement to arbitrate class claims, held that courts may only compel arbitration as a class if the parties expressly agreed.  Therefore, it declined to enforce a class arbitration, instead invalidating the Fensterstock clause.

Still, according to the panel, Stolt-Nielsen's holding is based on the idea that “the FAA embodies a preference not so much for arbitration as for the enforcement of arbitration agreements.”

Fensterstock is further evidence that class actions and class waivers are big arbitration law issues. Next term, the Supreme Court will hear AT&T Mobility v. Concepcion, No. 09-893, a Ninth Circuit case that found a cell phone contract's arbitration agreement to be unconscionable because it contained a class action waiver. Our coverage here.

Other circuit courts have been grappling with this issue in recent cases. The Third Circuit upheld a class arbitration waiver this summer in Puleo v. Chase Bank USA, No. 08-3837 (3d Cir., May 10, 2010)(our coverage here; opinion here).

The Eleventh Circuit currently is considering the validity of a class arbitration waiver under Florida law in Pendergast v. Sprint Nextel Corp., now on remand to the Florida Supreme Court for clarification on state unconscionability doctrine. Pendergast v. Sprint Nextel Corp., 592 F.3d 1119 (11th Cir. Jan 4, 2010).

The Second Circuit also found a class action arbitration clause unconscionable last year inIn re: American Express Merchants' Litigation, 554 F.3d 300 (2d Cir. 2009).  That decision, however, was vacated by the Supreme Court on May 3 via summary disposition.  The Court  remanded the case for further consideration in light of its Stolt-Nielsen decision.

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A  July 13 New York Law Journal article on the Second Circuit Fensterstock decision can be found here

--David Perechocky, CPR Intern