Court Refuses To Enforce Arbitration Clause That Tries To “Game” the System

02.05.2016

This week the U.S. Court of Appeals for the Fourth Circuit rejected an arbitration process that the Court found to be a “sort of farce.”  For many years, businesses routinely have been able to obtain favorable decisions enforcing arbitration clauses, even those that have contained what some perceive as onerous requirements or limitations.  While the facts in James Hayes et al. v. Delbert Services Corporation, No. 15-1170, U.S. Court of Appeals (4th Cir.)(Feb. 2, 2016), are pretty extreme, the decision may signal renewed scrutiny of dispute resolution clauses.

The case arose out of a consumer transaction, as so many challenges to arbitration requirements do.  But the Court’s grounds for rejecting the arbitration requirement did not spring from the consumer nature of the transaction.  Rather, the Court found that the arbitration provisions went too far in trying to create an alternative dispute process that ended up being a categorical rejection of all federal and state law.

The named challenger, James Hayes, borrowed $2,600 from Western Sky, an online payday lender operating from the Cheyenne River Indian Reservation in South Dakota.  The loan’s annual interest rate was 139.12%, with monthly payments of $294.46 over four years.  Other plaintiffs had loans with similar terms and interest rates.

The loan agreement stated that it was “subject solely to the exclusive laws and jurisdiction of the Cheyenne River Sioux Tribe” and that “no other state or federal law or regulation shall apply . . ..”  After issuance, the loan was transferred from one servicing and collection firm to another.  Ultimately, the loan ended with Delbert Servicing Corporation as the servicing agent. Delbert had no tribal ownership or affiliation with the Cheyenne River Sioux.

Hayes and other plaintiffs sued for relief from Delbert's allegedly unlawful collection practices.  Delbert immediately invoked the arbitration clause as well as choice of forum clauses that required resolution in the Cheyenne River Sioux Tribal Court.  Delbert also sought to enforce the Agreement’s statement that “no other state or federal law or regulation shall apply to this Loan Agreement, its enforcement or interpretation” and that the Agreement was not subject to the laws of any state or federal law.

The Agreement stated that any dispute would be resolved by binding arbitration “conducted by the Cheyenne River Sioux Tribal Nation by an authorized representative in accordance with its consumer dispute rules” and that the arbitrator would apply only the laws of the Cheyenne River Sioux Tribal Nation.  The Agreement, however, did purport to allow the borrower to choose to have the arbitration administered by the American Arbitration Association, Judicial Arbitration and Mediation Services, or another organization.

While the Court noted the strong policy in favor of enforcing arbitration agreements, the Court could not stomach the arbitration process dreamed up by Western Sky.  The scheme, the Court found, was illusory.  The Tribe has no representatives who conduct arbitrations, nor does it even have a process to select an arbitrator.  Another servicer for Western Sky, in fact, previously admitted in a legal proceeding that the Tribal form and procedure suggested in the Loan Agreement did not exist.

While the lack of a process was troubling, the Court held that the Agreement’s fundamental flaw was its attempt to completely repudiate the application of ANY federal law to the plaintiff’s claims.  The attempt to prospectively waive the application of all federal law was “simply unenforceable.”  The Agreement purported to provide an arbitration forum for resolution of a borrower’s claims, but then contained a waiver of any rights to make such claims.  “The just and efficient system of arbitration intended by Congress when it passed the FAA may not play host to this sort of farce.”

Often a waiver of specific rights and remedies has been upheld on the principle that parties have the freedom to contract.  That freedom, however, does not extend to the elimination of federally protected civil rights.  Waiving the right to a jury trial, for instance, is an acceptable waiver.  The Loan Agreement did not just carve out an agreed dispute resolution process, however, but set up an “outright prohibition” on exercising any rights or remedies under federal law through the guise of a dispute resolution process.  The Loan Agreement did not bring “predictability“ and “efficiency” through an agreed process, but instead “underhandedly convert[ed] a choice of law clause into a choice of no law clause.”  Parties cannot just agree to renounce the authority of federal law.  That is the invalid and “forbidden” step too far.

Dispute resolution processes set forth in contracts can be a valuable method of managing risk, increasing efficiencies, or increasing predictability.  The Hayes decision, however, underscores that these processes cannot be used to upend or circumvent the rights and public policies set forth in our laws.  If a clause seems to go “just a bit too far,” careful scrutiny should be applied to determine whether the entire process might be undone as a result of the overreaching.