By Jonathan Adler*
Adapted from Determining if Mandatory Arbitration is “Fair:” Asymmetrically-Held Information and the Role of Mandatory Arbitration in Modulating Uninsurable Contract Risks, by Paul Bennett Marrow

Introduction
The torches and pitchforks are being raised again.  This time, mandatory arbitration clauses are playing the role of Frankenstein’s monster.  Opponents of mandatory arbitration offer a litany of reasons to prohibit such clauses, arguing that they are unconscionable and designed principally to deny consumers their day in court.  Paul Bennett Marrow, in Determining if Mandatory Arbitration is “Fair:”  Asymmetrically-Held Information and the Role of Mandatory Arbitration in Modulating Uninsurable Contract Risks, aims to debunk this misconception and offers the rarely-heard and  unpopular position that mandatory arbitration is both necessary and positive.  In his view, we should be wary of any attempt to limit mandatory arbitration, such as the Arbitration Fairness Act of 2009.

Mandatory Arbitration:  A Positive Outlook
A mandatory arbitration clause is a contractual term that precludes disputes from being litigated in a court.  Instead, liability and damages are determined by a neutral third party.  According to Marrow:

Arbitration promotes efficiency and speed because it:
1. Does away with juries and the potential for high damage awards;
2. Provides confidentiality and serves to shield participants from publicity;
3. Insures that disputes are resolved using a nationally uniform set of procedures;
4. Saves on the cost of appeals;
5. Eliminates class action litigation;
6. Acts as a deterrent by imposing obligations to pay fees on claimants;
7. Reduces the costs of discovery;
8. Affords a hands-on opportunity to participate in the decision about who will resolve a dispute;
9. Insures dispositive decisions using commercial norms;
10. Acts as a substitute for insurance against “asymmetrically-held” information; and
11. Assures that the consumer of credit, the franchisee, and the employee will have access to a
forum for the airing of grievances because it reduces the cost of attorney fees.

Mandatory Arbitration and Asymmetrically-held Information
Every business transaction involves risk.  Contracting parties will always need at least some information about one another in order to foster a relationship based on trust.  Efficiency of communication and accurate information will always facilitate a higher level of trust, while the opposite will likely produce confusion and stifle business dealings.  According to Marrow, asymmetrically-held information exists in “situations where one economic agent knows something that another economic agent doesn’t.”  This undermines trust and unfairly advantages the party in possession of the information because it:

• Spontaneously magnifies the scope of an assumed risk, rendering that risk uninsurable;
• Creates new risks that are so ethereal they are uninsurable by third parties; and
• Forces the uninformed party to take extreme measures so as to overcome uncertainty.

Asymmetrically-held information is predominantly held by consumers/borrowers, franchisees, and employees. Therefore, as counter-intuitive as it might seem, creditors, franchisors, and employers are often the parties at risk.  Small business owners, students, and uninsured persons have the advantage because they possess information that affects the stability of the other party’s investment.  Such an imbalance creates an uninsurable risk that can only be mitigated through mandatory arbitration.

A Closer Look at Three Real-life Situations
Credit issuers use arbitration to protect themselves from borrowers who cannot repay their loans.  Though a borrower might have every intention of repaying a lender, there are numerous reasons that might prevent him/her from doing so.  Even if a lender fully researches the borrower’s credit history before providing a loan, there is usually something that the lender does not know about the borrower.  The conditions that make the borrower unable to fully repay the loan might exist prior to the exchange, but more likely a future event may change the borrower’s ability to make good on his promise.  While mandatory arbitration is no panacea, it gives lenders some ability to resolve disputes and remove or reduce the risks of asymmetrically-held information.

Franchisors are particularly put at risk by asymmetrically-held information.  The terms of a franchise agreement normally require a franchisor to provide a franchisee-recipient with access to various forms of capital, rights to use of trademark, confidential and proprietary information, and the franchisor business structure.  In return, the franchisor entrusts the franchisee with its reputation.  Because the public is not necessarily aware of the franchisor/franchisee arrangement, an error on the part of the franchisee can seriously damage the franchisor’s business.  Due to the risky nature of this relationship, a franchisor requires information to determine whether an applicant is qualified for a franchise.  This initial information request usually concerns past behavior, so the franchisor may require the franchisee to agree to some form of additional monitoring.  Realistically, a significant amount of time can ensue between the moment the franchisee’s behavior changes and when the franchisor discovers any problems.  During this lag period, there is a heightened potential for damage to the reputation of the franchisor.  A franchisor must protect its reputation, and arbitration is one of the only instruments that will allow it to act quickly enough to sufficiently mitigate damages.

Employers face the problems associated with asymmetrically-held information from a different perspective.  In the event of litigation, they are typically named as the defendant/respondent, while credit issuers and franchisors are usually the plaintiff/claimant.  An offer for employment always carries a number of unknown risks.  As Marrow argues in his article, an employer can never truly be sure of the potential candidate’s: (1) perceptions regarding appropriate and inappropriate employer behavior, (2) willingness to voluntarily submit to a form of alternate dispute resolution, and (3) ability to understand and enforce his or her rights including the right to hire an attorney.[i]  Even after hiring an employee, an employer continues to face the challenges related to asymmetrically-held information.  One example of a post-hiring problem occurs when the employee’s personal tolerances and prejudices, previously undetected by the employer, conflict with those of the company or its staff.  An employer can be blindsided by a complaint resulting from such differences in values.  Employers must be able to rely on alternate dispute techniques such as arbitration in order to uncover asymmetrically-held information, head off problems, and foster settlement.

Fairness
Many of the arguments for and against mandatory arbitration diverge on the issue of fairness.  Opponents consider mandatory arbitration a powerful weapon that can thwart class action litigation and single plaintiffs with minor grievances.  Marrow frames their view of arbitration as “a fail safe mechanism that insures that any consumer, with the fortitude to nevertheless persist, will find himself/herself before a forum that is anti-consumer, anti-franchisee, and anti-employee.”  This “staged” forum, opponents claim, allows businesses to use mandatory arbitration to “extract unwarranted financial gain.”

In contrast, proponents find mandatory arbitration efficient, faster, and more economical than the judicial system.  Businesses claim it is necessary to mitigate uninsurable risk.  And, absent conclusive evidence, they argue it is “unfair” to bar parties from using arbitration.

Marrow proffers that even if “hyperbole, speculation, unsubstantiated assumptions, and anecdotal evidence” continue to overshadow the debate, the cumulative weight of empirical evidence points in favor of mandatory arbitration as a fair process.  Marrow summarizes opponents’ unsubstantiated arguments as follows:

1. Mandatory arbitration is unfair by its very nature.
2. All arguments in favor of it lack substance.
3. The arbitration process doesn’t actually yield the benefits suggested.
4. Existing empirical evidence cannot confirm whether all of these benefits exist.
5. The real motivation for insisting on arbitration is that it “stacks the deck” against “the little guy.”

Flawed and Incomplete Metrics
Marrow argues the various studies that attempt to evaluate mandatory arbitration are flawed because they all failed to utilize a group of control points complete enough to substantiate their claims.  Some empirical studies discussed in Marrow’s article have tried to measure fairness by looking at litigation “win” rates, “usage” rates (the frequency at which mandatory arbitration clauses are negotiated as a contractual term), and cost comparisons between litigation and arbitration.

Win-rate studies are problematic because they provide relatively little insight into how a claimant would have fared in litigation.  They often define a “win” based on any amount awarded.  Surely, a claimant who receives a judgment for 1/100^th of the value of his/her   claim would hardly be likely to call such a result a win.  One particular study only looked at claims by credit issuers brought when the borrower defaulted on payments and did not contest the merits of the lender’s claim.  In instances like these, it is highly unlikely that a court would arrive at a different result than an arbitrator.  The only obvious difference is the disparity of cost to the lender in securing an award against the borrower.

Metrics based on usage rates are also problematic.  In at least one instance, a study failed to consider the uniqueness of individual contracts.  Specifically, complex securities agreements where the participants were fully aware of the other party’s financial stability tended to lack a mandatory arbitration clause.   The nature of this relationship decreased the likelihood that parties would be affected by asymmetrically-held information, thus an arbitration clause would have been frivolous.

Finally, some say that studies comparing arbitration results to court results are impossible to conduct because: (i) viable data cannot be obtained, (ii) even if it could, the data cannot be properly compared to court results, and (iii) merely considering win rates and award size is a flawed approach that bypasses the many other considerations involved in the arbitration process.

The Deadlock
Currently, there is pending federal legislation that, if passed, would ban the enforcement of all pre-dispute arbitration clauses for (1) consumer transactions, (2) franchise agreements, (3) employment agreements, and (4) disputes arising under any statute intended to protect civil rights.  This legislation would apply retroactively to all such agreements. Even if both parties advocated for a mandatory arbitration clause, they would have no choice but to go to the already-overburdened court system for a resolution.

Supporters of this bill maintain that legislation must be absolute in scope because anything less would be impractical and unrealistic.  They contend that no matter how sophisticated the regulatory scheme, those favoring arbitration would always find a way to circumvent regulation.  Those favoring the arbitration process consider an absolute restriction on arbitration to be highly unfair and, in response to their opponents, tout the many benefits of arbitration.  They proffer that, with few exceptions, pre-dispute mandatory arbitration clauses are seldom found by courts to be unconscionable.  Proponents of arbitration do not want to lose a valuable and efficient tool to settle disputes.

Both sides of the legislative debate consider themselves in a deadlock, with no compromising ground in sight.  Marrow disagrees with this sentiment.  He considers this “deadlock” to be smoke and mirrors because legislative action is not needed where, as in this case, the market can adequately address the concerns of all affected parties.  And, as Marrow makes clear in his article, the pending congressional legislation is neither necessary nor a valid course of action because there is no affirmative proof, backed by empirical evidence, that:

1. Mandatory arbitration serves no practical purpose but to unfairly benefit the party insisting on such a clause;
2. Mandatory arbitration is without economic justification;
3. Mandatory arbitration is substantively unconscionable; and
4. Mandatory arbitration directly harms the party against whom it is imposed.

If the Arbitration Fairness Act of 2009 Passes
Passage of the Arbitration Fairness Act of 2009 (which seems unlikely given its current status in both House and Senate committees) will cause more problems than it will solve.  For instance, without the availability of mandatory arbitration, many parties will be more vulnerable to potential litigation and its associated uncertainties.  As a result, overall transaction costs will increase.  These costs will be directly passed to borrowers and franchisees.  Employers will also pass these costs to business customers, albeit indirectly.

Beyond the market impact, there will be serious consequences for the judicial system because courts will become the only outlet for claims currently decided in arbitration.  Even though the arbitration ban will most likely only apply to disputes subject to litigation in the federal court system, the monetary impact will spread to the state and local level.  State and local courts will somehow have to provide space for millions of new cases sent by federal mandate.  Marrow warns “the influx of new cases will likely result in collapse of the existing system, and with that, a greater disrespect for law than already exists.”

So…
In considering whether to join the “not so popular” proponents of mandatory arbitration or the opposing camp, those who advocate the Arbitration Fairness Act of 2009 should reconsider their position based on the following rationale:

1. Entering into a contract containing a mandatory arbitration clause is essentially a voluntary choice made by all parties involved.
2. Mandatory arbitration is needed to mitigate the effects of asymmetrically-held information.
3. A commercial system without the right to arbitrate will (a) suffer from increased costs across the board, (b) limit lending to only the safest recipients, and (c) overburden courts.
4. There is insufficient empirical evidence to support enacting the Arbitration Fairness Act of 2009.

[i] See generally Scott Baker, A Risk Based Approach to Mandatory Arbitration, 83 Or. L. Rev. 861, 862–63 (2004).

*Jonathan Adler is a 2010 J.D. candidate of New York Law School

Click here to read Paul Bennett Marrow’s full article, Determining if Mandatory Arbitration is “Fair:” Asymmetrically-Held Information and the Role of Mandatory Arbitration in Modulating Uninsurable Contract Risks