The financial services industry is already forming battle lines in advance of the Consumer Financial Protection Bureau's expected proposal to curtail the use of mandatory arbitration in consumer financial contracts. The industry would like to continue its current widespread practice of eliminating consumer access to courts, including the right to bring class actions. Consumers are instead forced to resolve disputes in individual arbitrations with decision-makers chosen by the financial firms.
The debate over binding mandatory arbitration comes down to this: Is it fair for a business to effectively force its consumers into a dispute resolution system that it has selected? Arbitration's advocates argue that it is fair because arbitration provides justice as good as that of the court system, but at a cheaper cost. Both claims are suspect. Arbitration offers fundamentally different and inferior justice to the court system. Nor is it clearly cheaper when one considers how court rulings, unlike arbitration, often preclude other litigation and the cost savings of class actions relative to individual arbitrations.
Arbitration offers inferior justice to that of the court system for several reasons. First, unlike court decisions, arbitral rulings are not subject to appeal except on very limited grounds. When arbitrators make plain legal or factual errors, their rulings still stand. As a result, arbitration is more likely to produce erroneous outcomes than the court system. This problem is exacerbated by the fact that the financial firm picks the arbitrator. The major arbitration associations get their business from the financial firms, not consumers, and are thus incentivized to cater to the financial firms in order to get repeat business.
Second, arbitrations are not subject to standard rules of evidence and procedure, including the right to obtain information about the other party related to the case. This can make arbitrations more streamlined, but it also affects outcomes. The defendant often holds most of the evidence relevant to the case, but plaintiffs are often not allowed to get the evidence necessary to prove their cases by requesting documents or taking depositions. Even when plaintiffs do have sufficient proof, they may have to counter evidence that is prejudicial or would otherwise be inadmissible in court. It is consumers, rather than financial services firms, who suffer from the lack of these procedural protections.
Finally, and most importantly, binding mandatory arbitration provisions are often crafted so as to preclude class actions, including class arbitrations. Class actions are the only practical recourse for addressing widespread, small-dollar harms—the category under which most consumer claims fall. Preventing class actions is a license for unscrupulous businesses to steal from their consumers. If a bank overcharged all of its 25 million depositors $30 annually, the bank would have pocketed $750 million in unauthorized fees, but no individual consumer would bother litigating or even arbitrating. As one federal judge colorfully put it, the class action is an essential tool for justice because "only a lunatic or a fanatic sues for $30."
Some might argue that no bank would be so brazen as to treat customers this way. But the facts indicate otherwise. JPMorgan Chase charged a $10 monthly fee to nearly half a million credit card holders who had low- or zero-rate balances and raised their monthly minimum payments from 2% to 5% of the outstanding balance in 2008. Chase backed off the fee in the face of pressure from the Office of the Comptroller of the Currency, but stuck with the change in monthly minimum payments. This deprived consumers of advantageous low-rate credit. Chase wound up paying $100 million to settle a class action over the minimum payments. If Chase had been able to prevent the class action through arbitration, it would have kept an extra $100 million of unearned funds.
Arbitration advocates tend to focus on the alleged efficiency of arbitration, rather than the quality of the justice it provides. Arbitration's "efficiency," however, largely derives from the fact that it prevents small-dollar claims from ever being heard. If one were to compare the cost of a single class action that decided millions of claims versus the cost of individually arbitrating each of those claims, arbitration would be utterly inefficient. Eliminating meritorious claims is cheaper, but not efficient.
If one simply compares the direct costs to the parties for arbitration to the direct costs for litigation, arbitration is often less expensive. In part this is because arbitration often allows for more limited discovery and has no appeals process. Arbitration costs less because the parties are getting lesser quality justice.
Even so, comparing the cost of an individual arbitration to one individual court case is misleading. Litigation produces published court opinions and creates precedent on which other parties—businesses and consumers alike—can rely. Arbitration does not produce rulings that set precedent. The precedent created by a single court litigation that produces a clear opinion can preclude many other legal actions, thus creating huge cost savings. Making an apples-to-apples comparison of the cost of a single court case to that of a single arbitration misses this important benefit of a public judicial system.
Indeed, if arbitration is so efficient, where do the cost savings go? Financial services companies do not appear to be passing the cost savings of arbitration on to consumers in general. When Bank of America, JPMorgan Chase, Capital One and HSBC dropped arbitration clauses as the result of a litigation settlement their prices did not go up. Nor did mortgage rates go up when Fannie Mae and Freddie Mac stopped buying mortgages with arbitration clauses or when Congress later banned arbitration clauses in mortgages. Binding mandatory arbitration for consumer financial contracts has no consumer welfare benefit.
Dispute resolution is not only about efficiency. It is about balancing the fairness of the legal process with its costs. Arbitration comes up short on both counts. Consumers should not be forced to accept bargain-basement justice, much less at retail prices.
Adam J. Levitin is a professor at Georgetown University Law Center.