A pair of New Jersey Supreme Court decisions last week related to mandatory arbitration clauses offered mixed results for lenders, and the less favorable one left room for future court battles, industry lawyers said.
A mandatory arbitration clause binds the borrower and the lender to using an arbitrator instead of the courts to settle disputes. Lenders use the clauses to protect themselves from costly litigation.
But the strategy can backfire if consumers can pursue class arbitrations, which have the high stakes of a court case without the protections, such as the right to appeal.
In Muhammad v. County Bank, the court found the class-action waiver in the mandatory arbitration clause of a payday loan "unconscionable," because the arbitration agreement was "adhesive." In other words, without it, the consumer could not get the loan.
In Delta Funding Corp. v. Harris, the court upheld the foreclosure exemption in the mortgage lender's mandatory arbitration clause. Lenders insert such exemptions because they want a court to apply its considerable legal imprimatur to their title claims; an arbitrator's ruling in this area is considered less solid.
Alan Kaplinsky, a partner with Ballard Spahr Andrews & Ingersoll LLP in Philadelphia, said flatly, "The result in the Muhammad case is not good" for lenders, because the court clearly invalidated County Bank's waiver.
(He represented Delta Funding in its case.)
Kirk Jensen, an associate with Buckley Kolar LLP in Washington, said the Muhammad ruling "should be troubling to everyone," because "arbitration is poorly suited to deal with classwide resolution of claims." Rather, it is "designed to be a quick, efficient, cost-effective means of resolving disputes."
Class arbitration is bad for consumers, because the arbitration process does not include all the procedural protections that courts have to protect the interests of "absent" class members, Mr. Jensen said.
The Muhammad ruling is bad for lenders, because it does not resolve whether they can enforce a victory against absent class members, he said.
"The lender can't be assured that a victory is even a final resolution of a dispute."
As a result of the ruling, "lenders are going to be less willing to enter into arbitration agreements in New Jersey, because of the threat of class-basis arbitrations," Mr. Jensen said.
By contrast, the ruling in the Delta case was clearly seen as a win for the industry.
According to Mr. Jensen, taking the foreclosure process out of arbitration and into the courts will give lenders a firmer claim to title.
"In order for the title to be secure, you want an official proclamation. … Frequently, a court is the entity that makes that proclamation, which can be recorded in a chain of title, so there is a clear record of title showing the party that foreclosed has title."
Still, Mr. Kaplinsky said he expected the Muhammad case to be "just one battle in a longer war that has not yet been played out in New Jersey, because it didn't deal" with a couple of important issues.
One of those issues is what to do if a lender uses another state's law to govern its class-action waiver on a loan made in New Jersey, he said.
"The court didn't specifically decide what would happen if you were dealing with an out-of-state bank that had a 'choice of law' clause in its loan agreement calling for the application of some state law other than New Jersey's."
The court also did not address the Federal Arbitration Act's preemption of state law, Mr. Kaplinsky said.
"Many other courts have held that the FAA preempts state laws invalidating class-action waivers."
One way to circumvent the ruling is to let borrowers "opt out" of their arbitration agreements within a few days after the loans are made, he said.
When asked whether doing so would defeat the purpose of an arbitration clause - preventing litigation - Mr. Kaplinsky said most borrowers would not care enough about the clause to opt out.
Mr. Jensen said adding an opt-out clause to an arbitration agreement is "certainly an option" for lenders who want to continue using the agreements in the state. However, "courts have still found arbitration agreements unconscionable," so the lender could still lose if the borrower decides not to opt out.
Leonard Bernstein, a partner with Reed Smith LP in Princeton, said that the court may have been motivated in the Muhammad case to strike down County Bank's waiver because of the structure of the loan: a $200 principal with a 608% annual percentage rate.
"While the opinion was decided on a legal issue, the court was confronted with facts that many in the court might have considered unpleasant," he said.
Nevertheless, "the good news for both of these cases is that they said class-action arbitration waivers are not unconscionable per se," but only in certain instances, Mr. Bernstein said.
