Report • By Katherine V.W. Stone and Alexander J.S. Colvin • December 7, 2015

Supreme Court decisions on arbitration of employment contracts

The arbitration of employment disputes has its own history, although one that parallels the general trends described above. The FAA contains a clause that appears to exclude employment disputes from the statute’s coverage. Section 1 of the statute provides that “nothing herein contained shall apply to contracts of employment of seamen, railroad employees, or any other class of workers engaged in foreign or interstate commerce.” Despite this language, in 1991, in Gilmer v. Interstate/Johnson Lane Corp., 500 U.S. 20, the Supreme Court applied the FAA to an employment case, ruling that an employee was required to bring his age discrimination complaint to arbitration rather than to a court. The decision was ambiguous about the effect of the statutory exclusion for contracts of employment because, in that case, the arbitration clause was not in a contract between an employee and an employer, but rather was in a contract between an employee and the agency with which the employee was required to register to get the job. The Supreme Court clarified the ambiguity in 2001 in Circuit City Stores, Inc. v. Adams, 532 U.S. 105, interpreting the exemption for “contracts of employment” exceedingly narrowly. It ruled that the statute applied to all contracts of employment except those involving workers who, like seamen and railroad workers, were engaged in transportation that crossed state lines. Since then, courts have applied the FAA to numerous employment cases.

Legal issues in arbitration today: Arbitration and class-action waivers

The most controversial issue in arbitration law today grows out of the interaction between arbitration and class actions. Composite arbitration–class-action waivers have become common in contracts offered by credit card companies, banks, cell phone providers, and providers of other common services.8 They are also used with increasing frequency in employment contracts.9 Consumers and employees have challenged composite arbitration–class-action waivers on two grounds—that such composite clauses are unconscionable or that they make it impossible to vindicate statutory rights. Some state courts and lower federal courts have refused to enforce these composite clauses on both grounds, but recent decisions by the Supreme Court are calling these decisions into question.

The Supreme Court has addressed the issue of composite arbitration–class-action waivers several times in recent years. In 2011, in AT&T Mobility LLC v. Concepcion, 563 U.S. 333 (2011), it held that a California law making class-action waivers in most consumer cases unconscionable was invalid because it was preempted by the FAA. In 2013, in American Express Co. v. Italian Colors Restaurant, the Court enforced a class-action waiver even though the plaintiffs had shown that without a class action, it would be impossible for them to vindicate their legal rights. Although Italian Colors was not a labor case, it has significant ramifications for employees’ rights under the labor laws. Both these cases will be discussed below.10

Preemption, unconscionability, and class-action waivers

In 2011, in AT&T Mobility LLC v. Concepcion,11 the Supreme Court upheld a class-action waiver in a consumer contract against a challenge that the waiver was unconscionable under California state law. In that case, an AT&T customer brought a class action alleging that the company had engaged in fraudulent practices by charging sales taxes—approximately $15 per phone—to customers promised free cell phones in exchange for a two-year service contract. AT&T’s customer agreement included an arbitration clause that also banned class actions and classwide arbitration. The plaintiffs wanted to bring their case as a class action, so they argued that the class-action waiver was unconscionable.

The Ninth Circuit applied California’s three-pronged test, which determines that a class-action waiver in a consumer contract is unenforceable if (1) the agreement is a contract of adhesion—i.e., a form contract presented by a powerful party to a weaker party on a take-it-or-leave-it basis, (2) the dispute is likely to involve small amounts of damages, and (3) the party with superior bargaining power carried out a scheme to deliberately cheat large numbers of consumers out of individually small sums of money. The Ninth Circuit found all three prongs of the test satisfied, and therefore denied AT&T’s motion to compel arbitration on an individual basis.12

The Supreme Court reversed, holding that the California rule was preempted because it interfered with arbitration. Justice Scalia, writing for the majority, also disparaged the use of class arbitration. He enumerated the reasons he found class arbitration to be an unsatisfactory procedure. He stated that class arbitration would undermine the informality, efficiency, and speed that are the raison d’être for arbitration in the first place. He also stated that in class arbitration, an arbitrator would have to devise a method to afford absent class members notice, an opportunity to be heard, and a right to opt out. He then stated that class arbitration could impose great risks on defendants, who could receive a devastating judgment when numerous small claims were aggregated and yet would lose their right to interlocutory appeals or judicial review. For these reasons, he concluded that “[a]rbitration is poorly suited to the higher stakes of class litigation.”13

Some lower courts initially limited the Concepcion decision to the consumer setting and refused to extend it to the employment cases, but over time, most courts have extended it.14 Moreover, although the Concepcion case was about preemption of a specific state law, many courts have read it more broadly to disallow all unconscionability challenges to class-action waivers.15

The effective-vindication doctrine

Even though the Concepcion decision has been read to preclude most unconscionability challenges to arbitration in the employment setting, there is another line of argument some have used to invalidate waivers of the right to bring collective or class actions. That is the argument that a ban on class litigation would abrogate plaintiffs’ substantive statutory rights.

The U.S. Supreme Court has long maintained that arbitration is only appropriate when it entails no loss of substantive statutory rights. The Court first expressed this principle in 1985 in Mitsubishi Motors v. Soler Chrysler-Plymouth discussed above, in which the Court held that a party was required to arbitrate a claim arising under the Sherman Antitrust Act.16 In justifying its decision in Mitsubishi, the Court stated that arbitration could be ordered only if the litigant “may vindicate its statutory cause of action in the arbitral forum.”17 The Court further explained that “[b]y agreeing to arbitrate a statutory claim, a party does not forgo the substantive rights afforded by the statute.”18

The effective-vindication-of-substantive-rights principle is essential if courts are to justify closing the courthouse door to otherwise qualified litigants. In a number of consumer and employment cases, plaintiffs have asserted that the enforcement of class-action waivers would force litigants to forgo their substantive rights, and hence that arbitration should not be required.19 These cases were not controlled by Concepcion because, as explained above, the Concepcion decision involved a conflict between the FAA and state law, and the Court found the state law to be preempted. In contrast, the effective-vindication doctrine is of primary importance when there is a potential conflict between the FAA and a federal law.

Consumers have raised effective-vindication arguments against arbitration in cases in which it would be prohibitively expensive for them to arbitrate their claims. As we saw above, the Supreme Court has not been sympathetic to these arguments. Employees have raised effective-vindication arguments when arbitration combined with a ban on class actions would extinguish their substantive rights to engage in collective action.

Many effective-vindication cases arise under the Fair Labor Standards Act—a statute that explicitly provides that aggrieved employees can bring a “collective action.”20 Often these cases involved allegations of misclassification—for example, whether employees were improperly termed supervisors and thus improperly determined to be ineligible for overtime payments. In deciding FLSA class-action waiver cases, lower courts have to decide whether the provision in the FLSA statute for bringing “collective actions” is a procedural right or a substantive right. If it is a substantive right, then under Mitsubishi, it cannot be waivedMost courts that have considered this issue have held that the right to proceed in a collective action under the FLSA is procedural, and thus the composite arbitration and class-action waiver was required.21

While it might be reasonable to see the right to engage in a collective action to be a procedural right in the FLSA context, the same argument cannot be made concerning class-action waivers in claims arising under the National Labor Relations Act (NLRA). In the NLRA, the right to engage in collective and concerted action is the core right that the statute protects. Yet there is currently an open question as to whether a composite arbitration and class-action waiver clause would deprive workers of their substantive right to engage in collective action under the National Labor Relations Act. In D.R. HortonInc., 357 NLRB No. 184 (2012), the National Labor Relations Board took the position that a mandatory arbitration clause in an employment contract that required all actions to be brought on an individual basis interfered with the employee’s rights to engage in concerted activity under the labor laws. The D.R. Horton decision was overturned by the Fifth Circuit. There are several other similar cases pending in other circuits, and the issue may reach the U.S. Supreme Court.

Although the question raised by D.R. Horton has not yet been addressed by the Supreme Court, there is another recent Supreme Court case that bears ominously on the issue. In June 2013, the Supreme Court decided American Express Co. v. Italian Colors Restaurant.22 The case arose when a group of merchants brought a class action alleging that American Express (AmEx) imposed on them an illegal tying arrangement that violated the Sherman Antitrust law. Each of the merchant’s contracts with AmEx contained a clause that prohibited the merchant from bringing any dispute to a forum other than arbitration, and required that all disputes be arbitrated on an individual basis. AmEx moved to compel arbitration, and the district court granted the motion. The merchants contended that arbitration of the antitrust claim on an individual basis would cost hundreds of thousands of dollars, whereas the average recovery would be only $5,000. Hence, they claimed, without the ability to bring a class or collective action, they would lose their substantive rights. The Second Circuit agreed.23

The Second Circuit decision was overturned by the Supreme Court in June 2013. The Supreme Court upheld the class-action waiver despite irrefutable evidence that the cost of bringing an antitrust case was so high that without the ability to proceed as a class action, the case could not be brought. In doing so, Justice Scalia, writing for the majority, cast doubt on the effective-vindication-of-substantive-rights principle. He called the principle mere “dicta,” and stated that, at most, it might apply to “filing and administrative fees attached to arbitration that are so high as to make access to the forum impracticable.”24 He wrote, cryptically, “[T]he fact that it is not worth the expense involved in proving a statutory remedy does not constitute the elimination of the right to pursue that remedy.”25

Justice Kagan delivered a strong dissent in Italian Colors. The overall effect of the opinion, she explained, is that “[t]he monopolist gets to use its monopoly power to insist on a contract effectively depriving its victims of all legal recourse.”26 She argued that the effective-vindication rule was essential to prevent stronger parties from using these and other kinds of means to eviscerate statutory protections. As she explained, “The effective-vindication rule [ensures that] arbitration remains a real, not a faux, method of dispute resolution. With the rule, companies have good reason to adopt arbitral procedures that facilitate efficient and accurate handling of complaints. Without it, companies have every incentive to draft their agreements to extract backdoor waivers of statutory rights.”27

Although the Italian Colors case itself involved a dispute brought by merchants, the majority’s decision has important consequences for employment cases. By narrowing the effective-vindication doctrine, the Court has potentially undermined challenges to class-action waivers in arbitration clauses. That is, just as AT&T Mobility knocked out most unconscionability challenges to unfair arbitration agreements on preemption grounds, Italian Colors threatens to eliminate most challenges brought on the basis of the effective-vindication doctrine. And in doing so, Italian Colors suggests that the arbitration law trends may signal the destruction of the legal protection for collective action that has been at the heart of labor laws for over 60 years.28

Other current issues: Severance, interpretation of arbitration agreements, and private attorney general actions

There are two arbitration cases that will be decided by the Supreme Court this term. One, MHN Government Services, Inc. v. Zaborowski, concerns whether a court, when presented with an arbitration agreement that is unconscionable in several respects, can invalidate an entire arbitration agreement or whether it must simply sever the unconscionable elements and enforce the rest.29 The California courts have taken the position that when there are multiple unconscionable aspects to an arbitration clause, it can invalidate the clause in its entirety. This principle is important because it disincentivizes powerful parties from writing arbitration clauses with unduly harsh provisions. If a court would simply sever any unconscionable provision and enforce the rest of an arbitration clause, a powerful party might be tempted to include numerous harsh elements, knowing that even if some are deemed unenforceable, they can still require the counterparty to arbitrate. The principle is being challenged on the grounds that it is an arbitration-specific rule that disfavors arbitration and is therefore preempted by the FAA.

The other arbitration case currently before the Supreme Court involves a state court’s ability to interpret arbitration clauses. It has generally been assumed that contract law is a matter of state law, and that it is for state courts, not federal courts, to interpret contracts. In a consumer arbitration class-action waiver case called DIRECTTV, Inc. v. Imburgia, an arbitration clause provided that, notwithstanding the arbitration clause, “If, however, the law of your state would find the agreement to dispense with class arbitration procedures unenforceable, then [the entire section requiring arbitration] is unenforceable.”30 The case arose in California at a time when class-action waivers in consumer contracts of the sort in that contract were held to be unenforceable. Accordingly, the state court refused to enforce the class-action waiver. The Supreme Court has accepted review in order to determine whether the state’s own interpretation of the contract conflicts with the FAA and hence should be overturned.

Another issue that is likely to come to the Supreme Court soon involves the waiver of rights under statutes that permit individuals to enforce laws enacted for the public benefit. In 2004, California enacted a statute called the Private Attorney General Act, or PAGA law, to assist in the enforcement of its Labor Code.31 The purpose of the statute was to permit aggrieved employees to enforce the California Labor Code because the public enforcement agency lacked the resources to achieve maximum compliance with state labor laws.

In 2014, in Iskanian v. CLS Transport, a truck driver brought a class-action suit alleging failure to pay overtime and provide rest breaks.32 In that case, the employee was subject to an employment agreement that contained both an arbitration clause and a waiver of class or representative action. The California Supreme Court found that the waiver was not enforceable as applied to PAGA claims. Relying on the settled proposition that “[a]nyone may waive the advantage of a law intended solely for his benefit. But a law established for a public reason cannot be contravened by a private agreement,” it found that PAGA actions were representative actions and thus the right to bring the suit to a court could not be waived.

The lower federal courts in California have been inconsistent in their willingness to follow Iskanian and prevent a compelled waiver of employment PAGA actions. Some lower courts have done so, but many others have rejected Iskanian on the grounds that its reasoning and result are inconsistent with Concepcion.33 However, on September 30, 2015, the Ninth Circuit, in a divided opinion, affirmed the result in Iskanian and rejected a class-action waiver of PAGA claims.34 It is likely that this issue will go to the Supreme Court.

The future of arbitration law

Arbitration law is a dynamic area of law. Because the Supreme Court decisions have made arbitration the only forum available for resolving disputes in many cases, the particular details of arbitration procedures need to be resolved. Hence the number of cases continues to grow, and new issues are continually arising. However, the trends are clear: Courts will not permit states to constrict arbitration, and they will enforce arbitration agreements in all but the rarest circumstances, no matter how much advantage they give to the stronger parties. In light of these rulings, it is not surprising that the use of arbitration by private-sector businesses and employers has grown enormously.

How mandatory arbitration works

The prevalence of mandatory arbitration and class-action waivers

Arbitration in employment

Until the 1990s, arbitration in employment was almost exclusively a creature of the labor contracts of unionized workplaces. In the unionized setting, labor arbitration provides a jointly established mechanism for enforcing the provisions of collective-bargaining agreements and providing industrial justice in the workplace. Labor arbitration has been one of the most enduring and successful features of the American industrial relations system because it has served the interests of both unions and management, and both parties are equally involved in establishing and administering the system. These arbitration cases are decided by a well-established cadre of professional neutral labor arbitrators whom both parties must consider fair and neutral to be selected to decide cases. By contrast, prior to the 1990s, arbitration was only rarely used in nonunion workplaces precisely because there was no union present to play the institutional role as the bilateral partner to the employer in establishing arbitration.

The picture of arbitration as a creature of the unionized workplace started to shift as the Supreme Court began allowing statutory employment rights to be subject to arbitration agreements in its 1991 Gilmer decision, discussed above. Beyond simply providing for arbitration of statutory claims, Gilmer gave the green light to employers to require employees to sign arbitration agreements as a mandatory term and condition of employment. The case and its progeny allowed employers to unilaterally introduce arbitration procedures to cover statutory employment rights and make these procedures mandatory in the sense that the employer would refuse to hire a job applicant who would not sign the arbitration agreement.

Since 1991, arbitration has grown rapidly in nonunion workplaces.35 Many major corporations now use mandatory arbitration procedures, including Anheuser-Busch InBev, Citigroup, Darden Restaurants, Haliburton, J.C. Penney, Lowes, Oracle, Rent-A-Center, Securitas, Sysco, United Healthcare, and Wells Fargo.36 As this list suggests, mandatory arbitration now covers a wide range of employees in many different industries.

How many employees are covered by mandatory arbitration procedures? This is a surprisingly difficult question to answer, in part because of the private nature of these arbitration procedures. There is no requirement that employers who require their employees to sign mandatory arbitration agreements report this to a government agency such as the Bureau of Labor Statistics (BLS). Nor are data on the incidence of mandatory arbitration gathered in any of the official government surveys of employers. As a result, while the BLS releases detailed data annually on the extent of union membership and representation, there is no official government estimate of the extent of mandatory arbitration.

In the absence of official government statistics on the extent of mandatory arbitration, our best estimates come from academic surveys that have looked at aspects of this question. The picture they show is one of substantial growth over the 1990s and 2000s. These studies are summarized below.

A 1992 survey of corporate use of dispute-resolution procedures found that only 2.1 percent of the employers surveyed used mandatory arbitration.37 By comparison, a 1995 GAO survey of 1,448 establishments subject to Office of Federal Contract Compliance Programs (OFCCP) reporting requirements found that 7.6 percent of them had adopted mandatory arbitration procedures covering their employees.38 More recently, a 2003 survey of 291 employers in the telecommunications industry that one of us (Colvin) conducted found that 14.1 percent had adopted mandatory arbitration procedures.39 However, since the adopting employers tended to be the larger organizations, 22.7 percent of the nonunion employees in the organizations surveyed were covered by mandatory arbitration procedures. In that survey the focus was on procedures covering typical lower-level employees in the industry, such as customer service workers or technicians.

An important feature of the proliferation of mandatory arbitration procedures is that it has encompassed a broad range of lower-level employees. For example, use of mandatory arbitration is widespread in the retail industry, including in chains such as Macy’s and Target. It is also used by many restaurant chains, such as Hooters, the Olive Garden, and Waffle House. If the growth trends have continued since that 2003 survey, it is reasonable to estimate that today, a quarter or more of all employees in nonunion workplaces are subject to mandatory arbitration agreements. Put differently, it is likely that the share of American workers who are subject to employer-initiated mandatory arbitration procedures is twice the rate of the now only 11.1 percent who are union members.40

Arbitration in consumer contracts

Arbitration has become even more common in consumer transactions than in employment. The most comprehensive and recent study of the prevalence of arbitration in consumer transactions was conducted by the Consumer Financial Protection Bureau (CFPB). The Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd–Frank) that established the CFPB also mandated that it conduct a study of the use of mandatory arbitration clauses in consumer financial contracts. In addition, it empowered the CFPB to issue regulations governing the use of mandatory arbitration in these contracts based on the results of this study.

The CFPB began its study in 2012, released preliminary findings in December 2013, and issued its final report in March 2015. The CFPB’s Arbitration Study report documents that mandatory arbitration in consumer financial contracts is widespread and that mandatory arbitration clauses are included in a majority of contracts in many areas of consumer finance. The CFPB study found that credit card issuers representing 53 percent of the total credit card market include mandatory arbitration clauses. For prepaid cards, which tend to be used more by lower-income individuals, 92 percent of agreements include mandatory arbitration clauses. In student loans, 86 percent of the largest private lenders use mandatory arbitration clauses. The study found that in California and Texas over 99 percent of payday loan agreements include mandatory arbitration. Even among checking accounts, where use is lower, banks and credit cards that use mandatory arbitration represent 44 percent of insured deposits. In addition, the rate of use of mandatory arbitration in credit card agreements is likely to be temporarily depressed because the settlement of an antitrust lawsuit required four large banks to cease using mandatory arbitration for three-and-a-half years. Although these banks had not resumed using mandatory arbitration at the time of the study, which immediately followed the expiry of the settlement, if they were to resume using mandatory arbitration, this would raise the usage rate to over 90 percent for credit cards.

Regarding the content of these mandatory arbitration procedures, the most important finding of the CFPB study is that over 90 percent of them expressly prohibit class actions. Given the relatively small amounts of many consumer financial transactions and the similarity across claims, the availability of class actions is a crucial element in providing access to justice for consumer financial claims.

Another important finding of the CFPB study is that most consumers are unaware that they had entered into mandatory arbitration agreements. Three-fourths of the consumers surveyed in the study did not know that their credit card agreement included an arbitration clause. Misunderstandings were also widespread. Fewer than 7 percent of the consumers were aware that they were covered by an arbitration agreement that kept them from suing in court.

The CFPB study makes it clear that arbitration has largely displaced the civil justice system for most of the major transactions of ordinary people. A further question is whether this is a good thing. There is debate among researchers about whether consumers fare better in arbitration than in the courts. Some claim that consumers do better, and some claim the contrary.41 The evidence involves individual claims, each with its own merits.

The CFPB found that most arbitration agreements in consumer transactions include a class-action waiver. This finding reinforces a 2007 survey that found that the most prominent firms in the telecommunications, credit, and financial service industries routinely insert arbitration clauses into their contracts with consumers (76.9 percent), but rarely use them in their other commercial agreements. (6.1 percent).42 The authors of the survey opined that corporations preferred to have arbitration clauses in contracts with consumers because the clauses could be coupled with bans on class actions. In a similar vein, a survey conducted in 2009 by one of the authors of this report, Katherine Stone, found that arbitration was a mandatory term in the service agreements of all four of the largest cell phone companies, five of the eight largest cable companies, six of the nine major credit card companies, and three of four large national retail banks, and that all of the arbitration clauses were accompanied by a ban on class actions.43 Thus the detrimental impact of arbitration clauses on the ability of consumers to band together to pursue low-value claims seems undeniable. And it is only through collective efforts that consumer and employment rights can truly be protected.44