On November 9, 2010, the Supreme Court heard oral argument in AT&T Mobility LLC v. Concepcion, a case with far-reaching implications for class actions. Business and consumer groups are calling it the most important case of the Court’s term so far. In Concepcion, the issue is whether the Federal Arbitration Act (FAA) preempts challenges to class waivers in arbitration clauses as unconscionable under California common law.1 The answer to that question may and likely will have implications for all state law unconscionability challenges to arbitration clauses that do not provide for class arbitration.

Concepcion is the latest round in an ongoing controversy over the use of arbitration clauses in consumer contracts. Arbitration advocates maintain that arbitration on an individual (non-class) basis is a fair and cost-effective means to resolve consumer claims. Plaintiffs’ lawyers claim that arbitration clauses with attendant class waivers can and often do eliminate redress for consumers, who are unlikely to bring their claims on an individual basis.

The need for class waivers in arbitration clauses came about largely as a result of the 2003 Supreme Court decision in Green Tree Financial Corp. v. Bazzle.2 Class arbitration was all but unheard of prior to Green Tree, when an enterprising plaintiffs’ lawyer convinced a court in South Carolina to order arbitration on a class basis, even though the arbitration clause at issue was silent on the subject. As has been pointed out many times, class arbitration is the worst of all worlds: high stakes, no appellate review, and the potential for serious abuse. Nevertheless, in Green Tree, the plurality opinion authored by Justice Breyer held that the arbitrator should have decided the question of whether the arbitration should proceed on a class basis, which ducked the question of whether parties could be ordered to do so without any affirmative evidence that they intended that odd result.3 By ducking the question, Justice Breyer seemed to imply that an arbitrator had the authority to order class arbitration even in cases in which the arbitration agreement was silent on the subject.

As a result of Green Tree, many companies revised their arbitration agreements to explicitly prohibit class arbitration. Just last term, however, in Stolt-Nielsen S.A. v. AnimalFeeds International Corp., the Supreme Court negated the implication of the Green Tree plurality when it held that (1) parties to an agreement to arbitrate cannot be required to engage in class arbitration unless they agreed to do so and (2) silence on the subject in the agreement cannot be interpreted as implicit consent to arbitrate on a class basis.4 Concepcion is poised to resolve the leftover tension between, on the one hand, the FAA and its policy in favor of arbitration, which means individual (non-class) proceedings, according to Stolt-Nielsen, and, on the other hand, challenges to arbitration agreements providing that the arbitration shall be conducted on an individual (non-class) basis.

The plaintiffs in Concepcion alleged that AT&T engaged in fraudulent business practices by charging them sales tax of $30.22 on a cell phone advertised as “free.” They brought a complaint in federal court and AT&T moved to compel the plaintiffs to submit their claims to individual arbitration under the arbitration agreement signed by the plaintiffs.

The district court held that AT&T’s class waiver provision was unconscionable under California law, despite the existence of a “premium payment clause” that gave the consumer the right to collect $7,500 if the arbitrator issues an award greater than AT&T’s last written settlement offer made before an arbitrator was selected. The Ninth Circuit affirmed, holding the class waiver at issue violated the unconscionability rule set forth by the California Supreme Court in Discover Bank v. Superior Court of Los Angeles, because: (1) the agreement was set forth in a contract of adhesion (sometimes referred to as procedural unconscionability), (2) the claim involved “predictably small amounts of damages,” and (3) it was alleged that the party with superior bargaining power “carried out a scheme to deliberately cheat large numbers of consumers out of small sums of money.”5 In effect, the California law mandates that many if not most small-dollar consumer claims be subject to resolution on a class basis, either in arbitration or in court.

AT&T argued that the Discover Bank rule applies only to dispute resolution mechanisms, most notably arbitration clauses, and that all other contract provisions challenged as unconscionable under California law are evaluated under a “sliding-scale” approach (weighing the degree of substantive and procedural unconscionability) or, traditionally, under a test that asks whether the provision “shocks the conscience” or is one that a person would have to be “under delusion” to accept. AT&T argued that California has, in effect, created a special unconscionability rule for class waivers that violates Section 2 of the FAA. Under Section 2, agreements to arbitrate are “valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract.” This latter clause, referred to as the savings clause, means that arbitration clauses can be invalidated only on generally applicable state law contract grounds (e.g., lack of consideration) and cannot be singled out for hostile treatment. This is consistent with the purpose of the FAA, which is to protect arbitration clauses from hostile judicial treatment and place them on the same footing as all other contracts.

At the Supreme Court, the plaintiffs maintain that the FAA does not preempt California’s unconscionability law because the Discover Bank rule applies to any class waiver, whether in arbitration or litigation. AT&T points out that under the savings clause, a “rule must have arisen to govern contracts generally, not arbitration specifically – either directly or indirectly by regulating a gerrymandered subset of contracts, such as those involving dispute resolution. Were it otherwise, States would be able to superimpose on arbitration any procedure used in courts – jury trials, plenary discovery, application of the rules of civil procedure and evidence, etc. – by labeling it a ‘neutral’ requirement for all dispute-resolution agreements.”6

At oral argument, the Supreme Court focused on whether California common law discriminates against arbitration agreements. Justice Breyer (the author of the plurality opinion in Green Tree) phrased the issue as follows: “I would guess it’s like Switzerland having a law saying we only buy milk from cows who are in pastures higher than 9,000 feet. That discriminates against milk from the rest of the continent. But to say we want cows that have passed the tuberculin test doesn’t. So I guess we have to look at the particular case. And here, my impression is – correct me if I am wrong – the class arbitration exists. [I]t’s not like having a jury trial. You could have it in arbitration. You can have it in litigation. So where is the 9,000-foot cow, or whatever it is? Where is the discrimination?”7

Resolution of the Concepcion case may turn on Justice Breyer’s discrimination question. But a much larger question lurks in the room like a 9,000-foot cow: If class arbitration is something that under the FAA cannot be forced upon parties absent agreement (see Stolt-Nielsen), how could an agreement not to arbitrate on a class basis ever be invalidated under state law as “unconscionable”? That doctrine applies to contract terms that “shock the conscience” or that no person not “under delusion” would accept. Even if California’s Discover Bank test is just a refinement of the traditional rule, as the Ninth Circuit opined, isn’t the notion that arbitration on an individual basis is unconscionable and therefore unenforceable directly inconsistent with the basic principle that the FAA requires that arbitration contracts be enforced as written? It will be fascinating to see how the Court addresses this important issue. We predict that the Court will answer it and will substantially undercut unconscionability challenges to class waivers.

If so, then companies that use arbitration clauses will have scored a significant victory in their ability to control costs and effectively resolve disputes. The ultimate significance of the ruling, however, may be undercut by the actions of the recently-created Bureau of Consumer Financial Protection. Under Section 1028 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the bureau is authorized to impose limitations on the use of arbitration clauses in the financial services industry, but only after the bureau conducts a study of these clauses and makes a report to Congress. It is conceivable that the bureau could issue a rule substantially altering the legal landscape for financial services companies, who to date have been among the most important and numerous users of arbitration clauses.