Arbitration clause in subprime loan contract declared unconscionable.

The North Carolina Supreme Court has ruled that a lending company's contract was unenforceable because its mandatory arbitration clause was overwhelmingly unfair to plaintiffs. The decision marks the first time an appellate court in North Carolina has ruled a contract unconscionable. In its divided opinion, the state's highest court also declined a defense request to sever or rewrite the arbitration clause. (Tillman v. Commercial Credit Loans, Inc., 655 S.E.2d 362 (N.C. 2008).)

The court found that the clause allowed the lender, but not the borrowers, to take legal action; prohibited claims joinders and class actions; and imposed prohibitive costs on the plaintiffs, including arbitration costs and a "loser pays" rule. Writing for the court, Judge Patricia Timmons-Goodson said the judges were swayed by the "inequality of bargaining power between the parties and the oppressive and one-sided nature of the clause."

"Through the arbitration clause ... defendants have not only unilaterally chosen the forum in which they want to resolve disputes, but they have also severely limited plaintiffs' access to the forum of their choice," she wrote.

John Alan Jones, a Raleigh lawyer who represented the plaintiffs, called it a "powerful, well-reasoned decision that courts around the country will look to. Above all, it sends the clear message that a mainstream jurisdiction like North Carolina won't tolerate unconscionable arbitration provisions."

Even a judge who partially dissented agreed that "the inequality represented by the arbitration clause is so manifest as to shock the judgment" and "so oppressive that no reasonable person would offer it on the one hand or accept it on the other."

CitiFinancial, a subsidiary of Commercial Credit, Inc., was a subprime lender that made mortgage loans to low-income borrowers. In its loan packages, the lender frequently included a single-premium credit insurance (SPCI) policy, a type of policy now classed as predatory lending and illegal in North Carolina. CitiFinancial added the SPCI premium to the mortgage loan amount, which increased the loan by several thousand dollars.

Fannie Lee Tillman and Shirley Richardson received mortgage loans from CitiFinancial in 1998 and 1999, respectively. They later alleged that they were rushed through the paperwork, had no attorneys or other representatives present during loan closing, and were not told about several additional fees charged to them. They said they neither wanted nor requested SPCI and were not told that it was optional.

In 2002, Tillman and Richardson sued CitiFinancial for deceptive trade practices, unjust enrichment, and breach of the duties of good faith and fair dealing under North Carolina law. They asked for damages in the amount of the insurance premiums they paid.

On doing so, they faced the formidable terms of the company's arbitration clause. The clause obligates CitiFinancial to pay for the first day of arbitration but requires the nonprevailing party to pay all other costs, including the $125 administrative fee. The plaintiffs calculated that costs would average $1,225 a day, with additional costs if the case went to appeal (the loser would also have to pay for an appeal, which typically runs two to three days at the same rate). The clause also included exceptions from arbitration for two types of legal action: foreclosure instigated by the lender and claims where the amounts of damages and fees were less than $15,000. The clause prohibited class actions.

Since it incorporated this clause into its lending agreements in 1996, CitiFinancial has made over 70,000 loans in North Carolina and has sued 3,700 of its borrowers. No borrower has pursued legal action against CitiFinancial.

"The provision has been successfully used as a shield against liability," said Jones, "and a way to deny consumers any recourse, whether in court or through arbitration."

A trial court found for the plaintiffs, but the decision was overturned by a divided appellate court.

In rendering its decision, the North Carolina Supreme Court found that the clause was both procedurally and substantively unconscionable.

"Procedural unconscionability involves bargaining naughtiness in the form of unfair surprise, the lack of meaningful choice, and inequality of bargaining power," wrote Timmons-Goodson. "Substantive unconscionability, on the other hand, refers to harsh, one-sided, and oppressive contract terms."

Timmons-Goodson pointed out that the plaintiffs were left without legal representation because they could not afford to hire lawyers for an hourly fee, and the low damages made it unlikely that they would find contingent fee lawyers willing to take the case. "The likelihood is even less," she added, "because the arbitration clause prohibits the joinder of claims and class actions."

The court noted in its conclusion, "We ... reaffirm this court's previous statements acknowledging the state's strong public policy favoring arbitration. However, this particular arbitration clause simply does not allow for meaningful redress of grievances and therefore ... must be held unenforceable."

Jones said the decision will have far-reaching implications not only for other courts considering similar contracts but also in the financial industry.

"I know the decision came as a shock to corporate lawyers and is already on the radar screen of people who draft these clauses," he said. "Now they have two options. They can either be more clever about how they draft these provisions, to get around the law--or they can do the right thing and simply draft arbitration provisions that are fair."

The ruling may give support to decisions in similar cases. In March, in another case that Jones tried, the court affirmed a lower court ruling that Bank of America had used unfair and deceptive trade practices in its lending, and allowed an award of treble damages to the plaintiffs. (Richardson v. Bank of Am., 657 S.E.2d 353 (N.C. 2008).)

"Predatory lending and the subprime crisis have only recently become part of the national consciousness," Jones said. "But these practices have been going on for years. With these decisions, North Carolina is in the forefront of protecting consumers against unscrupulous lenders."