Supreme court weighs enforcement of arbitration clause in 'payday' loans.

If a contract is alleged to be illegal, but it contains a mandatory arbitration provision, should a court or an arbitrator determine the contract's legality? The U.S. Supreme Court recently heard oral arguments on that question in Buckeye Check Cashing, Inc. v. Cardegna. (No. 041264 (U.S. argued Nov. 29, 2005).)

John Cardegna filed a class action against Buckeye Check Cashing, Inc., a "payday lender," alleging that his and other borrowers' check-cashing transactions with Buckeye actually were usurious loans that violate Florida law. Consumers typically get cash from so-called payday lenders by providing a personal check (for an amount greater than the cash received), which the lender holds until the consumer's next payday. Then, the consumer repays the amount, allows the lender to cash the check, or rolls over the loan.

Buckeye charged customers interest rates between 137 percent and 1,317 percent APR, according to the plaintiffs' brief to the Supreme Court. In Florida, charging interest rates higher than 25 percent is criminal usury. The plaintiffs alleged that Buckeye's transactions violated Florida's Lending Practices Act, Consumer Finance Act, Deceptive and Unfair Trade Practices Act, and other laws.

Cardegna's contract contained an arbitration provision, so the company moved to compel arbitration to resolve the issue, arguing that the Federal Arbitration Act (FAA) preempts state law and the matter should be decided by an arbitrator, not a court. Cardegna alleged that the entire contract was illegal and usurious--and therefore void ab initio--so no part of it (including the arbitration provision) could be enforced until a court resolves the allegations.

The trial court denied Buckeye's motion to compel arbitration. The appeals court reversed that decision and held that an arbitrator must resolve the issue. The Florida Supreme Court disagreed and remanded the case.

"We conclude that Florida public policy and contract law prohibit breathing life into a potentially illegal contract by enforcing the included arbitration clause of the void contract," Justice Harry Anstead wrote for the majority. "Florida's law has long held that contracts which are determined to be against public policy and void should not be enforced."

The U.S. Supreme Court granted Buckeye's petition for certiorari in June. At oral argument, the Court considered whether arbitration provisions are severable from their underlying agreements, the difference between void and voidable contracts, and whether the FAA preempts state contract law.

"The payday lending companies, who exploit poor people in terrible ways, are counting on mandatory arbitration clauses as a means of letting them avoid liability even if they are completely breaking the law," said Paul Bland, a staff attorney at Trial Lawyers for Public Justice in Washington, D.C., who argued the case for the plaintiffs.

The plaintiffs' brief says that "to enforce a right arising from an illegal contract is to reward, and thus to encourage, unlawful--and in some cases criminal--behavior."

Contract validity

The FAA specifies that arbitration provisions are enforceable when they are in a contract, and Congress's choice of the word "contract" rather than "agreement" is important, Bland said. Because Buckeye's agreement was void from the beginning, no legal contract was ever formed, and the FAA does not apply, he said.

Buckeye argued that arbitration clauses are severable from their underlying contracts, citing Prima Paint Corp. v. Rood & Conklin Manufacturing Co. (388 U.S. 395 (1967).)

But the Florida Supreme Court said Prima Paint does not apply because the contract in that case was alleged to have been fraudulently induced rendering it voidable--whereas Cardegna's contract would be "void from the outset if it were determined that the contract indeed violated Florida's usury laws."

At oral argument, Justice Sandra Day O'Connor noted that voidness is a question of public policy, and voidability usually is a question about the parties' intentions. Chief Justice John Roberts remarked that sending a void contract to arbitration is "odd," and he questioned whether it is proper to ask arbitrators to enforce public policy. Christopher Landau, a Washington, D.C., lawyer who argued the case for Buckeye, responded that arbitrators can decide both legal and public policy questions.

Roberts asked Bland why he assumed that a contract's illegality bars the enforcement of an arbitration clause. Bland responded that the FAA says an arbitration clause is enforceable if it is in a contract--and that the existence of a contract is a precondition to enforcement.

Landau said the word "contract" brings with it "all the bells and whistles of state law," but the severability doctrine says that as long as the arbitration clause itself is not being challenged, any challenge to the contract goes to arbitration.

"In this case, the payday lenders are essentially arguing that arbitration clauses are some kind of supercontract and that they can be enforced even in settings where no other contract term would ever be enforced," Bland said in an interview. "They want to strip away any limits that state contract law would place on the enforcement of these terms. If they get their way, consumers could lose a lot of very important protections.

"The Supreme Court historically has taken the position that while the Federal Arbitration Act requires courts to enforce arbitration provisions in contracts, arbitration clauses aren't supposed to be any better than other types of contracts," Bland said.

At oral argument, Roberts asked whether a dispute over a hypothetical contract for murder should be sent to arbitration if it contains an arbitration clause. Landau said that going to arbitration doesn't mean the murder contract gets enforced; it means the arbitrator decides its legality. Bland countered that to order arbitration is to enforce the contract.

"They're insisting on the need to arbitrate an illegal contract--they're really reaching for straws," said John Vail, senior litigation counsel at the Center for Constitutional Litigation in Washington, D.C. He noted that arbitration is not open to public scrutiny, as court proceedings are. And if these decisions are left to arbitrators instead of courts, he said, juries are eliminated from the process entirely, and states can't develop common law.

Buckeye argued that the distinction between void and voidable doesn't matter, because the FAA's severability rule preempts state law. The plaintiffs said the rule applies only in federal court proceedings and therefore doesn't apply to Cardegna and other cases that arise in state court.

"The FAA entrusts states with determining the law in this area," and arbitration generally is governed by state contract law, the plaintiffs argued in their brief. E. Clayton Yates, a Fort Pierce, Florida, lawyer and cocounsel for the plaintiffs, noted, "In prior cases, the Supreme Court has said it's not a question for federal law unless there is some reason to believe the state is trying to discriminate against arbitration."

The Florida Supreme Court majority agreed, saying, "We do not believe federal arbitration law was ever intended to be used as a means of overruling state substantive law on the legality of contracts."

Dissenting from that majority, Justice Raoul Cantero wrote: "At their heart, Party Yards [a case on which the majority relied] and the majority opinion evince a basic distrust of arbitration and place the court as jealous guardian of the determination of legal issues."

Forty states, as well as the District of Columbia and Puerto Rico, joined in filing an amici brief in support of the plaintiffs. The states' brief urged the Supreme Court to "respect principles of federalism by halting the expansion of Prima Paint."

"Congress intended the FAA to be nothing more than a procedural statute designed to reverse the common law antipathy for arbitration agreements as it existed in early-20th-century federal courts," the brief says. "The FAA's legislative history demonstrates conclusively that the act was never intended to have any application in state court proceedings, and it certainly was never intended to supplant state substantive law."

"This is a states' rights case," said Florida Solicitor General Chris Kise, counsel of record on the states' brief. "Consumer protection has long been the bread and butter of state attorney general offices."

Effect of the case

Buckeye's supporters have predicted that if the Court accepts the plaintiffs' argument, trial courts will face increased litigation over whether contracts containing arbitration clauses are void. Parties making such claims will "invoke and attempt to expand contract doctrines that allow them--in some state courts--to evade their obligation to arbitrate," according to an amicus brief filed by the U.S. Chamber of Commerce.

Kise said the "Chicken Little" scenario that the Chamber, the American Bankers Association, and others warn about is absurd. "As long as they're confident that their members aren't engaging in illegal activity, they have nothing to worry about," he said.

Bland agreed. "The banks are trying to make it sound like, if they had to follow regular state contract laws, there would be this catastrophic breakdown in the banking system," he said. "I think that it doesn't hurt the system of mandatory arbitration to have arbitration clauses subject to normal contract laws."

Bland said at oral argument that plaintiffs asking courts to strike down contracts as void ab initio would have a hard case to make. The contracts would have to clearly violate a statute, and most of them would involve "companies operating at the edge of legality, mostly in the payday lending industry." As a practical matter, few contracts would be invalidated, he said.

He added that courts can get rid of any frivolous lawsuits that are filed. Justice Antonin Scalia remarked that courts can get rid of them--but only after frustrating arbitration. Landau said permitting such challenges would "allow open season on arbitration."

"If the banks get what they want, it's going to insulate [arbitration] provisions from all kinds of normal state laws that protect individuals," Bland said. "I'm very concerned about what would happen if the Court went for a position that's as broad as what they're requesting."

A ruling in favor of Buckeye would inhibit states' ability to protect consumers from unscrupulous business practices, Kise said. "The impact on state sovereignty can't be overemphasized--it would deny states' rights to enact legitimate public policy."