Courts regularly praise private arbitration as a means of affording flexibility to the parties, reducing costs and time, and lessening the burden on the judicial system. In some cases though, arbitration clauses can present a barrier to would-be claimants, particularly in consumer cases. As a result, arbitration agreements are often challenged by individuals and small businesses on grounds that they are unconscionable and should not be enforced. Those arguments just got much harder to make.

The North Carolina Court of Appeals dramatically altered the analysis for unconscionability of arbitration agreements in a unanimous opinion released in February in the case of Torrence v. Nationwide Budget Finance, No. COA 12-453 (N.C. Ct. App. Feb. 4, 2014). In Torrence, the Court of Appeals held that unconscionability attacks directed at the arbitration process (i.e., based on differences between arbitration and litigation) can no longer serve as a basis to invalidate arbitration agreements governed by the Federal Arbitration Act.

I.    Existing Law on Unconscionability

Before February, the leading case on unconscionability of arbitration agreements in North Carolina was the state Supreme Court’s decision in Tillman v. Commercial Credit Loans, Inc., 362 N.C. 93 (2008). In Tillman, the North Carolina Supreme Court set out a test allowing courts to set aside arbitration agreements where both procedural unconscionability (unfairness in the execution of the arbitration agreement) and substantive unconscionability (unfairness in the terms of the arbitration agreement itself) were present. For the substantive unconscionability prong of the test, the Supreme Court identified three relevant factors for ruling an agreement unenforceable: (i) “prohibitively high” arbitration costs, (ii) an “excessively one-sided” agreement that lacks mutuality, and (iii) a prohibition against joinder of claims and class actions that precludes the claimant from effectively vindicating its rights in the arbitral forum. The Tillman decision did not distinguish between arbitration agreements involving interstate commerce governed by the Federal Arbitration Act (“FAA”) and those involving purely intrastate commerce governed by the North Carolina Revised Uniform Arbitration Act (“RUAA”).

After Tillman, however, came a pair of cases decided by the United States Supreme Court: AT&T Mobility v. Concepcion, __ U.S. __, 131 S.Ct. 1740 (2011) and American Express Co. v. Italian Colors Rest., __ U.S. __, 133 S.Ct. 2304 (2013). In Concepcion, the U.S. Supreme Court held that the FAA bars any state laws (including judicial decisions) that set aside arbitration agreements or hold them to be unconscionable on grounds that are exclusive to arbitration agreements, as opposed to generally-applicable contract defenses and principles. In Italian Colors, the U.S. Supreme Court upheld the use of class action waivers in arbitration agreements and specifically rejected the argument that class arbitration was necessary to prosecute small claims that might otherwise slip through the legal system.

II.    Torrence v. Nationwide Budget Finance

The North Carolina Court of Appeals decided Torrence last month against this backdrop. Torrence involved a group of borrowers who received short-term consumer loans in North Carolina from an FDIC-insured Delaware bank. The loan agreements each contained identical arbitration provisions requiring arbitration for all disputes and waiving the borrowers’ right to participate in a class action related to the loans. Despite the arbitration agreement, the borrowers sued the defendants and sought class action certification for alleged violations of the North Carolina Consumer Finance Act, unfair trade practices laws and usury laws.

The defendants responded to the lawsuit with a motion to compel arbitration. The trial court denied the defendants’ motion and instead certified the case as a class action. In declining to compel arbitration, the trial court ruled that the North Carolina Supreme Court’s opinion in Tillman controlled its decision, and the arbitration agreement was substantively and procedurally unconscionable. The defendants appealed.

On appeal, the North Carolina Court of Appeals concluded the holdings of the North Carolina Supreme Court in Tillman conflict with those of the United States Supreme Court in Concepcion and Italian Colors. Because decisions of the United States Supreme Court are binding on issues of federal law, Tillman has been superseded for arbitration agreements governed by the FAA.

In reaching that determination, the Court of Appeals addressed each of the three factors recognized by Tillman in its substantive unconscionability analysis: (i) Italian Colors eliminated arguments over prohibitively high costs of arbitration, (ii) Concepcion eliminated arguments about one-sidedness and lack of mutuality, and (iii) both Concepcion and Italian Colors eliminated arguments about class action waivers because parties can “effectively vindicate” their rights in the context of a bilateral arbitration.

As has been customary since Tillman, the trial court had taken a great deal of evidence from the parties to conduct its substantive unconscionability review under the Tillman test. But, the Court of Appeals concluded that the “type of detailed analysis of the types of evidence required for plaintiffs to pursue their claims and of the potential costs of obtaining such evidence, at the state of the proceeding where the court determines whether the case should be sent to arbitration, is precisely the approach rejected by the United States Supreme Court in Italian Colors. This type of analysis, based upon extensive evidentiary presentation, is not only costly, but defeats the very purpose of arbitration, which is for the parties to have a quick, expedited resolution of their dispute.” This language should be music to the ears of defendants across North Carolina.

Courts will no longer consider substantive unconscionability arguments attacking the arbitration process called for in an arbitration agreement. Since Tillman requires both substantive unconscionability and procedural unconscionability to invalidate an agreement, the entire test fails and will not apply to agreements governed by the FAA.

Because the Court of Appeals based its decision on U.S. Supreme Court precedent and the FAA, it remains to be seen what effect, if any, Torrence will have on purely intrastate arbitration agreements governed by the North Carolina RUAA. The North Carolina Supreme Court may provide additional guidance in the coming months. The plaintiffs in Torrence filed petitions for discretionary review and for a writ of certiorari on March 11, 2014. Given the conflicts between its prior ruling and U.S. Supreme Court precedents, it is likely the state Supreme Court will grant review.

III.    Lessons from Torrence for Construction Industry Clients

Until the North Carolina Supreme Court weighs in, those in the construction industry should take away several key points from the Court of Appeals’ decision in Torrence.

If your construction contract affects or involves interstate commerce, your arbitration agreement just became much easier to enforce. The use of unconscionability attacks directed at the arbitration process can no longer serve as a basis to invalidate arbitration agreements. Courts will no longer weigh the relative costs of the arbitration. That and the fact the terms may be more onerous on one contracting party than the other or include class action waivers are no longer grounds to challenge the parties’ right (and obligation) to arbitrate.

Not sure whether your arbitration agreement affects or involves interstate commerce? Go ahead and designate it as the applicable law. Whether an agreement affects or involves interstate commerce is highly factual. It is generally a low bar, but not an insurmountable one. Choice of law provisions demonstrating the parties’ intent to apply the FAA to their arbitration agreement are generally binding in North Carolina. See King v. Bryant, 737 S.E.2d 802 (N.C. App. 2013). Note, however, that the opposite is not true. Agreements affecting interstate commerce will be subject to the FAA even where the parties designate a specific state’s law instead because the FAA is incorporated within state law by virtue of the Supremacy Clause of the United States Constitution.

If you do not have a class action waiver in your arbitration agreement, you need one. Class actions arbitrations and lawsuits are expensive and give plaintiffs tremendous leverage. After Torrence, class action waivers will be enforceable. Including them in your contracts should be the new normal, particularly for large material suppliers, tract home builders, warranty companies, lenders and other companies that regularly deal with consumers. Large contractors and other employers should also consider including class action waivers in their employment agreements to guard against class action wage and hour, discrimination and other employment-related lawsuits.

Arbitration agreements are still subject to challenge on grounds that apply to other contracts. Torrence, and the U.S. Supreme Court’s decisions in Concepcion and Italian Colors, only prohibit unconscionability attacks based on the arbitration process itself. Arbitration agreements can still be challenged based on generally applicable contract defenses, such as fraud, duress or unconscionability that is not directed at the arbitration process itself.

Inability of the named arbitrator to serve does not invalidate an arbitration agreement. During the Great Recession, a great many professional construction arbitration companies closed their doors. If your arbitration agreement identifies one of these defunct entities as arbitrator, it does not render the agreement unenforceable or incapable of being performed. The court in Torrence noted that Section 5 of the FAA specifically addresses situations where the arbitrator named in the agreement is unable to serve, or where the method agreed upon for the selection of the arbitrator fails. In those circumstances, the FAA permits either party to apply to the court to designate and appoint a substitute arbitrator. The key aspect of the analysis is the parties’ intent to arbitrate, not the identity of the arbitrator.

IV.    Conclusion
    
For now, Torrence applies to all arbitration agreements in North Carolina governed by the FAA. The North Carolina Supreme Court’s decision in Tillman, however, is still good law for contracts involving purely intrastate commerce where the parties have not specified the FAA as governing their agreement. We will continue to monitor the Torrence case as it moves forward on appeal and provide a further update once the Supreme Court has ruled. In the interim, however, we recommend that our construction industry clients revisit their own arbitration agreements to ensure they are taking full advantage of this important new development.

UPDATE:  On June 11, 2014, the North Carolina Supreme Court declined to hear the appeal of the Torrence decision. The Court of Appeals' decision will remain the law in North Carolina going forward.