Skip to main content

Key Points

  • Firms increasingly use arbitration clauses to limit consumers’ ability to pursue collective actions, foreclosing an important mechanism for remedy in the event of an abuse1.
  • In economic terms, the ability of firms to compel consumers to submit to arbitration clauses reflects their market power – the ability of a dominant firm or group of firms to impose uncompetitive terms because consumers lack alternatives.
  • Through an analysis of case settlements and the amount of revenue generated, Fideres has quantified in approximate terms the cost imposed on consumers by the imposition of an arbitration clause.
  • We find that in cases where an arbitration clause is imposed, and consumers could have otherwise brought a class action, the arbitration clause corresponds to a consumer loss of 5% to 16% of the transaction value.

Introduction

Class Actions as a Deterrent of Corporate Wrongdoing

Class action settlements often include behavioral clauses which commit the defendant to implement practice changes that are beneficial to harmed consumers. A study of class actions in 2006-2007 found that 75% of class action settlements included these behavioral clauses2. The same research compares six studies on class action settlements in the past, showing that the risk of class actions constitutes a deterrent against corporate wrongdoing.

Does Consumers’ Ability to Seek Legal Redress Have an Impact on Prices?

As a basic economic principle, the cost of goods and services should reflect the risk of abuse or manipulation by the seller. Buyers are willing to pay more for a product if they know that they can obtain compensation in the event the product is mis-sold or overpriced. Many firms offer warranties or free repairs to enhance the value of their products at the point of sale – the reassurance that a product or service will work as advertised helps to reduce the risk for consumers.

In a hypothetical scenario of perfect information, consumers would know exactly the quality of the product they are purchasing and how much they are paying for it. In reality, consumers cannot always foresee, nor appropriately quantify, externalities such as the risk of abuse by a seller. For example, a consumer who buys a wireless deal with a telecommunication company is not expecting to be overcharged for extra services they have not agreed to purchase3.

The fact that consumers have recourse to litigation serves as a form of implicit warranty on every transaction they enter into. Consumers’ ability to use the class action instrument increases the costs of corporations’ wrongful conduct, pushing firms to compete on prices that are transparent and innovate to improve product quality.

Conversely, consumers’ confidence in sellers’ products is positively impacted, because they are aware that sellers’ wrongdoing is mitigated by the risk of litigation.

All else equal, a product ‘guaranteed’ by the threat of class action litigation provides better value to consumers.

Enter Arbitration Clauses

Adoption of arbitration clauses in consumer contracts has significantly increased following a Supreme Court decision in 19914, growing from 2% in 1992 to over 55% in 20175.

Crucially, waiving the right to litigation precludes consumers from pursuing class action claims and forces them to seek individual redress. Given the expense and time investment required for an individual to pursue any form of legal action, including arbitration, this is nearly always infeasible. It is also wildly inefficient, as the legal expenses and burden on the court system are duplicated for each individual litigant.

Settling disputes through arbitration has numerous other disadvantages for consumers including:

  1. The cost of initiating arbitration is significantly higher than that of filing a lawsuit6, posing an initial barrier;
  2. Arbitration agreements can include total class action waivers and provide for limited discovery. This reduces the chances for plaintiffs to gain access to relevant information that may assist them in their actions for damages;
  3. Arbitration rulings cannot be appealed.

These factors make it hard for consumers to initiate an arbitration in the first place, providing, in many cases, a de facto immunity to the company to engage or continue the harmful behavior.

The Use of Market Power to Compel Arbitration

Even if consumers are not forced to enter into contracts with arbitration clauses, they often have no choice but to accept them. In many markets, consumers are left with a very unpalatable choice: either waive their right to class litigation or forego using a product altogether. For example, a consumer looking to subscribe to a mobile phone plan from one of the major telecommunication companies in the US cannot do so without accepting arbitration clauses.

In such cases, firms are exploiting their market power (their ability to dictate terms to customers due to a lack of an alternative). Under competitive conditions, firms insisting on arbitration clauses might face competition from firms that did not. When arbitration clauses become an implicit industry standard, firms are in effect tacitly colluding to provide their customers with a lower-value product or service – one which allows for no legal redress in the event of abuse.

Estimating the Cost of Arbitration Clauses

To quantify the harm of arbitration clauses, we analyzed a database of major class action lawsuits7 , examinig those lawsuits that were filed before the defendant introduced arbitration clauses in their consumer contracts. Because damages in these cases are, conceptually, the payments required to make consumers “whole” given an abuse, this figure quantifies the harm that would have been done by an arbitration clause preventing such redress.

As such, comparing the settlement amount with an estimate of the revenues generated from the harmful behavior, we can estimate the fraction of product revenues that companies must pay to cover damages, and the implicit “cost” of an arbitration clause. This ratio approximates the price discount that the company should offer, as a result of having imposed arbitration clauses to consumers.

Class Action Database

Fideres has analyzed five case studies of class action settlements

CaseDescriptionSettlement (million USD)Date Start
Toyota (Rust Frames)The lawsuit alleges that certain Toyota truck models have frames that were subject to rust, causing corrosion that could threaten the structural integrity of the trucks […]$3,4002005-2010
Western Union (Fraud)Western Union will provide $586 million in consumer refunds to settle a Federal Trade Commission and US Department of Justice complaint for failing to stop fraud-related wire transfers, including those committed by its own agents […]$586January 1, 2004 and January 19, 2017
Santander (Subprime Auto Loans)Santander agreed to a $550 million settlement regarding Santander’s auto loan practices […]$550before December 31, 2019
Ticketmaster (Order Processing Fees)Consumers who purchased tickets from ticketmaster.com from October 21, 1999 to February 27, 2013 and paid for an Order Processing Fee may be eligible for refunds […]$403 October 21, 1999 to February 27, 2013
JPMorgan Chase (Forced-Placed Insurance)JP Morgan Chase agreed to a $300 million settlement.  The lawsuit alleges that JP Morgan Chase forced consumers to purchase unnecessary expensive hazard insurance […]$300January 1, 2008 and October 4, 2013

Following their respective settlements, each of the companies in the above list imposed arbitration clauses into contracts relevant to the affected products.

CaseArbitration Clause
Toyota (Rust Frames) 8https://www.toyota.com/support/legal-terms/
Western Union (Fraud) 9https://www.westernunion.com/crewtransfer/pdfs/wucom_tc_mar19-en.pdf
Santander (Subprime Auto Loans) 10https://www.sec.gov/Archives/edgar/data/1383094/000119312517065852/d319087dex102.htm
Ticketmaster (Order Processing Fees)11https://help.ticketmaster.com/s/article/Terms-of-Use?language=en_US#section17
JPMorgan Chase (Forced-Placed Insurance) 12https://www.chase.com/content/feed/public/creditcards/cma/Chase/COL00095.pdf

Revenues Estimated for Relevant Products

We took a sample of cases from the database and calculated an estimate of the revenues generated by the relevant product. These estimates have different degrees of precision, depending on availability of historical prices and sales. For instance, data of Manufacturer’s Suggested Retail Prices (MSRP) and sales in each year of the class period was readily available for the Toyota case, conversely, a lack of data for the Ticketmaster case required us to estimate the value of order processing fees from 1999 to 2013.

CaseSettlement (million USD)Settlement / Revenue RatioEstimated Revenue from Product (million USD)
Toyota (Rust Frames)$3,40011%
$31,354
Ticketmaster (Order Processing Fees)$4035%
$8,660
Intuit (Turbotax) $14116%
$880
AT&T Mobility (Cramming)$10514%
$760
TracFone (Unlimited Data Plans)$40
7%
$585

The ratio between the settlement amount and the revenue from the relevant products shows that the size of damages that companies end up paying is between 5% and 16% of the revenues they have generated from that misconduct.

Arbitration clauses allow companies to reduce their costs at the expense of consumers, who are unaware that they are paying a price overcharge that is invisible to them at the time of purchase.

Conclusion

Although we have only analyzed a small number of sample cases, Fideres’s methodology allows us to estimate the real cost to consumers of arbitration causes.

We pose that the debate about the widespread use of arbitration clauses in the US is not exclusively confined to the legal realm but has real economic ramifications.

By restricting consumers’ ability to enforce their rights (especially in low value products) arbitration clauses can harm competition among firms and lead to uncompetitive prices and degraded product quality.

Sources:

1 A detailed investigation into this phenomenon was undertaken by the New York Times several years ago, available at: https://www.nytimes.com/2015/11/01/business/dealbook/arbitration-everywhere-stacking-the-deck-of-justice.html.

2 Fitzpatrick, Brian T. “Do Class Actions Deter Wrongdoing?” The Class Action Effect (Catherine Piché, ed., Éditions Yvon Blais, Montreal, 2018), Vanderbilt Law Research Paper 17-40 (2017).

See Federal Trade Commission v. AT&T Mobility LLC, Case No. 1:14-cv-03227-HLM.

4 Gilmer v. Interstate/Johnson Lane Corp.: 500 U.S. 20 (1991).

5 https://www.epi.org/publication/the-growing-use-of-mandatory-arbitration-access-to-the-courts-is-now-barred-for-more-than-60-million-american-workers/

6 One source estimates that $9,000 is needed to initiate a claim to arbitrate a contract claim worth $80,000, versus about $250 to file that action in state court. See https://www.nolo.com/legal-encyclopedia/arbitration-clauses-contracts-32644.html

7 https://www.consumer-action.org/lawsuits/by-status/closed

8 https://www.toyota.com/support/legal-terms/

9 https://www.westernunion.com/crewtransfer/pdfs/wucom_tc_mar19-en.pdf

10 https://www.sec.gov/Archives/edgar/data/1383094/000119312517065852/d319087dex102.htm 

11 https://help.ticketmaster.com/s/article/Terms-of-Use?language=en_US#section17

12 https://www.chase.com/content/feed/public/creditcards/cma/Chase/COL00095.pdf 

Leave a Reply