Internet arbitration clauses: shock and awe?

It is trite law that in Scotland the courts will regard a contractual agreement to resolve disputes by arbitration as highly persuasive (Hamlyn & Co v Talisker (1894) 21R (HL) 21) and also as good reason to sist proceedings, provided the motion is made in time. The law does not oust the jurisdiction of the court from consideration of contracts containing arbitration clauses, but “where the claim or dispute in question falls firmly within the terms of the arbitration clause it will only be in the most exceptional cases that the court will interfere to prevent the matter being resolved by arbitration” (Orkney Islands Council v Charles Brand Ltd, 2002 SLT 100).

Many internet contracts, especially those originating in the US, contain onerous dispute resolution provisions, requiring arbitration in a particular US state or place. Frequently the terms and conditions of contract on a website, or for downloaded materials, are clicked through unread. In the cause of EU consumer contracts, this hazardous approach at least attracts the benefit of the statutory cooling off period under the Consumer Protection (Distance Selling) Regulations 2000 (SI 2000/2334), which transpose into UK law EU Directive 97/7/EC).

At present there is no reported Scottish case dealing with arbitration in the context of internet contracts. But an indication of the sort of issues that may in future arise in these situations can be found in the recent US “class action” against PayPal (Craig Comb and Roberta Toher v Paypal, Inc, District Court for the Northern District of California San Jose Division, case no C-02-1227 JF (PVT)). Here the plaintiffs sought injunctive relief on behalf of a purported nationwide class for alleged violations of state and federal law by PayPal. The company filed a motion to compel individual arbitration pursuant to the arbitration clause contained in its standard user agreement and the Federal Arbitration Act.

PayPal customer complaints

PayPal is an online payment service that allows a business or private individual to send and receive payments via the internet. A PayPal account holder sends money by informing Paypal of the intended recipient’s email address and the amount to be sent and by designating a funding source such as a credit card or bank account. PayPal accesses the funds and immediately makes them available to the intended recipient. PayPal generates revenue from transaction fees and the interest it derives from holding funds until they are sent. In the first three quarters of 2001 Paypal experienced a sudden increase in its popularity, growing from around 10,000 to 10.6 million accounts – 8.5 million of which were held by private individuals.

The plaintiffs alleged, in short, that PayPal had grown too fast; that it was making damaging errors with transactions while failing to deal with complaints. Craig Comb, not even a PayPal customer, alleged that without his knowledge, consent or authorisation, PayPal removed sums from his bank account. As a result the bank charged him $208.50 (£122.65) for not maintaining his required balance.

Roberta Toher alleged that she opened a PayPal account sometime in 2000. PayPal failed to provide her with the name, address, and telephone number of a person she should notify in the event of an unauthorised electronic transfer. On 24 February 2002, Toher discovered that PayPal had transferred funds from her cheque account to four individuals without her knowledge, consent or authorisation. Her attempts to contact PayPal were largely unsuccessful.

Jeffrey Resnick alleged that he registered an account with PayPal and linked his email address to that account. A third party appropriated Resnick’s PayPal username and password and linked an almost identical email account to Resnick’s PayPal account. The third party sold two Apple Computers on eBay, and the buyers deposited their payment into the fraudulent account. When the buyers did not receive their product, they filed a complaint with PayPal, which without notice or explanation then restricted Resnick’s (legitimate) account.

The arbitration clause

PayPal’s user agreement contains an arbitration clause by which “Any controversy or claim arising… shall be settled by binding arbitration in accordance with the commercial arbitration rules of the American Arbitration Association. Any such controversy or claim shall be arbitrated on an individual basis, and shall not be consolidated in any arbitration with any claim or controversy of any other party. The arbitration shall be conducted in Santa Clara County, California, and judgment on the arbitration award may be entered in any court having jurisdiction thereof.”

Although California has a strong policy favouring arbitration, contractual defences, such as fraud, duress, or unconscionability, may be applied to invalidate arbitration agreements.

Dangers of unconscionability

The court proceeded on the assumption that there was a submission to arbitration. The plaintiffs argued that the user agreement and the arbitration clause were unconscionable. The judge accepted that in the US unconscionability has both procedural and substantive components. The procedural component is satisfied by the existence of unequal bargaining positions and hidden contractual terms. The substantive is satisfied by “overly harsh or one-sided results that shock the conscience”. The two elements operate on a sliding scale, so that the more significant one is, the less significant the other need be. Each case turns on its facts.

The concept of unconscionability is more familiar to English lawyers, notably in the area of estoppel. However its existence in Scots law has recently been restated (City Inn v Shepherd Construction 2002 SLT 781). Unconscionability normally arises in disputes about contractual terms that are so oppressive as to amount to a penalty clause, which as such is unenforceable. In City Inn, the court in discussing the nature of a penalty clause held that such a clause “does not constitute a genuine pre-estimate of the loss likely to be suffered by the latter party as a result of the relevant breach of contract, but is instead unconscionable in respect that it is designed to operate in terrorem, or oppressively or punitively”. This language clearly echoes the “shock the conscience” terminology adopted in the PayPal case.

PayPal argued, relying on Dean Witter Reynolds, Inc v Superior Court, 211 Cal App 3d 758, 769 (1989), that their arbitration clause was not procedurally unconscionable because it did not concern essential items such as food or clothing and because the plaintiffs had meaningful alternative sources for the subject services. However the District Court rejected this, noting that in Dean Witter, the party asserting unconscionability was “a sophisticated investor” whereas in the PayPal case, the amount of the average transaction was $55, the vast majority of PayPal customers were private individuals who were not “sophisticated,” and there was at least a factual dispute as to whether PayPal’s competitors offer their services without requiring customers to enter into arbitration agreements.

Overall reasonableness

In the US an unconscionable clause can still be enforced if its terms are overall reasonable (Craig v Brown & Root, Inc, 84 Cal App 4th 416, 422-423 where an arbitration clause was enforced). The court in PayPal therefore assessed reasonableness by looking at (a) lack of mutuality in the user agreement, (b) the practical effects of the arbitration clause with respect to consolidation of claims, (c) the costs of arbitration, and (d) forum.

Mutuality. Section V(3) of the user agreement stated that in the event of a dispute, PayPal “at its sole discretion” may restrict accounts, withhold funds, undertake its own investigation of a customer’s financial records, close accounts, and procure ownership of all funds in dispute unless and until the customer is “later determined to be entitled to the funds in dispute”. PayPal alone makes the final decision with respect to a dispute. The user agreement “is subject to change by PayPal without prior notice (unless prior notice is required by law), by posting of the revised Agreement on the PayPal website’’. PayPal argued that the user agreement did not lack mutuality because nothing in the agreement precludes a customer from using the court system to seek relief. This argument failed: PayPal could not show that “business realities” justified such one-sidedness.

Prohibition against consolidation. The arbitration clause prohibits PayPal customers from consolidating their claims. But in Szetela v Discover Bank, 97 Cal App 4th at 1094 the court determined that a large credit card company could not enforce the prohibition with respect to consumer claims against it because in practice most claims would involve consumers seeking the return of small amounts of money, and any remedy obtained by the few consumers who would not be dissuaded from pursuing their rights would pertain only to those consumers without collateral estoppel effect. The court concluded that such circumstances raise the “potential for millions of customers to be overcharged small amounts without an effective method of redress”. PayPal’s prohibition against consolidation was held unreasonable.

Costs of arbitration. The plaintiffs claimed that the cost of an individual arbitration under the user agreement was likely to exceed $5,000. Further, because the arbitration clause was silent as to who bore the cost of arbitration, under California law each party was required to pay a pro rata share of costs. The court concluded that these aspects of the arbitration clause were so harsh as to be unconscionable.

Forum. The user agreement required that any arbitration must take place in Santa Clara County, California. The judge was scathing, holding that “limiting the venue to PayPal’s back yard appears to be yet one more means by which the arbitration clause serves to shield PayPal from liability instead of providing a neutral forum in which to arbitrate disputes”.

Paypal’s motion to force individual arbitration in California was denied: a welcome victory for the little guys.

Paul Motion is a partner with Ledingham Chalmers, Edinburgh; and the Convener of the Law Society of Scotland’s E-Commerce Committee.