Although perceptions of unfairness have long followed them, it took just one lawsuit to knock two leading arbitration associations out of the consumer debt resolution game. After a year-long investigation, Minnesota Attorney General Lori Swanson filed suit July 14 against the National Arbitration Forum (NAF) for deceptive practices, alleging it hid financial ties with debt-collection companies and law firms.

NAF refuted the charges and settled the lawsuit July 19.

But it was an unequivocal win for Swanson and fellow opponents of consumer debt arbitration: In settling,

NAF agreed to permanently stop administering arbitration for consumer debt cases. The American Arbitration Association (AAA) followed suit July 21, announcing it would not administer consumer debt arbitration until Congress recommends reforms.

And those reforms might be coming sooner rather than later.

On the heels of NAF’s settlement, the House Subcommittee on Domestic Policy released the results of an investigation it initiated in fall 2008 into NAF’s practices. The report alleges numerous abuses by NAF, including lax enforcement of due process and, in 46 states, closed proceedings that obscure its methods and make it difficult to determine fairness. The committee also held a July 22 hearing to review the fairness of mandatory predispute arbitration for consumer debt.

With legislation in committee to ban mandatory arbitration clauses from consumer and employment contracts, and momentum rapidly swinging arbitration out of public favor, companies that rely on consumer arbitration agreements to limit lawsuits are preparing for a more litigious–and expensive–post-arbitration world.

Standard Practice

Arbitration clauses became standard in credit card agreements to help companies avoid litigation, says William O’Connor, chair of Crowell and Moring’s financial services group. Arbitration provides a quick, cheap way for companies to resolve consumer debt disputes without the necessity of counsel.

Questions of fairness arise, however, because agreements are often involuntary–people must agree to arbitration to get a credit card. “So that raises an issue of fairness because consumers aren’t generally represented by counsel in these transactions,” O’Connor says.

In 2007, a Public Citizen study of 34,000 arbitration cases in California, primarily administered by NAF, determined arbitration is heavily biased against consumers.

NAF ruled in favor of companies 94 percent of the time, according to the study. In a single day, one arbitrator ruled in favor of the companies in all 68 cases he adjudicated. “The arbitrators are basically rubber-stamping based on very little information,” says Graham Steele, policy counsel at Public Citizen.

Others argue, however, that the type of cases businesses bring to arbitration largely contributes to why arbitrators often rule in favor of companies.

“A lot of cases that NAF handled were collection cases where the consumer failed to pay a debt on his credit card,” says Sarah Cole, director of the Program on Dispute Resolution at the Moritz College of Law at The Ohio State University. “The only question [in such cases] is how much money the credit card company will collect from that consumer. Very few consumers win those cases in court, and very few consumers win those cases in arbitration because they already owe the money.”

Businesses won relief in 83.6 percent of collection cases they filed with AAA during the course of a study released in March and conducted by the Searle Civil Justice Institute at Northwestern University School of Law. In that study, consumers won relief in 53.3 percent of the cases they brought against businesses. The second part of the study, which is underway, will examine how consumer debt collection cases fare in court.

“When you compare debt collection cases in arbitration to debt collection cases in court, the results start looking pretty darn similar,” says Christopher Drahozal of preliminary results for the next phase of the study. Drahozal testified in the July congressional hearings and authored the Searle study. “It doesn’t necessarily mean arbitration and litigation are the same, but it undercuts any suggestion that you can tell arbitration is unfair because businesses win more of the cases.”

Debated Decisions

Whether or not arbitration is fair, the NAF lawsuit won’t help public perception, Cole says. “I don’t think most people are going to look at it as an isolated situation,” she says.

NAF’s alleged irresponsibility runs deep. According to the complaint, NAF partnered with some of the largest debt collection companies in the country, which invested tens of millions of dollars in the Forum and held partial governance in it. Swanson also alleged NAF lobbied credit card companies to include arbitration clauses in consumer agreements. While credit card companies still take a significant number of collection cases to court, she claimed NAF encouraged creditors to opt for arbitration, even though they advertised impartiality to customers.

The Forum does not admit fault in the settlement, but said in a statement it simply couldn’t afford to fight the charges in court. Former NAF CEO Mike Kelly, now CEO of Forthright, an NAF affiliate, cited legal fees, the economic climate and the uncertain future of arbitration as reasons to settle the suit and withdraw from handling consumer arbitrations.

Regardless of whether any corporate misconduct occurred, it’s unlikely to have affected the outcomes of arbitrations, says Alan Kaplinsky, chair of the consumer financial services group at Ballard Spahr Andrews & Ingersoll.

“The arbitrators were not employees of NAF,” he says. “They were independent people, many of them prominent retired judges, hired to arbitrate matters. My guess is they didn’t know anything about NAF’s ownership affiliations.”

But even if arbitrators didn’t know about NAF’s affiliations, the congressional report alleges the Forum stopped sending cases to an arbitrator in Maine who didn’t rule primarily in favor of businesses. The Public Citizen report said the large number of cases it found to be handled by the same small group of arbitrators was evidence NAF preferred arbitrators who favored corporations, citing an instance where NAF stopped sending cases to a law professor after she awarded $48,000 to a consumer in a case a credit card company filed.

While the possibility that NAF’s arbitrators were influenced by other parties is troubling, Coles says the question will likely remain unanswered. “Unquestionably there are bad cases in arbitration, just as there are bad cases in court,” she says. “But as a whole, I don’t think arbitration disadvantages consumers in the way some of these anti-arbitration groups portray it.”

Crowded Courtrooms

With both NAF and AAA bowing out of the consumer debt arbitration business, experts say the number of lawsuits to collect consumer debt will increase significantly. And if legislation barring mandatory arbitration clauses passes, companies are likely to see an increase in class action lawsuits since many of those clauses contain provisions prohibiting them.

Only a few major credit card issuers have sought arbitration to recover debt, but Kaplinsky says that each of those issuers brought a large number of cases–and NAF handled most of them. “Unfortunately, all those matters are going to end up in the court system, which can’t deal with the volume of collection cases it’s already handling,” he says. “The net result is to dump more cases on a court system that is not doing a very good job of handling collection cases to begin with.”

Kelly echoed these sentiments in his statement on the NAF settlement.

“Without access to arbitration, consumer disputes will now be forced into an overcrowded and underfunded legal system, where many consumers who cannot afford attorneys will have to navigate complex court procedures,” he said. “The consequence to American consumers is that there will be no meaningful alternative to costly and unpredictable litigation.”

But court provides one big advantage to consumers: the ability to appeal a ruling, Steele says. “There isn’t a chance for consumers to participate in the process [of arbitration],” he says. “If consumer loses, it’s next to impossible to vacate the arbitration award.”

Because there are consequences on all sides if arbitration ceases to be an option for collecting consumer debt, many are urging reform rather than complete elimination.

“If there are abusive practices, you can deal with the abusive practices,” Drahozal says. “Congress needs to consider that not all arbitration is the same.”