Arbitration with Uninformed Consumers

Mark Egan is an assistant professor at Harvard Business School; Gregor Matvos is a professor at the University of Texas at Austin McCombs School of Business; and Amit Seru is the Steven and Roberta Denning Professor of Finance at the Stanford Graduate School of Business. This post is based on their recent paper.

Arbitration is a private mechanism for resolving disputes outside of the court system. In arbitration the contracting parties present their case to a private arbitrator who then issues a legally-binding resolution to the dispute. When consumers purchase a product or service, the purchase often contains a pre-dispute arbitration provision, which legally mandates that the consumer must resolve any related dispute using arbitration. Moreover, the provision prohibits the consumer from suing the seller in court. Such arbitration clauses have become increasingly common in the U.S. and are currently used by all brokerage firms, the largest insurance companies (e.g., AIG, Aetna, Inc., etc.), the largest financial firms (e.g., American Express, Chase Bank, etc) and are also pervasive among non-financial “new economy” firms (i.e. Amazon, Verizon, Uber, etc.). Despite the prevalence of arbitration clauses in resolving consumer disputes spanning trillions of dollars of economic activity, there is little empirical analysis of the arbitration. Arbitration is also a hot button policy issue; in 2017 the Consumer Financial Protection Bureau unveiled a controversial consumer arbitration rule, which was later overturned by the U.S. Congress. In our paper Arbitration with Uniformed Consumers we examine consumer arbitration in the securities industry using a new detailed data covering 9,000 arbitration disputes between consumers and their financial advisers.

A central feature of arbitration is the ability of both parties to explicitly exert control in the arbitrator selection process. For example, in securities arbitration, each party is presented with a randomly generated list of arbitrators and can influence the arbitrator selection process by striking a limited number of arbitrators from the list. This is a notable difference compared to judicial proceedings, where judges are assigned to cases, and is touted as one of the advantages that arbitration has over the judicial process. Practitioners strongly believe that choosing an arbitrator can significantly affect the case outcome: “the selection of an appropriate arbitrator or arbitration tribunal is nearly always the single most important choice confronting parties in arbitration” (Protocols for Expeditious, Cost‐Effective Commercial Arbitration, 2010).

The full quote reads “It has been said that `the arbitrator is the process.’ This is not mere hyperbole: while the appropriate institutional and procedural frameworks are often critical to crafting better solutions for business parties in arbitration, the selection of an appropriate arbitrator or arbitration tribunal is nearly always the single most important choice confronting parties in arbitration” (Protocols for Expeditious, Cost‐Effective Commercial Arbitration, 2010)

The arbitrator selection process is based on the premise that arbitrators differ, and do so in terms of how favorable they will be to either party. Consistent with this intuition, we find empirical evidence suggesting that there are large persistent differences across arbitrators. Some arbitrators are systematically industry friendly while others are consumer friendly, and the differences are substantial. Our estimates suggest that, all else equal, a one standard deviation more industry friendly arbitrator grants awards that are 12 percentage points (pp) smaller (relative to the award requested). For a median case request ($175,000), this would translate to the consumer receiving $21,000 less.

Given that both firms and consumers can eliminate arbitrators on the randomly generated list who are biased against them, one might expect that the selected arbitrators would not be biased. Instead, we find that industry friendly arbitrators, those that grant lower awards, are more likely to be selected again relative to arbitrators who are consumer friendly. Industry friendly arbitrators are roughly forty percent more likely to be selected in a given year than their consumer friendly counterparts. In other words, our results suggest that firms are systematically better at selecting arbitrators than consumers. This advantage in selecting in in the pool of arbitrators is large, decreasing award amounts by about 2pp (relative to the award requested) or roughly $16,000, on average.

Firms’ informational advantage in selecting arbitrators likely comes from their additional experience in arbitration. While most consumers will participate in arbitration typically at most once in their lifetime, the average firm in our sample participates in roughly 100 different arbitration cases. We find that some consumers are able to compensate for their lack of personal experience by hiring attorneys who specialize in arbitration (PIABA members), faring better in arbitration. Of course, the knowledge that specialized attorneys exist, and how to find them already requires a certain level of familiarity and sophistication with arbitration. Overall, these findings suggest that the parties’ level of sophistication and experience plays a potentially critical role in the arbitrator selection process.

Unlike judges, arbitrators are only compensated if they are selected to arbitrate a case. Because industry friendly arbitrators are more likely to be selected, arbitrators are potentially incentivized to develop a reputation for being industry friendly. Arbitrators therefore compete to be selected on the arbitration panel by choosing their slant: how industry or consumer friendly they will act. To better understand and interpret our findings, and to quantify the effects of the current arbitrator selection process, we develop and calibrate a stylized model of arbitrator selection. In the model sophisticated firms observe arbitrators’ reputations, i.e. how industry or consumer friendly arbitrators are, and use this information to eliminate arbitrators, while uninformed consumers strike arbitrators randomly. Arbitrators compete with each other to be selected to arbitrate a case and compete with other arbitrators.

A key result of the model is that even though the underlying population of arbitrators may be unbiased, competition among arbitrators can drive all arbitrators to intentionally slant their case decisions. In fact, under a benchmark in which arbitrators only want to maximize their monetary payoffs, no arbitrator wants to be the least industry friendly arbitrator. This induces extreme competition between arbitrators, resulting in all arbitrators being maximally industry friendly. Intuitively, competition between arbitrators exacerbates the informational advantage of firms in equilibrium when consumers are uninformed. Our model estimates suggest that randomly selecting arbitrators—as opposed to selecting them using the current mechanism where firms have informational advantage over consumers—would increase investor awards by 5pp, or $40,000 on average. Moreover, several proposals which are aimed at improving customer outcomes in arbitration, such as increasing arbitrator incentives, lead to more industry friendly arbitration, once firms’ information advantage is accounted for.

While our analysis focuses on arbitration in the securities industry, the insights from our setting likely extend to consumer arbitration more broadly. In our setting, the arbitrator selection process results in biased outcomes because (i) both firms and consumers have control over the arbitrator selection process, and (ii) firms have an informational advantage in selecting arbitrators over consumers. Both of these features are common across other consumer arbitration forums such as the American Arbitration Association (AAA) and the Judicial Arbitration and Mediation Services, Inc. (JAMS). Using data on JAMS and AAA arbitration proceedings available online, we replicate our main findings in these settings, with the caveat that data are relatively sparse and span a wide range of industries and cases, leading to noisier estimates of arbitrator bias and selection. Nevertheless, our analysis suggests that our results may apply to consumer arbitration beyond just financial services.

Our results suggest that the current arbitrator selection mechanism employed in the securities industry and across other forums results in biased, industry friendly arbitration outcomes. Because firms are naturally more experienced in selecting arbitrators than consumers, industry friendly arbitrators are systematically selected to arbitrate more often which further incentivizes arbitrators to slant their award decisions in favor of the industry. These findings imply that increased disclosure, arbitrator term limits, expanding the list of available arbitrators, or lowering arbitrator incentives could improve outcomes for consumers.

The complete paper is available here.

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One Comment

  1. Larry Myers
    Posted Wednesday, April 10, 2019 at 6:38 pm | Permalink

    From my research, consumers should assume an arbitrator to be biased against consumers. Where there is a forced arbitration agreement, consumers are left to finding whatever tools they can with which to play hardball, per se, in order to coerce arbitrators to put aside their industry-leaning biases and render decisions based on actual law in the interest of actual justice.

    In Texas, a “public servant” is a person elected, selected, appointed, employed, or otherwise designated as an arbitrator, referee, or other person who is authorized by law or private written agreement to hear or determine a cause or controversy, even if he has not yet qualified for office or assumed his duties. Texas Penal Code § 1.07(a)(41)(C).

    “A person acts intentionally, or with intent, with respect to the nature of his conduct or to a result of his conduct when it is his conscious objective or desire to engage in the conduct or cause the result.” Texas Penal Code § 6.03(a). “A person acts knowingly, or with knowledge, with respect to the nature of his conduct or to circumstances surrounding his conduct when he is aware of the nature of his conduct or that the circumstances exist. A person acts knowingly, or with knowledge, with respect to a result of his conduct when he is aware that his conduct is reasonably certain to cause the result.” Texas Penal Code § 6.03(b).

    A public servant commits Official Oppression when he/she acts under color of his/her office or employment with intent and knowledge that his/her conduct is unlawful and subjects another to mistreatment (Texas Penal Code § 30.03(a)(1)) or denies or impedes another in the exercise or enjoyment of any right, privilege, power, or immunity. Texas Penal Code § 30.03(a)(1). Think substantive and procedural due process, equal protection of law &c., and realize that most arbitration agreements require an arbitrator to render decisions in accordance with state law. Official Oppression is a Class A misdemeanor (Texas Penal Code § 30.03(d)) punishable by a fine of up to $4,000, confinement in jail for up to one year, or both such fine and confinement (Texas Penal Code § 12.21).

    Fortunately, in Texas people have a statutory right to take criminal complaints directly to magistrates, grand juries and/or state prosecutors (police officers do not have to be involved and, in my experience, should be bypassed at every feasible opportunity).

    The above culminates in only one of many tools/tactics available for consumers to combat those who may be inclined to subject consumers to injustice in the name of personal greed. Many in the legal profession will likely look upon the use of such tools as dishonorable and “dirty.” However, in most cases, arbitration seems to be a game heavily-rigged against consumers, and one which will rarely be won by any consumer who does not play as dirty as the people (arbitrators) who render arbitration awards.

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