Arbitration Clauses, Class Actions and State Tax

What a funny combination of terms. You might be asking what state tax has to do with arbitration and class action suits. Two recent court decisions illustrate the connection.

In particular, a “bad day” for a corporate executive is receiving the complaint and summons for a class action lawsuit. While there have been fewer class action lawsuits in connection with state taxes than there have been in other areas of the law, the plaintiff’s bar has looked at state tax as a development opportunity and has commenced suits for inappropriate collection of state taxes. The basis commonly used for such a suit is that the state’s unfair and deceptive trade practices statute is violated by the collection of sales tax if such tax is not due. For example, a company might be collecting tax on food in a state in which food is not taxable. A better example would be collecting tax on Internet access, which is prohibited under a federal statute, the Internet Tax Freedom Act, 47 U.S.C. § 151n (1998) (“ITFA”), as amended, unless a state is grandfathered.

AT&T found out the hard way about class action lawsuits in the state tax area. It was collecting tax on Internet access services. Under the ITFA, it was prohibited from collecting such tax in all but a few states. Thus, as I wrote in my blog post of September 17, 2010, AT&T was slammed with a class action lawsuit, and settled for payment of millions of dollars of attorneys’ fees and other costs.

AT&T also recently discovered that there is a way to preclude such class action suits, at least in Texas. In particular, AT&T provided in its agreements with customers that the exclusive basis for resolving all disputes relating to its service was arbitration. When a class action lawsuit was brought against AT&T by Texas consumers for collecting tax on Internet access charges less than $25.00 (Texas, a grandfathered state, imposes tax only on Internet access charges in excess of $25.00 per month), AT&T filed a motion to dismiss the suit based on the arbitration clause in its agreement. Construing the clause broadly, the U.S. District Court for the Southern District of Texas ruled in the case of Stephen T. Johnson v. AT&T Mobility, LLC (12/21/2010), that the clause should be read to include disputes regarding the collection of sales and use tax. Thus, the court dismissed the class action lawsuit and stated that each customer would be required to bring its own dispute in arbitration. If such decision is sustained on appeal, it will significantly limit AT&T’s exposure.

Whether an arbitration clause will in all instances require potential plaintiffs to present their claims in private arbitration rather than public litigation will depend upon a number of factors, but any company doing business with consumers should consider the use of arbitration clauses as a means to resolve disputes. This, of course, is particularly appropriate in the case of a telecom company, but it can be used for Internet retailers and other direct marketers, as well.

The Conservative Approach of Over-Collection of Sales Tax Is Perilous

Many companies (and their advisors) believe there is no harm in “over-collecting” sales tax and, therefore, erring on the side of collection of tax in gray areas.  But that is a very risky course of action, as AT&T recently found out.

It seems that AT&T was collecting sales and use tax on Internet service it provided to customers.  It did so, despite the federal Internet Tax Freedom Act, 47 U.S.C. § 151 n. (1998), as extended and amended by the Internet Tax Nondiscrimination Act, P.L. 108-435 (2004) and the Internet Tax Freedom Act Amendments Act of 2007, P.L. 110-108 (2007), which prohibits states from imposing taxes on Internet access, with the exception of certain grandfathered states.  Even a company of the size of AT&T apparently got it wrong, since it continued to collect tax on Internet access in all states.  Its customers reacted, and commenced a class action law suit against AT&T.

AT&T recently settled the lawsuit with the class action plaintiffs at significant expense to AT&T.  See In re AT&T Mobility Wireless Data Services Sales Litigation, MDL No. 2147, Case No. 10 C 2278 (N.D. Ill. Aug.11, 2010).  While AT&T is not obligated to refund to the plaintiffs any amounts not refunded to AT&T by a state, it is required to seek such refunds.  If it obtains a refund, AT&T, of course, must distribute the amounts it receives to its customers, but it doesn’t have to dip into its own pocket to do so.

So, you say, what is the harm to AT&T?  As part of the settlement, AT&T is required to pay the cost of notice to each member of the class.  Given the size of the class, this likely will be a substantial cost.  In addition, AT&T must pay a contingency fee to the lawyers for the class action plaintiffs, which is generally based on the value of the settlement, and can be millions of dollars.  Thus, far from being an income neutral proposition for AT&T, AT&T’s decision to collect tax created a large expense to it.

The conclusion to be drawn is that retailers need to be very careful to make sure they get it right.  To simply err on the side of over-collection may prove to create substantial exposure.  Rather, the true amount due must be collected.  If a retailer gets in a bind by over-collecting, the state will not compensate the retailer for its additional expenses.