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Legal Update

Will California Strike Again? The Latest Word From the California Supreme Court On Enforcing Arbitration Agreements

29 October 2013
Mayer Brown Legal Update

The California Supreme Court has a long history of inventing new rules—either from common law or as “glosses” on statutes—to invalidate arbitration agreements entered into by consumers and employees. For example, in 2005, that court announced a new unconscionability rule—the“Discover Bank” doctrine, which was named after one of the parties to the case—that effectively blocked enforcement of every consumer arbitration agreement that did not permit class procedures. The U.S. Supreme Court’s landmark decision in AT&T Mobility LLC v. Concepcion held that the Federal Arbitration Act (“FAA”) preempted the Discover Bank rule.

Will the California Supreme Court faithfully apply Concepcion and the U.S. Supreme Court’s other recent rulings overturning lower courts’ refusals to enforce arbitration agreements? Or will it try to formulate new grounds for prohibiting arbitration, requiring the U.S. Supreme Court to intervene yet again to vindicate the Federal Arbitration Act’s “liberal federal policy favoring arbitration agreements, notwithstanding any state substantive or procedural policies to the contrary.” With four significant arbitration cases now pending before the California Supreme Court, we are likely to find out in the next 12 to 24 months.

The first of these decisions, handed down on October 17 in Sonic-Calabasas A, Inc. v. Moreno—in which our firm filed an amicus brief—contains a distinctly mixed message. In response to the U.S. Supreme Court’s order granting certiorari and vacating and remanding the case in light of Concepcion, the California Court overturned its own prior ruling invalidating the arbitration agreement, correctly holding that its original rationale could not stand. In an opinion by Justice Liu, the Court went on to discuss—although not explicitly mandate—a brand-new approach to unconscionability analysis that reintroduces the precise legal principle that the U.S. Supreme Court held preempted in Concepcion and rejected again this year in American Express Co. v. Italian Colors Restaurant. And it does so through an unconscionability standard specially constructed to apply only to arbitration contracts, notwithstanding the FAA’s express preemption of arbitration-specific contract enforcement standards.

Did the California Supreme Court, finding its prior decision clearly precluded by Concepcion, decide to create a new basis for refusing to enforce arbitration agreements that is different in appearance but the same in effect as its now-invalid ruling? The court’s musing about unconscionability doctrine is not tethered to any holding, because the court specifically leaves the question of unconscionability for determination on remand. And the court repeatedly says that its new analysis is simply “one factor” that could be considered in the unconscionability inquiry.

Even more important, the majority’s musing does not actually require a lower court to do anything in any particular case. As Justice Corrigan, who joined the majority, explained in her concurring opinion, the decision “does not require trial courts to adopt a new procedure or analytic approach”; rather “[c]onsiderations outlined in the majority’s opinion may be relevant to [unconscionability] analysis, but lower courts retain discretion to weigh these considerations as appropriate in each particular case.” That qualification is important, because if a California court were to apply this new test to invalidate an arbitration agreement, that ruling plainly would be subject to reversal on the ground that such state-law rulings are preempted on multiple grounds by the FAA.

Companies defending arbitration clauses in California now must be prepared to explain why, as a matter of California law, courts should not—indeed, must not—rest an unconscionability finding on this new analysis, as well as why a refusal to enforce an arbitration agreement based on the California Supreme Court’s new rationale would violate the FAA. If the California courts do not heed those warnings, the state’s law of unconscionability is on track for a return trip to the U.S. Supreme Court.

Sonic’s Background

Sonic involved an arbitration agreement that was part of an employment contract. The employee filed a claim for unpaid vacation pay with the state Labor Commissioner, invoking an administrative procedure known as the “Berman hearing,” which is an alternative to instituting an action in court. According to the California Supreme Court, that administrative procedure “is designed to provide a speedy, informal, and affordable method of resolving wage claims” through, for example, permitting only limited pleadings and requiring an expedited decision by the Labor Commissioner.

In its initial decision, the California Supreme Court refused to require arbitration, holding that a party dissatisfied with the outcome of the Berman hearing could then seek a de novo determination in arbitration (paralleling the statutory right to a de novo determination in court). The court held that substituting arbitration for the Berman hearing rendered the arbitration agreement unconscionable, because the agreement constituted a waiver of the employee’s statutory “right” to a Berman hearing. The court thus adopted an across-the-board rule refusing to compel arbitration of claims in which an employee had invoked the Berman procedures.

Following the Concepcion ruling, the U.S. Supreme Court vacated and remanded Sonic for reconsideration.

Categorical Prohibition of Arbitration Abandoned

The California Supreme Court reversed its prior decision, concluding that “[i]n Concepcion, the high court clarified the limitations that the FAA imposes on a state’s capacity to enforce its rules of unconscionability on parties to arbitration agreements.” Because “compelling the parties to undergo a Berman hearing would impose significant delays in the commencement of arbitration” and “‘efficient, streamlined procedures’ is a fundamental attribute of arbitration with which state law may not interfere,” the prior Sonic ruling could not stand: “[W]e now hold, contrary to Sonic I, that the FAA preempts our state-law rule categorically prohibiting waiver of a Berman hearing in a predispute arbitration agreement imposed on an employee as a condition of employment.”

But the court did not stop there.

Concluding that the employee in Sonic had also argued that the arbitration agreement was unconscionable, the California Supreme Court directed the superior court to address the unconscionability issue on remand.

If the California Supreme Court had ended its opinion at that point, there would be no question regarding its compliance with the U.S. Supreme Court’s rulings. But the California court instead embarked upon on a wide-ranging discussion of unconscionability doctrine in the context of arbitration agreements. That is where the court went astray.

A New Unconscionability Doctrine For (Some) Arbitration Agreements?

The starting point for the California court’s discussion was correct—arbitration agreements are subject to unconscionability standards as long as those standards also apply to other types of contracts. But the new mode of unconscionability analysis identified in Sonic is unique—it is unlike the unconscionability test that California courts apply in every other context.

Sonic says that, although the arbitration agreement’s elimination of the Berman administrative procedures cannot by itself bar enforcement of the arbitration agreement, a court may evaluate the dispute-resolution process specified in the arbitration agreement against the Berman procedures in order to determine whether the arbitration agreement provides a similarly “effective and low-cost approach to resolving wage disputes.” If the arbitration process falls short of the Berman procedures, that is “one factor” that a court may consider in the unconscionability inquiry, “although that factor alone does not necessarily render the agreement unconscionable.”

As a threshold matter, it is important to recognize the limited scope of the court’s new principle: it applies only where a legislature has created a special administrative procedure for adjudication of a specified category of claims. As the court put it, “[b]oth California and federal law treat the substitution of arbitration for litigation as the mere replacement of one dispute resolution forum for another, resulting in no inherent disadvantage”; it is only where “a particular class has been legislatively afforded specific protections in order to mitigate the risks and costs of pursuing certain types of claims”—through the creation of an administrative forum—that the test can even possibly apply.

But in that limited context, the Sonic court claimed that its new approach was no different than other sorts of unconscionability rules that have been applied to arbitration agreements—such as invalidating agreements that require an employee or consumer to pay arbitration filing fees or arbitrator costs that greatly exceeded court filing costs, confer on the party with superior bargaining power the right to select the arbitrator, limit the amount of damages recoverable in arbitration, or give only the party with superior bargaining power the right to recover attorneys’ fees if it prevails.

In fact, there are several significant differences between the Sonic court’s new approach and past unconscionability rulings.

First, all of these other rulings involved arbitration rules that applied across-the-board to all arbitrations conducted under the agreement. That is critically important: under California law the unconscionability determination must be made as of “the time [the contract] was made” (Cal. Civil Code 1670.5(a)). Because those provisions applied regardless of the claim to be arbitrated, their adverse effect was clear at the time the contract was signed.

Here, by contrast, the claimed unfairness relates to only one of the many types of claims that an employee could adjudicate under the arbitration agreement, and to none of the claims that an employer might seek to adjudicate. A finding of unconscionability could be based on claimed unfairness in the adjudication of a claim for withheld pay only if—at the time the contract was signed—it was (a) extremely likely that such a claim would arise; and (b) any supposed unfairness in the method of resolving withheld pay claims, as compared to the Berman procedures, was not counterbalanced by benefits conferred on employees from the availability of arbitration to resolve claims that the employee would have to assert or defend in court. (In addition, of course, the employee would have to show that the Berman procedures were more effective than arbitration—a question that was hotly disputed before the court and as to which the court took no position.) It seems highly unlikely that an employee would be able to make the necessary showing.

In fact, when the full panoply of claims that an employee could bring against an employer are considered—including claims for wrongful termination in California and claims under antidiscrimination statutes—there is significant evidence that employees fare better in arbitration than in court. As we noted in a recent amicus brief in the American Express case:

[E]mployees who arbitrate their claims are more likely to prevail than employees who litigate. See, e.g., Lewis Maltby, Private Justice: Employment Arbitration and Civil Rights, 30 Colum. Hum. Rts. L. Rev. 29, 46 (1998). And awards obtained by employees in arbitration are typically the same or even larger than court awards. See Michael Delikat & Morris Kleiner, An Empirical Study of Dispute Resolution Mechanisms: Where Do Plaintiffs Better Vindicate Their Rights?, 58 Disp. Res. J. 56, 58 (Nov. 2003–Jan. 2004).

By focusing its discussion only on the arbitration-Berman procedure comparison, the Sonic court created the misimpression that a court could base an unconscionability determination solely or in large part on the finding that the arbitration procedures fell short. But such a determination would violate California’s unconscionability law.

Second, the supreme court’s unconscionability discussion appears to encourage opponents of arbitration clauses to argue that even a relatively small difference in the perceived effectiveness and cost of the arbitral procedures, as compared to the Berman procedures, could suffice to establish at least a partial basis for invalidating the arbitration agreement. As the majority opinion put it, the “loss of [the] benefit” of the Berman procedures “may be one factor in an unconscionability analysis.”

But if courts were to place weight on the absence of Berman procedures in arbitration, that approach would work a sea change in California law. In contexts other than arbitration, courts have found a contract unconscionable only if it “shocks the conscience.” And even in the arbitration context, California courts have applied that test, albeit not consistently. Basing an unconscionability finding on a lesser standard would conflict with a long line of California cases—something that the justices who concurred in part and dissented in part in Sonic pointed out. Indeed, although the majority declined to reconcile the different formulations of “unconscionability,” Justice Corrigan forthrightly stated in her concurrence that “the proper test for determining unconscionability here is whether the terms are so one-sided as to ‘shock the conscience. Courts are not free to alter terms to which the contracting parties agreed simply because they find the terms unreasonable or ill-advised. The unconscionability test requires a much stronger showing of unfairness.”

In sum, while it is hard to say any factor is totally off limits in the unconscionability inquiry—apart from considering core features of arbitration (such as the lack of a jury trial, limited discovery, and the waiver of class procedures)—existing California law makes clear that a deviation from the Berman procedures could not provide even partial support for an unconscionability finding unless the arbitral proceeding was rendered fundamentally unfair to employees as a result. (Even in that situation, a court still could find the agreement unconscionable only if that unfairness was sufficient to find the contract unfair ex ante when the employee agreed to it, which—as discussed above—would require an assessment of the benefits and burdens that the arbitral system provides to employees with respect to all other types of disputes that could arise between the parties.)

Because the Sonic opinion focuses solely on differences between the arbitral procedures and the Berman procedures—and therefore fails to place its unconscionability discussion in the context of California’s generally applicable statutory standard for finding unconscionability—the opinion might be read, mistakenly, to convey the impression that any deviation from the Berman procedures would inexorably lead to a finding of unconscionability. But the court could not, and did not, overturn the State’s settled standards for making that determination, and those standards leave no doubt that such a deviation could never by itself justify an unconscionability determination.

Any Unconscionability Holding Based On This New Approach Would Violate The FAA

If—in the context of a claim for unpaid wages—a court were to base a finding of unconscionability on the differences between the process specified in an arbitration agreement and the Berman procedures, the FAA would preempt that application of state law to the same extent, and for the same basic reasons, that the FAA preempts California’s Discover Bank rule.

In Concepcion the U.S. Supreme Court held that a state-law unconscionability rule that “interferes with fundamental attributes of arbitration” is preempted because that rule “creates a scheme inconsistent with the FAA.” The Court concluded that conditioning enforcement of an arbitration agreement on the availability of class procedures violates that principle.

In Sonic the California Supreme Court acknowledged the principle, but concluded that the principle would not be violated by refusing to enforce an arbitration agreement unless it specified dispute-resolution procedures equivalent to those that were otherwise required by state law for adjudication of the particular claim. Pointing to the U.S. Supreme Court’s identification of informality, lower cost, greater speed and efficiency, and use of expert adjudicators as key attributes of arbitration, the California court stated that its new approach “will, if anything, tend to promote the FAA’s objectives rather than lead to any increase in cost, procedural rigor, complexity, or formality.”

But the California court’s analysis ignores the critical fact that one of the “fundamental attributes of arbitration” that the FAA protects is—in the words of the Concepcion opinion—that the parties “may agree . . . to arbitrate according to specific rules”; “[t]he point of affording parties discretion in designing arbitration processes is to allow for efficient, streamlined procedures tailored to the type of dispute” (emphasis added).

Basing a finding of unconscionability on the California court’s new test would interfere directly with the FAA’s protection of the freedom to tailor appropriate arbitral procedures, because it would force parties to adopt different arbitration processes for any claim to which this test could apply. Adopting a menu of different procedures would be the only way to avoid a determination that the arbitral process in any particular case insufficiently mirrored the approach specified by statute for such claims. But forcing parties to design a variety of claim-specific arbitral processes—rather than a single process that would apply to any claim covered by the agreement, regardless of the legal basis and regardless of who was asserting it—is the very opposite of the simplicity and autonomy that the FAA protects.

The California Supreme Court stated that there was no interference with the fundamental attributes of arbitration because the court concluded that the Berman procedures promote the same objectives as arbitration: efficiency, informality, low cost, and speed. But the court’s approach would (a) preclude parties from adopting procedures that embody a more efficient and informal approach than the Berman procedures; (b) require the adoption of multiple procedures, as discussed above; and (c) require parties to adopt complex procedures if a statute specifies a special dispute resolution system that embodies detailed formal procedures for resolution of a particular sort of state-law claim. All three of these consequences interfere with the fundamental principle that parties may design the dispute-resolution procedures that will be used in arbitration.

To be sure, as the court recognized, this principle does not require that every arbitration agreement be enforced as written, regardless of its terms. If procedures specified in an arbitration agreement violate generally applicable unconscionability doctrine because they are so unfair as applied to the entire range of disputes that could be subject to arbitration as to “shock the conscience,” then the FAA’s preemptive force would not be triggered. But the California court is wrong in asserting that a finding of unconscionability based on its new test would not be preempted by the FAA.

Indeed, the California court’s contrary conclusion is based on the very reasoning that the U.S. Supreme Court rejected in both Concepcion and American Express. The plaintiffs in those cases argued against enforcement of the arbitration clauses because the absence of class action procedures would prevent the “effective vindication” of the underlying statutory right, and the Court in each case held the argument irrelevant to FAA preemption analysis. In Concepcion, the Court explained that “[t]he dissent claims that class proceedings are necessary to prosecute small-dollar claims that otherwise might slip through the legal system. . . . But States cannot require a procedure that is inconsistent with the FAA, even if it is desirable for unrelated reasons.” And in American Express, the Court held that “the fact that it is not worth the expense involved in proving a statutory remedy does not constitute the elimination of the right to pursue that remedy.”

The American Express dissenters made the point even more clearly: “When a state rule allegedly conflicts with the FAA, we apply standard preemption principles, asking whether the state law frustrates the FAA’s purposes and objectives. If the state rule does so—as the Court found in AT&T Mobility—the Supremacy Clause requires its invalidation. We have no earthly interest (quite the contrary) in vindicating that law. Our effective-vindication rule comes into play only when the FAA is alleged to conflict with another federal law.”

Here, the California Supreme Court expressly invoked the discredited form of “effective vindication” theory, stating that its new unconscionability test requires an arbitration agreement “to provide for accessible, affordable resolution of wage disputes” as measured by a comparison between the arbitral procedures and a state’s specified litigation or administrative procedures. That is the precise rationale that the U.S. Supreme Court, including the dissenters in American Express, have recognized to be preempted under the FAA.

The two justices in Sonic who dissented from the majority’s unconscionability discussion explained that, under American Express, the FAA precludes “the very process the majority prescribes for determining the accessibility and affordability of the arbitration procedure in a particular case,” because “‘[s]uch a preliminary litigating hurdle . . . would undoubtedly destroy the prospect of speedy resolution that arbitration in general and bilateral arbitration in particular was meant to secure.’” The author of the partial dissent, Justice Chin, put it bluntly: “[T]he majority’s ‘anticipat[ion]’ that its approach will not create the kind of preliminary, arbitration-delaying litigating hurdle [that the American Express Court] discussed . . . is just wishful thinking.”

Finally, an unconscionability finding based on this new test would be preempted on the additional ground that it rests on a state-law rule that specially targets arbitration contracts, and therefore violates the express preemption standard of Section 2 of the FAA, which permits the invalidation of an arbitration agreement only based on “such grounds as exist at law or in equity for the revocation of any contract.”

The California court’s opinion leaves no doubt that its new unconscionability test applies only to arbitration agreements. The court relied only on precedents involving arbitration, and—as discussed above—its standard plainly conflicts with the unconscionability rule that applies generally.

Moreover, arbitration agreements are the only—or at least by far the most common—type of contracts that specify dispute-resolution procedures. As the Ninth Circuit recently held in Mortensen v. Bresnan Communications, LLC, “We take Concepcion to mean what its plain language says: Any general state-law contract defense, based in unconscionability or otherwise, that has a disproportionate effect on arbitration is displaced by the FAA.” The Ninth Circuit held the Montana state-law unconscionability principle in that case to be preempted by the FAA, and the same result would apply for any ruling based on the new California test.

The California court made its error clear, resting its no-preemption determination on an interpretation of Concepcion directly opposite to the one adopted by the Ninth Circuit in Mortensen. Thus, the supreme court stated (while quoting the seemingly contrary language from Concepcion): “a facially neutral state-law rule is not preempted simply because its evenhanded application ‘would have a disproportionate impact on arbitration agreements.’”

Finally, the California Supreme Court tried to bolster its anti-preemption argument by asserting that California could, consistent with the FAA, adopt an “unwaivable statute” that required a set of procedures mirroring the exceptionally pro-consumer AT&T arbitration provision at issue in Concepcion. The Sonic majority suggested that a state could “requir[e] a defendant to pay a penalty plus attorneys’ fees if a plaintiff with a low-value claim obtains an award through litigation or arbitration greater than the defendant’s last settlement offer.” Although the goal of such a statute would be “to achieve the same objective as a rule forbidding class waivers” by mandating the same procedural regime as the AT&T arbitration provision, the court asserted that such a statute nevertheless would be valid because it did not “somehow circumvent[] the FAA’s preemption of state-law rules forbidding class waivers.”

But such a statute would suffer from the same fatal flaw as an unconscionability ruling based on the California court’s new test: it would significantly limit the discretion to determine arbitral procedures protected by the FAA, effectively imposing a procedural requirement that defendants make settlement offers in virtually all arbitrations to avoid the potential penalties imposed if a defendant fails to do so. It is true, of course, that many companies have made a choice to adopt procedures like the ones in AT&T’s arbitration provision—but that does not mean that a state can mandate those procedures as a condition of enforcing arbitration without running afoul of the FAA. As Justice Chin put it in his partial dissent, the majority’s view that “states, for policy reasons, [may] impose all sorts of arbitration procedures that are not within the terms of the parties’ arbitration agreement, so long as those procedures do not interfere with fundamental attributes of arbitration,” is contrary to Concepcion, because “under the FAA, a state . . . may not refuse to enforce an arbitration agreement according to its terms simply because the arbitration procedure lacks features the Legislature, as a matter of policy, established for a ‘particular class’” to facilitate the pursuit of certain kinds of claims. The dissent’s view is consistent with Concepcion, which made clear that the FAA forbids courts from imposing procedures required by the rules governing civil litigation on arbitration to further substantive policies.

Conclusion

For its first major decision on arbitration since Concepcion, the California Supreme Court earns a decidedly mixed grade. Although the court finally discarded the blanket rule forbidding the enforcement of employment arbitration agreements whenever an employee seeks a Berman hearing, it nonetheless adopted a new, arbitration-specific approach to unconscionability that raises more questions than it answers, and that threatens to mire the state courts in multiple rounds of litigation and appeals over the enforceability of arbitration agreements in wage-and-hour cases.

Ultimately, any court that actually applies the Sonic majority’s new test to hold an arbitration agreement unconscionable will find its decision overturned on the ground that it is preempted by the FAA, both by federal courts deciding challenges to arbitration agreements under California law and ultimately by the U.S. Supreme Court itself. For the California Supreme Court’s own sake, one can only hope that the state court will do a better job in the three remaining arbitration cases than it has so far of faithfully applying the U.S. Supreme Court’s FAA precedents.

For more information about the topics raised in this Legal Update, please contact the authors.

Andrew J. Pincus
+1 202 263 3220

Archis A. Parasharami
+1 202 263 3328

 

Authors

  • Andrew J. Pincus
    T +1 202 263 3220
  • Archis A. Parasharami
    T +1 202 263 3328

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