State, Federal Rules Conflict on Crucial Arbitration Issue

Alternative Dispute Resolution
April 1, 2005

by Lawrence C. Waddington

Drafting arbitration agreements no longer warrants copying a form or using boilerplate language in commercial contracts. And "commercial" agreements are not restricted to contracts for sales or services.

The Federal Arbitration Act, as interpreted by Supreme Court and U.S. Circuit Court of Appeals precedent, includes employment, consumer and franchise agreements within the ambit of "commerce." California courts also conclude these categories are subject to arbitration under the California Arbitration Act (Code of Civil Procedure Section 1280 et seq.). But conflicting federal and state rules attributable to the doctrine of federal pre-emption formulated by the Supreme Court marks the crucial issue in drafting an arbitration clause.

Federal pre-emption of state statutory and decisional law forbidding or unreasonably burdening arbitration originated in Southland Corp. v. Keating, 465 U.S. 1 (1984). Divesting state courts of jurisdiction, the Supreme Court applied the Federal Arbitration Act to validate and enforce any written agreement between parties to resolve disputes by arbitration if the underlying transaction involved interstate commerce.

Although the Federal Arbitration Act does not confer independent jurisdiction on federal courts, an action filed in state court and removed on grounds of diversity (28 U.S.C. 1331) serves as a source of federal jurisdiction. Because of disagreements between 9th Circuit decisional law and California appellate courts interpreting the Federal Arbitration Act and California Arbitration Act, the outcome of an arbitration may yield different results depending on the jurisdiction selected by the parties or ordered by the court.

In the 9th Circuit case Fidelity Federal Bank FSB v. Durga Ma Corp., 386 F.3d 1306 (2004), the parties agreed to arbitrate without filing a petition in court to compel arbitration and stay litigation. The arbitration clause provided: "If any disputes or controversies ... arise in connection with this agreement ... such disputes or controversies shall be submitted to and resolved by binding arbitration in accordance with the law of the State of California ... and judgment may be entered in a state or federal court with jurisdiction over the parties."

On appeal from the subsequent arbitration award entered in district court, and despite the breadth of this choice-of-law clause, the 9th Circuit held the arbitration clause applied only to California substantive law whereas procedural rules of the Federal Arbitration Act, described by the court as the process of arbitration, govern arbitration in federal court.

Fidelity Federal Bank alerted counsel to elect options in drafting choice-of-law clauses: Either specifically reference California substantive and procedural law in the arbitration agreement to invoke the California Arbitration Act, or identify the Federal Arbitration Act to govern the arbitration process, unless the parties select another state law.

The choice is important. As the First Fidelity Bank court notes, any objections to the neutrality of the arbitrator under the Federal Arbitration Act are confined to a petition to vacate an award for "evident partiality in the arbitrators." 9 U.S.C. 10(a)(2). In California state court, the Legislature has enacted sweeping personal and professional pre-arbitration disclosure requirements for arbitrators in noncollective bargaining cases; Code of Civil Procedure 1281.9.

The statute also provides for disqualification of arbitrators, and nondisclosure is grounds for appeal of an award. Code of Civil Procedure Section 1286.2(a)(6); International Alliance of Theatrical Stage Employees and Moving Picture Operators of U.S. and Canada v. Laughon, 118 Cal.App.4th 1380 (2004).

These California procedural statutes are presumably inapplicable in federal court in an arbitration conducted under the narrower Federal Arbitration Act rule permitting a party to vacate an award only on grounds of "evident partiality ... in the arbitrator[s]" - an extremely difficult standard to meet and deferred until after rendition of the award. 9 U.S.C. 10 (a)(2).

The only other nonstatutory ground for indirectly challenging an arbitrator in federal court is an award issued in "manifest disregard" of the law. But in California courts, "manifest disregard" is not a ground to vacate an award. Blue Cross v. Superior Court, 67 Cal.App.4th 42 (1998).

Drafting arbitration clauses is further complicated by a recent U.S. Supreme Court decision describing the role of a trial court in deciding "arbitrability," that is, the validity and enforcement of an arbitration clause. In ruling on a petition or motion to compel arbitration, the Supreme Court has repeatedly confirmed the duty of district courts to apply state substantive contract law in determining whether an arbitration agreement is subject to an arbitrable forum.

The existence and formation of an arbitration clause in a contract, its scope and the parties bound by the agreement are resolved under state substantive law regardless of federal or state jurisdiction. The court has characterized this determination as an issue of "arbitrability" as distinguished from arbitration resolving the merits of the underlying transaction.

In Howsam v. Dean Witter Reynolds Inc., 537 U.S. 79 (2002), the Supreme Court held that in federal court, or state court involving a commercial transaction in interstate commerce pre-empted by the Federal Arbitration Act, a determination of "arbitrability" is a "gateway issue." Courts are confined to the language of the clause in determining the existence and formation of the arbitration clause in the contract, not the execution (or termination) of the underlying contract - whereas the arbitrator decides "procedural questions which grow out of the dispute and bear on its final disposition ... [including] allegations of waiver, delay or like defense to arbitrability."

The court apparently expects arbitrators to decide significant and crucial procedural issues including time limits, notice, laches, estoppel and other conditions precedent to an obligation to arbitrate. Howsam.

Contracting parties may not always know in advance whether subsequent litigation or arbitration will ultimately lie in state or federal court. A party - usually the defendant - in state litigation may seek removal to federal court on grounds of diversity (28 U.S.C. 1332) and petition the district court for an order compelling arbitration and a stay of litigation (9 U.S.C. 3, 4).

If the district court orders "procedural" arbitration of issues under Howsam, or "process issues" under Fidelity Federal Bank, the issues of forum selection, conditions precedent, statutes of limitation, laches and estoppel in federal court are subject to different interpretations than in state courts.

For example, consolidation of multiple civil actions in litigation or arbitration is quintessentially a procedural issue. In Cronus Investments Inc. v. Concierge Services, 2005 WL 549615, the California Supreme Court reviewed a choice-of-law clause in an arbitration agreement that any disputes between the parties will be "construed and enforced" in accord with California law.

The trial court, confronted by multiple contracting parties, some of whom had signed contracts containing the arbitration clause and others who had not, denied a petition (by plaintiff) to stay litigation and compel arbitration; granted the motion (by defendants) to stay arbitration pending the outcome of litigation; and consolidated the arbitrable claims.

Citing the potential for conflicting results in arbitration claims and litigation of nonarbitrable claims, the judge invoked Code of Civil Procedure Section 1281.2(c), statutorily authorizing a stay of arbitration and consolidation of arbitration if "one party is a party to a pending court action with a third party arising out of the same transaction ... and there is a possibility of conflicting rulings on a common issue of law or fact."

Code of Civil Procedure Section 1281.2(c) is unquestionably a procedural rule, and the parties agreed the underlying transaction involved interstate commerce. On appeal, the plaintiffs/appellants contended the Federal Arbitration Act pre-empted the California statute. Cronus holds the Federal Arbitration Act does not pre-empt state procedural rules and the choice-of-law clause is interpreted under state law.

In addition, the court holds that "the FAA's procedural provisions [do not] apply to state court proceedings."

In district court, a federal rule prevents application of the trial court order in Cronus. In Dean Witter Reynolds Inc. v. Byrd, 470 U.S. 213 (1985), the Supreme Court, although acknowledging a potential for conflicting rulings, mandated arbitration of arbitrable claims despite nonarbitrable claims alleged in the same action. Subsequent decisional federal law confirms this rule.

In Wolsey Ltd. v. Foodmaker Inc., 144 F.3d 1205 (1998), the 9th Circuit held that a generic choice-of-law clause did not incorporate Code of Civil Procedure Section 1281.2(c) and precluded the federal district court from applying the state rule. Cronus rejects this case.

The dispositive rule, according to Cronus, is contained in Volt Information Sciences Inc. v. Bd. of Trustees of Leland Stanford Jr. University, 489 U.S. 468 (1989). A state procedural rule applicable in state court arbitration proceedings permits a court to stay arbitration unless the procedural rule inhibits or forecloses federal policy enforcing arbitration agreements. Code of Civil Procedure Section 1281.2(c), the same statute involved in Volt, does not inhibit arbitration, but only provides a procedural mechanism to simplify state court procedure and avoid inconsistent rulings.

According to Cronus, Section 1286.2 is a beneficent procedural rule and does not thwart federal policy, even if the statute indirectly eliminates or retards arbitration.

The continuing conflict between state and federal courts is not confined to differing procedural rules. Remedial limitations inserted in an arbitration clause, that is, determining whether an arbitration clause prohibits class actions, or other unilateral restrictions imposed by one party, are not "gateway issues" for the judge either in federal court or state court litigation pre-empted by the Federal Arbitration Act. Green Tree Financial Corp. v. Bazzle, 539 U.S. 444 (2003).

In PacifiCare Health Systems Inc. v. Book, 538 U.S. 401 (2003), the Supreme Court refused to consider an arbitration clause prohibiting one party from obtaining punitive damages. The court held that remedies are abstract at the onset of arbitration and contingent on the arbitrator's decision, not "gateway issues" for the court. Enforcement of remedies, said the court, are reviewable only on a motion to vacate the award and unrelated to existence or formation of an arbitration clause.

If the underlying action permits statutory punitive damages, but the arbitration clause limits the arbitrator from awarding this remedy, resolution must await a motion to vacate the award.

In contrast, California courts have embraced the doctrine of "unconscionability" of remedial limitations or the absence of bilateral terms to deny enforcement of arbitration in a variety of contexts: employment (Armendariz v. Foundation Health Psychare Services Inc., 24 Cal.4th 83 [2000]); consumer (Gutierrez v. Auto Nation Inc., 114 Cal.App.4th 77 [2003]); real estate (Woodside Homes of California v. Superior Court, 107 Cal.App.4th 723 [2003]); construction defect (Pardee v. Superiro Court, 100 Cal.App.4th 1081 [2003]).

California courts have characterized "unconscionability" as substantive state law applicable to general contract law and relevant in determining formation of contracts. If the only ground for refusing to enforce an arbitration clause is a remedial limitation, PacifiCare contradicts this analysis in its holding that the allegedly unconscionable arbitration clause does not resolve contract formation. Under PacifiCare, a court can only determine this issue on a petition to confirm or vacate an award.

The jurisdictional conflict is not confined to choice-of-law clauses, remedies or arbitrability. Franchise contracts drafted by a franchiser may include a forum selection clause geographically distant from the franchisee. In Bolter v. Superior Court, 87 Cal.App.4th 900 (2001), the California Court of Appeal denied enforcement of the forum selection clause although severing it and permitting arbitration. The 9th Circuit held the Federal Arbitration Act pre-empted the same clause and enforced it. Bradley v. Harris Research Inc., 275 F.3d 884 (2001).

In consumer contracts, the California Supreme Court has held that portions of the Consumer Legal Remedies Act (Civil Code Section 1750, et seq.) permit the trial court to order arbitration of nonpublic rights listed in the statute. Broughton v. Cigna Healthplans of California, 21 Cal.4th 1066 (1999). The 9th Circuit held the Federal Arbitration Act pre-empts the legal remedies act. Ting v. AT & T, 319 F.3d 1126 (2003).

Arbitration clauses should agree on the arbitrable forum, the situs of the arbitration, all procedural rules of either the state or federal court (or agree to use California procedural and substantive law in federal court) - and they should add a clause incorporating California choice of law jurisprudence (or specifically dispense with substantive choice of decisional law).

Lawrence Waddington, a retired judge of the Los Angeles Superior Court, is currently an arbitrator and mediator for JAMS.

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