The Supreme Court of the United States To Review California’s Contract Severance Rule as Applied to Agreements to Arbitrate.

On its docket this term, the Supreme Court of the United States will consider MHN Government Services, Inc. v. Zaborowski, case no. 14-1458, and whether the Federal Arbitration Act (“FAA”) preempts the application of a California statute.  California's law affords courts discretion when faced with agreements containing unconscionable provisions -- strike entirely or sever and save.  At issue is whether, in practice, the application of this law to arbitration agreements has resulted in more striking than saving.  If history is a guide to the possible outcome, consider that in 2011 in AT&T Mobility LLC v. Concepcion, 563 U.S. 333 (2011) , the Court’s 5-4 majority struck down another California rule, concerning class-action prohibitions in arbitration agreements, because it “interfere[d] with fundamental attributes of arbitration” in violation of the tenets of the FAA.

Underlying the Zaborowski dispute are military consultants who were classified as independent contractors rather than employees.  As a result of this classification, the consultants did not receive overtime compensation and asserted various claims against their defendant employer.   In turn, the defendant employer, relying the parties’ services contract, moved to compel mandatory arbitration.  To oppose arbitration, the plaintiff consultants argued that many terms in the arbitration agreement were unconscionable and therefore the whole arbitration agreement was unenforceable.

The district court agreed with the plaintiffs and held, inter alia, that certain terms—including the limitations period of only 6 months, a punitive damages waiver, and an arbitrator-selection procedure that permitted the defendant employer to limit the universe of possible arbitrators to three from which the plaintiffs could select one— were “overly harsh,” “generated one-sided results,” and therefore were unconscionable.  Zaborowski v. MHN Gov't Servs., Inc., 936 F. Supp. 2d 1145, 1153, 1156 (N.D. Cal. 2013).  The district court then went a step further.  It acknowledged that Cal. Civ.Code § 1670.5(a) gives courts the authority either save contracts by striking the unconscionable portions or refuse to enforce contracts altogether.  Here, the district court held that the agreement was both procedurally and substantively unconscionable and was so permeated with these one-sided terms that it declined to save the agreement by severing them.  Id. at 1157.  The court denied the motion to compel arbitration.

As an aside, consider that at issue in this matter was whether there was unconscionability in the arbitration agreement, not whether the plaintiffs were unconscionably induced into making the arbitration agreement.  Where the AAA Rules are incorporated into the agreement, as here in Zaborowski, the arbitrator has specific authority to decide “objections with respect to the existence, scope, or validity of the arbitration agreement.” AAA Commercial Rules at R-7.  Consider whether the district court could have declined to address the plaintiffs’ unconscionability arguments and left them for the arbitrator to decide.  See, e.g., Brennan v. Opus Bank, 796 F.3d 1125, 1127 (9th Cir. 2015) (holding that the determination whether the arbitration clause is substantively or procedurally unconscionable belongs to the arbitrator especially where the AAA Rules are incorporated to the agreement).

The defendant employer appealed to the 9^th Circuit, where the decision was affirmed.  Zaborowski v. MHN Gov't Servs., Inc., 601 F. App'x 461 (9th Cir. 2014).  The appellate court noted that although “Federal Arbitration Act expresses a strong preference for the enforcement of arbitration agreements,” there was no federal preemption concern because the FAA does not “license a party with superior bargaining power to stack the deck.”  Id. at 464.  It therefore concluded that the district court did not err when it applied California law and declined to sever unconscionable provisions.  Id.   There was a dissent that sided with preemption.  The dissenting judge explained that the application of the California law, as here, rejecting arbitration agreements will cause a “disproportionate impact on arbitration agreements” that is in fact preempted by the FAA.  Id. at 465 (citing AT&T Mobility LLC v. Concepcion, 563 U.S. 333 (2011) (which held that the Federal Arbitration Act preempts California’s rule regarding the unconscionability of class arbitration waivers in consumer contracts)).

On October 1, 2015, the Supreme Court of the United States agreed to hear this preemption argument on certiorari.   The petitioner employer staged the question before the Court as an unequal application of law.   It recognized that the California law purports to be neutral and applicable to all contracts.  But in practice the law has a “disproportionate impact on arbitration agreements” especially here where the subject arbitration agreement contained its own provision for excising invalid terms, which was not given effect.  The petitioner asserted that the “California courts show a clear preference against enforcing an agreement to arbitrate” and have used this California law as their vehicle for this agenda.  The petitioner then presented a history of the disparate treatment citing various general contract vs. arbitration contract cases.  It observed that the California Supreme Court’s precedent that “multiple unconscionable provisions will render an arbitration agreement’s purpose unlawful” necessarily treats arbitration contracts differently than other contracts under the California law.  Armendariz v. Found. Health Psychcare Servs., Inc., 6 P.3d 669, 697 (Cal. 2000).  The Petitioner concluded that because the “FAA preempts state-law defenses that single out or otherwise burden arbitration agreements more than any other contract,” this California law must be preempted by the FAA.

For their part, the Respondents focused on the facially neutral language of the California law as applicable to all contracts.  They also observed that the law directed courts, as the district court did here, to exercise discretion whether to sever the terms or reject the contract altogether.   The respondents emphasized the instant arbitration agreement contained five unconscionable provisions, not just one or two, that went to material, as opposed to collateral, issues of arbitration relationship.  They noted also that numerous other courts have refused to enforce this very same agreement.

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The author, Katharine Kohm, is a committee member for The Dispute Resolver. Katharine practices construction law and commercial litigation in Rhode Island and Massachusetts.  She is an associate at Pierce Atwood, LLP in Providence, Rhode Island.  She may be contacted at 401-490-3407 or kkohm@PierceAtwood.com.