Arbitration Denied: Third Appellate District Holds Arbitration Clause Procedurally and Substantively Unconscionable

Stephen M. Tye and Lawrence S. Zucker II | Haight Brown & Bonesteel

In Cabatit v Sunnova Energy Corporation, the Third Appellate District held that an arbitration clause in a solar power lease agreement was unenforceable because it was procedurally and substantively unconscionable.

In Cabatit, Mr. and Ms. Cabitat entered into a solar power lease agreement (the “Agreement”) with Sunnova Energy Corporation (“Sunnova”). Ms. Cabitat, who signed the agreement, speaks English but does not understand complicated or technical terms. The salesperson scrolled through the agreement language and Ms. Cabatit initialed where the salesperson indicated, even though she did not understand most of what he was saying. The salesperson did not explain anything about the arbitration clause nor did he provide Ms. Cabatit with a copy of the Agreement.

Subsequently the Cabatits sued Sunnova, alleging Sunnova damaged their roof during installation, and that the replacement roof was inferior to the roof they had damaged.  In addition, the Cabatits alleged violations of the California Home Improvement Law, Home Solicitation Law, Unfair Competition Law, and Consumer Legal Remedies Act. Sunnova moved to compel arbitration based on an arbitration clause in the Agreement. The trial court found the arbitration clause unconscionable and denied Sunnova’s motion.

On appeal, Sunnova contended (1) the arbitration clause requires the Cabatits to submit to an arbitrator the question whether the clause is enforceable, (2) the trial court erred in finding the arbitration clause unconscionable, and (3) despite the trial court’s conclusion to the contrary, the rule announced in McGill v. Citibank, N.A. (2017) 2 Cal.5th 945 (McGill) — that an arbitration agreement waiving statutory remedies under the Consumers Legal Remedies Act, the unfair competition law, and the false advertising law is unenforceable — does not apply to the circumstances of this case.

In affirming the trial court, the Court of Appeal first discarded Sunnova’s argument that the arbitration clause requires the Cabatits to submit to an arbitrator the question whether the clause is enforceable because Sunnova failed to raise that argument to the trial court. The Court of Appeal then examined the clause itself and the surrounding circumstances, providing a two-step analysis in determining that the Agreement was procedurally and substantively unconscionable.

First, the Court of Appeal determined the Agreement was a contract of adhesion that indicated oppression and surprise. The Court quoted Sonic-Calabasas A, Inc. v. Moreno (2013) 57 Cal.4th 1109, 1142, for the proposition that “[o]ne common formulation of unconscionability is that it refers to an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party.” (quotation marks omitted). The Court pointed to the following factors in making its determination, that (1) Sunnova drafted the Agreement and the Cabatits had no option other than to take or leave it; (2) Ms. Cabatit did not understand the Agreement; (3) the arbitration clause was not explained by the salesman, and (4) the Cabatits were not given a copy of the Agreement. The Court of Appeal rejected arguments from Sunnova that (1) Ms. Cabatit signed a statement that she had read the terms of the Agreement; (2) the arbitration clause is conspicuous; (3) there were no facts showing Sunnova had superior bargaining strength or that the Cabatits were without a meaningful choice whether to sign the Agreement; and (4) the Cabatits had the right to cancel the Agreement within seven days.

Second, the Court determined the arbitration clause was substantively unconscionable. In doing so, the Court relied upon Sanchez v. Valencia Holding Co., LLC (2015) 61 Cal.4th 899, 910, for the proposition that substantive unconscionability focuses on whether the terms of an agreement are overly harsh, unduly oppressive, or so one-sided as to shock the conscience. Here, the Court found the arbitration clause to be clearly one sided because Sunnova reserved the right to take most of its claims to court but purported to deny the Cabatits the same opportunity.

Finally, the Court of Appeal rejected Sunnova’s argument that the rule announced in McGillsupra, 2 Cal.5th 945, applied. In McGill, the California Supreme Court held that an arbitration agreement waiving statutory remedies under the Consumers Legal Remedies Act, the unfair competition law, and the false advertising law is unenforceable. (Id. at pp. 951-952.) The Court determined general considerations of unconscionability, independent of the McGill rule, was sufficient to support the trial court’s denial of the motion to compel arbitration.

Cabatit is important for two reasons. First, it demonstrates the high-bar that allows a court to find a contract of adhesion. Second, it demonstrates the need for arbitration clauses not to favor the drafting party.

This document is intended to provide you with information about general liability law related developments. The contents of this document are not intended to provide specific legal advice. If you have questions about the contents of this alert, please contact the authors. This communication may be considered advertising in some jurisdictions.

Contractor Loses Effort to Bind Remote Home Purchaser to Arbitration Clause

Jon Paul Hoelscher and Amendeep S. Kahlon | Buildsmart

On December 8, 2020, in Taylor Morrison of Texas, Inc. v. Kohlmeyer, a Texas Court of Appeals rejected a contractor’s appeal of a trial court order denying the contractor’s motion to compel arbitration in a home construction defect dispute. The appellate court concluded that the theories of direct benefits estoppel and implied assumptions did not permit the contractor to bind a subsequent purchaser to mandatory arbitration required under the original purchase agreement.

In 2013, the contractor, Taylor Morrison, executed a purchase agreement with a homeowner for the construction of a new home in League City, Texas. The purchase agreement included a mandatory arbitration provision and provided that it may not be assigned without the prior written consent of Taylor Morrison. In March 2016, the homeowner sold the house, and, later that year, the property was sold again to the Kohlmeyers. In 2018, the Kohlmeyers sued Taylor Morrison “asserting that the house had a substantial amount of mold growth throughout resulting from numerous water and moisture sources caused by construction defects.” Taylor Morrison moved to compel arbitration under the doctrines of equitable or direct benefits estoppel and implied assumption, but the trial court denied the motion. Taylor Morrison then appealed.

The appellate court confirmed the trial court’s decision. The appellate court acknowledged that an arbitration agreement may bind a non-signatory such as the Kohlmeyers but only when one of the following six theories — none of which were applicable here — applies: “(1) incorporation by reference, (2) assumption, (3) agency, (4) alter ego, (5) equitable estoppel, and (6) third-party beneficiary.” Taylor Morrison only argued assumption and equitable estoppel applied in the instant action.

With respect to estoppel, Taylor Morrison contended that the Kohlmeyers’ claim sought a direct benefit of the original purchase agreement relating to the quality of workmanship and construction. According to the court, for Taylor Morrison’s direct benefits estoppel theory to apply, Taylor Morrison must show that the Kohlmeyers’ claims depended on and were unable to stand independently of the purchase agreement. Mere relation of the claims to the purchase agreement was insufficient to apply the estoppel theory to bind the Kohlmeyers to arbitration. The appellate court concluded that the Kohlmeyers’ claims did not arise solely from the purchase agreement because the Kohlmeyers did not allege breach of the purchase agreement, the economic loss doctrine could not be applied to bind the Kohlmeyers on a contract they never signed, and the Kohlmeyers’ claims for breach of implied warranties did not arise solely from the purchase agreement.

The appellate court also rejected Taylor Morrison’s argument for binding the Kohlmeyers to the arbitration clause under the theory of implied assumption because the purchase agreement had not been assigned to the Kohlmeyers. According to the court, an implied assumption of contract obligations arises when a contract is assigned to an assignee (here, the Kohlmeyers) and the benefit received by the assignee is so entwined with the burden imposed by the assignor’s contract that the assignee is estopped from denying assumption and the assignee would otherwise be unjustly enriched. Taylor Morrison argued the implied warranties in the purchase agreement had been automatically assigned to the Kohlmeyers when they bought the house and that the benefits of the implied warranties under the purchase agreement were entwined with the arbitration provision.

The court disagreed. Per the court, the alleged automatic assignment of the implied warranties was inapposite because there was no dispute that the purchase agreement (i.e., the contract) had not been assigned to the Kohlmeyers. Indeed, the appellate court noted that assignment of the purchase agreement was contingent on Taylor Morrison’s written consent, which the record showed had not been provided. Therefore, the court rejected the implied assumption theory and held that the Kohlmeyers could not be compelled to arbitrate.

Lessons from Taylor Morrison

Since arbitration is typically an animal of contract, it is important for contractors to understand how their arbitration clauses will be interpreted by a court. While attempts to compel arbitration of non-signatories to an agreement may invite some creative application of the applicable theories described above, a belt-and-suspenders approach in drafting a dispute resolution clause may provide more options to the party attempting to compel arbitration. Here, the appellate court appeared wary of applying a purchase agreement’s arbitration provision to a homeowner who was two-times removed from the original purchase agreement transaction. However, the court noted that three of the potential theories to enforce the arbitration clause were inapplicable based on how the agreement was structured.

Subrogation Claims And Arbitration Clauses In Construction Contracts

David H. Fisk | Kane Russell Coleman Logan

In Texas, while an insurer can assert a subrogation claim independently of its insured, the insurer still stands in the shoes of its insured, meaning the insurer’s claims are limited to those the insured could bring and are subject to the same defenses.  A common defense when a loss involves a construction project is that subrogation has been waived in the construction contract.  The application and enforceability of a waiver of subrogation clause depends on the specific contract language, but common industry waivers (such as the standard AIA waiver of subrogation clause) are generally upheld and enforced under Texas law to preclude insurers’ subrogation claims.  It makes sense then that a subrogated insurer pursuing a claim against a contractor could also be subject to any dispute resolution provisions agreed to by its insured in the construction contract, including arbitration clauses.

The Thirteenth Court of Appeals, which serves the Corpus Christi and Edinburg area of Texas, recently issued a memorandum opinion addressing this exact issue – whether a subrogated insurer is bound by an arbitration clause in a construction contract between the insured and the party responsible for a loss.  Roland’s Roofing Co., Inc. v. Nationwide Mut. Ins. Co., 13-19-00580-CV, 2020 WL 3478658 (Tex. App.—Corpus Christi June 25, 2020, no pet. h.).

As set forth in the opinion, Nationwide Mutual Insurance Company insured Haidar Properties, LLC, which operated an IHOP restaurant in McAllen, Texas.  After a hailstorm severely damaged the restaurant’s metal roof, Haidar contracted with Roland’s Roofing Company, Inc. to replace the roof.  While the roof was being replaced, the restaurant manager discovered a fire in a second-floor equipment room.  The local fire department determined that heat produced from a halogen light mounted to the exterior roof, which faced the roof’s wooden decking, ignited the decking and caused the fire.  Haidar submitted a claim to Nationwide for the damages caused by the fire, and Nationwide filed a subrogation action against Roland’s Roofing and others to recover its payments to Haidar.

About eleven months after Nationwide filed suit, Roland’s Roofing filed a motion to compel arbitration.  The contract between Haidar and Roland’s Roofing included an arbitration clause that required “[a]ny controversy or claim arising out of or relating to this Agreement or breach thereof [to] be settled by arbitration binding on both parties in accordance with the Federal Arbitration Act (FAA) and the Construction Industry Arbitration Rules of the American Arbitration Association.”  After more than a year of procedural wrangling, the trial court denied Roland’s Roofing’s motion to compel arbitration.  Roland’s Roofing appealed that decision.

On appeal, one of Nationwide’s arguments was that it should not be compelled to arbitrate its subrogation claim against Roland’s Roofing because it was not a signatory to the contract that included the arbitration clause.  In rejecting this argument, the appellate court relied on Texas case law stating that a subrogated insurer stands in the shoes of its insured and the “insurer’s right to subrogation derives from the right of the insured, and is limited to those rights.”

Arbitration clauses commonly appear in construction contracts; and, as noted by the court in Roland’s Roofing, “Texas policy and federal policy favor arbitration.”  In practice, this means that generally any doubts concerning the scope of an arbitration agreement will be resolved in favor of arbitration.

While the pros and cons of arbitration over litigation can be debated, arbitration is often touted as being less expensive than litigation, which is not always the case.  Depending on the forum and the amount of the claim, the filing fee for arbitration can be significantly more than the filing fee in litigation.  Additionally, parties typically pay for the time of an arbitrator that presides over the arbitration in a proceeding administered by the American Arbitration Association (AAA) or similar organization.  In contrast, parties do not have to pay for a judge’s time, and jury fees are often nominal.  If a panel of three arbitrators will hear and decide a case, the costs can increase exponentially.  In fact, the AAA notes on its website that a three-arbitrator panel can actually cost five times as much as a single arbitrator.  These additional costs could substantially impact the net recovery in a subrogation case.

When a loss involves a construction project, early identification of the proper forum in which to bring a subrogation claim – litigation or arbitration – could save considerable time and expense.  The parties in Roland’s Roofing incurred two years of costs in litigation before being ordered to arbitration, which likely compounded the overall costs incurred.

Subrogation professionals know the importance of looking for and analyzing the impact of a waiver of subrogation clause in a construction contract.  The Roland’s Roofing case highlights the importance of also looking for and analyzing the impact of any arbitration clause or other dispute resolution provision that may be included in the contract.  If the construction contract contains an arbitration clause but litigation is preferred, the parties can always agree to litigate rather than arbitrate.

Questions To Ask When Changing Your Arbitration Clause

Jay Ramsey and Abby Meyer | Class Action Defense Strategy Blog

In a prior post (here), we highlighted some questions that companies may want to ask when evaluating whether their arbitration clauses are enforceable.  If changes need to be made to those clauses, then companies should consider how to implement those changes so as to ensure those are enforceable too.  The following is what you should be thinking about and asking.

If an agreement needs to be amended to add or modify an arbitration clause, you should strongly consider having customers re-agree to a contract or set of terms and conditions with the new arbitration clause.  This could be done a number of ways, including by having customers agree to an entirely new contract or having them agree to just a replacement arbitration clause.  For companies who engage their customers online or through mobile applications, this may be as simple as requiring customers to re-register or log-on in a way that confirms their assent to the new agreement.

In some cases, the original agreement may have a provision that permits the company to amend or modify the agreement unilaterally.  These provisions generally require that the company post the amended terms to its website or in some other location and indicate that a customer’s continued use of the company’s services constitutes agreement to the amended terms.  The provision may also require that the company provide its customers with some type of notice of the amended terms.

The law permitting unilateral amendments in accordance with these types of modification provisions is still developing.  Some courts have permitted unilateral amendments if the company follows the terms of the modification provision, even if notice of the amended terms is not separately provided.  See Miracle-Pond v. Shutterfly, Inc., No. 19 cv 04722 (N.D. Ill. May 15, 2020).  Other courts have rejected modifications if notice was not provided. See, e.g.Douglas v. U.S. District Court, 495 F.3d 1062 (9th Cir. 2007).  What constitutes adequate notice is often up for debate.

In light of this mixed law, if you are considering modifying a set of terms without requiring a new agreement from your customers, you should consider at least the following:

  1. Does the original agreement permit modifications?  If so, are you complying with the modification provision?
  2. Does the modification provision require that a particular notice be sent to the customer regarding the amended terms?  Should you provide that notice even if the provision does not require it?
  3. Does any notice that you are sending out clearly indicate that changes are being made to the terms?  What does the subject line of the email notification say?  If changes are mailed, do the documents make clear that your company’s terms are changing?  Is there anything on the envelope indicating that changes to the terms are included inside?
  4. Does any notice that you are sending not only provide the amended terms or access to them, but also describe any material changes to the terms?  Does the notice clearly indicate that the customer agrees to the amended terms by continuing to use the company’s services?
  5. Is the notice being sent to the best, most up-to-date contact information for the customer?

As we noted in our last post (here), the above questions may not cover everything that you and your company should consider when updating your agreements or terms and conditions, particularly when adding or modifying an arbitration provision.  Crafting a solution for each company, while satisfying the concerns and desires of the legal department, the marketing department, and the business teams can sometimes be challenging, but it should be done.  There is no reason to risk unnecessary exposure to consumer class actions.

Does Your Construction Contract Involve Interstate Commerce? If So, Expect Your Arbitration Agreement to Be Enforced

Jim Archibald, Ryan L. Beaver & Amandeep S. Kahlon | Buildsmart

Whether an arbitration agreement is enforceable is a frequently litigated matter in construction disputes. Federal policy strongly favors arbitration. Typically, the Federal Arbitration Act (FAA) will preempt any contrary state law that might otherwise void an arbitration provision. On June 10, 2020, the South Carolina Court of Appeals reaffirmed this view when it overturned a trial court’s decision denying a motion to compel arbitration.

In Patricia Damico, et al. v. Lennar Carolinas, LLC, et al., a group of homeowners sued the developer, general contractor, and subcontractors of a development in Berkeley County, South Carolina, alleging construction defects in their homes. The general contractor, Lennar Carolinas, sought to compel arbitration. The trial court denied the motion to compel ruling that (1) the South Carolina Uniform Arbitration Act (SCUAA) applied to the parties’ agreement instead of the FAA, (2) the general contractor failed to comply with the SCUAA’s conspicuous notice requirement, and (3) the arbitration agreement included a provision from the parties’ sales agreement, as well as terms from a separate warranty agreement, and was unconscionable. The general contractor appealed.

The Court of Appeals overturned the trial court and ruled that the FAA applied to the parties’ contract. The court explained that the FAA applies to transactions involving interstate commerce, and the parties specifically agreed in their sales agreement that the transaction involved interstate commerce. The court applied basic rules of contract interpretation to enforce this provision, as written, like any other contract term. Moreover, because construction of the homes required use of out-of-state subcontractors and material and equipment suppliers, the court concluded the transaction in fact involved interstate commerce.[1] Therefore, the FAA applied.

The court next determined the trial court improperly voided the sales agreement’s arbitration agreement as unconscionable. The trial court should have considered the validity of the arbitration provision in isolation without reference to separate arbitration language in the warranty agreements or the arbitrability of certain disputes thereunder. Questions of arbitrability of a particular dispute are to be decided by the arbitrator, and the trial court should have addressed only whether the arbitration agreement was enforceable. Once the Court of Appeals concluded the agreement was valid, the FAA required it to be enforced, and the court reversed the trial court’s order denying the motion to compel.

Closing Thoughts

If you agree to arbitrate disputes in your construction contract, think carefully before pursuing litigation and trying to contest a motion to compel. While there are instances where an arbitration agreement may be void or inapplicable to a particular dispute, more often than not the trial court will enforce the arbitration provision and grant the motion to compel. And, even if you succeed at the trial level, this is one of the few circumstances when appellate courts routinely reverse lower court decisions. Absent unique contract language or a novel set of facts, this particular fight may not be worth the time or expense.

In contrast to the above circumstances, if you want your arbitration agreement enforced and would rather avoid the cost of appealing an incorrect ruling from a state trial court, consider reviewing, prior to execution, the form arbitration language in your contract for compliance with state law. Here, had the sales agreement complied with the conspicuous notice requirements of the SCUAA, the general contractor might have, at least partially, avoided the bad result from the trial court.