Wednesday, December 5, 2012

Reaching the Pinnacle?

California Supreme Court Rules That CC&R Arbitration Provisions Are Enforceable Against HOAs

Matt J. Malone

This is the first in a two-part series on the Pinnacle case.  In this first part, attorney Matt J. Malone describes the nature of arbitration, the details and reasoning behind the ruling, and the issues and questions remaining now that Pinnacle is the law.  In the second part, attorneys Tyler P. Berding and Randolph M. Paul will discuss both the myths concerning arbitration and the reasons why not all developers or insurers will jump at the chance to arbitrate association defect disputes.

For the past several years, the Courts of Appeal in California have struggled with the enforcement of arbitration provisions in homeowner association Conditions, Covenants and Restrictions (“CC&Rs”).  These provisions waive an association’s right to jury trial in construction defect disputes against developers or converters.  And largely, the Courts of Appeal had refused to enforce them on the grounds that associations never consented to them and/or they were unconscionable.  But in August, the issue finally came before the California Supreme Court in the case of Pinnacle Museum Towers Association v.  Pinnacle Market Development (U.S.) LLC.  And the Court spoke clearly:  CC&R arbitration provisions are valid, enforceable and are not unconscionable under California law.

In order to provide a background for why enforcement of arbitration provisions is such a significant issue for associations, this article will begin by briefly discussing the arbitration process and its potential difficulties.  Then we examine the Pinnacle decision itself, to understand why the Court enforced CC&R arbitration provisions even though an independent, owner-controlled association never consented to them.  Finally, we take a look forward to examine the potential effect of Pinnacle on associations with defect claims, as well as what other consequences may arise from the Court’s decision.

What Is Arbitration?

Arbitration is a form of alternative dispute resolution in which the parties agree to remove their dispute from the courts, and instead present the case to a private arbitrator.  This individual is usually – though not necessarily – a lawyer or former judge with some expertise in the subject matter of the dispute.    

An arbitration is not a trial.  The rules for arbitration are set forth in the CC&Rs or in the guidelines issued by the arbitrator.  There is no requirement that an arbitrator hear live testimony or provide for witness cross-examination.  A party must be able to present its side of the case, but this can be through declarations or prior deposition testimony.  Moreover – unless the arbitration rules provide otherwise – an arbitrator is not bound by the rules of evidence that would constrain a trial court judge.  An arbitrator may consider evidence that would be completely inadmissible in a trial.  Nor must an arbitrator necessarily follow the law.  Indeed, in the name of fairness or “equity,” an arbitrator can render a decision contrary to the law.  Legal error is not a basis for challenging the arbitrator’s final award.

An arbitration is also not a mediation.  A mediator attempts to get both parties to agree upon a resolution and settle the case.  An arbitrator hears each side of the case and makes a ruling.  Arbitration does not end with a mediated settlement. 

Arbitration can be binding or nonbinding.  In nonbinding arbitration, the arbitrator’s decision is not final or binding on the parties.  But binding arbitration is the one that more frequently appears in CC&Rs, the one that appeared in the Pinnacle CC&Rs, and the one that is the focus of this article.  In binding arbitration, the arbitrator’s decision is final and may be entered as the judgment in any action between the parties.  With very limited exceptions, an arbitrator’s decision in a binding arbitration is not subject to appeal.  

Finally, the cost of the arbitrator is typically split between the parties.  Depending on the size and complexity of the case, an arbitrator can charge thousands of dollars per day.  In some cases with more limited facts, arbitration may be less time consuming and costly than litigation and trial.  But construction defect cases are exceedingly complex, with many documents, many percipient witnesses, and a plethora of expert testimony.  An arbitrator, paid by the hour, is not necessarily incentivized to move such cases quickly.  

Thus, the potential pitfalls for an association in arbitration of a defect claim are many.  There is no jury to hear the association’s case. The expense of arbitration can be considerable.  There is virtually no right to appeal an arbitrator’s award.  And the arbitrator is not bound by the law.  The question is why, given this, an association can still be bound to an arbitration provision that it only “consented” to when it was under developer control. 

The Pinnacle Decision: Arbitration Clauses in CC&Rs Are Enforceable

In Pinnacle, the CC&Rs included a binding arbitration provision that applied to construction defect disputes where the developer was a party.  Importantly, the arbitration provision could not be amended out of the CC&Rs unless the developer consented.  Each of the individual purchase agreements with owners provided that the purchasers were binding themselves to the CC&Rs and waiving their right to jury trial and their right to appeal, as the arbitration provision provided. 

The association challenged the arbitration provision, winning before the Court of Appeal.  That court held that the provision was not an “agreement” to arbitrate since the developer drafted the clause unilaterally and the association was controlled by the developer at the time the CC&Rs became effective.   But the Court of Appeal went even further.  It held that even if the association were bound by the arbitration provisions as referenced in the individual purchase-and-sale-agreements, those agreements were unconscionable and unenforceable.

The California Supreme Court reversed.  Despite the fact that the association did not exist independent of the developer at the time the CC&Rs were effective, the Court ruled that the arbitration provision could still be enforced against the association.  In addition, the provision was not unconscionable.
But how exactly could an HOA consent to arbitration before it even existed as an independent entity, controlled by its owners?  To find this consent, the Court focused on two key concepts: 1) the consent of the purchasers – and association members – to the arbitration provision; and 2) the Davis-Stirling Act, which permitted a developer to insert “any other matters” into the CC&Rs that it desired.

As to the first, the purchasers who made up the association had all signed purchase and sale agreements binding them to the arbitration provision.  Thus, the members of the association had “every right to expect that the association, in representing their collective interests” would abide by the CC&Rs, including the arbitration provision.  Ultimately, because the owners paid the assessments which funded defect litigation, the Court felt the association should not be permitted to “frustrate the expectation of the owners” by avoiding arbitration.  Nor did it matter that the purchasers may not have read or completely understood the voluminous CC&Rs because the general principles of contract law charge a party with reading what they sign.  Moreover, the Davis-Stirling Act binds purchasers to the recorded CC&Rs.  

Second, under the Davis-Stirling Act, the Legislature created the scheme for a developer’s drafting and recording CC&Rs with the understanding that the developer would do this without input by an owner-controlled association.  And Civil Code section 1353(b) specifically allows CC&Rs to contain “any other matters” the developer considers appropriate.  The Court found this to be a broad enough Legislative authorization to allow the developer to include an arbitration provision.  

And what about the fact that the Pinnacle arbitration provision could not be amended without the developer’s consent?  The Court found this unproblematic because Civil Code section 1356(e)(2) prohibits any court from striking “special rights, preferences or privileges” of the developer in the CC&Rs, without the developer’s consent.  In the Court’s view, this section was Legislative permission for developers to draft CC&Rs with special non-amendable, developer-only privileges, which privileges would then be protected from court interference.  Arbitration was simply one of those privileges.

Finally, the Court held that arbitration provisions in CC&Rs were not unconscionable.  So long as the developer followed the procedure authorized by the Legislature in the Davis-Stirling Act, there was no procedural unfairness even though the association was not owner-controlled.  Substantively, the provision bound both the developer and the association, so it was not so one-sided as to be unconscionable. Having found both consent and no unconscionability, the Court ruled that the arbitration clause was enforceable against the association.

Life After Pinnacle

With arbitration provisions in CC&Rs now enforceable, the question becomes what practical effect this will have on association defect claims – both those pending and those yet to come.  For claims in their infancy or not brought until after Pinnacle was decided, associations now must be prepared to arbitrate.  Not all developers or insurance counsel will want to arbitrate, but an association can no longer rest on the idea that the arbitration provision is unenforceable.  Finding counsel with experience in the arbitration and trial setting is now paramount to an association considering a defect action.  When considering whether to bring such claims, associations should seek budgets for both possible contingencies in order to properly evaluate the potential costs.

What about association defect claims that are currently in litigation?  More likely than not, those claims will not be affected by Pinnacle, particularly if they have been in litigation for some time and if the developer never requested arbitration at the outset.  Courts do not like to enforce arbitration provisions mid-stream, for example after the parties have conducted substantial discovery.  By that point, the benefit of arbitration to the courts – that is, completely removing the matter from the already-clogged court calendar – no longer applies.  And where the developer has not requested arbitration, its later action of continuing the litigation can be held to constitute a waiver of the right to arbitrate.  Less clear are cases that are early in litigation, or where the developer made an arbitration request but it was denied under the pre-Pinnacle cases.  In those situations, a court may be more receptive to a developer’s new or renewed arbitration request.  

An additional question is whether the Pinnacle rule applies to other forms of alternative dispute resolution that are similar to arbitration.  One of these is judicial reference, where the parties agree to have their matter heard by a referee.  That referee – unlike an arbitrator – must certify that he or she will comply with the Canon of Judicial Ethics and the Rules of Court.  Also unlike binding arbitration, the proceedings under judicial reference may be reviewed on appeal.  In Pinnacle, the Court distinguished arbitration from judicial reference on the grounds that arbitration was a pre-dispute agreement, specifically authorized by statute and favored by public policy, to take a case out of the judicial forum altogether.  In contrast, judicial reference provisions fell under a different statute with different requirements and did not remove the case entirely from the judicial forum.  Thus, the Pinnacle rule regarding enforcement of arbitration provisions may very well be inapplicable to other forms of alternative dispute resolution, which would still be open to an association’s challenge.

Next, given the language of Civil Code section 1353(b) which allows the developer to insert “any other matters” into CC&Rs which it deems appropriate, can the developer include anything in the CC&Rs no matter how harmful it may be to the association’s rights?   No, there are still limits.  Even after Pinnacle, CC&R provisions are still subject to the general rule – found in Civil Code section 1354(a) – that they cannot be unreasonable.  So, for example, if the developer inserted a clause that purported to waive all claims the association may have for construction defects, that would be unlikely to survive even post-Pinnacle.  Arbitration is judicially favored, meaning courts (particularly higher courts such as the California and U.S. Supreme Courts) will lean on the side of enforcing arbitration provisions.  But a complete waiver of all construction defect claims – or another similarly unreasonable CC&R provision – has no such “favored” status under public policy and thus is more likely to be found to be unreasonable and unenforceable.  In short, there are outside limits to what the developer can do.  

The extent of those outside limits will unquestionably be the subject of future Court of Appeal decisions, as litigants and justices wrestle with the practical effects of Pinnacle.  Indeed, as is the case with many California Supreme Court decisions, the precise impact of Pinnacle remains to be seen.  Associations may find many more harmful CC&R provisions inserted by the developer, and Pinnacle leaves open the question of whether they are enforceable or may still be successfully challenged as “unreasonable.”  Developers and their insurance carriers may have no more desire to arbitrate than the association, given the lack of appeal rights.  But this much is clear:  It is no longer possible for an association to shout “unenforceable” or “unconscionable” when confronted with a CC&R arbitration clause, and associations must now have arbitration in their minds when evaluating the relative costs and benefits of pursuing defect claims against developers.

In the next article, Tyler P. Berding and Randolph M. Paul examine, in more detail, the plusses and minuses of the arbitration process.  Can it be preferable to jury trial, and if so, in what circumstances?  And why might developers and insurers be hesitant to enforce these arbitration provisions?

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