Pinnacle: The Latest on the Enforceability of Arbitration Clauses

On Aug. 16, the state Supreme Court surprised many observers in the real estate and legal industries by overturning the decision of the Court of Appeal in Pinnacle Museum Tower Association v. Pinnacle Market Development (US), LLC, et al.,S186149 (Cal. Aug. 16, 2012). In Pinnacle, the court decided that homeowners associations may be bound by arbitration clauses contained in declarations of covenants, conditions and restrictions (CC&Rs) for common interest developments, thereby reversing a trend of lower court decisions holding such clauses unenforceable by the declarant (developer).

Several members of the court foreshadowed this decision in May, when oral argument featured a string of questions relating to the Davis-Stirling Act. Prior to that time, advocates of real estate developers had relied on either the law of contracts or equitable servitudes to justify enforcement. These arguments were falling on deaf ears at the Court of Appeal. The majority of the court saw no need to base its decision on these common law theories, however. Instead, the majority looked to the Davis-Stirling Act, and specifically Civil Code Section 1353(b) authorizing the inclusion of "any other matters the original signatory of the declaration [e.g., the developer] or the owners consider appropriate" in CC&Rs. In the majority's view, such broad authorization from the Legislature, coupled with effective oversight by the California Bureau of Real Estate, allows these provisions to overcome any shortcomings that might prevent enforcement based on common law principles. In addition, it is by virtue of this statutory system that the homeowners association could be deemed to have consented to the arbitration provision contained in the CC&Rs. This deft maneuver, accompanied by its analogy to the doctrine of delegated consent employed in Ruiz v. Padolsky, 50 Cal. 4th 838 (Cal. 2010), allowed the court to sidestep the question of whether CC&Rs ought to be enforced as contracts, equitable servitudes or neither.

In Ruiz the court held that heirs could be compelled to arbitrate wrongful death claims against healthcare providers if the deceased patient had agreed to arbitrate with the provider. The statute allowing patients and health care providers to contract for arbitration was intended to allow patients to bind their heirs to arbitration. The court held that the Davis-Stirling Act similarly authorized a developer and the members of an association to bind the association to arbitrate its construction claims against the developer. Underpinning both decisions is the notion that binding nonsignatories to arbitration does not extinguish or restrict their claims, and that this did not violate the state constitutional right to a jury trial. Justice Joyce Kennard, who dissented in Ruiz, disagreed with its application and dissented from the 6-1 decision in Pinnacle on the grounds that the association could not consent before it existed.

Despite its decision to forego express reliance on contract law, the majority applied traditional unconscionability analysis to assess the enforceability of arbitration provisions in CC&Rs. Within the purview of procedural unconscionability, the Supreme Court agreed with the Court of Appeal in finding that the particular provisions at issue in Pinnacle do not raise issues of surprise. The majority did, however, take issue with the lower court's ruling on oppression, which was based largely on the argument that since the association had no opportunity to negotiate the terms of the CC&Rs, they must therefore be oppressive. Looking again to the legislative scheme, the majority held that "a developer's procedural compliance with the Davis-Stirling Act provides a sufficient basis for rejecting an association's claim of procedural unconscionability." With the BRE's thumb in the developer's favor on the procedural scale, the association's remaining arguments about substantive unconscionability also fell short.

The application of unconscionability analysis was not unanimous, even among those who voted in favor of enforcement of the arbitration provision. Although she concurred in the result, Justice Kathryn Werdegar wrote separately, as she would reject the enforcement of CC&Rs by a developer on the basis of contract law and also locate the grant of legislative authority in different subsections than the majority. Further, because Justice Werdegar tethers enforcement to the law of equitable servitudes, she would apply a different standard than unconscionability, calling instead for enforcement unless provisions are "wholly arbitrary, violate a fundamental public policy, or impose a burden on the use of affected land that far outweighs the benefit."

The decision yields interesting practical questions for the legal community. The most immediate question is how Pinnacle will impact the resolution of construction defect disputes arising out of common interest developments. By giving the green light to arbitration, does Pinnacle create another opportunity after SB 800 ("Right to Repair Act") to revamp the practice of residential construction defect litigation? Complex construction defect cases already employ legions of neutrals as discovery referees and mediators. Many now suggest that the streamlined and cost-efficient arbitration is a myth. Nevertheless, there are those who believe the prospect of having a trained and experienced neutral party as the ultimate fact finder will streamline cases, embolden developers and subcontractors to risk submittal of more disputes to the fact-finder, and potentially reduce the settlement value of some cases.

What are the implications of having a large category of disputes relegated to private contractual arbitration? Traditionally, one explanation for a perceived hostility to arbitration has been the lack of appeal rights and case law precedent. Following Cable Connection, Inc. v. Direct TV, Inc., 44 Cal. 4th 1334 (Cal. 2008), however, parties can opt to preserve appellate rights after arbitration. Judicial reference, as an alternative ADR process, also preserves the right of appeal. Such provisions were ruled out of bounds based on contract principles in Treo@Kettner Homeowners Association v. Superior Court, 166 Cal. App. 4th 1055 (Cal. 2008), but the rationale of Pinnacle may re-open the door. The Pinnacle majority does distinguish Treo and Grafton Partners v. Superior Court, 36 Cal. 4th 944 (Cal. 2005), but does not answer the question of whether Civil Code Section 1353(b) could be read to allow judicial reference provisions in CC&Rs.

Pinnacle takes a broad view of what can be included in CC&Rs. The decision is sure to lead to the consideration of new ADR provisions other than a traditional arbitration clause. In the broader context, is it possible to have an unconscionable ADR provision in recorded CC&Rs? Conceivably any CC&Rs that make it to the county recorder's office have already passed muster with the BRE, and therefore would be given deference if challenged for procedural unconscionability. With greater guidance from case law, creative developer's counsel may believe they have a free hand to add developer-friendly provisions within the bounds of what the BRE will approve.

The answers to all of these questions will have a significant impact on the legal practice of many in the industry. For now, two things are certain: one is that arbitrators rather than juries will be deciding many construction defect cases in the future, and the other is that the next generation of CC&Rs will include innovative new ADR provisions.