Initial Those Arbitration Provisions

Whether or not the Federal Arbitration Act preempted Code of Civil Procedure section 1298.7 relating to construction defect litigation, and whether or not sufficient interstate commerce existed for such preemption were integral issues in Edward D. Basura, Jr., et al., vs. U.S. Home Corporation, (Case No. B151131, Second District Court of Appeal, filed May 31, 2002).

The court of appeal reviewed the order by the Los Angeles County Superior Court (Case No. BC240683) in the construction defect litigation filed by Edward Basura and more than 60 other Plaintiffs. The lower court had denied Defendant Home’s petition to compel arbitration.

The nature of the litigation was allegations of construction and design defects in the residential housing built by Home. Although each of the plaintiffs initialed the arbitration clause in paragraph 14 of their contracts, Home initialed only 48 of the arbitration provisions. When the superior court litigation was filed, Home filed a petition to compel arbitration of all of the 60-plus plaintiffs’ claims.

The plaintiffs opposed Home’s petition as follows: First, that the arbitration provisions was unenforceable against certain plaintiffs because Home had failed to initial them; second, CCP section 1298.7 specifically permits a buyer of real property to pursue a construction defect case in court regardless of the existence of an arbitration provision in a sales contract; and third, Federal Arbitration Act does not preempt CCP section 1298.7 because there was no “interstate commerce” involved in the subject real estate purchase contract. [See, Allied-Bruce Terminix Cos. v. Dobson (1995) 513 U.S. 265, 274: the FAA’s “reach” is coincident with that of the Commerce Clause, therefore the FAA applies to contracts “relating” to interstate commerce].

Home replied as follows: First, since all of the plaintiffs had consented to arbitration by initialing the arbitration provisions, the lower court had to order them into arbitration; second, CCP section 1298.7 does not unequivocally prohibit arbitration of construction defect litigation and third, the FAA preempts CCP section 1298.7 because the sales agreements “involve” interstate commerce.

The Second District Court of Appeal reinforced the requirements of CCP sections 1298 through 1298.8, noting that arbitration provisions must meet certain print size and capitalization of words requirements, contain a prominent notice provision and must be initialed if the parties agree to arbitration. [CCP section 1298, subd. (c)], and see, Villa Milano Homeowners Assn. V. Il Davorge (2000) 84 Cal.App.4th 819, at 829-830.

In Basura, the court cited Villa Milano, supra, reaffirming that a buyer may pursue a construction/design defect action in the court even if he signed an agreement conveying real property and containing an arbitration provision. “With respect to the impact of section 1298.7, Villa Milano explained: ‘[S]ection 1298.7…provides that even when an arbitration provision is included in an agreement to convey real property, ‘it shall not preclude or limit…any right of action to which…Section 337.1 or 337.15 is applicable.’ [Fn. Omitted.]…[S]ections 337.1 and 337.15 pertain to litigation to recover damages for construction and design defects. In other words, the net effect of section 1298.7 is to permit a purchaser to pursue a construction and design defect action against the developer in court, even if the purchaser signed an agreement to convey real property containing an arbitration clause. [Fn. Omitted] [Citation.]” Villa Milano, supra, at 830.

What follows next in the analysis is a question of federal preemption: does the Federal Arbitration Act preempt CCP section 1298.7?

Section 2 of the FAA, gives validity, enforceability and irrevocability to written arbitration clauses, (save for the contractual defenses for revocation at law or in equity, such as fraud, duress or unconscionability). But courts may not invalidate arbitration agreements under those state laws, which by definition apply only to arbitration provisions. The U.S. Supreme Court has ruled previously that CCP section 1298.7 directly conflicts with section 2 of the FAA, “…[b] ecause the California statute is a state law applicable only to arbitration agreements, allowing a purchaser to pursue a construction and design defect action against a developer in court, despite having signed an agreement to convey real property containing an arbitration clause”. See, Doctor’s Associates, Inc. v. Casarotto (1996) 517 U.S. 681, 683

It is well settled that the FAA applies to a contract “involving” interstate commerce. Referencing the U.S. Supreme Court’s holding in Allied-Bruce Terminix Cos. V. Dobson, supra, at 269, the Second DCA reaffirmed that the term “involving” interstate commerce is broad and is the “functional equivalent” of “affecting” commerce. Here, the court decided that there existed sufficient evidence of interstate commerce so as to invoke the reach of the FAA. For example, two of Home’s executives submitted declarations stating that the construction of the Palmdale residential development involved the receipt and use of building materials and equipment such as GE Appliances, World Carpet, Armstrong Flooring, and other products manufactured and/or produced in various states outside of California.

Further evidence showed that Home contracted with out-of-state design professionals, trade contractors and subcontractors. It utilized a marketing and advertising plan, which initiated marketing activities throughout the United States. Home communicated by interstate mail and telephone with its out-of-state independent contractors and agents. All of these facts persuaded the appellate court that interstate commerce was, in fact, “involved” in the underlying sales contracts and therefore CCP section 1298.7 could not be used to avoid the agreements to arbitrate.

As to Home’s failure to initial the arbitration provisions contained in 28 of the sales agreements, the superior court had ruled that accordingly, those 28 plaintiffs could not be compelled to arbitrate. In essence, there was no “agreement” to arbitrate between the parties. Although the Federal Arbitration Act does in fact create a presumption in favor of arbitration, the presumption does not mean that a court is free to compel a party to arbitrate that which it has not agreed to do so.

Courts typically apply ordinary state law principals when determining whether or not a party agreed to arbitrate a particular matter, notwithstanding the issue of federal preemption. “When it is clear, both from a provision that the proposed written contract would become operative only when signed by the parties as well as from any other evidence presented by the parties that both parties contemplated that acceptance of the contract’s terms would be signified by signing it, the failure to sign the agreement means no binding contract was created. [Citations.] This is so even though the party later sought to be bound by the agreement indicated a willingness to sign the agreement [Citations.]

On the other hand, if the respective parties orally agreed upon all of the terms and conditions of a proposed written agreement with the mutual intention that the oral agreement should thereupon become binding, the mere fact that a formal written agreement to the same effect has not yet been signed does not alter the binding validity of the oral agreement. [Citations.]” See, Banner Entertainment, Inc. v. Superior Court (1998) 62 Cal.App.4th 348, 358.

Accordingly, the Second DCA concluded that the lack of a perfected written arbitration agreement does not automatically foreclose the possibility that the parties intended to arbitrate. Here, those 28 plaintiffs who had each initialed the arbitration provisions in their sales contracts clearly evidenced an intention to arbitrate. As to Home’s failure to initial 28 contracts, the court concluded a reasonable inference could be drawn that its failure was simply inadvertent and the result of clerical error, employee oversight or time constraints.

The Second DCA on remand directed the superior court to conduct an evidentiary hearing for the express purpose of assessing the likelihood of Home’s intention to be bound by arbitration. If the evidence showed such intention the lower court was directed to produce an order compelling those 28 plaintiffs to arbitrate their claims with Home.

The facts and the law in this case underscore the importance of several logical deductions: First, real estate developers (and their lawyers) should make every effort to ensure that each and every arbitration provision in the operative sales contracts are initialed by all parties. In the instant case one of the issues was related to the question of a party’s “intention to arbitrate” — the corresponding litigation might have been avoided. Second, review the FAA and the relevant cases assessing its “reach”. Recall that when advising a client on the merits of binding arbitration any effects of the FAA should be reviewed, discussed and analyzed to avoid surprise. Third, reliance on the notion that CCP section1298.7 is sacrosanct is legal folly: if interstate commerce is involved in the subject contracts, it may well provide the nexus for federal preemption of the state statute.

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