Arbitration Provision in Condo Association's CC&R's Enforceable for Construction Defect Litigation

August 21, 2012Article

The California Supreme Court ruled on August 16, 2012, that an arbitration provision in the Association's "Declaration of Restrictions" (CC&R's) requiring all construction disputes be decided through binding arbitration was enforceable by the Developer, even though these CC&R's were drafted by the Developer and before the Association existed which deprived it of the opportunity to negotiate this provision, i.e., "contract of adhesion."

The Supreme Court decided two questions of law. First, it decided that the arbitration clause was binding on the Association because an equitable servitude and under contract principles, and second, it decided that the clause was valid and enforceable because not "unconscionable." If a term or clause is found unconscionable, a court can invalidate that contract provision on public policy grounds.

As background, the sole plaintiff was the Association for a condominium project located in San Diego, California. It sued the developer for construction defects (Pinnacle Market Development). The Association brought the suit for damage not only to its own property, but also for damage to the interests of its members under Civil Code section 1368.3. The Developer moved to compel arbitration, and the trial court found that the clause applied to the Association but was invalid under the unconscionability doctrine. The Court of Appeals went further and found that the provision was not binding on the Association and unconscionable. The Supreme Court granted the Developer's petition for review.

In reversing and finding the arbitration clause binding and enforceable, the Supreme Court held that it could be enforced against the Association even though the Association did not consent to the provision because, in essence, the Developer was the only party to CC&R's when first drafted. It is a cardinal principle that for an arbitration provision to be applied, the party must consent to arbitrate the dispute and that the provision be reasonable.

First, the Court pointed out that each sales agreement with the individual buyers contained an arbitration provision and that as a part of the sale, every homeowner received a copy of the CC&R's. So even thought the Association did not literally "consent" to arbitration, the Supreme Court found that because the Developer complied with Davis-Stirling Act when it recorded the CC&R's, the Supreme Court determined there was consent. It reasoned that by complying with the requirements of the Davis-Stirling Act, each individual owner of the condominiums had expressly consented to the provisions in the CC&R's or had deemed by law to have agreed to the terms in the recorded declaration.

Specifically, the Court pointed out that Section 1353(b) authorizes the declarant to include "... any other matters the original signator of the declaration or the owners consider appropriate" in the CC&R's." Given this statutory authority coupled with the entire statutory scheme in place for the establishment of common interest developments, the Court reasoned that the Association was deemed to consent to the arbitration provision.

Second and on the issue of unconscionability, the Supreme Court again found that due to the compliance with the Davis-Stirling Act, the arbitration clause was valid and enforceable. Under the law, contractual provisions that are agreed to by the parties can still be found unenforceable because they violate public policy. There are two elements of unconscionability. The provision must be both procedurally and substantively unconscionable. Procedural unconscionability addresses the circumstances of contract negotiation and formation, focusing on oppression or surprise due to unequal bargaining power. Substantive unconscionability pertains to the fairness of the provision's actual terms assessing whether they are overly harsh or one-sided. To be substantively unconscionable, the term must be so one-sided as to "shock the conscience."

The issue here dealt with the lack of any negotiations and if this satisfied the procedural unconscionable element. The Supreme Court recognized that the CC&R's were drafted entirely by the Developer and without any negotiations by the Association (which did not exist). The Supreme Court held that because of the Developer's compliance with the Davis-Stirling Act, which is the legislative means for enacting a condominium development, there was no procedural unconscionability. The Supreme Court also explained that based upon the recorded declaration, the condominium owners' expectation was that construction disputes would be arbitrated, and the Association could not go against this anticipated forum.

Finally, the Supreme Court held that the Association was unable to point to any part of the provision which was substantively unconscionable. The Court held that no single part of the provision was so harsh or one-sided as to shock the conscience.

Interestingly, in assessing the impact of this new case, the attorneys for both Developer and Association have stated that they did not believe this decision would reduce the amount of condominium construction defect litigation. Notwithstanding the statement of the Supreme Court that arbitrations are less expensive and more expedient than litigation in the Superior Court, it is our experience that the decision to arbitrate a complex construction defect case versus litigating it in Court must be made on a case by case basis. In many instances, an arbitration will prove more costly than standard superior court litigation.

As an additional comment, this case may be used to try to validate contract provisions that are not negotiated. When this case first appeared, the concern was the use of the Supreme Court's analysis on other provisions, such as limitation of liability provisions and indemnity and defense provisions in construction and/or design contracts. But we believe that the case will likely be limited to only arbitration provisions involved in condominium or similar multi-family residences where the provision is recorded or otherwise required by law and therefore binding as an equitable servitude (as are CC&R's). The problem is that Supreme Court decisions are typically applied more broadly than Appellate decisions. It remains to be seen how broad a reach this decision will have on other, non-arbitration contractual provisions.