Justices to Review Arbitration Preemption Issue

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By Kevin McGowan
Oct. 1 — Granting a military contractor's petition, the U.S. Supreme Court Oct. 1 agreed to review whether the Federal Arbitration Act preempts a California state court rule regarding the enforcement of contracts containing unconscionable provisions that allegedly discriminates against arbitration agreements (MHN Gov't Servs, Inc. v. Zaborowski, U.S., No. 14-1458, cert. granted 10/1/15).

The justices will review the U.S. Court of Appeals for the Ninth Circuit's 2-1 decision that denied arbitration to MHN Government Services Inc. on the Fair Labor Standards Act and state law claims of consultants that MHN uses to provide counseling services to military service members and their families (501 Fed. App'x 461 (9th Cir. 2014)).
The case marks the second California decision regarding arbitration the Supreme Court will review in its term beginning Oct. 5, as it earlier granted DirecTV Inc.'s petition to review a state court's refusal to enforce a consumer arbitration agreement barring class actions (55 DLR AA-1, 3/23/15).

Severability Rule at Issue

The consultants contended that MHN incorrectly classified them as independent contractors rather than employees. When they sued in federal court for overtime pay and other employee benefits, MHN moved to compel arbitration under service contracts the consultants had signed that included mandatory arbitration clauses.

But the Ninth Circuit affirmed a district court decision denying arbitration on grounds those agreements contained unconscionable terms that couldn't be severed from the rest of the pact.

The agreements contained severability clauses stating that if any provision was “rendered invalid or unenforceable,” the agreement's other provisions “shall remain in full force and effect.”

But the district court ignored the severability clauses and refused to sever the allegedly unconscionable portions of the agreement and enforce the remainder, MHN said in its petition for review.

Instead, the district court ruled the entire agreement was invalid, including the arbitration clause, and didn't hold the consultants to their agreement to arbitrate all disputes, MHN said. In its 2-1 decision, the Ninth Circuit affirmed the district court's reliance on a California state court ruling that arbitration agreements with more than one unconscionable provision can't be saved by a severability clause.

MHN asked the Supreme Court to resolve whether California's non-severability rule, which the company said applies only to arbitration agreements, is preempted by the FAA, which states a strong federal policy in favor of arbitration.

Rule Discriminates Against Arbitration

California applies one severability rule to contracts in general, favoring contract enforcement and severing invalid terms whenever possible, MHN said.

But when it comes to arbitration pacts, the state “improperly applies a distinct rule” that scuttles the arbitration agreement if it includes any invalid terms, even if the parties agreed to severability, MHN said.

“The Ninth Circuit's decision here upholding that rule is contrary to binding precedents from this [Supreme] Court construing the FAA, creates conflicts among the courts of appeals and plainly warrants this Court's review,” MHN said.

In AT&T Mobility LLC v. Concepcion, 131 S. Ct. 1740 (2011) , the Supreme Court ruled that although arbitration agreements are subject to “generally applicable contract defenses,” state law rules that apply only to arbitration run afoul of the Federal Arbitration Act if they obstruct the arbitration process and prevent enforcement of the parties' agreement to arbitrate (81 DLR AA-1, 4/27/11).

The Concepcion decision was just the Supreme Court's most recent iteration of the FAA's “broad preemptive force,” MHN said. “The Court has repeatedly stated that the FAA preempts state law defenses that single out or otherwise burden arbitration agreements more than any other contract.”

The FAA preempts the California state rule regarding severability because it disfavors arbitration agreements while providing that contracts in general should be enforced even if they contain some invalid terms, MHN said.

“The California court-created rule disfavoring agreements to arbitrate cannot stand in light of the FAA,” the company said.

Alleged Circuit Conflict

The Ninth Circuit's application of a state's non-severability rule limited to arbitration contracts also conflicts with decisions from at least three other federal appeals courts, MHN said.

Unlike the Ninth Circuit or the California state courts, those other federal circuits “recognize that enforcing a contractual severability clause not only respects the parties' contractual agreement, but also adheres to the liberal federal policy favoring arbitration,” the company said.

California's arbitration-specific rule against severability of invalid terms “illustrates a troubling pattern” in which the state courts repeatedly exhibit hostility to arbitration, MHN said.

The Supreme Court's intervention again is required to prevent the California state courts from subverting the mutual benefits of parties' agreements to arbitrate, the company said.

The state rule “allows courts to invalidate an entire arbitration agreement simply upon a showing that it contains more than one unconscionable provision,” a standard that isn't applied to any other type of contract, MHN said. “This Court should grant certiorari and hold the California arbitration-only severability rule preempted by the FAA.”

Robert M. Loeb of Orrick Herrington & Sutcliffe LLP in Washington is counsel of record for MHN.

No Preemption of Generally Applicable Rule

In a brief opposing review, Thomas Zaborowski and the four other named respondents said the Ninth Circuit correctly ruled the FAA doesn't preempt application of California's general rule of contract severability when the agreement at issue contained five unconscionable provisions.

California's severability rule applies to all contracts, giving courts the discretion either to sever unconscionable provisions or, if such unfair provisions are rife, to refuse enforcement of the entire agreement, the consultants said. The rule doesn't discriminate against arbitration agreements, they said.

“The doctrine applies to all contracts equally, consistent with the FAA and this [Supreme] Court's precedent,” the consultants said. “Where there are multiple unconscionable provisions, the doctrine neither requires nor prohibits severance, but instead vests discretion in the trial court.”

“In short, [MHN] complain[s] about the court of appeals' application of arbitration-neutral statutory and case law that is consistent with the FAA and this [Supreme] Court's interpretation of it,” the consultants said.

Jahan C. Sagafi of Outten & Golden LLP in San Francisco is counsel of record for Zaborowski and the other consultants.

To contact the reporter on this story: Kevin McGowan in Washington at kmcgowan@bna.com
To contact the editor responsible for this story: Susan J. McGolrick at smcgolrick@bna.com