Surety Case Law Note: When is an Arbitration Provision Unconscionable and Unenforceable Under California Law?
September 12, 2023
In this Surety Today blog post we will provide a Case Law Note to consider the issue of whether an arbitration provision of a contract is unconscionable and unenforceable under California law. Unconscionability under general contract law is generally speaking a pretty high bar to reach, but in the context of arbitration agreements in California it is surprisingly more attainable, and, as held in this case, something a surety could establish. The case is:
GREAT AMERICAN INSURANCE COMPANY v. OXNARD UNIFIED HIGH SCHOOL DISTRICT,
No. CV 22-8780-JFW(AFMX), 2023 WL 5504967 (C.D. Cal. June 22, 2023)
The School District entered into a construction contract with Fast-Track Construction Corporation (“FTCC”) for the new HVAC modernization of the Channel Islands High School. Great American Insurance Company (“GAIC”) provided the statutory payment and performance bonds on behalf of FTCC for the Project. The Bonds did not specifically include an arbitration provision for disputes between the surety and the School District. However, the Bonds incorporated by reference the contract documents between the School District and FTCC, which included the following arbitration provision:
If mediation under this section does not resolve the parties’ dispute, the District may, but does not require arbitration of disputes under private arbitration or the Public Works Contract Arbitration Program.
The School District terminated FTCC for cause and demanded that GAIC pay for the completion of the Project. GAIC filed the suit against the School District and the District filed a demand for arbitration. GAIC objected to the demand for arbitration asserting that it was not required to arbitrate. Thus, the primary issue in the case was whether GAIC could be compelled to arbitrate.
The court recognized that doubts concerning the scope of arbitrable issues should be resolved in favor of arbitration. Moses H. Cone Memorial Hosp. v. Mercury Constr. Corp., 460 U.S. 1, 24-25 (1983). However, certain issues are presumptively reserved for the court. Howsam v. Dean Witter Reynolds, Inc., 537 U.S. 79, 84 (2002). These issues include “gateway” questions of arbitrability, such as “whether the parties have a valid arbitration agreement or are bound by a given arbitration clause, and whether an arbitration clause in a concededly binding contract applies to a given controversy.” Momot v. Mastro, 652 F.3d 982, 987 (9th Cir. 2011).
GAIC argued that the arbitration provision was unconscionable because it allowed only the School District, and not the contractor or surety, to elect to arbitrate disputes. The court noted that “[l]ike other contracts, arbitration agreements can be invalidated for fraud, duress, or unconscionability.” Chavarria v. Ralphs Grocery Co., 733 F.3d 916, 921 (9th Cir. 2013). “Unconscionability under California law ‘has both a procedural and a substantive element, the former focusing on oppression or surprise due to unequal bargaining power, the latter on overly harsh or one-sided results.’” Armendariz v. Foundation Health Psychcare Services, Inc., 24 Cal. 4th 83, 99 (2000). Both procedural and substantive elements must be present. But, California courts apply a “sliding scale” analysis in determining unconscionability: “the more substantively oppressive the contract term, the less evidence of procedural unconscionability is required to come to the conclusion that the term is unenforceable and vice versa.” Poublon v. C.H. Robinson Co., 846 F.3d 1260 (9th Cir. 2017). Thus, although procedural and substantive unconscionability must both be present for the contract to be declared unenforceable, “they need not be present to the same degree.” Baltazar v. Forever 21, Inc., 62 Cal.4th 1237, 1243 (2016). The party opposing arbitration has the burden of proving that the arbitration agreement is unconscionable. See Engalla v. Permanente Medical Group, 15 Cal. 4th 951, 972 (1997); Pinnacle Museum Tower Ass’n v. Pinnacle Market Development (US), LLC, 55 Cal. 4th 223, 236 (2012).
The California Supreme Court has emphasized that “unconscionability requires a substantial degree of unfairness beyond ‘a simple old-fashioned bad bargain.’” Id. at 1245 (quoting Sonic-Calabasas A, Inc. v. Moreno, 57 Cal.4th 1109, 1160 (2013)). “Rather, unconscionable contracts are those that are so one-sided as to ‘shock the conscience.’” Mohamed v. Uber Technologies, Inc., 848 F.3d 1201, 1210 (9th Cir. 2016) (quotations and citations omitted).
A. Procedural Unconscionability
The procedural element of unconscionability focuses on oppression or surprise due to unequal bargaining power. Oppression arises “from an inequality of bargaining power [that] results in no real negotiation and an absence of meaningful choice.” Circuit City Stores, Inc. v. Mantor, 335 F.3d 1101, 1106 (9th Cir. 2003) (quoting Stirlen v. Supercuts, Inc., 51 Cal. App. 4th 1519, 1532 (1997)). Surprise “involves the extent to which the contract clearly discloses its terms as well as the reasonable expectations of the weaker party,” Chavarria v. Ralphs Grocery Co., 733 F.3d 916, 922 (9th Cir. 2013), and “involves the extent to which the supposedly agreed-upon terms of the bargain are hidden in the prolix printed form drafted by the party seeking to enforce the disputed terms.” Stirlen, 51 Cal. App. 4th at 1532. “[T]here are degrees of procedural unconscionability. At one end of the spectrum are contracts that have been freely negotiated by roughly equal parties, in which there is no procedural unconscionability …. Contracts of adhesion that involve surprise or other sharp practices lie on the other end of the spectrum.” Baltazar v. Forever 21, Inc., 62 Cal.4th 1237, 1244 (2016). The court in this case concluded that there was “at least some degree of procedural unconscionability” because the terms of the Bonds and the contract documents were presented on a “take it or leave it” basis and could not be modified, as is true in most government contracting situations. In addition, the arbitration provision was not included as a separate term of the Bonds, but was included in the contract documents that were incorporated by reference. From the surety standpoint, this analysis would lead to the conclusion that there is almost always procedural unconscionability in government contracting.
B. Substantive Unconscionability
Under California law “[A]n arbitration agreement imposed in an adhesive context lacks basic fairness and mutuality if it requires one contracting party, but not the other, to arbitrate all claims arising out of the same transaction or occurrence or series of transactions or occurrences.” Armendariz v. Found. Health Psychcare Servs., Inc., 24 Cal. 4th 83, 120 (2000). “Given the disadvantages that may exist for plaintiffs arbitrating disputes, it is unfairly one-sided for [a party] with superior bargaining power to impose arbitration on the [party with weaker bargaining power] but not to accept such limitations when it seeks to prosecute a claim against the [party with weaker bargaining power], without at least some reasonable justification for such one-sidedness based on ‘business realities.’” Armendariz, 24 Cal. 4th at 117.
The School District did not dispute its unilateral arbitration provision, instead it argued that the unilateral arbitration provision was permitted by the California Public Contract Code. However, the court held that, contrary to the District’s argument, there is nothing in the Public Contract Code that permits the District to impose an unconscionable unilateral arbitration provision. Rather, the Code merely provided that the District was permitted to include a valid arbitration provision in its contracts, but certainly not an unconscionable arbitration provision. Accordingly, the court held that the arbitration provision was unconscionable and thus unenforceable.
The takeaway here is that if the surety is in California dealing with a government contract and only the owner is allowed to select arbitration, unconscionability may exist as a defense against being compelled to arbitrate.
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (410-659-1321/mstover@wcslaw.com) or any member of the Surety and Fidelity Practice Group.