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Do “Illegal” Contract Provisions Void Otherwise Valid Arbitration Agreements?

By October 18, 2018 Posted in Arbitration

Two courts reach two very different conclusions.

Not every contract is perfect.  In fact, there can be times when a contract contains provisions that are void as against public policy (sometimes referred to as “illegal” provisions).  When that happens, a potentially thorny question arises: Do those “illegal” provisions invalidate an otherwise enforceable arbitration clause in the same agreement?  Two courts, the California Supreme Court and the New Jersey Court of Appeals, recently considered this issue and, surprisingly, reached two very different conclusions.

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In Sheppard, Mullen, Richter & Hampton v. J-M Manufacturing Co., Inc., 6 Cal. 5th 59 (August 30, 2018), the California Supreme Court considered this issue in the context of a fee dispute between a law firm and its client.  The law firm represented a manufacturing company in a federal qui tam action brought on behalf of numerous public entities.  At the same time, the law firm also represented one of those public entities in an employment matter.  The firm admitted there was a conflict but relied on a broad waiver provision in its engagement letter where each client agreed to waive current and future conflicts.  The engagement letter also contained an arbitration provision.

The law firm was disqualified from the qui tam case and an arbitration ensued in which the law firm sought its unpaid legal fees of $1 million plus interest.  The manufacturing client cross-claimed for, among other things, breach of contract, breach of fiduciary duty, and disgorgement of the $2 million in legal fees it had already paid.  The arbitrators ruled in favor of the law firm and awarded it $1.3 million in damages.  The California Court of Appeals vacated the award, and the California Supreme Court affirmed finding that the law firm’s broad conflict waiver violated the California Rules of Professional Conduct and, therefore, public policy.  As a result, the court declared the entire agreement between the law firm and the client was void, including the arbitration provision.  The court affirmed vacatur of the award and remanded the case to the trial court to determine whether the law firm could recover some portion of its fees pursuant to equitable remedies.

An opposite conclusion was reached by the New Jersey Court of Appeals in Roman v. Bergen Logistics, LLC, Case No. A-5388-16T3, 2018 WL 4012025 (N.J. App. Div. August 23, 2018).  In that case, a former employee filed a lawsuit in New Jersey Superior Court alleging sexual harassment, hostile work environment, retaliation, and intentional infliction of emotional distress.  The employer moved to dismiss on the basis of an arbitration agreement that the employee signed when hired.  In opposing arbitration, the employee claimed the entire agreement was unenforceable because it contained a prohibition against seeking punitive damages in violation of the New Jersey Law Against Discrimination.  The New Jersey Court of Appeals agreed with the employee that the provision waiving punitive damages was against public policy and unenforceable.  The court disagreed with the plaintiff, however, that this offending provision should void the whole contract.  Instead, it found the agreement to arbitrate was severable from the punitive damages provision and, therefore, enforceable.  As a result, the employee’s claims were compelled to arbitration but the employee was expressly allowed to pursue punitive damages in that arbitration.

Under well-established Supreme Court precedent, neither case should have been a close call.  As the Securities Arbitration Commentator noted when reporting on Sheppard, Mullen, the well settled “severability doctrine” established by the U.S. Supreme Court in Prima Paint Corp. v. Flood & Conklin Mfg. Co., 388 U.S. 395, 87 S. Ct. 1801 (1967) provides that an arbitration clause is severable from the contract in which it appears.  When the Supreme Court revisited this doctrine in 2006 in Buckeye Check Cashing, Inc. v. Cardegna, 546 U.S. 440, 126 S. Ct. 1204 (2006), it set down three guiding principles that should have made quick work of both of these cases:

First, as a matter of substantive federal arbitration law, an arbitration provision is severable from the remainder of the contract. Second, unless the challenge is to the arbitration clause itself, the issue of the contract’s validity is considered by the arbitrator in the first instance. Third, this arbitration law applies in state as well as federal courts.

Id. at 445–46, 1209.

There are, of course, always distinguishing factors.  For one, Sheppard, Mullen arose from an order vacating an arbitration award whereas Roman arose from an order compelling arbitration.  In addition, each case is not the last word and could still be reviewed by a higher court.  Nevertheless, if the California Supreme Court continues to flout the Federal Arbitration Act by striking down contractual arbitration provisions, it will continue to invite scrutiny (and reversals) from a Supreme Court that is fast losing its patience with California’s decisions on arbitration.  See DIRECTV, Inc. v. Imburgia, 136 S. Ct. 463 (2015); AT&T Mobility LLC v. Concepcion, 563 U.S. 333, 131 S. Ct. 1740 (2011).

Jonathan J. Brennan
(212) 388-6957

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