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June 01, 2016 Articles

The Court, Not the Arbitrator, Decides the Validity of an Agreement Containing an Arbitration Clause

By Komal Chokshi

Sometimes the end of the arbitration is not the end of the dispute. A party prevailing in arbitration is not out of the woods, given that the underlying contract can still be challenged under traditional defenses to the formation of contract and a court, not an arbitrator, determines the enforceability of a contract under California law. 

The case of Sheppard v. J-M Manufacturing Co., 2016 Cal. App. LEXIS 69 (Jan. 29, 2016), grapples with and clarifies the role of the courts in determining the fate of arbitration clauses in situations where the validity of the underlying contract is under attack. The California Court of Appeal made it clear that determining the validity of the contract is the forte of the courts and not an arbitrator. 

The Underlying Case: A Conflict Arises
The underlying case arose when the law firm of Sheppard, Mullin, Richter & Hampton attempted to recoup attorney fees after being disqualified as counsel for J-M due to a conflict of interest. The conflict arose when the law firm represented defendant J-M without disclosing it represented a plaintiff in the matter, South Tahoe Public Utility District, in a separate matter. After disqualification, Sheppard Mullin filed suit in superior court, seeking to recoup unpaid fees. J-M cross-complained and sought, among other things, a disgorgement of fees previously paid. 

Sheppard Mullin then filed a petition to compel arbitration, based on the parties’ fee agreement. J-M argued the entire fee agreement (not just the arbitration clause) was invalid because it contained a broad waiver of all present and future conflicts of interest and was therefore contrary to public policy. J-M relied on the public policy embodied in Rule 3-310 of the California Rules of Professional Conduct, which prohibits simultaneous representation of adverse clients.  

The Case Goes to Arbitration
The trial court granted Sheppard Mullin’s petition to compel arbitration. In making its determination, the court noted that the parties had chosen California law to govern any disputes arising out of the fee agreement and, by doing so, had opted out of procedural requirements of the Federal Arbitration Act (FAA). The court rejected J-M’s arguments, finding that the arguments related to the doctrine of fraudulent inducement and such an issue is one for the arbitrator to decide. Per the terms of the arbitration clause in the fee agreement, the arbitration was conducted with a panel of three arbitrators. 

The arbitration panel ruled for the firm—despite conceding an ethical violation had transpired—and awarded it fees based on the firm’s arguments that (1) it did not recognize the conflict at the time it entered into the fee agreement, (2) the ethical violation was not so egregious as to warrant a forfeiture of fees, and (3) the firm’s representation of South Tahoe was in a matter unrelated to the J-M representation. J-M attempted to vacate the award at the trial court level, while Sheppard Mullin sought to confirm it. Irrespective of whether an ethical violation occurred, the trial court held that such a violation would not necessarily preclude the firm from collecting legal fees under the fee agreement and the arbitrators were in a position to make this determination. 

The Appellate Court Remands the Case
The appellate court disagreed with the arbitration panel and the trial court, finding Sheppard Mullin’s representation of both parties, without disclosing the conflict or obtaining client consent, violated public policy as set out in Rule 3-310. The appellate court’s first ruling was that only a fully informed waiver is effective. The court also held that because such a purported waiver is contrary to California public policy as embodied in the California Rules of Professional Conduct, an arbitration award that refuses to invalidate the waiver cannot be enforced in court and must be vacated.  

The court also maintained that, under California law, “a challenge to the legality of an entire contract that contains an arbitration provision must be determined by the trial court, not the arbitrator.” In coming to this conclusion, the court relied on cases such as Loving & Evans v. Blick, 33 Cal. 2d 603, 610 (1949), which stated that “[t]he power of an arbitrator to determine rights under a contract is dependent upon the existence of a valid contract under which this right may arise, and the question of the validity of the basic contract is essentially a judicial question, which cannot be finally determined by an arbitrator.” The court contrasted cases such as Loving with cases involving a challenge to just a portion of an agreement as opposed to the whole agreement. For instance, in Ahdout v. Hekmatjah, 213 Cal. App. 4th 21, 36 (2013), which involved a challenge to only a portion of the agreement, the court noted “the alleged illegality in the instant case does not infect the entire contract.” 

If the parties had chosen the FAA as the controlling law, the result would have been different because cases applying the FAA hold that “the validity of the agreement as a whole, is decided by the arbitrator.” Phillips v. Sprint PCS, 209 Cal. App. 4th 758 (2012) (involving an agreement governed by the FAA).  

The appellate court did remand the case to the trial court for a factual inquiry into whether the representation of South Tahoe had ceased by the time the agreement was entered into with J-M and for the purpose of determining the amount of fees that should be returned by Sheppard Mullin. The case was remanded on January 29, 2016. On March 9, 2016, Sheppard Mullin filed a petition for review with the California Supreme Court. J-M Manufacturing Co. filed an answer to the petition for review on March 30, 2016. Additional information about the procedural disposition of the case can be found in the appellate court’s online docket.  

Sheppard demonstrates that a party seeking to enforce an arbitration provision in an agreement may have more than one barrier in getting that provision enforced. Not only will the validity of the actual provision be scrutinized, but the validity of the entire agreement may become an issue. Although the Sheppard ruling dealt specifically with the issue of illegality of contract, the outcome of the case may very well be possible in situations where another challenge to the formation of a contract is raised, invalidating the contract as well as the arbitration provision contained in it. Furthermore, the enforceability of the arbitration provision may be affected by the parties’ choice of law.  

Keywords: litigation, ADR, illegality, arbitrability, conflict 

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