chevron-down Created with Sketch Beta.
June 01, 2016 Articles

Does the FAA Preempt California's Severability Rule as Applied to Arbitration Agreements?

By Charles E. Harris II, Sarah E. Reynolds, and Logan A. Steiner

The Supreme Court granted certiorari in MHN Government Services v. Zaborowski to decide whether the Federal Arbitration Act preempts California's arbitration-only severability rule, under which courts are given the discretion to invalidate an arbitration agreement with more than one unconscionable clause or to sever the unconscionable terms and enforce the remainder of the agreement. The answer to this question will have to wait for another day because the parties settled their dispute prior to the scheduled oral argument.

The centerpiece of the FAA, section 2, provides that an arbitration agreement "shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract." 9 U.S.C. § 2. The effect of the last clause, often referred to as the "savings clause," is that courts may refuse to enforce an arbitration agreement that would be subject to generally applicable state law contract defenses such as fraud, duress, or unconscionability. However, an arbitration agreement may not be invalidated by state law defenses that affect only those agreements; arbitration agreements and other contract terms must not be subjected to discriminatory treatment. AT&T Mobility LLC v. Concepcion, 563 U.S. 333, 339 (2011).

California courts, in particular, have frequently refused to enforce arbitration agreements based on a variety of state law defenses that the courts claim are "generally applicable" to all types of contracts and thus within the FAA's savings clause. But the U.S. Supreme Court has overturned several such decisions because the state law defense is in reality applied by courts to single out arbitration agreements for disfavor or frustrates federal policy favoring arbitration. For instance, in Concepcion, decided in 2011, the Court held that the FAA preempted a California state law unconscionability rule that barred the enforcement of arbitration agreements requiring arbitration on an individualized basis and waiving class procedures.

In 2015, the Court granted petitions for writ of certiorari in two cases in which California courts had invalidated an arbitration agreement based on state law defenses. In DIRECTV v. Imburgia, 136 S. Ct. 463 (2015), the parties' service agreement, which included an arbitration provision with a class arbitration waiver, specified that the entire arbitration provision was unenforceable if the "law of your state" made class arbitration waivers unenforceable. The Court held that the California Court of Appeal's idiosyncratic interpretation of the phrase "law of your state" to include invalid state laws—in that case, the very rule regarding unenforceability of class waivers struck down in Concepcion—failed to place arbitration agreements on equal footing with other contracts. Thus, it held that the court's interpretation was preempted by the FAA.

The Court also granted certiorari to review the Ninth Circuit's decision in Zaborowski v. MHN Government Services, 601 F. App'x 461 (9th Cir. 2014). The question before the Court was whether California's severability rule, which affords courts the discretion to invalidate an arbitration agreement with more than one unconscionable clause or to sever the unconscionable terms and enforce the remainder of the agreement, disfavors arbitration agreements and thus does not place them on equal footing with other contracts. The Court's answer to that question will have to wait for another day; the case recently was dismissed because the parties settled it shortly before the scheduled oral argument. Even so, Zaborowski serves as a timely reminder to businesses maintaining arbitration programs that the terms in their arbitration agreements should be fair and balanced and that the arbitration clause should be conspicuous, so as not to give California courts any excuse for refusing to enforce such agreements.

The California District Court Proceedings
MHN Government Services and Managed Health Network (together, MHN), the defendants in Zaborowski, hired the plaintiffs to provide financial services, child services, and victim advocacy counseling services to military service members and their families. The counseling services contract that the parties entered into contained an arbitration clause. Therefore, when the plaintiffs sued MHN in federal district court alleging that MHN improperly failed to pay them overtime in violation of federal and state labor laws, MHN moved to compel arbitration.

In response, the plaintiffs argued that the arbitration clause was unconscionable. The Northern District of California agreed. It held that the clause was procedurally unconscionable because it was a "contract of adhesion," "oppressive" due to MHN's purportedly superior bargaining power, and "created an unfair surprise" because the clause appeared in "paragraph twenty of twenty-three paragraphs." The court also held that five provisions in the clause were substantively unconscionable. These provisions specified that (1) the arbitration must be initiated within six months of an injury; (2) MHN chooses a pool of three arbitrators from which the opposing party then selects a single arbitrator; (3) the fee for commencing an arbitration is not shifted to MHN; (4) arbitration costs and attorney fees are borne by the non-prevailing party; and (5) the parties may not be awarded punitive damages. Zaborowski v. MHN Gov't Servs., Inc., 936 F. Supp. 2d 1145, 1151–57 (N.D. Cal. 2013).

Notwithstanding the arbitration clause's severability provision, the court refused to sever its allegedly unconscionable provisions and, instead, invalidated the arbitration clause. In doing so, the court relied on Armendariz v. Foundation Health Psychcare Services, 6 P.3d 669, 695 (Cal. 2000), in which the California Supreme Court held that when an arbitration agreement is "permeated" with unconscionability, trial courts have the discretion to decide whether to sever unconscionable terms in an arbitration agreement or to refuse to enforce it entirely. Zaborowski, 936 F. Supp. 2d at 1156–57. The Zaborowski court held that the arbitration clause at issue was "so permeated with unconscionability that it is not severable." Id. at 1157.

The Ninth Circuit Opinion
The Ninth Circuit affirmed the district court in an unpublished decision. The three-judge panel agreed that certain terms in the arbitration clause were unconscionable. But only two of the judges agreed that the district court "did not abuse its discretion by declining to sever the portions of the arbitration provision." Zaborowski, 601 F. App'x at 464. Those judges reasoned that striking the "five unconscionable clauses would require [the district court] to assume the role of contract author rather than interpreter." Id. (internal quotation marks omitted).

Judge Ronald Gould dissented, stating that "the reasoning in Armendariz that multiple unconscionable provisions will render an arbitration agreement's purpose unlawful has 'a disproportionate impact on arbitration agreements'" and thus "should have been preempted" by the FAA. Id. (quoting Concepcion, 131 S. Ct. at 1747). He reasoned that, in light of Concepcion and its progeny, there should be "a presumption in favor of severance when an arbitration agreement contains a relatively small number of unconscionable provisions that can be meaningfully severed." His dissent included a redlined version of the arbitration clause at issue to demonstrate how easily the allegedly unconscionable terms—which amounted to 4 sentences and 1 clause—could have been severed from the 18-sentence, 400-word arbitration clause in a manner that would permit the court to enforce it. Id. at 465. While Judge Gould "recognize[d] that one can imagine an arbitration agreement where the number and content of unconscionable provisions are so pervasive that they rebut the presumption in favor of severance," the 5 "challenged provisions" in question—some of which were "arguably not unconscionable" and instead "entered into in good faith"—did not "rebut a presumption in favor of severance." Id. at 465 n.1.

The Certiorari Petition and MHN's Merits Brief
MHN's certiorari petition and its merits brief emphasized that the Ninth Circuit's holding was not an isolated occurrence. It criticized California courts for "routinely display[ing] the flagrant hostility to arbitration that the FAA was designed to end," explaining that "the severability issue presented here arises literally every time a court finds one or more provisions of an arbitration agreement to be invalid under California law." MHN alleged that California applies a separate (and allegedly harsher) rule of severability to arbitration agreements than to other types of agreements. In response, the plaintiffs underscored the district court's discretion and argued that California's severance doctrine is not limited to arbitration agreements, but "derives from statutes that apply to all contracts and from cases dealing with contracts of various sorts."

The Settlement and Its Implications
The parties reached a confidential settlement a month and a half before the date the Court set for argument and after MHN had filed its brief on the merits. Based on the Court's precedents, there is a strong likelihood that the Court would have held that California's severability rule is preempted by the FAA because, among other reasons, it is being applied in a fashion that disfavors arbitration. Nevertheless, with no decision from the Court on the validity of the rule, some California courts will undoubtedly continue to apply California's malleable severability rule in a manner that disfavors arbitration. This presents a risk for companies that have arbitration programs and may face lawsuits in California. Given the continued uncertainty about severability, every company with an arbitration agreement that does business in California would be well advised to revisit the agreement to ensure that none of its features could be used as a justification for taking down the entire provision.

Keywords: litigation, ADR, MHN, Zaborowski, Supreme Court, settlement, arbitration 

Copyright © 2018, American Bar Association. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. The views expressed in this article are those of the author(s) and do not necessarily reflect the positions or policies of the American Bar Association, the Section of Litigation, this committee, or the employer(s) of the author(s).