Daily Development for Wednesday, November 9, 2000

By: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
randolphp@umkc.edu

SERVITUDES; VALIDITY: Provision in CC&R's requiring that association and homeowners proceed to binding arbitration on construction or design defect claims is "unconscionable" and void.

Villa Milano Homeowners Association v. Il Davorge, 00 C.D.O.S. 8968 , No. G023526 (Cal. App. (4th Dist) 11/6/00)

The court notes that this is a case of first impression.

The clause in question in fact required that *any* dispute between the homeowners or the association on one side and the developer on the other side was required to be submitted to binding arbitration. The clause was included in CC&R's recorded two years before the sale of the first unit. In fact, the developer later failed and the property passed at foreclosure to its construction lender, and the units were sold thereafter.

Faced with numerous alleged construction defects, the association, representing the interests of the homeowners, brought suit against the developer, which responded with a demand for binding arbitration.

The trial court denied the petition, likening the arbitration clause to an adhesion contract and calling it "unAmerican."

The appeals court affirmed, noting that California CCP Section 1298.7 provides home buyers the right to bring a judicial action for construction or design defect damages even when the purchase agreement contains a binding arbitration clause. It concluded that public policy will not permit a developer, who is unable to use a purchase agreement to block a home buyer' s access to a judicial forum, to cut off that access by circuitous means the CC&R' s.

The court starting out by confirming the analysis of the trial court that CC&R's in general constituted contracts of adhesion.

The developer argued that the trial court's ruling that the contract was an adhesion contract was erroneous because contract analysis should not apply. It contended that a different law - real property law instead of contract law - determined its rights. But the court indicated that it would not get bogged down in characterization issues. Whether in a real estate document or not, the right to enforce the covenant to arbitrate must necessarily be contractual. It noted that a court would compel arbitration only if a binding agreement to arbitrate existed. Thus, unless the CC&R's in fact constituted a valid agreement to arbitrate, as determined under contract law, the petition to compel arbitration would have to be denied.

The developer then argued that the CC&R's could not be characterized as an adhesion contract because the homeowners could have purchased property elsewhere in a condominium development whose governing CC&R' s did not contain an arbitration clause..

The court cited Madden v. Kaiser Foundation Hospitals 17 Cal.3d 699, 711 (1976), for the conclusion that in fact adhesion contracts are based upon an imbalance in bargaining power, but not necessarily one that *requires* the weaker party to accept the contract: "In the characteristic adhesion contract case, the stronger party drafts the contract, and the weaker has no opportunity . . . to negotiate concerning its terms. . . . In many cases of adhesion contracts, the weaker party lacks not only the opportunity to bargain but also any realistic opportunity to look elsewhere for a more favorable contract; he must either adhere to the standardized agreement or forego the needed service. In short, even where a weaker party has the option to go elsewhere, the contract can still be one of adhesion."

The court noted that a major distinction between the typical adhesion contract and CC&R' s is that, once the homeowners have made their purchases, they ordinarily have the collective power to amend the CC&R' s to suit their changing needs. This is because the CC&R' s, unlike most contracts, establish a system of governance. Indeed, the Villa Milano CC&R' s specifically provided that they were amendable. But the terms of the CC&R's stated that the arbitration provision could not be amended without the consent of the developer, even when the developer no longer owned property in the complex. With respect to the arbitration provision in question, then, it truly is a "take it or leave it" proposition, with no opportunity for subsequent amendment at the sole discretion of the homeowners.

The court, however, ultimately concluded that , whether the arbitration clause contained in the CC&R' s could be characterized as an adhesion contract or not, the question of the enforceability of the clause remained, for even an adhesion contract may be enforceable. But no contract, whether adhesive or otherwise, will be enforced if it is unconscionable.

In determining whether an arbitration clause is unconscionable, California courts generally apply a twoprong test. They determine whether the clause is procedurally unconscionable and whether it is substantively unconscionable. Both procedural and substantive unconscionability must be present for a contract to be unenforceable. It characterizes the question of "procedural unsonscionability as a question of "meaningful choice:" "'Procedural unconscionability' concerns the manner in which the contract was negotiated and the circumstances of the parties at that time. It focuses on factors of oppression and surprise. The oppression component arises from an inequality of bargaining power of the parties to the contract and an absence of real negotiation or a meaningful choice on the part of the weaker party. . . The surprise component comes into play when 'the terms to which the party supposedly agreed [are] hidden in a prolix printed form drafted by the party seeking to enforce them.'"

In the view of the court, the procedural unconscionability in this case is obvious. Its conclusion that the contract was one of adhesion would appear to resolve the question, but the court went further. It noted that unit purchasers had no opportunity to object to specific parts of the CC&R's. There being absolutely no opportunity to negotiate, there was no meaningful choice, or for that matter any choice, as to the terms of the CC&R' s.

Further, the court noted that the clause itself was "buried" in a 70 page Declaration, and likely supplied to buyers with other documents of similar poundage - not an environment conducive to full disclosure.

The court found that the second element of unconscionability the substantive element - also was satisfied. This element has to do with the social acceptability of the term in question: "While courts have defined the substantive element in various ways, it traditionally involves contract terms that are so onesided as to ' shock the conscience,' or that impose harsh or oppressive terms."

In the court's view, the homeowners, by agreeing to CC&R' s that include a binding arbitration clause, waived their constitutional right to a jury trial. While this they certainly may do, "the right to pursue claims in a judicial forum is a substantial right and one not lightly to be deemed waived."

The court noted that various California statutes concerning home sales require very clear disclosure of arbitration requirements and in fact prohibit requiring binding arbitration relating to construction defects. It concluded that the developer sought to accomplish by way of the CC&R's that which California statutes blocked it from doing via a purchase agreement. It intended to bar the individual unit owners from filing construction or design defect actions against it in court. "This flies in the face of the obvious legislative intent to permit home buyers to have their construction and design defects claims heard in a judicial forum. It is a blatant attempt to curtail the statutory rights of the home buyers and simply shocks the conscience. "

Furthermore, the court noted, the Legislature has not overlooked the issue of whether homeowners associations should be compelled to engage in the binding arbitration of construction and design defect disputes. Civil Code section 1375 establishes a set of prelitigation procedures to be followed before a homeowners association may file suit against a builder for construction or design defects. Those procedures require a homeowners association and a builder to either "attempt to settle the dispute or attempt to agree to submit it to alternative dispute resolution." But if the attempts are unsuccessful, section 1375 permits the association to file a judicial action against the developer. The provision demonstrates that the Legislature has chosen to encourage alternative dispute resolution between homeowners associations and developers, but not to require it. In the end, a homeowners association has access to the courts.

The court acknowledged that legislative and administrative authority in California did countenance use of arbitration clauses in certain subdivision contexts, but only subject to special disclosure requirements. But it commented that permitting such clauses to be used in some instances is not an endorsement of them in all instances.

The Developer attempted to rely upon established California law supporting the enforceability of CC&R's generally. For instance, California Civil Code section 1354, subdivision (a), provides: "The covenants and restrictions in the declaration shall be enforceable equitable servitudes, unless unreasonable, and shall inure to the benefit of and bind all owners of separate interests in the development. Unless the declaration states otherwise, these servitudes may be enforced by any owner of a separate interest or by the association, or by both."

Restrictions in recorded CC&R' s, under California's famous Nahrstedt case, are presumed reasonable and the burden is on the party challenging a given restriction to prove otherwise. In order to do so, that party must show the restriction "violates public policy; . . . bears no rational relationship to the protection, preservation, operation or purpose of the affected land; or. . . otherwise imposes burdens on the affected land that are so disproportionate to the restriction' s beneficial effects that the restriction should not be enforced." (Id. at p. 382.)

The developer further argued that public policy generally favors arbitration. But the court responded that in this case a more specific public policy controls. Public policy concerning the arbitration of home buyer construction and design defect claims is established by the California Code of Civil Procedure. Arbitration clauses, while generally favored, are against public policy when hidden by a developer in that prolix form called CC&R' s, in a deliberate attempt to circumvent statutory protections for home buyers with construction and design defect claims.

At the end of the opinion, however, the court retreated from some of the more extended applications of its prior analysis. It stated that it did not address whether an arbitration provision contained in CC&R' s would be unconscionable were a different type of claim at issue for example a dispute over a homeowners association' s right to control the kind of improvements made to a home or a disagreement about whether a homeowners association could compel a homeowner to remove a boat from his or her driveway. It commented that "it is easy to conceive of many contexts in which an arbitration clause in CC&R' s would not circumvent statutory protections, violate public policy, or otherwise pose issues of substantive unconscionability. In fact, we observe that California law encourages alternative dispute resolution with respect to certain disputes related to the enforcement of CC&R' s."

It concluded with very specific narrowing of the scope of the opinion: "Our holding is very narrow. It speaks only to the enforcement of a CC&R' s provision compelling binding arbitration of construction and design defects claims against the developer who drafted, signed and recorded the CC&R' s. It is not intended to cast doubt upon the enforceability of CC&R' s in general. To the contrary, CC&R' s "should be enforced unless they are wholly arbitrary, violate a fundamental public policy, or impose a burden on the use of affected land that far outweighs any benefit." (Nahrstedt v. Lakeside Village Condominium Assn., supra, 8 Cal.4th at p. 382.) Moreover, "recorded CC&R' s are the primary means of achieving the stability and predictability so essential to the success of a [common interest] development." (Ibid.) The presumption of validity afforded to recorded CC&R' s "provides substantial assurance to prospective condominium purchasers that they may rely with confidence on the promises embodied in the . . . CC&R' s."

Comment: Aren't there really two separate opinions here? And is the first one really relevant or useful? In the first opinion, the court sweepingly concludes that the concept of CC&R's is inherently a contract of adhesion unless the provisions contain language for amendment. Note, however, that amendment language in fact can lead to far greater problems than the court envisions here - as demonstrated by the DD for October 25, 2000, Windemere Homeowners Ass'n Inc. v. McCue, 990 P.2d 769 (Mont.1999). (language permitting amendment allows subsequent changes to relationship of parties that go far beyond originally contemplated scheme - including creation of a homeowner's association with assessment power for purposes never contemplated originally.)

The fact is that, in most cases, CC&R's are not deals cut with the developer as much as they are understandings mutually agreed to by the homeowners themselves. The dangers of any argued adhesion are balanced by the fact that this is the only rational way to bring together in a common scheme diverse purchasers coming to the development at different times.

Comment 2: Why not just conclude that developers cannot use these CC&R's to feather their own nests, as opposed to creating common schemes? The traditional "touch and concern" rule, much maligned, might at least have carried out that objective. Can't we have something similar in this brave new world of judicial second guessing?

Comment 3: In fact, can't we just conclude that the public policy clearly established against binding arbitration agreements on construction defects in real estate sales contracts extends to this situation, and void the provision on that ground alone? Do we really need an extended analysis of the weaknesses of the servitude regime as a model of contract law? As the court ultimately acknowledges, other courts, and the California legislature, have recognized the special benefits of this device, and have approved its use. Why beat the concept of servitude regimes to half to death, thus inviting other courts to do so in other contexts, when the real problem is the very specific arbitration requirement? Note that the court acknowledges that a prior California case, Izzi v. Mesquite Country Club186 Cal.App.3d 1309 (1986), in fact upholds binding arbitration clause in a condominium declaration in a context unrelated to construction defects. The court distinguishes that case on the grounds that it predated the statute on construction defect issues in sale contracts, but does not overrule it.

Consequently, despite all the bluster, it appears that this case applies solely to that aspect of the arbitration clause apply to construction defect litigation.

Comment 4: Ironically, the much shorter "second opinion" contained in the court's opinion does praise the merits of servitude regimes and suggests that nothing it said in the pages and pages of diatribe concerning those regimes really means anything. This latter portion of the opinion must have been written by someone who never met the author of the first part, or at least we must assume that they rarely spoke to one another.

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