Are Arbitration Provisions Defective In Construction Defect Cases?

Many developers of condominium projects prefer alternative dispute resolution (ADR) when construction defect claims arise. ADR is seen as a more efficient way to resolve these disputes. Arbitration is one method of ADR that many developers have incorporated into their condominium documents.

If you are a developer, providing for binding arbitration in your sales agreements or other documents is often advisable. You are already faced with many uncertainties during the entitlement, financing and construction process. Arbitration provisions are intended to avoid the threat and expense of protracted litigation. Accordingly, your sales agreements and association governing documents probably include binding arbitration as an expedient and efficient means to deal with potential construction defect claims.

The Legal Issue

Courts have become increasingly willing to invalidate arbitration provisions in construction defect cases on the basis of unconscionability. The test for determining whether a provision in any agreement is unconscionable focuses on two elements: 1) Oppression and surprise due to unequal bargaining power (procedural unconscionability); and 2) overly harsh or one-sided results (substantive unconscionability). Both procedural and substantive unconscionability must be present in order for a court to refuse to enforce an arbitration provision.

The Case Law

In defect cases, courts are likely to find arbitration provisions unconscionable where 1) buyers have inferior bargaining power and the arbitration provisions are “buried in the form contracts drafted by [the developer]” (Pardee Construction Co. v. Superior Court (2002) 100 Cal. App. 4th 1081, 1089) (procedural unconscionability); and 2) “the arbitration provisions are unfairly one sided [because] the builder…would have no conceivable reason to institute legal proceedings against a homeowner after escrow closed, but virtually every claim the homeowners might raise against [the builder…] would be subject to arbitration.” Thompson v. Toll Dublin, LLC (2008) 165 Cal. App. 4th 1360, 1373 (citations and internal quotations omitted) (substantive unconscionability).

The typical development scenario appears to leave developers vulnerable to these claims. The developer drafts the sales agreement, CC&Rs and dispute resolution documents before the sale. (The arbitration provision is sometimes found in the CC&Rs, but is also placed in a separate agreement that is recorded against the project.) Because of this, a court may find that the buyer had inferior or no bargaining power. Second, in order to comply with statutory and regulatory requirements, and provide specific project information and disclosures, the condominium documents will be lengthy, thus arbitration provisions could easily be determined to be “buried” in the agreement. These two factors would satisfy the procedural prong of the test.

The court in Thompson also noted that the developer is unlikely to have cause to sue a buyer after escrow closes, but almost all of the buyer’s claims would arise after close of escrow-a result the court found unfairly one-sided, thus satisfying the substantive prong of the unconscionability test. In these relatively common circumstances a court could find both the procedural and substantive prongs are met and refuse to enforce the arbitration provisions.

Now what? What can a developer do? Is there any harm in including arbitration clauses even if they may not be enforceable? Are there alternatives to arbitration to efficiently resolve construction defect disputes? Based on current case law trends, developers should revisit how and on what basis or whether they include binding arbitration provisions in their condominium documents, and discuss alternative procedures with legal counsel.

This summary is by no means a complete list of all applicable laws and regulations related to arbitration provisions, and should not be relied upon as such. For further information, please contact Kevin Rose, Jay Drake, or Shannon Lindsay at Reuben & Junius, LLP.

Reuben & Junius, LLP is a full service real estate law firm. We specialize in land use, development and entitlement law. We also provide a wide range of transactional services, including leasing, acquisition and sales, financing and workouts, formation of limited liability companies and other entities, subdivision and condominium work.