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California Court of Appeal Decision Demonstrates How Not to Draft an Arbitration Agreement

April 28, 2004

A recent unpublished opinion of the California Court of Appeal presents a textbook example of how not to draft an arbitration provision in an employment agreement. In United Revenue Service, Inc. v. Prall, 4th Dist. No. G032279, 2004 Cal. App. Unpub. LEXIS 3051 (April 5, 2004), a unanimous panel of the Fourth District Court of Appeal affirmed the trial court's refusal to enforce an arbitration agreement containing "multiple unlawful and disturbing clauses." Because it is an unpublished opinion, this decision cannot be cited in the California courts, but it nevertheless serves as a cautionary tale for other employers.

Denise Prall was employed by United Revenue Service for a number of years. She was required to sign an employment agreement containing an arbitration provision in 1998 and again in 2000. The 2000 agreement contained a clause providing that it superseded all prior oral and written agreements. Prall testified that she did not want to enter into either agreement, but that her supervisor David Kalai told her that if she did not sign the agreement, "he would withhold her paycheck until she did."

In February 2001, Prall took a medical leave of absence. She later informed United Revenue Service that she would not be returning and then filed a lawsuit against the company alleging sexual harassment by Kalai and constructive termination.

The employer insisted that the matter be arbitrated and Prall countered that the arbitration agreement was unduly burdensome and unenforceable. Ultimately, the parties agreed in January 2002 that Prall would dismiss her lawsuit and that the claim would go forward in arbitration, with United Revenue Service initially paying the arbitration expenses, but with the costs ultimately shifting to the losing party.

Prall then dismissed her lawsuit but the employer refused to advance the fee for the arbitration until Prall had filed a formal demand for arbitration. Prall then re-filed her lawsuit in the Superior Court and took the position that the employer had waived its right to arbitration under the January 2002 agreement by refusing to advance the fee as previously agreed. United Revenue Service moved for summary judgment, arguing that it was entitled to mandatory arbitration. The court sided with Prall and held that the 2002 letter agreement was "not binding" on Prall and the 2000 arbitration agreement was unconscionable and unenforceable under Armendariz v. Foundation Health Psychcare Services, Inc. (See California Supreme Court Provides Guidance on Mandatory Employment Arbitration Agreements (Aug 29, 2000).) Undeterred, the employer immediately filed a petition to compel arbitration, which the court also rejected.

United Revenue Service appealed the denial of its petition to compel arbitration and contended that it was entitled to arbitration under any one of the three agreements Prall had signed: the 1998 employment agreement, the 2000 employment agreement, and the January 2002 post-employment agreement to arbitrate. The Court of Appeal found otherwise, holding that the 1998 agreement was of no effect once it was superseded by the 2000 agreement. It also refused to disturb the trial court's finding that the 2002 letter agreement was "not binding" on Prall because United Revenue Service acted in bad faith by refusing to pay the arbitrator's fee.

The court also examined the 2000 agreement to determine whether it was enforceable and concluded that it was not. In so holding, the court considered the two grounds available under the Armendariz decision by which a party may avoid an agreement to arbitrate: procedural and substantive unconscionability. The court concluded that the 2000 agreement "clearly" was procedurally unconscionable, both because it was imposed on Prall as a condition of employment with no opportunity to negotiate and because Kalai told Prall that she would not receive her paycheck until she signed the agreement.

The court also found the 2000 agreement to be substantively unconscionable, that is, unfairly one-sided. The agreement contained a provision that allowed the company to pursue its claims against Prall in whatever venue it pleased, but required Prall (a California employee) to pursue her claims against the company in Nevada. The agreement also required Prall—in violation of Armendariz's requirements—to pay the entire cost of the arbitration up front, subject to reimbursement only if she prevailed. As yet another basis for the finding that the agreement was unconscionable, the court noted that the agreement "significantly limited" the amount of discovery or information that the parties could obtain in the arbitration process. These limitations significantly interfered with Prall's ability to pursue her claims in the arbitration forum to the same extent she would be able to in a court action.

United Revenue Service argued that the offending provisions should be severed from the agreement and the arbitration should be allowed to go forward. The court refused, stating: "[T]he arbitration provision includes multiple unlawful and disturbing clauses, which anyone would understand to place almost impossible burdens on Prall's ability to bring a claim, and then make clear that even if she did, she would not be entitled to anything like the discovery she would be entitled to in court." The court went on to find that the evidence was "more than sufficient to indicate bad faith" on the part of United Revenue Service, and affirmed the trial court's refusal to compel arbitration.

What does this decision mean for employers doing business in California? If an employer's arbitration agreement complies with the substantive and procedural requirements of Armendariz, nothing. However, if an employer uses a pre-2000 arbitration agreement that unduly limits employees' rights, it is definitely time to review and update the agreement. Please contact any of the attorneys in our San Francisco office for further information.