Can Mandatory Arbitration be Avoided if the Underlying Contract is Illegal?

If a contract calls for arbitration but the contract itself is void (or large important parts of the contract are void) then the arbitration provision is also void.

The general rule in California is that arbitration provisions and contracts will be enforced. The California State Legislature has made it clear that state policy favors contractual arbitration and the finality of arbitration awards. If you agree to arbitrate, then the courts will compel you to arbitrate any disputes and you will be bound by the award.

However, an arbitration clause will not be enforced if the agreement itself is not valid and not enforceable. Thus, for example, many who oppose arbitration clauses in employment and/or consumer contracts argue that consumers and low-level employees do not really understand what they are agreeing to. Since a “knowing agreement” is required for a valid contract, some argue that the contracts themselves are invalid, which invalidates the arbitration provisions.

A recent case from the California Supreme Court provides another example. In the case of Sheppard, Mullin, Et. Al. v. J-M Manufacturing Co., Inc., Case No. S232946 (Cal. Supreme Court August 30, 2018), the court held that a contract between a law firm and a manufacturing company for legal services was void because it was contrary to public policy. The engagement agreement contained an arbitration provision which the court also deemed void.

If a contract is void or is contrary to public policy, the contract will not be enforced. A common example is an agreement to commit a crime, like burglary. The subject matter of the agreement is a crime and, as such, the contract will not be enforced by California courts.

In the Sheppard Mullin case, the law firm failed to fully inform the client of potential conflicts of interest. Under the attorney ethical rules, lawyers must inform their clients of all conflicts and obtain waivers before beginning work. Since the law firm violated the ethical rules, the California Supreme Court affirmed the trial court’s decision that the engagement agreement was void which, as noted, also voided the arbitration provision.

The decision followed the rule of an old case from 1949 called Loving & Evans v. Blick, 33 Cal.2d 603 (Cal. Supreme Court 1949). Loving & Evans involved a construction remodeling company. In that case, the contractors entered into a contract for various construction work, but at no time did they have the state-required licensure. This violated then-section 2028 of the California Business and Professions Code. Section 7028 stated that “[i]t is unlawful for any person to engage in the business or act in the capacity of a contractor within this State without having a license therefor …” Since Loving & Evans did not have a license, then the contract at issue was deemed void for violating the public policy of the State of California. As with Sheppard Mullin, the construction contract in Loving & Evans contained an arbitration provision. Since the whole contract was deemed void, the arbitration provision was also deemed void.

Contact San Diego Corporate Law

For more information, contact attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard was recently named as “Best of the Bar” by the San Diego Business Journal for 2018. Mr. Leonard has received that honor for the past four years. Mr. Leonard can be reached at (858) 483-9200 or via email.

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