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Judicial Review of Arbitrator Awards: Who decides whether the underlying contract is illegal or enforceable?

February 8, 2016

By MARK LEHOCKY, ESQ.

Judicial Review of Arbitrator Awards: Who decides whether the underlying contract is illegal or enforceable?

-Mark LeHocky © 2016

In separate decisions published the same day by different divisions of the Second Appellate District of the California Court of Appeal, two appellate panels addressed the scope of judicial review of arbitration proceedings challenging the legality of underlying contracts. In one – Epic Medical Management, LLC v. Paquette, 16 C.D.O.S. 1178 (1/29/16) – the Court upheld an arbitrator’s award over a challenge that the underlying contract was illegal in part or in its entirety. In the other – Sheppard Mullin Richter and Hampton, LLP v. J-M Manufacturing Co., Inc., 16 C.D.O.S. 1205 (1/29/16) - the Court vacated a three person arbitration panel’s award after conducting a de novo review and finding that the underlying contract was illegal in its entirety. At first blush, the decisions might seem contradictory. However, as is often the case, the devil is in the details. Further, those details offer instructive tips for litigation attorneys as well as contract drafters.

The underlying dispute in Paquette was between a doctor (Paquette) and a medical management company (Epic) with which Paquette contracted for management services to his practice. After the two had a falling out, both claimed that the other owed them money. The matter went to arbitration where Epic won. After the trial court confirmed the award, Paquette appealed, arguing that the arbitrator improperly modified the contract’s terms and that the contract was illegal because it provided for alleged kickbacks to Epic in violation of Bus. & Prof. Code Section 650. The arbitrator first found that the contract had been modified from its written terms by the parties’ conduct, and then rejected the illegality argument on the basis that the supposed violation was merely “technical” and not core to the contract.

On a petition to confirm the award, the trial court again rejected Paquette’s arguments, and the Court of Appeal agreed. The Court of Appeal first held that the arbitrator had not exceeded her authority by finding that the parties had modified the original contract by their conduct where that contract did not limit the arbitrator’s authority to make factual findings, interpret the contract or award any relief based upon those findings and interpretation.

The Court in Paquette then rejected appellant’s contract illegality argument. First, it held that if the alleged illegality goes to only a portion of the contract, judicial review isn’t appropriate. Then, the Court rejected the notion that the contract was illegal in its entirety, finding that the arbitrator’s award did not contravene an explicit legislative expression of public policy that undermined the presumption in favor of arbitration. For good measure, the Court also found no legal violation as a matter of law after reconciling the specific compensation provisions with Section 650 of the Business and Professions Code.

In the J-M Manufacturing case, by contrast, the appellate court reversed the finding of a three-person arbitration panel that had found in favor of the law firm Sheppard Mullin seeking to collect unpaid fees by its client J-M Manufacturing. The fees in question had been incurred prior to the time that a district court had disqualified Sheppard Mullin from representing J-M in the underlying dispute. J-M in turn refused to pay such fees on the grounds that the law firm had not disclosed facts indicating a potential conflict of interest, and hence that the law firm’s representation of J-M violated California Rule of Professional Conduct 3-310 (which bars simultaneous representation of adverse clients). In other words, J-M argued that based upon the non-disclosure of a potential conflict, its fee agreement with Sheppard Mullin was illegal in its entirety.

At the arbitration hearing over Sheppard Mullin’s fee clam, the arbitration panel’s final award found that (a) the assumed ethical violation did not require automatic fee disgorgement, and (b) the violation was not serious enough to require disgorgement. On the subsequent petition to confirm the arbitration award, the trial court confirmed the award, and J-M appealed.

The Court of Appeal first found that under California law, the trial court -- not the arbitrator -- must decide a challenge to the legality of an entire contract that contains an arbitration provision. The Court distinguished cases addressing limited judicial review when a party claims that only a portion of a contract is illegal or enforceable, noting that J-M was challenging the legality of the contract as a whole. As a result, the Court of Appeal found that the trial court erred in deferring to the arbitrators.

From there, the Court in J-M Manufacturing reviewed J-M’s illegality argument de novo, and found that the law firm (1) failed to inform J-M about the potential or actual conflict with the adverse party, and (2) did not obtain J-M’s informed, written consent to continued representation. Based upon those findings, the Court held that the fee agreement violated the duty of loyalty imbedded in Rule 3-310 and was accordingly unenforceable. As a result, the fee award to the law firm was vacated and the case remanded to determine how much J-M is due by way of a refund.

Some takeaways and cautions from Paquette and J-M Manufacturing:

· Based upon the general deference given to arbitration awards (e.g., SingerLewak LLP v. Gantman (2015) 241 Cal App. 4th 610, 674-675), courts will not second guess an arbitrator’s finding that parties have modified their contract by their course of conduct absent an express and unambiguous limitation in the underlying arbitration provision that limits the arbitrator’s authority to find the facts, interpret the contract, and award any relief rationally related to his or her findings and contractual interpretation. Practically speaking, this means that any proposed limitations on an arbitrator’s subsequent review must be well thought out in advance and clearly articulated in the arbitration provision. If not, an arbitrator – like a trial court – may evaluate and rule upon appropriate evidence indicating modification or other alteration of the underlying agreement. Anticipating all of the possible permutations of when such limitations may be appropriate is no easy task, but bears serious thought at the drafting stage.

· While J-M Manufacturing and Paquette appear to agree that de novo judicial review is reserved for claims that a contract is illegal in its entirety – rather than in part – making the broad assertion of illegality is clearly not enough.

Rather, the alleged illegality must be shown to permeate the core of the underlying agreement. The Court in Paquette conducted enough of a review to conclude that the illegality claims were not core to the agreement (and in turn not illegal in any event), while the Court in J-M Manufacturing found that the non-disclosure impacted the core duly imbedded in the client fee agreement. One takeaway for litigators headed toward arbitration – as well as a later petition to vacate – is to carefully diagnose where a contract illegality defense fundamentally infects the core agreement or instead touches less substantive aspects of the underlying agreement. If unsure, it might be worthwhile to get a second opinion and consider a path toward settlement, whether directly or with the help of a neutral.

Mark LeHocky is a mediator and arbitrator, as well as the Director of Commercial Arbitration for JudicateWest. A former complex litigation attorney for plaintiffs as well as defendants, as well as the former general counsel to different public companies, Mark began his neutral work in the 1990s. Mark also teaches Mediation Advocacy at the University of California, Davis’ School of Law, and is listed among the Best Lawyers in America for Mediation for successive years by U.S. News – Best Lawyers©. His background is detailed on his website – www.marklehocky.com

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