Legality of contract with arbitration clause is to be determined by court and not by arbitrator

One party argued throughout an arbitration proceeding that the agreement containing the arbitration clause was illegal and void as against public policy. The other side had obtained an order compelling arbitration, and then prevailed in front of the arbitrators. Reviewing a lower court order confirming the arbitration award, though, a California Court of Appeal has held that the question of enforceability is for the courts, and not the arbitrators, when the issue is illegality of the contract that contains the arbitration clause.

The underlying case was whether a law firm, which was disqualified from representing a company due to a conflict of interest, could still recover its fees from that company, the erstwhile client. The company argued that the fee agreement was illegal and void, given the conflict. The arbitrators weighed the ethical issues and decided to award fees to the firm, on the basis of a determination that the firm did not recognize the conflict at the time of entering into the agreement. And even if there was an ethical violation, that fact did not require forfeiture of fees, per the panel.

But the California appellate court disagreed. It noted, first: “A central issue in this case is the court’s role where a party has alleged that an entire contract, rather than a portion of a contract, is unenforceable because it violates public policy.” It also noted that the contract was to be construed under California law, and thus not under the Federal Arbitration Act. Under California law, “a challenge to the legality of an entire contract that contains an arbitration provision must be determined by the trial court, not the arbitrator.” And where the challenge comes after the arbitration award (note, however, that the challenge was asserted throughout the process and not just after the arbitration outcome), the court is to review the situation de novo “to determine whether the arbitration award was based on illegal agreements or transactions.”

Since the existence of the conflict had been accepted – setting aside when the conflict was identified, since the firm and the company had vastly differing views on that subject – the court noted that the underlying fee agreement was entered into contrary to the rules of ethics and thus in violation of law. As an illegal contract, it was void and unenforceable. As a void and unenforceable contract, the arbitration clause contained within it was also void and unenforceable. And the arbitrators' award in favor of the firm was overturned by the appellate court.

The case is Sheppard v. J-M Mfg. Co., 2016 Cal. App. LEXIS 69 (Jan. 29, 2016), available here or here. An appeal to the California Supreme Court is likely, so we may not yet have the final word.