Arbitration of Construction Defect Claims Likely to Increase
- By Michael G. Kim, Esq. (originally published in Fall 2002)
Our legal system provides an orderly process designed to resolve disputes. The most distinguishing features of our legal system are the right to due process and the various procedures whereby one party to a dispute can discover, or learn, what evidence the other side possesses before trial. The benefits are fairness and the opportunity to make informed decisions before justice is meted out. A recent California Court of Appeal decision, Basura v. U.S. Home Corporation, filed May 31, 2002, may limit access to our legal system for both homeowners associations and individual homeowners suing for construction defects depending on the depth of its subsequent application by California Courts.
The Calderon Process
Before a homeowners association of 20 units or more can file a lawsuit against the builder over construction defects in its common area or other areas it is obligated to maintain, it must go through a legislated negotiation procedure known as “Calderon,” named after the law’s sponsor, California State Senator Charles M. Calderon. The Calderon process is set forth in California Civil Code Section 1375. It was recently amended by the Legislature to include subcontractors who actually built the homes and common areas in the process. The Calderon process tolls (stops) the running of statutes of limitations for construction claims to enable a negotiation process between the homeowners association, the developer and the subcontractors. If the Calderon process fails to resolve the case, a lawsuit may be filed.
There are three sets of individuals who may sue builders directly without following the Calderon process. These are: (1) Individual homeowners; (2) Groups of homeowners not considered a common interest development; and (3) Homeowners associations of less than 20 units. This article will collectively refer to these parties as “individual homeowners.”
The Basura Case
Many home purchase contacts contain arbitration provisions. In Basura, the plaintiffs attempted to argue around the arbitration requirements by utilizing Code of Civil Procedure Section 1298.7. This section indicates that certain lawsuits for bodily injury, wrongful death or construction design defects are not precluded merely because of the existence of an arbitration provision in a contract. The Court of Appeal in Basura disagreed with the plaintiffs and held that purchasers of homes suing over construction defects could not invoke Code of Civil Procedure Section 1298.7 to avoid the effect of the arbitration agreements contained in their home purchase contracts.
The Court of Appeal instead held that the Federal Arbitration Act (”FAA”) applied to the facts in Basura, and because of Federal supremacy principles, the FAA pre-empted and prohibited the application of state law provisions such as those set forth in Section1298.7. The Court of Appeal relied upon the United States Supreme Court case of Doctors Associates, Inc. v. Casarotto, for the proposition that written provisions for arbitration “shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract.” Because there was no ground for revocation of the Basura plaintiffs home purchase contracts, the Court of Appeal held that the arbitration agreements contained in the purchase contracts were valid and enforceable.
The key to the Basura holding was the finding that the FAA was applicable to the purchase contracts signed by the homeowners. By its terms, the FAA only applies to contracts “evidencing a transaction involving commerce.” “Involving commerce” means “involving interstate commerce.” Here comes the legal equivalent of the Robert Horry clutch three-point shot. Please try to keep from spilling your popcorn. The Court of Appeal relied upon a 1995 Supreme Court case applying the FAA to a dispute between two Alabama homeowners and two large multi-state corporations (Allied-Bruce Terminix Cos. v. Dobson), to find that the contracts involved in construction of the Basura plaintiffs’ homes “involved interstate commerce.” Their stated rationale was based on declarations submitted by U.S. Home stating that it received and used building materials and equipment manufactured and/or produced in states outside of California.
The Court of Appeal further noted that U.S. Home executives submitted declarations stating that they had contracted with out of state design professionals, trade contractors, subcontractors and others, and had utilized interstate mail and telephone lines with these persons in pursuit of the development of the subject homes. Nowhere is there mention in the Basura opinion that U.S. Home is a multi-state corporation. Based on this broad expansion, the FAA arguably applies to every home built anywhere whose purchase contract contains an arbitration clause.
The Ramifications of the Basura Case
What does all this mean for a homeowners association facing the prospect of having to deal with construction defects? As a practical matter, the Basura ruling will have little to no immediate effect on how any particular homeowners association decides to address construction defects. The holding in Basura is dependent on its facts, the most important of which is that the individual homeowners who were suing U.S. Home all had original purchase contracts with U.S. Home that contained an arbitration provision. We are aware of no homeowners association that has entered into a purchase contract containing an arbitration provision with its developer for association common areas. Therefore, the typical construction defect case brought by a homeowners association will proceed through the Calderon process and then to litigation if the issues are not resolved in Calderon.
Basura, however, may form the basis for an expansion of case law limiting homeowner association access to courts for construction issues. In addition, Basura may motivate developers to change their common area “turnover” procedures to include arbitration agreements. Given that the Calderon process already requires pre-lawsuit discussions, it will be interesting to see how this, or subsequent cases, apply this issue to homeowners associations.
Basura clearly means that individual homeowners with purchase contracts that contain arbitration provisions who decide to sue the developer of their home for construction defects likely will have their lawsuits forced out of court and into arbitration.
Litigation v. Arbitration
All of this begs the question: Is there any difference between arbitration and a lawsuit? Emphatically, yes.
Typically, in arbitration, there are no rights to what is called “discovery,” (formal investigation of claims and defenses). On the other hand, litigation permits discovery, and in fact there are various rules and procedures set forth in California statutes and established court practices that afford both sides to a lawsuit an adequate opportunity to build up their case.
Why is this difference significant? Practical realities and simple economics hold the answer. Often, construction defects are hidden or “latent” (structural or soil problems most often are latent) and unless one discovers them either through observation, testing or chance, those defects may never be discovered and addressed. Most individual homeowners and many homeowners associations for that matter do not have the money to hire construction engineers to investigate all defects. Most individual homeowners and homeowners associations only know about construction defects when they manifest, such as through the observation of window or roof leaks, cracks, etc. More often than not, what is seen is only the “tip of the iceberg.” The discovery that occurs in a lawsuit allows a much more thorough assessment of what defects exist because both sides will actively investigate the property.
On the other hand, in arbitration without discovery, the homeowner or homeowners association must first find all the construction problems on its own before submission of its construction defect claim to the builder. Lack of sufficient funds generally prohibits this from occurring. Furthermore, without any reason or rule to the contrary, it is highly unlikely that the builder will perform any investigation on its own in an arbitration, simply preferring to let “a sleeping dog lie.”
Consult Your Attorney
What does all this mean? The Basura case, at least for the moment, suggests that California Courts will be more inclined to enforce arbitration provisions contained in purchase contracts for homes. As explained above, the Basura opinion has limitations, and the four corners of the factual scenario from which the decision originates limits its application. The bottom line, however, is that a homeowners association or an individual homeowner with construction defects should consult with qualified legal counsel as to how to best avoid the pitfalls of having a construction dispute forced into the limited arena of arbitration.
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