An otherwise unconscionable employment arbitration obligation is saved - by the employer's unilateral right to modify the terms

A recent decision by the California Court of Appeals (Second District) sheds needed light on the issue of the enforceability of arbitration clauses in the employment context, and does so in a surprising way. Employment terms that allow an employer to unilaterally modify them are subject to the implied covenant of good faith and fair dealing, the court held - thus saving a one-sided arbitration clause that would otherwise be unconscionable.

In Serpa v. California Surety Investigations, Inc. (decision filed March 21, 2013; publication order filed April 19, 2013), the plaintiff sued her employer for sexual harassment, employment discrimination and wrongful termination. The employer filed a motion in the district court to compel arbitration, based on a one-way (non-mutual) binding arbitration agreement that the plaintiff signed. The agreement obligated the employee to resort to binding arbitration, but not the employer.

Normally, a one-way arbitration clause is a one-way ticket to a ruling of unconscionability under California law, and the district court so held, rendering the arbitration agreement unenforceable. See Armendariz v. Foundation Health Psychcare Services, Inc. (Cal. S. Ct. 2000) (arbitration agreement that imposes obligation only on employee to arbitrate employee's claims lacks mutuality and is unconscionable).

However, on appeal the arbitration agreement was saved from a ruling of unconscionability by an unlikely source: an employee handbook incorporating the arbitration policy that included language that (arguably IMO) describes the arbitration obligation as mutual. The result is somewhat surprising, given that this employee handbook contained language that allowed the employer to unilaterally modify the terms of the handbook at any time and without notice.

The plaintiff argued, and the lower court agreed, that the employee handbook’s terms were illusory, as the employer can unilaterally change those terms at any time. As such, the handbook cannot save the enforceability of the arbitration agreement. Mattei v. Hopper (Cal. S. Ct. 1958) (an agreement is illusory if it leaves one party "free to perform or to withdraw from the agreement at his own unrestricted pleasure”).

In rejecting the plaintiff's argument and overruling the lower court, the appellate court held that the implied covenant of good faith and fair dealing prevents the employer from unilaterally changing the agreement in such a way as to frustrate the purpose of the contract. After citing numerous cases in support of this proposition in the context of employment-based arbitration obligations, but without explaining how the implied covenant would actually restrict the employer in this case, the court rather summarily concluded that the covenant saved the agreement from a finding of unconscionability:

[W]e need not consider whether … modifications to arbitration procedures affecting accrued claims would not be subject to the implied convenant of good faith. Simply stated …, the implied covenant of good faith and fair dealing is properly applied in this case and saves this arbitration contract from being illusory.

What’s puzzling about this decision is that the court fails to articulate how the implied covenant would have operated so as to prevent the employer from removing the arbitration language in the handbook and thus rendering the arbitration agreement unenforceable due to its lack of mutuality. The employee handbook rather coincidentally saved the arbitration agreement. The employer could have unilaterally removed all language in the employee handbook referring to arbitration, thus leaving in place the arbitration agreement’s one-sided provisions. Why would the implied covenant be violated if the employer did so? If simply removing all reference to arbitration in the handbook would not violate the implied covenant, then why should the mere existence of the implied covenant save the one-sided and otherwise unconscionable arbitration obligation?

In any case, the most difficult aspect of this decision, and the other decisions the Serpa court relies on its opinion, is that their logic forces the courts to be in a position of writing the parties’ contract for them, after the fact, in the rarefied and reality-divorced atmosphere of litigation. Now all changes to an employee handbook that becomes the focus of litigation will be judged against this nebulous and unpredictable covenant of “good faith and fair dealing”. The law should not be such that it forces judges to write contract terms for litigating parties after the fact. It would be preferable if the rule were otherwise, so that a clause allowing one party to unilaterally change the terms either renders the agreement illusory or is simply disregarded and unenforceable. The contours of the parties' bargain should be limited to the four corners of the contract, as much as possible. 

From a practical perspective, practitioners need to be aware that despite language granting employers the right to unilaterally modify employment conditions or terms, the implied covenant of good faith may tie employers’ hands. Such changes may in fact be judged against this vague standard of fair dealing, and if so, a subjective (and expensive) determination of fairness may in the end rule the day.

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