California Court of Appeal Creates Split in State Authority, Holds Federal Arbitration Act Preempts Section 1281.97 of the California Arbitration Act

Rebecca Kutlow and Fred Norton

In Hernandez v. Sohnen Enterprises Inc., 102 Cal. App. 5th 222 (2024), reh’g denied (June 3, 2024), review filed (June 28, 2024) the California Court of Appeal, Second Appellate Division, made several important findings regarding arbitration agreements. The court held that unless the parties’ arbitration agreement expressly selected California’s arbitration provisions, the Federal Arbitration Act (“FAA”) preempts California Civil Procedure section 1281.97 (part of the California Arbitration Act (“CAA”)). The Court also found that a superior court order allowing a party to withdraw from arbitration per section 1281.97 is immediately appealable as it is the functional equivalent of an order denying arbitration.

The Hernandez decision creates a conflict in the California Courts of Appeal concerning preemption of Civil Code sections 1281.97 and 1281.98, an issue that the California Supreme Court will address in yet another case for which it has recently granted review, Hohenselt v. Superior Court, 99 Cal. App. 5th 1319 (2024) (review granted, June 12, 2024).

Summary of Facts

In Hernandez, the Plaintiff employee, Massiel Hernandez (“Hernandez”), executed an arbitration agreement with the Defendant employer, Sohnen Enterprises Inc (“Sohnen”). The arbitration agreement stated, “This Agreement is governed by the Federal Arbitration Act (‘FAA’), 9 U.S.C. [section] 1, et seq.” The agreement further explained that the arbitration fees would be paid by Sohnen, not Hernandez. Hernandez filed a complaint against Sohnen for disability discrimination, and related actions, and the parties stipulated to proceed to arbitration. They further stipulated that they would apply the Federal Rules of Civil Procedure to arbitration. Sohnen paid the arbitration initiation 36 days after the arbitration and mediation service sent the notice regarding the filing fees. Hernandez then filed a motion in the trial court to withdraw from arbitration pursuant to California Civil Procedure section 1281.97 (“section 1281.97”). The trial court granted that motion and Sohnen immediately appealed the decision.

The Text of Section 1281.97

Section 1281.97 states that a material breach occurs if the drafting party to an arbitration agreement does not pay the fees to initiate arbitration proceedings within 30 days after the due date. By failing to make the payment in time, the party waives the right to demand arbitration. Section 1281.97, subdivision (a)(1) explicitly states: “In an employment or consumer arbitration that requires…the drafting party to pay certain fees and costs before the arbitration can proceed, if the fees or costs to initiate an arbitration proceedings are not paid within 30 days after the due date[,] the drafting party is in material breach of the arbitration agreement, is in default of the arbitration, and waives its right to compel arbitration under Section 1281.2.”

A Court Order under Section 1281.97 is immediately appealable

As a threshold matter, the court first looked at whether the superior court’s order under section 1281.97 was immediately appealable. The court acknowledged that there is not a statute that expressly states that orders under section 1281.97 are appealable. Instead, the court turned its analysis to other California court decisions which have found that orders that are the “functional equivalent” of denying a petition to compel arbitration are appealable, such as Henry v. Alcove Investment Inc., (1991) 233 Cal.App.3d 94, 98.  The court then held that an order under section 1281.97, finding that the drafting party materially breached the arbitration agreement, is the functional equivalent of denying a petition to compel arbitration because it operates as a complete defense to enforcement of the parties’ arbitration agreement. Therefore, the decision was immediately appealable.

How Section 1281.97 Interacts with the FAA

Next, the court analyzed whether section 1281.97 is preempted by the FAA. The court acknowledged that where an arbitration agreement expressly calls for the application of the California Arbitration Act, there is no preemption issue. Similarly, where an arbitration agreement expressly calls for the application of the FAA, there is no preemption issue.

The court found that in this case, the agreement expressly referenced the FAA and its procedural terms. Therefore, section 1281.97 did not apply, and the superior court order was reversed. However, the court went even further with its analysis. The court stated that even if section 1281.97 did apply, it was preempted by the FAA in a case like this, where the agreement fell within the scope of the FAA, and it did not expressly select California arbitration procedures. The court explained that in that scenario, the FAA preempts section 1281.97 as it “violates the equal-treatment principle [of the FAA] because it mandates findings of material breach and waiver of late payment that do not apply generally to all contracts or even to all arbitrations.”

This holding is directly in conflict with that of several other California courts. The California Courts of Appeal in Gallo v. Wood Ranch USA, Inc. (2022) 81 Cal.App.5th 621, 629 & 633-634, Espinoza v. Superior Court (2022) 83 Cal.App.5th 761, 775-776, Suarez v. Superior Court (2024) 99 Cal.App.5th 32, 42-43 and De Leon v. Juanita’s Foods (2022) 85 Cal.App.5th 740, 750, found that section 1281.97 in fact furthers the goals of the FAA by encouraging or facilitating arbitration. Even more recently, in Keeton v. Tesla, Inc., ___ Cal. Rptr. 3d ___, No. A166690, 2024 WL 3175244 (Cal. Ct. App. June 26, 2024), another Court of Appeal decision rejected the argument that the FAA preempted Civil Code Section 1281.98, expressly rejecting and distinguishing the holding of Hernandez

Key Takeaways

The California Court of Appeal decision in Hernandez highlights the importance of using clear and express language in any arbitration agreement. The drafting party should carefully analyze whether it would like any future arbitration to fall under the FAA or the CAA, and make sure that the arbitration agreement explicitly states which arbitration act governs future arbitration. The decision in Hernandez also created a split within the California Courts of Appeal on the issue of whether section 1281.97 violates, or furthers the goals of, the FAA. Parties should therefore look for any future cases that fall on either side of the split. Since this decision was published, the California Supreme Court granted a petition for review in a similar case, Hohenselt v. Superior Court. The California Supreme Court will directly address the question: “Does the Federal Arbitration Act (9 U.S.C. § 1 et seq.) preempt state statutes prescribing the procedures for paying arbitration fees and providing for forfeiture of the right to arbitrate if timely payment is not made by the party who drafted the arbitration agreement and who is required to pay such fees?” It will be interesting to see what the Supreme Court decides on this issue.