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September 24, 2012

Arbitration Decision Can Make Condominium Developers More Insurable

Summary:

Every insurer that insures developers of condominium projects in California for their liability for claims of construction defects should carefully review the decision of the California Supreme Court in Pinnacle Museum Tower v. Pinnacle Market Development

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Effective Underwriting Requires Review of CC&R's
Every insurer that insures developers of condominium projects in California for their liability for claims of construction defects should carefully review the decision of the California Supreme Court in Pinnacle Museum Tower v. Pinnacle Market Development, No. S186149 (Cal. 08/16/2012). The holding of the California Supreme Court should be kept in mind during the underwriting process before agreeing to insure the developer against the risk of loss by claims of construction defects. The prudent insurer might insist that an effective arbitration agreement be included in the covenants, conditions and restrictions (“CC&R's”) before selling any units to a buyer.

The Supreme Court resolved a dispute between an owners association and the original developer over an arbitration agreement made part of the CC&R's  before the owners association came into existence. The association filed a construction defect action against a condominium developer, seeking recovery for damage to its property and damage to the separate interests of the condominium owners who compose its membership. In response, the developer filed a motion to compel arbitration, based on a clause in the recorded declaration of CC&R's that provided that the association and the individual owners agreed to resolve any construction dispute with the developer through binding arbitration in accordance with the Federal Arbitration Act (“FAA”).

Factual And Procedural Background
Pinnacle Market Development (US), LLC, and others (collectively Pinnacle) developed a mixed use residential and commercial common interest community in San Diego known as the Pinnacle Museum Tower Condominium (the Project). Pinnacle, as the owner and developer of the Project property, drafted and recorded a “Declaration of Restrictions” to govern its use and operation (the Project CC&R's). The Project CC&R's contain a number of easements, restrictions and covenants.

The individual owners bought condominium units in the Project pursuant to a standard purchase agreement. The Association filed the instant action against Pinnacle, alleging that construction defects caused damage to the Project. As the sole plaintiff, the Association seeks recovery not only for damage to its own property, but also for damage to the interests held by its individual members.

Pinnacle filed a motion to compel arbitration, contending the FAA mandates enforcement of article XVIII's arbitration provisions. The trial court determined that the FAA is applicable and that article XVIII embodies an agreement to arbitrate between Pinnacle and the Association. Nonetheless, the court invalidated the agreement upon finding it marked by slight substantive unconscionability and a high degree of procedural unconscionability.

Discussion
To ensure that arbitration agreements are enforced according to their terms, the FAA preempts state laws which require a judicial forum for the resolution of claims which the contracting parties agreed to resolve by arbitration. The FAA also precludes a court from construing an arbitration agreement in a manner different from that in which it otherwise construes nonarbitration agreements under state law. Nor may a court rely on the uniqueness of an agreement to arbitrate as a basis for a state-law holding that enforcement would be unconscionable, for this would enable the court to effect what the state legislature cannot.

The party seeking arbitration bears the burden of proving the existence of an arbitration agreement, and the party opposing arbitration bears the burden of proving any defense, such as unconscionability.

Settled principles of condominium law establish that an owners association, like its constituent members, must act in conformity with the terms of a recorded declaration.

That a developer and condominium owners may bind an association to an arbitration covenant via a recorded declaration is not unreasonable; indeed, such a result appears particularly important because (1) the Davis-Stirling Act confers standing upon an association to prosecute claims for construction damage in its own name without joining the individual condominium owners and (2) as between an association and its members, it is the members who pay the assessments that cover the expenses of resolving construction disputes. Given these circumstances, an association should not be allowed to frustrate the expectations of the owners (and the developer) by shunning their choice of a speedy and relatively inexpensive means of dispute resolution. Likewise, condominium owners should not be permitted to thwart the expectations of a developer by using an owners association as a shell to avoid an arbitration covenant in a duly recorded declaration.

In sum, even though the Association did not bargain with Pinnacle over the terms of the Project CC&R's or participate in their drafting, it is settled under the statutory and decisional law pertaining to common interest developments that the covenants and terms in the recorded declaration, including those in article XVIII, reflect written promises and agreements that are subject to enforcement against the Association.

The Doctrine of Unconscionability
As indicated, procedural unconscionability requires oppression or surprise. Here, the trial court found no evidence of surprise. Nonetheless, the court perceived a high degree of procedural unconscionability, because the Project CC&R's were drafted and recorded by Pinnacle before any unit was purchased and before the Association was formed. Noting the Association had no opportunity to participate in the drafting of the recorded declaration, the court determined it was oppressive.

By providing for Pinnacle's capacity to record a declaration that, when accepted by the first purchaser binds all others who accept deeds to its condominium properties, the Act ensures that the terms reflected in the declaration — i.e., the covenants, conditions, and restrictions governing the development's character and operation — will be respected in accordance with the expectations of all property owners and enforced unless proven unreasonable. Far from evidencing substantive unconscionability, the consent provision reflects a restrictive term that the Legislature, for policy reasons, has determined is reasonably and properly included in a recorded declaration.

Conclusion
Article XVIII of the Project CC&R's is consistent with the provisions of the Davis-Stirling Act and is not procedurally or substantively unconscionable. Its terms requiring binding arbitration of construction disputes are therefore enforceable.

Writing for the majority, Justice Baxter stated the following:

Even when strict privity of contract is lacking, the Davis-Stirling Act ensures that the covenants, conditions, and restrictions of a recorded declaration — which manifest the intent and expectations of the developer and those who take title to property in a community interest development — will be honored and enforced unless proven unreasonable. Here, the expectation of all concerned is that construction disputes involving the developer must be resolved by the expeditious and judicially favored method of binding arbitration.

We hold that article XVIII's covenant to arbitrate is not unconscionable and is properly enforced against the Association. Accordingly, we reverse the judgment of the Court of Appeal and remand the matter for further proceedings consistent with the views herein.

Justice Kennard, in dissent, stated that the evidence lacked a showing that the owners association's consented to an arbitration provision in the CC&R's drafted and recorded by the developer before the association's independent existence. In compelling arbitration, which offers no right to a jury, the majority deprives the owners association of its constitutional right to have its construction defect dispute decided by a jury. In the words of our state Constitution: “Trial by jury is an inviolate right and shall be secured to all …” (Cal. Const., art. I, § 16.)

Although this case never mentioned the word insurance, it is an important decision for insurers and may, if properly underwritten, make it possible to insure condominium developers for lower premium because they can effectively avoid litigation and trial and compel the resolution of construction defects by binding arbitration. Since arbitration is usually less expensive and much quicker than litigation and since arbitration does not put the parties at the risk of confusing a jury of 12 who know nothing about construction or construction defects, an actuary can more accurately calculate the potential losses and charge a competitive and fair premium to the developer.

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