On August 4, 2005, the Supreme Court of California held that pre-dispute waivers of the right to a jury trial are unenforceable under California law. “Grafton Partners L.P. v. Superior Court.” The court based its ruling on California statutory construction and constitutional law principles. It held that the relevant statute, Section 631(d)(2) of the California Code of Civil Procedure, does not provide for pre-litigation jury trial waivers. It also held that the California Constitution does not permit the right to a jury trial to be waived absent an explicit statutory authorization.
In its decision, the court acknowledged that its ruling is contrary to the rule of other states. The court then stated the California Constitution would permit pre-dispute waivers of the right to a jury trial if the relevant statute expressly authorized such waivers. Indeed, one of the California Supreme Court Justices who “reluctantly” concurred in the decision, wrote a separate opinion in which he urged that Grafton be overturned by legislative action.
Grafton is an expansive decision – it applies even when both parties to a contract are sophisticated commercial entities represented by counsel. Grafton also applies retroactively to contracts entered into before it was decided.
This client alert discusses Grafton’s effect on financial institutions and other commercial entities in lending transactions that do not involve consumers. Put simply, if a financial institution sues (or is sued by) an entity in California state court, that financial institution must be prepared to face the possibility of a jury trial. Given this, what should a financial institution do?
Do Not Remove Jury Trial Waivers in Existing (or New) Loan Agreements
Initially, we believe lenders should not remove jury trial waivers from their commercial loan documentation. There are two good reasons to keep them in:
- there may be litigation in bankruptcy or another federal court (if there is federal question or diversity jurisdiction), or in the court of a state other than California; and
- ultimately, Grafton might be overturned by legislative action in California.
Jury trial waivers between sophisticated commercial parties may be enforced in federal courts and by the courts of states other than California.(1) And as noted above, the Grafton court acknowledged that appropriate legislative action could permit jury trials to be waived prior to litigation as a matter of California constitutional law. We expect that banking and other institutional lender trade groups will vigorously pursue a legislative solution to this problem.
Consider Alternatives that Might Permit a Jury Trial to be Avoided
There are a number of alternatives that might permit a potential litigant to avoid a jury trial. These include:
- arbitration; and
- judicial reference.
A properly drafted arbitration clause is generally enforceable as a matter of California law. For an arbitration clause to be properly drafted, however, it cannot provide for judicial review of the merits of an arbitration award in violation of applicable statutory provisions or otherwise contain “problematic” provisions. Thus, an arbitration clause needs to be tailored carefully to a client’s particular circumstances.
Arbitration suits some, but not all, commercial entities. Many perceive (whether rightly or wrongly) that arbitrators are inclined to “split the baby,” while lenders want to be repaid in full.
If a lender chooses arbitration, it should first consider the issues it may face when enforcing its loan documents. This will help it determine what it should include in its form arbitration clause. For example, does the lender want to add or modify discovery rules? Does it want one (or three) arbitrators? Should there be a time limit by which the arbitrator must render his or her decision? What rules should the arbitrators follow (e.g., AAA, contractually specified or something else)? Who may serve as an arbitrator? How is an arbitrator chosen? Does the arbitrator have power to grant provisional relief, or may the parties bring a court action for such relief?
Judicial reference is another alternative. Sections 638 through 645.2 of the California Code of Civil Procedure provide for a so-called “referee” (usually a retired judge) to be appointed if a case is brought in California state court. If the parties agree to this “judicial reference” procedure in a contract, such as a loan agreement, and a lawsuit is commenced in California state court, the judge may refer all issues to the referee, who will report a statement of decision. The court must adopt the referee’s decision as its own, and a judgment is rendered on the decision as if the action had been tried to the court. This judgment is subject to normal appellate review.
If a referee is appointed by the court, there will be no jury trial in the lawsuit. You should note, however, that even when a contract provides for a mandatory judicial reference, the option to refer a matter to a referee is left to the discretion of the court. Even though such provisions tend to be enforced by California state court judges, the judge ultimately has discretion as to whether he or she will refer the matter to a referee. As is the case with arbitration clauses, a judicial reference clause needs to be carefully tailored to a client’s particular circumstances. And referees, like arbitrators, charge a fee for their services.
Consider Choice of Law and Forum Provisions
A lender, by choosing the law of another state, might be able to avoid California jury trial issues if it were willing to agree to a mandatory forum selection clause (e.g., the parties must bring any action only in New York state court or the Southern District of New York). But lenders frequently need to avail themselves of the courts of more than one jurisdiction if it becomes necessary to enforce their rights. If a borrower has property in California, a lender may well need to sue the borrower in California to enforce its loan. Consequently, a mandatory forum selection clause may hamper a lender’s collection efforts. Unless there is federal jurisdiction, the lender may need to sue in California state court.
Most lenders have permissive forum selection clauses in their documents (e.g. the parties may bring an action in New York state court or the Southern District of New York). With a permissive forum selection clause, one of the parties could bring an action in California state court. For instance, if a contract specifies New York law as its governing law, a California court could apply New York law to the contract but still require a jury trial. Given that the Grafton court described the right to a jury trial as “inviolate,” choosing the law of a state other than California in a contract may not effectively permit a financial institution to avoid a jury trial if a lawsuit is brought in California state court.
Consider California Real Property Issues
If California real property is collateral security for a transaction, any arbitration or judicial reference clause needs to take into account the special issues raised by California’s “one form of action” and anti-deficiency statutes. Generally, arbitration is not an appropriate vehicle for the resolution of disputes concerning indebtedness where California real property directly or indirectly secures the indebtedness.
Sheppard Mullin’s Recommendations
Lenders should keep Grafton in perspective. As noted above, we do not recommend that lenders remove jury trial waivers from either new or existing commercial loan documents. In light of Grafton, a financial institution may wish to review its policy (if it has one) relating to arbitration and judicial reference provisions in its loan documents. Our experience is that a number of lenders dislike arbitration, and we expect that some of our lender clients may continue with their current policy of not including arbitration or judicial reference clauses in their loan documentation. Others may change their policy.
In all events, if a lender decides to change its policy, we suggest that Grafton not lead it to put together a hastily prepared and poorly drafted arbitration or judicial reference clause. Before a lender changes its approach, it should review how it generally enforces its loan documents and the issues it may face in enforcement. After this review, either an appropriate judicial reference clause or arbitration clause may be added, or a lender may simply conclude that the risks imposed by a potential jury trial in California state court are not significant enough to adopt either arbitration or judicial reference clauses in its contracts. There is no “one size fits all” for lenders in response to Grafton.
1) You should note, however, that outside of bankruptcy, federal question jurisdiction is unusual in loan transactions, and there is no way to assure that diversity jurisdiction will exist.