Mark Twain famously wrote that the reports of his death were exaggerated.  Following the South Carolina Supreme Court’s decision in Smith v. D.R. Horton, Inc. last month,[1] you may have heard arbitration is dead for South Carolina residential builders.  In that decision, the Court found an arbitration agreement unconscionable and therefore unenforceable.  While the decision makes clear that South Carolina courts remain hostile to arbitration, reports of arbitration’s death are greatly exaggerated.  Despite the D.R. Horton decision, we believe residential builders can still use arbitration provisions so long as builders carefully draft the provisions to avoid the problems with the arbitration provision at issue in the D.R. Horton case.

When moving to enforce arbitration agreements, the most common challenge we see is an argument that an arbitration agreement is unconscionable.  For an agreement to be unconscionable, it must lack a meaningful choice by the party entering into it and contain oppressive, one-sided terms.  The D.R. Horton decision appears to make it easier for parties opposing arbitration agreements in contracts for the construction and sale of residences to establish both requirements.  First, the decision seems to create a presumption that such contracts do not provide a meaningful choice.  Second, the decision purports to expand courts’ consideration of whether oppressive, one-sided terms exist from just the arbitration terms to any related terms and to provide that disclaimers and limitation of liability provisions can be oppressive terms creating unconscionability.

For residential builders facing South Carolina’s construction defect litigation environment and the threat of class action suits, an enforceable arbitration provision can be crucial to reduce litigation costs.  The D.R. Horton decision certainly hurts residential builders, and the decision’s rationale and validity are questionable, but we believe the decision leaves room, through careful drafting, for residential builders to continue to use arbitration provisions.  We offer four suggestions for post-D.R. Horton arbitration provisions:

  1. Provide an option for purchasers to opt out of the arbitration provision in order to create a “meaningful choice,” but place the burden of opting out on the purchaser.
  1. Recognize that broad disclaimers and limitation of liability provisions are potentially unenforceable and may impact the enforceability of an arbitration provision. Draft narrow disclaimers and limitations that do not restrict the purchaser’s remedies exclusively to a limited warranty provided by the builder and do not eliminate the purchaser’s ability to recover direct damages.
  1. Locate the arbitration provision in a separate, distinct portion of the contract from all other provisions. Do not include any references in the arbitration provision to other portions of the contract.
  1. Include a severability clause providing that if a court finds any term unenforceable, the court is to sever that provision and enforce the remainder such that the parties’ intent to submit disputes to arbitration is still carried out.

The D.R. Horton Decision

D.R. Horton, a national, residential builder, entered into a contract with the Smiths for the construction of a new home.  The contract contained a section entitled “Warranties and Dispute Resolution” with ten subsections.  Two of those subsections provided that the parties agreed to arbitrate any claims arising out of the construction of or warranties for the home.  The section also contained language disclaiming all implied warranties, providing that D.R. Horton could not be liable for “monetary damages of any kind,” and restricting the homeowners’ remedies to a limited warranty provided by D.R. Horton.

After completion, the home experienced water intrusion, and the homeowners filed suit.  D.R. Horton moved to compel arbitration, and the homeowners opposed on the basis the arbitration agreement was unconscionable and therefore unenforceable.  The circuit court found the agreement unenforceable, the Court of Appeals affirmed, and the Supreme Court granted certiorari and affirmed.

In affirming, the Supreme Court first held that all of the terms of the entire “Warranties and Dispute Resolution” section were relevant to the unconscionability analysis, rather than just the two subsections providing for arbitration.  The Court acknowledged United States Supreme Court decisions providing that in challenging an arbitration provision a court can only examine whether the terms of the arbitration provision itself are unconscionable and other terms in the contract are not relevant.  However, the Court distinguished that rule on the basis that the entire section was a “single provision.”  The Court reasoned that all of the subsections “must be read as a whole to understand the scope of the warranties and how different disputes are to be handled” and that the subsections “contain numerous cross-references to one another.”

For the first prong of unconscionability, the Court found the homeowners lacked a meaningful choice.  The Court relied on a presumption that a purchaser of a new home “is normally in an unequal bargaining position as against the seller.” The Court then found no reason to not follow the presumption because there was no evidence these homeowners were in a stronger position than the average home purchaser, they were not represented by a lawyer, and they were not a substantial business concern for D.R. Horton.  The Court may be signaling that it will presume the first prong of the unconscionability analysis is satisfied for any agreement for the construction and sale of a new home unless the buyer has a unique position of strength or is represented by a lawyer when entering into the contract.

For the second prong, the Court found the arbitration agreement contained oppressive, one-sided terms because it disclaimed implied warranties and prohibited any recover of monetary damages.  The Court indicated its main concern was whether the homeowners would be left with an adequate remedy, explaining that the only remedy the homeowners were left with was D.R. Horton’s warranty.

Finally, the Court found it could not sever the oppressive terms and enforce the remaining provisions requiring arbitration because the contract did not contain a severability clause.

Drafting Arbitration Provisions More Likely to be Enforced After D.R. Horton v. Smith

After D.R. Horton, residential builders should consider whether to take any or all of the following four steps to draft an arbitration provision more likely to be enforced:

  1. Provide an option to opt out of the arbitration provision.

D.R. Horton indicates South Carolina courts may find an arbitration provision in a contract for the construction and sale of a residence lacked a meaningful choice absent facts indicating the purchaser had bargaining power.  One potential way around this obstacle is to give purchasers the ability to bargain on whether to be bound to arbitration, and this can be accomplished by giving purchasers the ability to opt out of the arbitration provision.

There are many ways builders can give purchasers the ability to opt out.  For example, the contract could provide that the purchaser is bound by the arbitration provision unless he or she sends a certified letter stating a request to opt out of the arbitration provision to a specified address within thirty days of signing the contract.  One downside is that this method creates an administrative complication in that someone must collect, record, and store all of the opt out letters received.

Another option is to provide a space in the contract where the purchaser can indicate a decision to opt out subject to an increase in the contract price in an amount the builder estimates to be equal to the value of arbitration.  This method also creates an administrative issue in that the employee walking through the contract with the purchaser must be aware of the opt out provision and know what to do if a purchaser decides to opt out.  A second issue with this method is that as builders increase the amount the contract price goes up as a result of opting out, at some point courts are likely to find the purchaser no longer had a meaningful choice to opt out.  In other words, there likely needs to be a reasonable relationship between the expected value of arbitration and the increase in price resulting from opting out.

Builders’ initial reaction to the idea of allowing purchasers to opt out of arbitration provisions may be that this eviscerates the whole point of the arbitration provision because every purchaser will opt out.  However, because opting out under these scenarios would require additional thought and effort by purchasers, the likely result is that relatively few purchasers will go through the effort of opting out.[2]  This is especially true where the opt out is conditioned upon an increase in the contract price.

  1. Do not overreach in terms of disclaimers and limitations on liability.

Parties drafting contracts for repeated use, as opposed to contracts drafted for a specific transaction and with rounds of negotiation, are tempted to include strong provisions limiting the party’s liability as much as possible.  While reducing liability is an understandable goal, taking this goal to the extreme can backfire, especially when another goal of the contract is to resolve any resulting disputes through arbitration.  For example, D.R. Horton clearly had a goal of minimizing potential liability through its contractual provisions, but in doing so it eliminated the usefulness of its arbitration provision.

Therefore, builders need to weigh which is more valuable: provisions minimizing liability or arbitration provisions.  A factor to consider when making this choice is that attempts to minimize liability also may not be enforceable.  The D.R. Horton decision found the arbitration provision there unconscionable in large part because the contract purported to disclaim all implied warranties, including the implied warranty of habitability.  Such a waiver is only enforceable where it was conspicuous, known to the buyer, and specifically bargained for.[3]  Thus, while the waiver killed D.R. Horton’s arbitration provision, it may not even be enforceable.

If an attempt to disclaim implied warranties may harm your arbitration provision and also may not be enforceable, it may be better to just focus on having an enforceable arbitration provision.  If the arbitration goal takes precedence, do not try to disclaim all implied warranties or bar any monetary recovery.  Instead, consider a more reserved measure such as a provision limiting the builder’s potential liability to the contract price.

  1. Make the arbitration provision separate from the other provisions.

The D.R. Horton decision found the Court could consider the warranty disclaimers and limitations of liability as part of its unconscionability analysis because those provisions were lumped together with and referenced by the contract’s arbitration language.  To avoid this result, ensure the contract’s arbitration provision is contained within its own separate section, and do not use arbitration language that references any of the other provisions of the contract.  If drafted in this way, a court should only be able to consider the language of the arbitration provision itself in determining whether the provision is unenforceable as unconscionable.[4]

  1. Include a severability clause.

Finally, the arbitration provision should include a severability clause stating the provision is severable from the remainder of the contract if any portion of the contract is found unenforceable and that the individual terms of the arbitration provision are severable from the provision’s other terms.  In short, there should be a severability clause expressing the parties’ intent that even if terms are found unenforceable, the parties want those terms severed from the remainder and still want their desire to submit claims to arbitration to be enforced.

Will D.R. Horton Have a Lasting Impact?

Fortunately for residential builders, the D.R. Horton decision may not remain good law in South Carolina for long.  First, three of the Supreme Court’s five Justices, a bare majority, made up the justices signing on to the majority opinion.  The remaining two Justices offered a sharp dissent asserting the majority opinion violates binding precedent from the United States Supreme Court.  One of the three Justices making up the majority is no longer on the Court, and in a new case, the Court’s newest member could agree with the dissent’s view.

Second, as the dissent points out, the majority opinion may be contrary to binding federal law.  D.R. Horton moved for reconsideration, and should it not receive a different result through reconsideration, it may petition the United States Supreme Court.  There is a chance, albeit small, that the United States Supreme Court could reverse the South Carolina Supreme Court’s decision.

While the D.R. Horton decision may have a short life, even were it no longer the law our recommendations for arbitration provisions in residential construction contracts remain worthwhile.  For years South Carolina courts have been hostile to arbitration and there is no evidence the hostility will end in the near future.  Therefore, carefully drafting residential construction contracts will remain necessary to avoid the common argument that an arbitration provision is unenforceable because unconscionable.

[1] Op. No. 27645 (Shearouse Adv. Sh. No. 27 at 12) (July 6, 2016).

[2] Social science shows that people generally take whatever option is easiest, and that when people are presented with a default option, the majority tend to stick with that option rather than putting forth the effort to think about, decide on, and carry out an alternative option.  See Richard Thaler & Cass Sunstein, Nudge 83–87 (2008).

[3] Kirkman v. Parex, Inc., 369 S.C. 477, 485, 632 S.E.2d 854, 858 (2006).

[4] This result may turn on whether the arbitration agreement is subject to federal law (the Federal Arbitration Act) or state law (the South Carolina Uniform Arbitration Act), and it is important that a builder’s contract is drafted to ensure the application of federal law.