KERNAHAN AND JUDICIAL HURDLES TO ARBITRATION
By Jacqueline A. Muttick, Esq.
By Jacqueline A. Muttick, Esq.
New Jersey courts have continued the trend of applying an exacting reading to arbitration provisions, resulting in cases where such provisions have been struck down for failure to state clearly and unambiguously that the parties waive the right to seek relief in court and instead elect arbitration. A recent decision from late last year held an arbitration provision to be unenforceable when it did not set forth a specific arbitration forum (or a process for choosing an arbitration forum), and otherwise did not itemize the rights that replaced the right to proceed in court. Flanzman v. Jenny Craig, Inc., et al., 456 N.J. Super. 613 (App. Div. 2018). Likewise, the Court earlier this year struck down an arbitration provision that it similarly deemed ambiguous when, among other things, the provision itself was not labeled an “arbitration” provision and contained contradictory language that failed to inform the parties of the rights they were waiving. Kernahan v. Home Warranty Administrator of Florida, Inc., __ N.J. __ (2019).
In Kernahan, the parties entered into a consumer agreement and, after plaintiff consumer filed litigation, defendants moved to dismiss the complaint and enforce arbitration pursuant to the agreement. The Court found that the contract failed to inform consumers, including the plaintiff, that they were waiving their right to trial. Specifically, the arbitration provision was found in a section of the agreement labeled “Mediation,” the font size was small making the provision difficult to read, and the provision itself contained contradictory terms including requiring the arbitration to proceed under the AAA’s Commercial Mediation Rules. (Mediation and arbitration are vastly different, with mediation still providing parties with the opportunity to litigate while arbitration is a process that results in a final disposition.) The Plain Language Act, N.J.S.A. 56:12-1 to -13, requires consumer contracts be written in such a manner as to be understandable by a lay person, and the case law regarding arbitration provisions applies this standard as well. Since the provision in the Kernahan agreement failed to meet these requirement, there was no mutual assent to arbitration and the provision was deemed unenforceable. The Court again reaffirmed the position that “an arbitration agreement is clearly enforceable when its terms affirmatively state, or unambiguously convey to a consumer in a way that he or she would understand, that there is a distinction between agreeing to resolve a dispute in arbitration and agreeing to resolve that dispute in a judicial forum.” Id. slip op. at 24 (citing Atalese v. U.S. Legal Services Group, L.P., 219 N.J. 430, 442-444 (2014)).
The Kernahan decision is significant for its discussion of Kindred Nursing Centers Ltd. Partnership v. Clark, 137 S. Ct. 1421 (2017). In Kindred Nursing, the United States Supreme Court reviewed a Kentucky case requiring a power of attorney agreement to explicitly state that the agent (the attorney-in-fact) held the authority to waive the principal’s right to a jury trial. The Supreme Court held that such a requirement contravened the Federal Arbitration Act, 9 U.S.C. §§ 1 to 16, by holding arbitration agreements to a more exacting standard than other agreements, and by adding an additional barrier to the enforcement of arbitration agreements. The Court in Kernahan was not asked to review whether Atalese and other New Jersey cases violated Kindred Nursing. Nevertheless the Court did note that such an analysis would not be required for Kernahan because the threshold issue of whether the arbitration provision was clear was easily answered, as the provision did not contain the clarity required for mutual assent. In his concurring opinion, Justice Albin directly addressed this issue and found that Atalese did not conflict with Kindred Nursing, as New Jersey's case law does not disfavor arbitration agreements, but instead only requires the same mutual assent for enforcement that is required of all contracts.
While the majority opinion avoided directly opining on whether Atalese and its progeny runs afoul of Kindred Nursing, it appears from Kernahan that the Court is poised to uphold current New Jersey case law. Given the Court’s ruling in Kernahan, it is anticipated that New Jersey courts will continue their reading of consumer arbitration provisions, which currently favors jury trial in the event there is any ambiguity regarding the mutual assent to arbitrate. At the moment, the Court requires an explicit waiver of jury trial (see, e.g, Atalese), selection of the specific arbitration forum, itemization of the rights replacing the right to proceed in court (see Flanzman), and observance of the Plain Language Act, including clarity in contract terms and headings.
A Ticking Time Bomb: Existing Arbitration Clauses in Light of New LawPermalink
By: Jacqueline A. Muttick, Esq.
Associate, New Jersey
Date: December 3, 2018
Associate, New Jersey
Date: December 3, 2018
While there is a strong public policy in favor of arbitration, the Appellate Division in Flanzman v. Jenny Craig, Inc., et al., __ N.J. Super. __ (App. Div. 2018), has held that arbitration provisions need to specify the arbitral forum or otherwise set forth the process for arbitration in order to be enforceable. The Appellate Division, in a November 13, 2018, published opinion that superseded its prior October 17, 2018, opinion, held that an arbitration clause that did not specify the forum or process for arbitration was unenforceable, as there is no “meeting of the minds” when the parties do not understand the rights that replace the right to a jury trial.
The Court found that parties to an arbitration agreement must select the forum, like the American Arbitration Association (“AAA”) or the Judicial Arbitration and Mediation Services (“JAMS”), or otherwise set forth the process for arbitration at the time of the agreement. Failure to specify the forum or set forth the process for arbitration may result in an unenforceable arbitration agreement.
In Flanzman, plaintiff filed a lawsuit for employment discrimination and defendant, relying upon an arbitration clause, sought to compel arbitration. The clause at issue specifically stated the following:
“Any and all claims or controversies arising out of or relating to [plaintiff's] employment, the termination thereof, or otherwise arising between [plaintiff] and [defendant] shall, in lieu of a jury or other civil trial, be settled by final and binding arbitration. This agreement to arbitrate includes all claims whether arising in tort or contract and whether arising under statute or common law including, but not limited to, any claim of breach of contract, discrimination or harassment of any kind.”
While the trial court compelled arbitration, the Appellate Division reversed and held that there is no “meeting of the minds” between the parties when the arbitration clause lacks an agreed upon forum or process for arbitration. Citing Atalese v. United States Legal Services Group, 219 N.J. 430 (2014), the Court explained that arbitration agreements, like any other contract, require mutual assent and a “meeting of the minds” before the agreement will be found enforceable. Parties to an arbitration agreement must “clearly and unambiguously” agree to waive their otherwise statutory right to a trial, and the parties must understand the ramifications of that waiver. “[T]o understand the ramifications of a waiver of a jury trial, the parties must generally address in some fashion what rights replace those that have been waived.”
This fashioning includes setting forth the arbitrator(s) who will be used, or identifying an arbitral institution, like AAA or JAMS. Selection of an arbitral institution “informs the parties about the right that replace those that they waived in the arbitration agreement,” including the rules, procedures, and setting for the arbitration. The Court noted that if an arbitration agreement does not specify an arbitration forum it could nonetheless suffice by setting forth the process for selecting a forum.
The Court distinguished this matter from one in which a court under the Federal Arbitration Act (9 U.S.C. §5) or the New Jersey Arbitration Act (N.J.S.A. 2A:23B-11(a)) could appoint an arbitrator. The Court noted that the case under review was not a matter in which the parties could not select an arbitrator; rather, in this matter the forum, not the arbitrator, was unspecified. In the absence of a forum or forum selection process, there was no “meeting of the minds” or agreement to arbitrate.
The Court stressed in its ruling that there are no “talismanic words” required in an arbitration provision to make it enforceable, other than the requirement for a “clear mutual understating of the ramifications” of judicial waiver as set forth in Atalese. Since the arbitration provision in Flanzman did not set forth any arbitration forum or process for choosing an arbitration forum, or otherwise specify the rights replacing the right to proceed in court, the clause was unenforceable.
While the Appellate Division emphasized that this ruling does not require specific language in an arbitration clause to make it enforceable, it does add a previously unarticulated condition for such clauses to be valid. The Court in Atalese mandated that arbitration provisions clearly and unambiguously state that parties waive the right to seek relief in court and instead elect arbitration. The Flanzman ruling now requires the arbitration forum, or the process of choosing a forum, be denoted in sufficient detail so the parties understand the replacement forum.
While Flanzman dealt with an employment matter, it will likely have a far-reaching impact on arbitration clauses in other contracts, especially contracts between “sophisticated parties” and individuals. Now, parties seeking to enter into arbitration agreements need take heed not only to waive explicitly the right to bring an action in court (as required by Atalese), but also to specify the arbitration forum or forum-selection process in accordance with Flanzman.
New Year, New Contract Drafting and Due Diligence Concerns for PartnershipsPermalink
By: Michael E. Kar
Associate, New York
Date: December 27, 2017
Entities that are taxed as partnerships enter 2018 with fresh concerns in relation to due diligence and contract drafting, in reaction to changes in the statutory regime impacting audit procedures for taxable years starting after December 31, 2017.
By way of background, in the early 1980s a series of statutes, consolidated as the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), changed the way partnerships were audited by the IRS. Where previously each partner was individually audited and then collected from, TEFRA supposedly streamlined the process by auditing the partnership as a whole, and then applying the results to each individual partner, taking into account his or her specific tax attributes. This meant that these adjustments were based in part on each individual partner’s taxable rate. Now, however, new rules will alter that statutory regime, regulations that follow the Bipartisan Budget Act of 2015. The rules of the BBA are effective for partnership returns for tax years beginning after December 31, 2017.
TEFRA was deemed in need of improvement for a collection of reasons. One such reason was who exactly the IRS would deal with in regard to the partnership. There was difficulty in ascertaining who the single ‘tax matters’ partner was. Sometimes, this was an unofficial coalition of partners who would deal with the IRS, creating conflicting information and procedural confusion. Along with a series of other inefficiencies, it was determined that TEFRA resulted in fewer tax-eligible partnerships being audited.
Following the new rules at hand, the most immediate consideration imposed upon partnerships is the necessary designation of a “tax partnership representative”. This is a designated individual (or entity) with whom the IRS interacts. Unlike the ‘tax matters partner’, the tax partnership representative does not have to be a member of the partnership; the only statutory requisite is a substantial presence in the United States.
Although requisites are minimal, this tax partnership representative is given substantial power in regard to potential audits. This representative of a partnership has the sole authority to act on behalf of the partnership with respect to auditing, including any settlement, and can make certain unilateral Internal Revenue Code elections. All partners are bound by this representative’s decisions as well as any final IRS determination relating to the pertinent audit. Drafting tip: a partnership representative should be chosen before 2018 because if there is no designation, the IRS will make the selection. In addition to the benefit of autonomy of choice due to this increased power, partnerships should select their own representative because IRS consent is needed to revoke any IRS-made designation.
The second and far more substantial consideration is that the new rules allow the IRS to collect directly from the partnership, not just from the individual partners therein. This has been termed the “imputed underpayment”, and this adjustment is applied to the year in which the audit was centered, the “review year.”
In terms of tax rates, in contrast to TEFRA and the prior statutory regime which utilized the tax attributes of individual partners, the new rules would apply one rate to the entire partnership. It is important to note that this rate would not be based on the traditional aggregate method of determining tax on partnerships.
For this reason, among other potential considerations, partnerships may wish to avoid these changes. For qualifying partnerships, there are two options available.
The first option is an opt out, exercisable each year by partnerships that furnish less than 100 required (not possible) K-1s. Partnerships can qualify to opt out, generally, as long as there are no owners that are: trusts; tax-disregarded entities; or other partnerships not meeting certain requirements. These qualifications may and should factor into the acquisition and disposition decisions of a partnership, both today and in the future.
The second option, a sort of retroactive opt-out, is the election of a “push out.” If an audit tries to collect based on a previous review year, the partnership can push out the tax responsibility to the partners in that reviewed year, removing the tax responsibility of the partnership as a whole. Drafting tip: in consideration of possible adjustments that may be made under these rules, partnerships may want to impose an obligation on the partnership to push out in the event of an imputed underpayment.
Pushing out requires (i) a timely election within 45 days of IRS notice of final audit adjustment, and (ii) that the partnership provides to each partner during that reviewed year their share of the adjustment. The latter share adjustment must also be sent to the IRS. If executed properly, each notified partner is thereafter responsible for payment. Drafting tip: a partnership may want to secure these obligations contractually with owners, either during the relationship or during the sale or transfer of that owner’s interest. This drafting consideration works both ways. Alternatively, owners who are releasing their interest may seek contractual indemnity for any future audits being done under these new rules, particularly for possible review years in which that owner held interest.
Although this article addresses just a portion of the changes under the new rules, two obvious changes are needed moving forward for most impacted partnerships. First, existing tax distribution provisions should be reviewed in light of these developments, even if a partnership plans on systematic opting or pushing out. Second, new agreements to acquire or transfer interest should consider these rules and inject potential indemnities, preceded by new due diligence as to the partnership’s previous tax and ownership circumstances.
These changes to the statutory regime may and should result in global considerations for acquisition and disposition of partnership interests, as well as a multitude of amendments to operating agreements, partnership agreements, contracts, and other instruments. Some of these changes, especially the designation of a tax partnership representative, demand immediate attention.
NOTE: This is not tax advice.