State Court Should Leave Enforceability of Noncompetes to Arbitrator: US Supreme Court

Practical Law Legal Update 2-522-6738 (Approx. 5 pages)

State Court Should Leave Enforceability of Noncompetes to Arbitrator: US Supreme Court

by PLC Labor & Employment

Key Litigated Issues

The key litigated issue in Pacific Nitro-Lift v. Howard was whether the Oklahoma Supreme Court correctly interpreted the Federal Arbitration Act (FAA), including its national policy favoring arbitration, by declaring the noncompetition agreements in two employment contracts null and void, rather than leaving that determination to the arbitrator in the first instance.

Background

Two former employees of Nitro-Lift, Howard and Schneider, entered into a confidentiality and noncompetition agreement with Nitro-Lift that contained an arbitration clause:

"Any dispute, difference or unresolved question between Nitro-Lift and the Employee (collectively the "Disputing Parties") shall be settled by arbitration by a single arbitrator mutually agreeable to the Disputing Parties in an arbitration proceeding conducted in Houston, Texas in accordance with the rules existing at the date hereof of the American Arbitration Association."

After working for Nitro-Lift on oil and gas wells in Oklahoma, Texas and Arkansas, Howard and Schneider resigned and went to work for a competitor. Believing that Howard and Schneider had breached their noncompetition agreements, Nitro-Lift served them with an arbitration demand. Howard and Schneider then filed suit in District Court in Oklahoma, asking the court to enjoin enforcement of the noncompetes and declare them null and void. The District Court dismissed the complaint, finding that the contracts had legitimate arbitration clauses under which an arbitrator, and not the court, must settle the parties' dispute.

However, the Oklahoma Supreme Court retained Howard and Schneider's appeal and ordered the parties to show cause why the matter should not be resolved by application of Oklahoma Statute, Title 15, Section 219A, which limits noncompete enforcement. Nitro-Lift responded that disputes about the contracts' enforceability were questions for arbitration. Nitro-Lift cited, among others, the US Supreme Court's case interpreting the FAA, Buckeye Check Cashing, Inc. v. Cardegna (Buckeye), which indicated that the FAA applied equally in state and federal court.

The Oklahoma Supreme Court disagreed, holding that despite the US Supreme Court precedent, the existence of an arbitration agreement in an employment contract does not prohibit judicial review of the underlying contract. The Oklahoma Supreme Court relied on the US Supreme Court's Bruner v. Timberlane Manor Ltd. Partnership decision, which found that US Supreme Court jurisprudence did not prohibit the lower court's review of the underlying contract's validity. Taking on review of the contract, the Oklahoma Supreme Court held that the noncompetition agreements were void and unenforceable against Oklahoma public policy, citing adequate and independent state grounds.

Outcome

On November 26, 2012, the US Supreme Court issued a per curiam decision in Nitro-Lift v. Howard reversing the Oklahoma Supreme Court holding. The US Supreme Court held that:

State courts (rather than federal courts) are most frequently called on to apply the FAA. It is important, therefore, that state supreme courts correctly interpret the FAA.
In this case, the Oklahoma Supreme Court failed to correctly interpret the FAA's national policy favoring arbitration by declaring the noncompetition agreements in the two employment contracts null and void, rather than leaving that determination to the arbitrator in the first instance.

For these reasons:

The petition for certiorari was granted.
The judgment of the Oklahoma Supreme Court was vacated.
The case was remanded for further proceedings consistent with the US Supreme Court opinion.

In reaching its holding, the US Supreme Court stated that:

The Oklahoma Supreme Court's decision disregards:
- the US Supreme Court's precedents on the FAA; and
- the FAA's national policy favoring arbitration.
(Southland Corp. v. Keating.)
It is well settled that the substantive law the FAA created is applicable in state and federal courts (Southland Corp.).
Under the FAA, attacks on the validity of the contract, as opposed to attacks on the validity of the arbitration clause itself, must be resolved by an arbitrator initially and not by federal or state court (Preston v. Ferrer).
For resolving attacks on the validity of the contract, the arbitration provision is severable from the rest of the contract and the clause's validity is subject to initial court determination, but the validity of the remaining portion of the contract (if the arbitration provision is valid) left to the arbitrator to decide (Buckeye).
The Oklahoma Supreme Court must abide by the FAA and US Supreme Court interpretations of it.
US Supreme Court jurisprudence attempts to prevent this type of "judicial hostility towards arbitration" (AT&T Mobility LLC v. Concepcion).
When state law prohibits arbitration of certain claims, the FAA displaces state law. The arbitrator must decide initially whether the noncompetes are valid as a matter of applicable state law (Buckeye).

Practical Implications

Employers should be aware that when they commit to arbitrate contractual disputes with current or former employees, the substantive law of the FAA states that attacks on the validity of the contract, as distinct from attacks on the validity of the arbitration clause itself, are to be resolved by arbitration in the first instance and not by a federal or state court. For this purpose, an arbitration provision can be severed from the remainder of the employment contract. While the validity of the arbitration provision is subject to initial court determination, the validity of the remainder (if the arbitration provision is valid) is for an arbitrator to decide.

State Court Should Leave Enforceability of Noncompetes to Arbitrator: US Supreme Court | Practical Law