Nelson v. Watch House Int’l, L.L.C., No. 15-10531 (5th Cir. Mar. 2, 2016)

On the first day of Michael Nelson’s (“Nelson”) employment with Watch House International, L.L.C. (“Watch House”), Nelson received a copy of the employee handbook, which contained Watch House’s Arbitration Plan.  The Arbitration Plan broadly provided for mandatory arbitration of any claims relating to Nelson’s employment, including harassment and discrimination claims, and confirmed that arbitration was the sole and exclusive remedy for resolving such disputes. 

Nelson alleged that, during his four years of employment with Watch House, he was harassed by coworkers because of his religion and his race.  Shortly after he reported the harassment to his supervisor, Watch House terminated Nelson’s employment.  Nelson then brought suit in federal district court asserting employment discrimination claims and Watch House moved to compel arbitration under the Arbitration Plan.  The district court found the parties’ arbitration agreement was enforceable and not illusory, granted Watch House’s motion to compel arbitration, and dismissed Nelson’s case.  He appealed. 

On appeal, the Fifth Circuit held that to submit claims to arbitration: (1) there must be a valid agreement to arbitrate between the parties; and (2) the dispute in question must fall within the scope of that arbitration agreement.  Nelson argued that Watch House’s Arbitration Plan was illusory and unenforceable under the first prong of this test.

In deciding whether an agreement to arbitrate is valid, courts apply state-law principles that govern the formation of contracts.  Texas law requires that arbitration agreements, like other contracts, be supported by consideration.  A mutual agreement to arbitrate is sufficient consideration.  However, where one party can unilaterally terminate its own obligation to arbitrate, the agreement is illusory. 

In the seminal Texas case, In re Halliburton Co., the Texas Supreme Court carved out an exception to this rule.  Under Halliburton, where an arbitration agreement contains savings clauses including a ten-day notice provision and a provision that any amendments only apply prospectively, then an employer cannot avoid its promise and the arbitration agreement is not illusory.  Following Halliburton, the Fifth Circuit articulated a three-prong test to determine whether a Halliburton-type savings clause sufficiently restrains an employer’s unilateral right to terminate its arbitration obligation:  An arbitration agreement is not considered illusory if (1) the employer’s retention of termination power extends only to prospective claims; (2) termination applies equally to both claims by employer and employee; and (3) advance notice to the employee is required before termination is effective.

Here, Watch House’s Arbitration Plan failed the three-prong test because it did not include a savings clause requiring advance notice to the employee of termination of the arbitration agreement.  Instead, the Arbitration Plan provided that Watch House could unilaterally change the Arbitration Plan, purportedly including termination of the Arbitration Plan, and that such a change was immediately effective upon notice to employees.  Accordingly, the Fifth Circuit ruled that Watch House’s Arbitration Plan was illusory, that Nelson was not bound by the Arbitration Plan, and that Watch House could not compel arbitration.