While Section 1298.7 of the California Code of Civil Procedure generally allows homebuyers to pursue defect litigation in court regardless of an agreement to arbitrate, the Third District Court of Appeal recently ruled the Federal Arbitration Act preempts California law and binds homebuyers to arbitration provisions when the transaction involves interstate commerce. Because homes built in California today likely incorporate at least some construction materials originating outside the state and therefore implicate interstate commerce, the court's ruling may effectively preclude homebuyers from relying on this section of the Code of Civil Procedure to avoid arbitration.

Plaintiff John Shepard ("Shepard") purchased a house within the Cottonwood subdivision from defendant Mackay Enterprises, Inc. ("Mackay"). Shepard claimed a plumbing pipe installed by defendants Mackay and Cottonwood Development leaked and damaged Shepard's property. Shepard's lawsuit stated causes of action for negligence, breach of contract, breach of implied warranty, and strict liability.

The defendants moved to compel arbitration based on an arbitration provision in the real estate purchase agreement. Pursuant to that provision, the parties agreed to arbitrate any dispute "regarding" the real estate purchase agreement and any dispute "arising out of" the agreement. Shepard relied on Section 1298.7 of the Code of Civil Procedure to oppose the defendants' motion. Section 1298.7 permits a purchaser of real property to bring an action in court for construction and design defects, even if the purchaser signed an agreement containing an arbitration clause.

The defendants supported their motion to compel with evidence that supplies used in the Cottonwood subdivision originated outside of California. The defendants argued that federal law therefore applied and preempted Section 1298.7. The trial court disagreed and denied the motion, concluding that the defendants failed to demonstrate the transaction involved interstate commerce. The defendants appealed.

The Court of Appeal reversed the trial court, concluding that Shepard was bound by the arbitration provision. The appellate court explained that the Federal Arbitration Act ("FAA") makes valid and enforceable any arbitration provision in a contract "evidencing a transaction involving commerce." The FAA preempts conflicting state anti-arbitration laws like California's Section 1298.7 when the contract at issue has a substantial effect on interstate commerce.

The Court of Appeal cited the U.S. Supreme Court's decision in Allied-Bruce Terminix Companies, Inc. v. Dobson, where the court found the FAA preempted an Alabama law making written, predispute arbitration agreements invalid. The Supreme Court explained the phrase "involving commerce" in the FAA normally signals Congress' intent to exercise its Commerce Clause powers to the full. The contract at issue was an agreement for a lifetime termite protection plan between an Alabama homeowner and a termite control company. The Supreme Court readily concluded the transaction involved interstate commerce. In addition to the "multistate nature" of the termite control company, the "termite-treating" and "house-repairing" material used by the company came from outside Alabama.

The Court of Appeal then turned to three California cases where courts considered FAA preemption in disputes involving real estate purchase agreements. In two of the cases, the courts held that interstate commerce was involved, based on the use of building materials manufactured outside California; contracts with out-of-state design professionals; communications by interstate mail and telephone; nationwide marketing and advertising activities; and the use of federal home loans. In contrast, the FAA did not preempt Section 1298.7 where a contractor made no evidentiary showing that the transaction involved interstate commerce.

Applying these principles, the Court of Appeal considered whether the transaction between Shepard and the defendants involved an activity having a substantial relation to interstate commerce. The defendants did not present any evidence that the parties were from out-of-state, engaged in business out-of-state, or used interstate media to engage in advertising. However, the defendants produced evidence that the construction of Shepard's house involved the use of building materials that were manufactured outside California. There is no requirement, the court wrote, that the dispute arise from the particular part of the transaction involving interstate commerce, "the pertinent question is whether the contract evidences a transaction involving interstate commerce …." The court concluded the defendants' evidence was sufficient to show the transaction at issue substantially affected interstate commerce. The court therefore found the FAA preempted Section 1298.7 and reversed the denial of the defendants' motion to compel arbitration.