Lugli v. Medical Investor Holdings, LLC et al.
Case No: 19CV01829
Hearing Date: Tue Sep 10, 2019 8:30

Nature of Proceedings: Demurrer; Motion to Strike

Russell and Susan Lugli, on behalf of themselves as individuals and as trustees of the Lugli Family Trust (together, “plaintiffs”), allege as follows[1]: Plaintiffs own two parcels of property known as Wellsprings Ranch, located in Buellton. The property consists of 400 acres of cultivable land, is located in a remote location, and is a secure area for cannabis cultivation. Defendants Francine Shulman and Emerald Sky Agricultural Acquisition, LLC wanted to buy the property and develop to grow cannabis. In July 2017, plaintiffs entered a Purchase and Sale Agreement (PSA) for $7.5 million dollars. Escrow was to close on January 15, 2018. Shulman wanted to occupy the property prior to close of escrow, so the parties entered into a lease agreement from July 15, 2017 through January 15, 2018.

In 2014, Ms. Shulman purchased property from plaintiffs. She leased that parcel to defendant Todd Kaplan (“Kaplan”), for purposes of cultivating cannabis. In the late summer of 2017, Ms. Shulman introduced plaintiffs to Kaplan who, on behalf of Medical Investor Holdings Inc. and NCAMBA 9, Inc., began a lengthy campaign of soliciting plaintiffs’ investment in his cannabis business.

On November 20, 2017, plaintiffs and Ms. Shulman executed an amendment for the PSA, in which they agreed to extend escrow through January 15, 2019; and on the same date, plaintiffs executed a document titled Agreement to Share Profits with Ms. Shulman and Mr. Kaplan. Under that Agreement, the parties agreed to split net cash flows for cannabis grown on the Property “in consideration for the use and Purchase of the [Ranch]. . . Plaintiffs shall be entitled to the net cash flow on up to two (2) acres worth of cannabis production for cannabis grown on the Property for calendar years 2018 . . . ”

On September 19, 2018, Mr. Lugli executed a “subscription agreement” (“Subscription Agreement”) intending only to obtain access to defendants’ confidential operating agreement to assess whether to commit to an investment. In fact, the Subscription Agreement represented that Mr. Lugli “agree[d] to purchase 90,194 Units for a total subscription price of $2,000,000 . . .” (See Subscription Agreement attached to Complaint, Exhibit 6, p. 9.)

On April 4, 2019, plaintiffs filed their complaint, and filed an amended complaint on July 3, 2019, for (1) declaratory relief as to the Subscription Agreement; (2) elder abuse; (3) fraud in the execution of the Subscription Agreement; (4) fraud in the inducement of the Subscription Agreement; (5) recession of the Subscription Agreement; (6) breach of contract (profit share); and (7) waste committed on Ranch.

On Calendar

Defendants Medical Investor Holdings, LLC; Todd Kaplan; and NCAMBA9, Inc. move for an order compelling arbitration. Defendants have simultaneously filed a demurrer and motion to strike. The court will consider the motion to compel arbitration first. Opposition was filed on August 21, 2019. Reply was filed on September 4, 2019.

Request for Judicial Notice

Plaintiffs request the court take judicial notice of the opinion of the court in Neal Feay Company v. Lugli, filed in the California Court of Appeal, Second District, Division 6, Case No. B255943 pursuant to Evidence Code section 452 subdivision (d)(1), which allows judicial notice to be taken of court records. Defendants object to the request on the basis that it is irrelevant and noncitable. Defendants offer this evidence to demonstrate that plaintiffs are not naïve investors, as they have portrayed themselves in the FAC. To the extent this is relevant to the determination on the motion to compel arbitration, the objection is overruled.

Defendants request the court take judicial notice of (1) the fact that MIH filed a Demand for Arbitration with JAMS on March 11, 2019, (2) of the Demand itself; and (3) of the nature of the claims asserted in the Demand. Defendants contend that the court may do so under Evidence Code section 452 subdivision (h), which provide that the court may take judicial notice of “[f]acts and propositions that are not reasonably subject to dispute and are capable of immediate and accurate determination by resort to sources of reasonably indisputable accuracy.” Plaintiffs object on the basis that “[j]udicial notice under Evidence Code section 452, subdivision (h) is intended to cover facts which are not reasonably subject to dispute and are easily verified. These include, for example, facts which are widely accepted as established by experts and specialists in the natural, physical, and social sciences which can be verified by reference to treatises, encyclopedias, almanacs and the like or by persons learned in the subject matter. (Comment, Assem. Judiciary Com. accompanying enactment of Evid. Code, § 452, 29B West’s Ann. Evid. Code (1966) pp. 351-352.)” (Gould v. Maryland Sound Industries, Inc. (1995) 31 Cal.App.4th 1137, 1145.) They argue that the fact of filing a demand for arbitration is not at all similar. While it appears true that the fact of filing a document is not akin to facts that are established by experts and specialists in the natural, physical, and social sciences, it also remains the case that the fact of filing is easily verifiable. Plaintiffs don’t dispute that an arbitration has been filed—and frankly should not be able to mask the existence of an ongoing arbitration on a technicality. The objection is overruled.

Defendants request the court take judicial notice of JAMS Comprehensive Rules & Procedure, effective July 1, 2014, Rule 11. Plaintiffs raise the same arguments as above and the court similarly overrules them.

The court grants the request to take judicial notice of the identified documents.

Merits

The Subscription Agreement contains the following language:

I hereby covenant and agree that any dispute, controversy or claim arising out of or relating to this Subscription Agreement (other than claims for injunctive or equitable relief), including, but not limited to, the interpretation breach or termination hereof (including whether the claims asserted are arbitrable), shall be referred to and by arbitration in finally determined accordance with the Judicial Arbitration and Mediation Services, Inc. (“JAMS”) Arbitration Rules. The tribunal will consist of a sole arbitrator selected in accordance with the JAMS Arbitration Rules. The place of arbitration shall be Los Angeles, California. Any award rendered therein shall be final and binding on each and all of the parties thereto and their personal representatives, and judgment may be entered thereon in any court of competent jurisdiction. The arbitrator may, in the award, allocate all or part of the costs of the arbitration, including the fees of the arbitrator. Discovery in accordance with California law shall be permitted. The prevailing party shall be entitled to an award of its reasonable costs and expenses, including, but not limited to, attorneys’ fees, in addition to any other available remedies.

(Subscription Agreement, ¶ 11.)

Defendants thus move for an order compelling arbitration of the 1st – 4th causes of action because they are covered by the arbitration agreement, and of the 5th – 6th causes of action because they “relate to” the Subscription Agreement.

Initially, courts generally decide whether the arbitrability of the parties’ dispute is governed by the Federal Arbitration Act (FAA). (See 9 U.S.C. §§ 1, 2.) The primary substantive provision of the FAA is section 2, which provides:

“A written provision in … a contract evidencing a transaction involving commerce to settle by arbitration a controversy thereafter arising out of such contract or transaction … shall be valid, **1067 irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract.”

(9 U.S.C. § 2.)

“Section 2 is a congressional declaration of a liberal federal policy favoring arbitration agreements, notwithstanding any state substantive or procedural policies to the contrary. The effect of the section is to create a body of federal substantive law of arbitrability, applicable to any arbitration agreement within the coverage of the [FAA].” (Moses H. Cone Hospital v. Mercury Construction Corp. (1983) 460 U.S. 1, 24.) The rule of enforceability established by section 2 of the FAA preempts any contrary state law and is binding on state courts as well as federal. (Southland Corp. v. Keating (1984) 465 U.S. 1, 10–16.)

The policy of enforceability stated in section 2 of the FAA is implemented in the remaining sections of the FAA, especially sections 3 and 4, which concern attempts to resist arbitration or to litigate an issue subject to arbitration. Section 3 requires any court “of the United States” to grant a party’s request for a stay of litigation on an arbitrable issue, pending completion of the arbitration. (9 U.S.C. § 3.) Section 4 requires a “United States district court” to entertain an application to compel arbitration. (9 U.S.C. § 4.) Five days’ notice of the application is required, to be served on the party in default “in the manner provided by the Federal Rules of Civil Procedure.” (Ibid.) The court is to order arbitration if satisfied “that the making of the agreement for arbitration or the failure to comply therewith is not in issue.” If such an issue is presented, the court is to “proceed summarily to the trial thereof.” (Ibid.) Despite the summary nature of the proceeding, the party resisting arbitration may demand a jury trial on issues of the existence of the arbitration agreement or the party’s default thereunder. Upon this demand, the court is to refer the matter to a jury “in the manner provided by the Federal Rules of Civil Procedure, or may specially call a jury for that purpose.” (Ibid.)

In most important respects, the California statutory scheme on enforcement of private arbitration agreements is similar to the FAA. Code of Civil Procedure section 1281, like section 2 of the USAA, provides that predispute arbitration agreements are “valid, enforceable and irrevocable, save upon such grounds as exist for the revocation of any contract.” Code of Civil Procedure section 1281.2 (hereafter section 1281.2), like the FAA’s section 4, provides a procedure by which a party may petition the court to order arbitration of a controversy. Under section 1281.2, as under section 4 of the FAA, the court may deny the application if it finds the party resisting arbitration did not in fact agree to arbitrate. Like section 3 of the FAA, Code of Civil Procedure section 1281.3 provides that when a court has ordered arbitration of a controversy, any pending litigation on the same controversy is to be stayed. In one important respect, however, section 1281.2 differs from section 4 of the FAA: the California statute does not provide for a jury trial of issues as to the making of the arbitration agreement or the resisting party’s default thereunder. Instead, our statutory scheme requires petitions to compel arbitration to be determined “in the manner … provided by law for the making and hearing of motions.” (Code Civ.Proc., § 1290.2.)

The parties spend much time briefing whether the FAA or the CAA applies to the case at hand. But it doesn’t make a significant difference in this case because the primary question—whether the court or the arbitrator resolves the arbitrability of this claim—is the same under both the FAA and the CAA. Under both the FAA and the CAA, the court may deny an application to arbitrate if it finds the party resisting arbitration did not, in fact, agree to arbitrate. (FAA, § 4[2]; Code of Civ. Proc., § 1281.2.)

This is particularly significant in cases where fraud is alleged, as it is here. Both the US Supreme Court and Cal. Supreme Court have held that fraud claims going to the making of the arbitration agreement itself are to be decided by the court. (Prima Paint Corp. v. Flood & Conklin Mfg. Co. (1967) 388 U.S. 395, 403–404; Rosenthal v. Great Western Fin. Securities Corp. (1996) 14 Cal.4th 394, 415.) On the other hand, claims that the contract as a whole was fraudulently induced must be resolved by the arbitrator, not the court. (See Buckeye Check Cashing, Inc. v. Cardegna (2006) 546 US 440, 445-446.)

In Prima Paint, the parties entered into a consulting contract and defendants failed to pay as provided by the contract. Plaintiff’s complaint included a claim “that [defendant] had fraudulently represented that it was solvent and able to perform its contractual obligations, where as it was in fact insolvent and intended to file a petition under Chapter XI of the Bankruptcy Act, 52 Stat. 905, 11 U.S.C. s 701 et seq., shortly after execution of the consulting agreement.” (Prima Paint at 398.) The Cal. Supreme Court held that “no claim has been advanced by Prima Paint that F & C fraudulently induced it to enter into the agreement to arbitrate . . .” (Id. at 406 [emphasis added].) Because the arbitration provision was otherwise broad enough to encompass plaintiff’s claims of fraud, the arbitrator, not the court, was to adjudicate the question. (Id.)

The California Supreme Court subsequently interpreted Prima Paints and determined that claims of fraud in the execution of the entire agreement[3] are not arbitrable under either state or federal law: “If the entire contract is void ab initio because of fraud, the parties have not agreed to arbitrate any controversy.” (Rosenthal v. Great Western Fin’l Secur. Corp. (1996) 14 Cal.4th 394, 416—rejecting contention that Prima Paint required court to order arbitration under such circumstances; see Three Valleys Mun. Water Dist. v. E.F. Hutton & Co., Inc. (9th Cir. 1991) 925 F.2d 1136, 1141—because an arbitrator’s jurisdiction is rooted in the agreement of the parties a party who contests the making of a contract containing an arbitration provision cannot be compelled to arbitrate the threshold issue of the existence of an agreement to arbitrate.)

Defendants argue that Prima Paint’s holding must be narrowly construed to challenges to the arbitration provision itself—in other words, unless the fraudulent statements concern the arbitration clause itself, a fraud challenge must be referred to the arbitrator. As the allegations here concern the entire contract, defendant argues, the arbitrator and not the court should determine the arbitrability of the claims. Defendants rely on Rent-A-Center, West, Inc. v. Jackson (2010) 561 US 63, 72, in which the US Supreme Court held that “[A] party’s challenge to another provision of the contract, or the contract as a whole, does not prevent a court from enforcing a specific agreement to arbitrate.” However that case is distinguishable. The court was considering whether a contract was unconscionable—not whether the contract had been formed in the first instance. Rosenthal governs.

In conclusion, the court, not the arbitrator, must determine whether a valid arbitration agreement exists. (FAA, § 4; Code of Civ. Proc., § 1281.2.) This is so even if the parties ostensibly agreed to allocate the burden of making such decision to the arbitrator (see AT & T Technologies v. Communications Workers (1986) 475 U.S. 643, 649—the question of arbitrability is for judicial determination unless the parties clearly and unmistakably provide otherwise; Dream Theater, Inc. v. Dream Theater (2004) 124 Cal.App.4th 547, 552), since the court must determine whether a valid agreement exists in the first instance.

The issue of fraud in the execution is normally determined on hearing the motion to compel arbitration. (Rosenthal v. Great Western Fin’l Secur. Corp., supra, 14 Cal.4th at 414.) The petitioner (seeking to compel arbitration) bears the burden of proving the existence of an arbitration agreement by a preponderance of the evidence. The party claiming fraud bears the same burden as to the fraud defense. (Rosenthal v. Great Western Fin’l Secur. Corp., supra, 14 C4th at 413-414; Hotels Nevada v. L.A. Pac. Ctr., Inc., supra, 144 CA4th at 763-764, 507.)

Detailed factual affidavits or declarations are usually required. Oral testimony is discretionary with the court. But where the facts are in dispute or credibility issues are involved (which is usually the case when fraud is claimed), “the better course” is for the trial court to hear oral testimony and allow the parties the opportunity for cross-examination. (Rosenthal v. Great Western Fin’l Secur. Corp., supra, 14 Cal.4th at 414; Ashburn v. AIG Fin’l Advisors, Inc., supra, 234 CA4th at 98; Hotels Nevada v. L.A. Pac. Ctr., Inc., supra, 144 CA4th at 762.)

The court must examine the declarations for sufficiency of plaintiff’s showing of fraud in the execution. Here, the parties have submitted competing declarations. Mr. Lugli states (among other things): “Defendant Kaplan affirmed that executing the Subscription Agreement would not bind us for either Subscription: that it was an inconsequential document and that we should not bother with reading it.” (Lugli Decl., ¶ 16.) Mr. Kaplan states (among other things): “I never represented to him that the subscription agreement was merely a “confidentiality agreement” nor that it would not be binding.” (Kaplan Decl., ¶ 6.)

Fraud in the execution does not apply where the party claiming fraud had a reasonable opportunity to discover the real terms of the contract and failed to do so: “If a party, with such reasonable opportunity, fails to learn the nature of the document he or she signs, such ‘negligence’ precludes a finding the contract is void for fraud in the execution.” (Rosenthal v. Great Western Fin’l Secur. Corp., supra, 14 Cal.4th at 423.) Stated another way, “one party’s unreasonable reliance on the other’s misrepresentations, resulting in a failure to read a written agreement before signing it, is an insufficient basis, under the doctrine of fraud in the execution, for permitting a party to avoid an arbitration agreement contained in a contract.” Rosenthal, supra, at 423.) In Rosenthal, many plaintiffs declared that defendant’s representatives “told them the written client agreement were unimportant, or that plaintiffs need not read them.” (Id. at 424.) The court held that “Such statements, even if falsely and fraudulently made, do not void a written contract, because it is generally unreasonable, in reliance on such assurances, to neglect to read a written agreement before signing it.” (Id.) However, as to the plaintiffs who, in addition to the foregoing, stated that they were legally blind or had a limited ability to read English, the declarations sufficiently showed facts, which if believed and interpreted in their favor would suffice to establish reasonable reliance for purposes of showing fraud in the execution. (Id.)

Here, Mr. Lugli states (among other things) that as a result of a fire, he “ha[s] resulting difficulties seeing and reading, specifically small print.” (Lugli Decl., ¶1.) “Kaplan asked multiple questions about our health conditions and inquired as to whether I bothered or was able to read ‘small print.’” (Lugli Decl., ¶ 5.) “Defendants then specifically completed and filled out two (2) Subscription Agreements and mailed them to us-all that was missing was the date and our signatures. We were told by them that we should not bother with reading them as all would be explained by Kaplan.” (Lugli Decl., ¶ 13.) “Defendant Kaplan then informed me that these were not the actual “Subscription Agreements,” rather they were a “confidentiality agreement.” (Lugli Decl., ¶ 14.) “Defendant Kaplan affirmed that executing the Subscription Agreement would not bind us for either Subscription: that it was an inconsequential document and that we should not bother with reading it.” (Lugli Decl., ¶ 16.) In reliance thereon, I executed the Subscription Agreement, believing it to only be a “precondition” and/or “confidentiality agreement,” solely granting us access to Defendants’ operating agreement and all other financial documents, prior to any actual agreement that was to include both my wife and I as co-trustees. My wife never signed the agreement, and our Trust instrument does not allow unilateral action by a sole Trustee.” (Lugli Decl., ¶ 17.) Mr. Lugli’s declaration sufficiently shows facts, which if believed and interpreted in their favor would suffice to establish reasonable reliance for purposes of showing fraud in the execution.

These facts are far from undiputed. Mr. Kaplan states (among other things): “[Mr. Lugli] never indicated to me that he could not read.” (Kaplan Decl., ¶ 4.) “During this meeting [to discuss the Subscription Agreements], Mr. Lugli made statements that indicated his understanding that the agreement was a contract to purchase stock in MIH . . . I never represented to him that the subscription agreement was merely a “confidentiality agreement” nor that it would not be binding.” (Kaplan Decl., ¶ 6.) “I did not pressure Mr. Lugli to sign to Subscription Agreement, nor was I even present when he did sign it.” (Kaplan Decl., ¶ 7.)

These factual issues are to be resolved by the trial court. A petition to compel arbitration is essentially a suit in equity to compel specific performance of a contract, and there is no right to jury trial.[4] Any issues of fact are determined by the court “in the manner … provided by law for the making and hearing of a motion.” (Code Civ. Proc. § 1290.2; see Rosenthal v. Great Western Fin’l Secur. Corp., supra, 14 C4th at 413; Hotels Nevada v. L.A. Pac. Ctr., Inc., supra, 144 CA4th at 761-762.)

Plaintiff’s waiver argument is, in reality, an argument that the contract was never formed. The court will not address it here. Plaintiff’s argument that the arbitration clause is both procedurally and substantively unconscionable is also based on the argument that the contract was never formed and is, in any event, irrelevant if the court determines no clause exists. Decision thereon will be deferred. Defendants’ demurrer and motion to strike will likewise be taken off-calendar subject to resetting at the end of the court hearing as noted above.

Appearance are required at the hearing to discuss the setting of the evidentiary hearing.

[1] The first amended complaint contains 167 paragraphs—or 24 pages—of facts. They are not all recounted here.

[2] According to section 4: “The court shall hear the parties, and upon being satisfied that the making of the agreement for arbitration or the failure to comply therewith is not in issue, the court shall make an order directing the parties to proceed to arbitration in accordance with the terms of the agreement. . . If the making of the arbitration agreement or the failure, neglect, or refusal to perform the same be in issue, the court shall proceed summarily to the trial thereof.”

[3] California law distinguishes between fraud in the “execution” or “inception” of a contract and fraud in the “inducement” of a contract. In the former case the fraud goes to the inception or execution of the agreement, so that the promisor is deceived as to the nature of his act, and actually does not know what he is signing, or does not intend to enter into a contract at all, mutual assent is lacking, and the contract is void. In such a case it may be disregarded without the necessity of rescission. Fraud in the inducement, by contrast, occurs when the promisor knows what he is signing but his consent is induced by fraud, mutual assent is present and a contract is formed, which, by reason of the fraud, is voidable. In order to escape from its obligations the aggrieved party must rescind ….” (Rosenthal, supra at 415 [internal citations omitted].)

[4] FAA § 4 provides that on a motion to compel arbitration, parties are entitled to a jury trial on issues as to the existence of an arbitration agreement or default thereunder (9 USC § 4). But where such a petition is heard in a California state court, it is heard without a jury trial (CCP § 1281.2). The state procedural rule is not preempted because it serves to further, rather than impede, the objectives of arbitration. (Rosenthal, supra, 14 Cal.4th at 410.)