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Decided: April 29, 2014

The Fourth Circuit held that the warranty companies could not proceed in federal court because the claims required the joinder of necessary and indispensable parties under the Federal Rules of Civil Procedure (F.R.C.P.) 19, which eliminated diversity jurisdiction.

Hanna entered into a contract with Clark Lamp II (Lamp) and Innovative Design & Construction, LLC (Innovative) to have a home built.  Lamp gave Hanna a Builder’s Warranty, with no authorization or indication in this agreement that Lamp would enroll the new house in a warranty offered by a third party.  Before closing, Lamp and Innovative enrolled the house into a 2-10 Home Owners Warranty (2-10 Warranty) with third party warranty companies, which included an arbitration clause.  The 2-10 Warranty was issued pursuant to a builder application of home enrollment that Hanna allegedly signed with the builder.  However, Hanna claims no such document was signed, and the record contains no application for enrollment.  Though Hanna found out about the 2-10 Warranty before closing on the house, Hanna claims no knowledge of the arbitration clause until after closing.  Believing the house had some defects, Hanna notified the builders, who then filed a claim with the third party warranty companies.  Unsatisfied with the warranty companies and the claims adjusters, Hanna filed suit in state court against the builders, warranty companies, and claims adjusters for state law claims, including tort claims.  Hanna argued that the arbitration clause was unenforceable on state law grounds; the warranty companies sought enforcement of the arbitration clause in federal court based on diversity jurisdiction.  The builders were not joined as parties.  Hanna filed for dismissal because the entire controversy included non-diverse parties.  Alternatively, Hanna argued for dismissal because the builders were non-diverse parties who were necessary and indispensable parties which the warranty companies failed to join under F.R.C.P. Rule 19.  The warranty companies were foreign parties; however, Hanna shared state citizenship with Lamp, Innovative, and at least three other builders.

The warranty companies argued that the parties were diverse and that, under the Federal Arbitration Act (FAA) and Moses H. Cone Memorial Hosp. v. Mercury Construction Corp., 460 U.S. 1 (1983), the co-defendants in the state court action need not be joined in this action.  The district court abstained based on the factors in Colorado River Conservation District v. U.S., 424 U.S. 800 (1976), and determined that there was no reason the petitioners’ could not pursue their rights in the state court system, nor that the arbitration decision could be decided only in federal court.  The lower court dismissed without addressing subject matter jurisdiction.  The warranty companies appealed.

The Fourth Circuit did not reach the issues of abstention or enforceability because the district court lacked subject matter jurisdiction.  A party must demonstrate that the court has jurisdiction because federal courts are courts of limited jurisdiction through Article III of the Constitution, or Congressional statute.  The warranty companies argued federal jurisdiction under both 28 U.S.C. § 1332 (diversity) and 9 U.S.C. § 4 (FAA).  The Court rejected the warranty companies’ argument that § 4 of the FAA created federal jurisdiction because § 4 only applies when there is diverse citizenship or an independent basis for federal jurisdiction.  Thus, jurisdiction could only be found if the citizenship of each plaintiff differs from each defendant under 28 U.S.C. § 1332.

F.R.C.P. Rule 19 sets forth a two-part test to determine whether a party is “necessary” and “indispensable”: (1) “whether a party is necessary to a proceeding because of its relationship to the matter” and (2) if the party is necessary, but would destroy complete diversity, the court must then decide “whether the proceeding can continue in that party’s absence.”  The court should use this test pragmatically, taking into account the possible prejudice to all parties.  Provident Tradesmens Bank & Trust Co. v. Patterson, 390 U.S. 102 (1968); Owens-Illinois, Inc. v. Meade, 186 F.3d 435 (4th Cir. 1999).

A party is necessary if the non-joined party “claims an interest relating to the subject of the action” and the non-joined party’s absence would interfere with its “ability to protect the interest”, F.R.C.P. 19(a)(1)(B)(i), or that absence would “leave an existing party subject to substantial risk of incurring…inconsistent obligations because of the interest,” F.R.C.P. 19(a)(1)(B)(ii).  The Court concluded that the builders were necessary parties because of the potentially prejudicial outcomes under either standard.  Under Rule 19(a)(1)(B(i), the builders have a direct pecuniary interest, and are actively contesting their liability in state court for tort claims.  Though joint tortfeasors are not automatically necessary parties, the builders’ interest extended beyond the possible tort liability to a natural interest in any interpretation of the contract terms.  Furthermore, the builders are critical to determining the enforceability of the arbitration clause.  F.R.C.P. Rule 19(a)(1)(B)(ii) protects against inconsistent obligations for the non-joined party.  The state court and the federal court may both have to determine whether the arbitration clause is enforceable because the builders are already in front of the state court.  The more efficient approach would be to allow the state court to determine the enforceability of the arbitration clause along with Hanna’s other state law claims.  F.R.C.P. Rule 19(a)(1)(A) also requires the builders to be present for the determination of the arbitration clause due to the importance of all defendants being bound by a common judgment.

After considering the possible prejudice to the parties, the Court also determined that the builders were indispensable to the litigation based on the four factors in F.R.C.P. Rule 19(b).  First, the risk of prejudice is high since the builders would not be arguing their own interests; Hanna has a strong interest in having all of her claims addressed with all the defendants before one tribunal.  Second, parallel proceedings would likely be prejudicial because the courts would not have sufficient protective measures to avoid confusion.  Third, the results could lead to incomplete, inconsistent, and inefficient rulings, which are not in the interest of the courts or the public.  Fourth, all parties would have an adequate remedy for their claims in the state courts.  Furthermore, the FAA is not a separate source of subject matter jurisdiction despite its strong public policy to enforce arbitration agreements, and the Court found no clear reason why an arbitration clause must be enforced in federal court over state court.

Full Opinion

Verona Sheleena Rios