In its recent decision in Vaden v. Discover Bank, 1 the U.S. Supreme Court held that a federal court must “look through” a petition to compel arbitration under Section 4 of the Federal Arbitration Act 2 to determine whether the court would have federal question jurisdiction over the underlying controversy.

The Court also held that, for a federal court to have jurisdiction, the initial complaint, not any anticipation of a federal defense or a federal counterclaim, must establish a basis for federal jurisdiction.

An actual or potential counterclaim will not suffice to establish federal jurisdiction, even if arbitration is sought only for such claim and even if the counterclaim is governed by federal law. Chief Justice John Roberts Jr., joined by Justices John Paul Stevens, Stephen Breyer, and Samuel Alito Jr., agreed with the majority that a federal court should “look through” a §4 petition. They dissented, however, over how a federal court should determine jurisdiction, explaining that only the specific issue for which arbitration is sought should be relevant.

The dispute in Vaden originated from a complaint filed in Maryland state court by Discover Bank’s servicing affiliate, which sought to recover past-due charges from credit cardholder Betty Vaden. 3

The Maryland action presented only claims arising under state law.

Vaden answered and filed several counterclaims, styled as class actions, alleging that Discover Bank’s finance charges, interest and late fees violated state law.

Discover Bank then filed a §4 petition in the U.S. District Court for the District of Maryland to compel arbitration of Vaden’s counterclaims only pursuant to an arbitration clause in the cardholder agreement.

Discover Bank contended that the Maryland federal court had subject matter jurisdiction because Vaden’s state-law counterclaims were completely preempted by federal law, i.e., the Federal Deposit Insurance Act (FDIA). The District Court agreed with Discover Bank and ordered arbitration.

Vaden appealed to the U.S. Court of Appeals for the Fourth Circuit, which remanded the case to the district court, instructing it to “look through” the §4 petition to the substantive controversy between the parties to determine whether such controversy presented “a properly invoked federal question.” 4

On remand, Vaden conceded that the FDIA preempted any state law claims against a federally insured bank. The district court therefore held that it had federal question jurisdiction over Discover Bank’s §4 petition, and again ordered arbitration. The circuit affirmed, predicating jurisdiction on the fact that the FDIA completely preempted Vaden’s state law counterclaims.

The Supreme Court reversed in a 5-4 decision holding that the federal court lacked subject matter jurisdiction to consider Discover Bank’s §4 application under the Federal Arbitration Act (FAA).

The Court first addressed the issue of federal jurisdiction. The majority began by noting that Discover Bank relied on 28 U.S.C. §1331, which vests jurisdiction in federal district courts over “all civil actions arising under the Constitution, laws, or treaties of the United States.” The majority explained that “[u]nder the longstanding well-pleaded complaint rule . . . a suit ‘arises under’ federal law only when the plaintiff’s statement of his own cause of action shows that it is based upon federal law.” 5

Defenses, whether actual or anticipated, provide no basis for federal jurisdiction according to the majority: “It is not enough that the plaintiff alleges some anticipated defense to his cause of action and asserts that the defense is invalidated by some provision of federal law.”

Similarly, federal jurisdiction cannot rest upon an actual or anticipated counterclaim, the majority held, citing Holmes Group Inc. v. Vornado Air Circulation Systems Inc. 6 The majority pointed out that the Holmes Group Court reasoned that it would undermine the clarity and simplicity of the well-pleaded complaint rule if federal courts were obliged to consider the contents not only of the complaint but also of responsive pleadings in determining whether a case arises under federal law.

Thus, although a complaint purportedly based on state law can be recharacterized as one arising under federal law and removed to federal court if the law governing the complaint is exclusively federal, a state law-based counterclaim is not subject to removal even if it could similarly be recharacterized. 7

The Vaden majority then turned to the issue of whether federal courts can properly “look through” a §4 petition to determine jurisdiction. The majority found “relevant instruction” in the language of §4:

When one party seeks arbitration pursuant to a written agreement and the other resists, the proponent of arbitration may petition for an order compelling arbitration in ‘any United States district court, which save for the arbitration agreement, would have jurisdiction . . . of the subject matter of a suit arising out of the controversy between the parties. 8

Under the majority’s interpretation, the phrase “save for the arbitration agreement” in FAA §4 indicates that a district court should determine whether it would have jurisdiction in the absence of the arbitration agreement by looking through the petition to the substance of the dispute as framed in the initial complaint. In answering this question, under the language of §4, a federal court must determine whether it has jurisdiction over the “controversy between the parties,” which to the majority meant the substantive conflict between the parties, not the particular issue or issues as to which a party may seek arbitration.

Approach Not Proper

Turning to the dispute between Vaden and Discover Bank, the Court held that the Fourth Circuit’s decision to look through the petition was proper, although the execution of the approach was not.

The majority explained that the Fourth Circuit, in looking through the petition, should have looked only to Discover Bank’s initial complaint and not to Vaden’s responsive pleadings in assessing whether there was federal jurisdiction (the approach supported by the dissent). The majority concluded that there was a “fundamental flaw” in the dissent’s analysis:

In lieu of focusing on the whole controversy as framed by the parties, the dissent hypothesizes discrete controversies of its own design. As the parties’ state court filings reflect, the originating controversy here concerns Vaden’s alleged debt to Discover [Bank]. Vaden’s responsive counterclaims challenging the legality of Discover [Bank's] charges are a discrete aspect of the whole controversy. . . . The relevant question is whether the whole controversy between the parties – not just a piece broken off from that controversy – is one over which the federal courts would have jurisdiction. 9

The majority recognized that the results of its analysis might have been different had the controversy unfolded differently, i.e., if Vaden had filed her claims first (thus triggering complete preemption of her complaint) instead of in response to Discover Bank’s compliant.

Yet, according to the majority, §4 “does not invite federal courts to dream up counterfactuals when actual litigation has defined the parties’ controversy.” 10

Dissenting Opinion

The dissent – penned by Chief Justice Roberts and joined by Justices Stevens, Breyer and Alito – agreed with the majority that a federal court asked to compel arbitration pursuant to §4 of the FAA should “look through” the dispute over arbitrability in determining whether it has jurisdiction to grant the requested relief. 11

The dissent, however disagreed with the majority as to what constitutes “the controversy between the parties” under §4 of the FAA. It pointed out that Discover Bank’s petition to compel arbitration did not seek to arbitrate its state-law debt collection claims, but only Vaden’s counterclaim that Discover Bank had charged her and other members of the proposed class fees that violate the FDIA.

In the dissent’s view, looking solely at the issue for which arbitration was sought, a federal court “would have jurisdiction . . . of the subject matter of a suit arising out of the controversy” that Discover Bank seeks to arbitrate. In the dissent’s view, the majority approach is contrary to the language of §4, as the FAA’s consistent use of the term “controversy” means the specific dispute purportedly subject to arbitration, not some broader understanding of the disputes between the parties.

Conclusion

The Vaden decision makes clear that a federal action to enforce arbitration agreements under the FAA is available only when federal subject matter jurisdiction is present on the face of a “well pleaded complaint.”

Jurisdiction cannot be predicated on the anticipation of a federal defense or counterclaim in the dispute.

Where the initial action is a state law collection suit, a practical effect of Vaden is to compel the state court, not a federal court, to determine whether the class action waiver clause is enforceable.

Samuel Estreicher is Dwight D. Opperman Professor at New York University School of Law and counsel to Jones Day. Steven C. Bennett is a partner at Jones Day and the author of “Arbitration: Essential Concepts” (ALM 2002). Joseph J. Bernasky, an associate at the firm, assisted in the preparation of this article.

Endnotes:

1. U.S., 129 S.Ct. 1262 (2009).

2. 9 U.S.C. §4.

3. 129 S.Ct. at 1268.

4. Id. at 1269 (quoting 396 F.3d 366, 373 (4th Cir. 2005)).

5. Id. at 1272.

6. 535 U.S. 826, 122 S.Ct. 1889 (2002).

7. Id. at 1273.

8. Id. (quoting 9 U.S.C. §4).

9. Id. at 1276.

10. Id. at 1277.

11. Id. at 1279.