The Importance Of Vaden V. Discover Bank

May 14, 2009 Law360

All Content Copyright 2003-2009, Portfolio Media, Inc.

The U.S. Supreme Court redefined the enforceability of agreements to arbitrate in its March 9 decision in Vaden v. Discover Bank, et al., 556 U.S. ___ (2009).

While Vaden involved a dispute between a credit card holder and credit card company, the decision may significantly impact the securities industry by making it easier for investors to avoid arbitration, despite the existence of a valid arbitration agreement.

Factual Background

Discover Bank’s servicing affiliate commenced the suit in state court based exclusively on state law in Maryland. The affiliate sought the recovery of past due charges from Vaden. Vaden counterclaimed, alleging that Discover’s finance charges, interest and late fees violated state law.

Pursuant to an arbitration agreement executed between the parties, Discover filed a Section 4 petition in the U.S. District Court for the District of Maryland to compel arbitration of Vaden’s counterclaims.

The district court granted the petition, reasoning that it had subject matter over the petition because Section 27(a) of the Federal Deposit Insurance Act (FDIA) completely preempted Vaden’s state law claims.

Section 27(a) prescribes the interest rates state-chartered, federally insured banks like Discover can charge, “notwithstanding any state constitution or statute which is hereby preempted.”

On appeal, the Fourth Circuit affirmed and reasoned that a federal court has subject matter jurisdiction over a Section 4 petition if the parties’ underlying dispute presents a federal question.

In so doing, the Fourth Circuit held that it must “look through” the Section 4 petition to the underlying controversy and independently determine if the district court had subject matter jurisdiction.

While the Fourth Circuit recognized that federal question jurisdiction depends on the contents of a well-pleaded complaint, and not on a counterclaim, the court nevertheless held that, because Section 27(a) of the FDIA completely preempted Vaden’s counterclaim, the complete preemption doctrine overrode the well-pleaded complaint rule.

The U.S. Supreme Court granted certiorari because of a conflict regarding whether a court should “look through” the Section 4 petition to determine subject matter jurisdiction.

The U.S. Supreme Court reversed the Fourth Circuit and held that the district court did not have subject matter jurisdiction to entertain Discover’s Section 4 petition.

The Vaden court first analyzed the text of Section 4 of the Federal Arbitration Act (FAA) and agreed with the minority view that a district court may “look through” the petition to compel arbitration to “the controversy between the parties” — meaning that the courts must look at the “substantive conflict between the parties.”

In its reasoning, the court in Vaden stated that, because Section 4 of the FAA directs courts to determine whether they have jurisdiction “save for [the arbitration] agreement,” the existence or applicability of an arbitration agreement cannot be “the controversy” that the district court must analyze.

The Vaden court next analyzed whether the district court would have federal question jurisdiction over a suit arising out of a controversy between Discover and Vaden.

The court in Vaden stated that a party seeking to compel arbitration may gain a federal court’s assistance only if the entire, actual controversy between the parties could be litigated in federal court. To make this determination, a district court must look at the well-pleaded complaint and analyze whether a federal question exists.

The Vaden Court reasoned, however, that a completely preempted counterclaim is still a counterclaim, and cannot be the basis for federal question jurisdiction. The court in Vaden stated that district courts must look at the whole controversy between the parties, and not a “broken off piece” from a controversy.

Accordingly, because Discover’s well-pleaded complaint only involved state law claims, the Vaden court reversed the Fourth Circuit and held that the district court did not have jurisdiction to hear the Section 4 petition to compel arbitration.

Analysis

Although Vaden involves a dispute between a credit cardholder and a credit card company, the practical impact could significantly limit the scope and ability of an investment firm to file a Section 4 petition to enforce an arbitration agreement.

Indeed, Vaden could limit the impact of long-standing Supreme Court precedent in favor of enforcing industrywide agreements to arbitrate that are commonplace between broker-dealers and their customers.

Moreover, Vaden flies in the face of two fundamental hallmarks of the FAA — preventing forum shopping and uniformity in interpreting arbitration agreements.

As a result of Vaden, a disgruntled investor could initiate a lawsuit against a broker-dealer based only on state law claims in a state court that has a more restrictive approach to enforcing agreements to arbitrate.

In response, a broker-dealer could initiate a counterclaim based on federal law. If there is no independent basis for federal jurisdiction, the broker-dealer would be without federal relief. Because the investor chose the forum, the broker-dealer would have to petition the state court, under state law, to compel arbitration.

If the investor wisely “selected” a more restrictive forum, the broker-dealer might be unable to enforce an arbitration agreement even though such agreements are uniformly enforceable. The investor could effectively circumvent the arbitration agreement by choosing a specific forum.

Importantly, the court in Vaden failed to address the consequences of a party forum shopping to avoid agreements to arbitrate. The Vaden court stated that, even though it was denying Discover’s Section 4 petition, Discover could still enforce its arbitration agreements by seeking relief in Maryland state court.

If Maryland is a forum that takes a more restrictive view of agreements to arbitrate, Vaden would have essentially circumvented the arbitration agreement. The majority fails to address this possibility, which could potentially result in broker-dealers litigating complicated securities claims in state court, in front of a local jury.

The Vaden decision could also result in a potential rush to the courthouse. If Vaden had filed FDIA claims before Discover sought to collect money that Vaden owed to Discover, the district court would have had jurisdiction to hear the Section 4 petition.

Similarly, if a potential federal law claim exists in a controversy between a broker-dealer and investor, whether a district court will have jurisdiction to enforce an arbitration agreement will only depend on who and what was filed first.

As a result of Vaden, there may be lack of uniformity in interpreting and enforcing arbitration agreements because more and more arbitration agreements would be interpreted under the various state laws.

Moreover, investors could easily game the system by forum shopping or initiating (or not initiating) claims to prevent a securities broker-dealer from petitioning a federal court to arbitrate a claim.

At a time when Wall Street firms (and anyone associated with them) are very unpopular, limiting a securities broker or investment firm’s ability to arbitrate a claim could have significant financial impact on the entire system, which is now faced with the prospect of a jury trial in a local court.