The Federal Arbitration Act (“FAA”) guarantees the enforceability of private agreements to arbitrate, but guarantees a federal forum to compel arbitration only some of the time. State courts are bound to give effect to the FAA in enforcing agreements to arbitrate, and limitations on federal subject matter jurisdiction often will require that they do so.

Section 4 of the FAA provides for a civil action whose sole purpose is to obtain an order to compel a recalcitrant party to arbitrate. No court action concerning the underlying dispute need be pending; the Section 4 petition is an independent proceeding. It permits such an action to be
brought by a party to an arbitration agreement against another party to the same agreement who has “fail[ed], refus[ed], or neglect[ed]” to arbitrate a dispute between the parties that is covered by their arbitration agreement.

But Section 4 contains an important limitation: It may only be invoked to get relief in a federal district court if “save for [the arbitration] agreement” that court would have federal subject matter jurisdiction of “a suit arising out of a controversy between the parties.”

Application of Section 4 — and especially the requirement for federal jurisdiction based on a hypothetical suit on the merits that has not been commenced in federal court — has vexed and divided federal courts for many years. On March 9, 2009, the Supreme Court of the United States in Vaden v. Discover Bank, 2009 U.S. LEXIS 1781, 173 L.Ed. 2d 206 , eliminated some of this confusion, at least for cases where the parties are already involved in state court litigation over the ostensibly arbitrable controversy.

The Court, in an opinion by Justice Ginsburg joined by four other justices, held that: (1) the federal court considering its subject matter jurisdiction over a Section 4 petition should “look through” (or past) the controversy over arbitrability as described in the petition, to determine if the actual merits controversy involves a question of federal law, and (2) where a state court litigation is already pending, whether such a “federal question” would be presented in “a suit concerning the subject matter of the controversy between the parties” must be determined according to the standards for remove to federal court of a pending state court suit: i.e. the question of federal law must appear from the well-pleaded allegations of plaintiff’s state court complaint, not from the defendant’s answer or counterclaims.

It was the first point that prompted the Supreme Court to review the case. Federal Courts of Appeals had reached different outcomes on whether the District Court could “look through” the Section 4 petition to the actual underlying controversy for the purpose of ascertaining whether subject matter jurisdiction exists. On this point the Court was unanimous in holding that the “look through” approach is correct. But the complaint-versus-counterclaim conundrum turns out to have been the more interesting and controversial issue – and while it is not explicit in the Court’s opinions, the underlying tension appears to be over the role state courts should be permitted to play in enforcing agreements to arbitrate that are governed by the FAA.

The Vaden case began as an ordinary state court/state law lawsuit in Maryland by Discover, to recover unpaid credit card charges. The amount in dispute was below the $75,000 minimum for federal diversity jurisdiction. The customer asserted purported class action counterclaims for violations of Maryland’s credit laws. Discover then elected to arbitrate only the counterclaims, and filed in federal court a petition under Section 4 to compel arbitration. In support of the requirement of federal jurisdiction over the underlying dispute, Discover correctly alleged that the counterclaim was governed exclusively by federal banking law, and that Maryland’s credit laws were pre-empted.

The District Court held that courts considering Section 4 petitions to compel arbitration should “look through” the petition’s description of the controversy to determine the actual controversy. But the District Court held, and the Fourth Circuit agreed, that the relevant “controversy” for federal jurisdiction analysis is only the singular dispute that the Section 4 petitioner seeks to arbitrate, even if the “controversy” pending in the state court was commenced based on state law claims made by the party seeking to compel arbitration.

On the latter point, the Court, by a narrow 5-4 margin, held that where the controversy has already spawned litigation in a state court, the controversy must be viewed, for purposes of subject matter jurisdiction to adjudicate under the FAA, the same way as if removal of that action had been sought for adjudication of the merits: the state court plaintiff’s pleaded allegations are dispositive, and the counterclaim is irrelevant. In a phrase most succinctly capturing its holding, the majority opinion states: “Under the well-pleaded complaint rule, a completely preempted counterclaim remains a counterclaim and thus does not provide a key capable of opening a federal court’s door.” 2009 U.S. LEXIS 1781 at *34. It is important to note, however, that the Court’s holding is not limited to cases where an action is already pending. More broadly stated, the Court’s holding is that the District Court must consider not the merely the controversy a Section 4 petitioner seeks to arbitrate, but the entire controversy between the parties. Where state court litigation is already pending, however, the question of what federal claims the Section 4 petitioner might assert as a plaintiff becomes what federal claims did the state court plaintiff actually assert in the state court complaint.

Chief Justice Roberts, joined by three members of the Court, wrote in dissent from the second branch of the Court’s holding. For the dissenters, the words “a suit arising out of the controversy” calls for assessment of hypothetical jurisdiction over the particular dispute petitioner desires to arbitrate, even if an actual suit is already pending based on claims the petitioner does not seek to arbitrate. In the dissenters’ view, the majority’s approach unduly limits the federal court’s role in enforcing arbitration agreements. The majority opinion, in contrast, applies the words of the statute to the case presented: the “controversy between the parties” in this context necessarily included all claims in the state court action, and thus the question of hypothetical subject matter jurisdiction was the same as whether the state court case could be removed to the federal court. What seems to be implicit in the dissenters’ position is that the justification for applying “well-pleaded complaint” rule, i.e. to limit the federal court workload by limiting access, is not as compelling under the FAA, where the federal court’s role is mainly to decide whether to compel arbitration or to enforce an award.

The majority observed that Plaintiff had recourse in the Maryland courts to compel arbitration, and that the command of Section 2 of the FAA that private arbitration agreements shall be enforced is fully applicable in state courts (even though the procedure prescribed by the state, not
section 4 of the FAA, would govern the proceeding). The dissent reflects, on the other hand, a concern based on experience that state courts are not as uniformly and consistently vigilant as federal courts in enforcing agreements to arbitrate.

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The Court’s decision in Vaden is mainly significant for domestic arbitration. It serves as a reminder that the “domestic” FAA is not a jurisdiction-giving statute, and that state courts play an important role in the enforcement of arbitration agreements and awards to which the FAA applies. As to awards, federal jurisdiction depends not only on the existence of a federal question in the arbitration, or diversity of citizenship of the parties, but also that there be language in the arbitration agreement whereby the parties consent to confirmation of the award in the federal district court.

Section 4 petitions are relatively rare in relation to international arbitrations. Most international arbitration rules provide that the tribunal may proceed to enter an award even if a respondent fails to appear, so long as there is adequate notice of the proceedings and the Claimant proves its case. For this reason, the international arbitration claimant generally is not “a party aggrieved” (in the words of Section 4) by the adverse party’s refusal to participate. Further, if the arbitration-dodging party to an agreement governed by the New York Convention has already started an action in a U S. Court, relief to compel arbitration and stay or dismiss the action is available under Article II (3) of the New York Convention and Section 206 of the FAA. Section 206 simply provides for a motion to compel arbitration, and does not require as does Section 4 that the movant be “aggrieved by a failure, neglect, or refusal” of the adverse party to proceed to arbitration.

Thus, there is little that Section 4 can accomplish in a New York Convention case that cannot be accomplished through Section 206 alone. Some litigants have conceived of a Section 4 petition to compel arbitration as the equivalent of a request for an anti-suit injunction to stop foreign litigation of an arbitrable dispute. But the courts have rejected this, and limited Section 4 relief to an affirmative direction to arbitrate, without corresponding directions to discontinue parallel
litigation.

Thus, the Vaden decision may be received by international arbitration practitioners as an item of “domestic” FAA arcana. But there are many cases where the applicability of the New York Convention is uncertain, notably when two or more U. S. parties are involved, their citizenship
is non-diverse or not completely diverse, and the Convention applies only if the underlying transactions involve some “substantial” foreign or international element. Indeed, two U.S. parties might proceed to arbitrate under ICDR or ICC international arbitration rules, only to learn at the enforcement stage that for federal jurisdiction purposes there is doubt about whether the cases arises under the New York Convention.

For parties who must, or may have to, look to Section 4 for a federal forum to compel arbitration, the lesson of Vaden is small but significant: an initial decision to litigate an arbitrable claim in a state court will likely mean that a decision to change course and seek to compel arbitration of all or part of the case is likely to remain a matter for state court determination. This in turn brings into play a host of uncertainties about enforcement of the FAA in courts often more familiar with their own state arbitration statutes and often lacking clear jurisprudence on the interplay of state and federal arbitration law.

For foreign arbitration practitioners viewing the U. S. arbitration law landscape from afar, the uncertainty resulting from overlapping state and federal jurisdiction, and inconsistent state and federal arbitration law, is a defining attribute of American arbitration law. The Vaden decision will likely serve to reinforce this perception.

Last summer I published a commentary in the Mealey’s Class Action Report entitled Unconscionable Consumer Class Action Waivers and the Federal Arbitration Act. (located on my website, www.lexmarc.us/Documents/Consumer_Class_Action_Waivers.pdf) The article reported on the trend of federal cases to find the clauses requiring all claims to be resolved in individual, non-class arbitration are unconscionable under state law, and that non-enforcement of arbitration agreements to the extent of refusing to give effect to the class action waiver does not violate the Federal Arbitration Act.
That commentary was critical
of a decision of the United States Court of Appeals for the Third Circuit, Gay v. Creditinform, 511 F.3d 369 (3d Cir. 2007).
The Court in Gay had stated, in dicta intended to have controlling impact, that the FAA pre-empts, and thus prevents enforcement of, state law principles of unconscionability in regard to arbitration clause class action waivers. The Gay panel reasoned that state law principles that had evolved to strike down such waivers were particular to arbitration agreements, and thus violated the command of Section 2 of the FAA that arbitration agreements may be denied enforcement only on grounds for denying enforcement to contracts generally. I wrote that the Gay panel had misconstrued Supreme Court precedents concerning Section 2, which essentially hold that Section 2 prevents a state from refusing to enforce arbitration clauses based on state law principles hostile to arbitration – because the FAA was enacted precisely to pre-empting such state laws. The class action waiver may operate to immunize corporations from liability for unlawful conduct, whether in arbitration or in court, because individual claims cannot economically be prosecuted. That state law principles involved were, in my view, that coercive covenants not to sue violate public policy, and whereas these principles are not specifically concerned with arbitration agreements, the FAA does not pre-empt them.
Last month, a different Third Circuit panel in Homa v. American Express Co., 2009 U.S. App. LEXIS 3688 (3d Cir. Feb. 24, 2009), agreed. The Homa Court held that the class action waiver in the arbitration clause of a consumer credit card agreement was unconscionable under New Jersey law, and that the FAA does not prevent the application of such law. The Court reasoned that New Jersey law views the arbitral class action waiver as unconscionable not because the agreement requires an arbitral forum, but rather because the agreement deprives the consumer of the class-action mechanism in any forum. Without saying directly that Gay was decided incorrectly, the Homa panel is critical of Gay and in effect rejects Gay’s FAA pre-emption analysis. The Homa Court cites as the correct approach – as did my Summer 2008 article – the Ninth Circuit’s decision in Lowden v. T-Mobile USA, 512 F.3d 1213, 1221 (9th Cir. 2008) (holding that the application to an arbitration provision of a general ban on class-action waivers was not preempted by the FAA because that ban “appl[ies] equally to a contract that permits only individual, not aggregate, litigation in court.”).

The U.S. Court of Appeals for the Second Circuit has held that a class action waiver in an arbitration clause that operates in practice to stifle prosecution of federal antitrust claims, violates public policy and therefore is invalid under the Federal Arbitration Act (“FAA”). In re American Express Merchants’ Litigation, 2009 U.S. Dist. LEXIS 1646 (2d Cir. Jan. 30, 2009).

Whether the decision will affect the economic balance between consumer products companies and their customers is difficult to predict. Consumer services companies have sought over the last decade to limit their exposure to class-wide damages judgments by requiring claims to be arbitrated in non-class, non-consolidated, individual actions. The plaintiffs’ bar has responded by challenging the enforceability of such arbitral class action waivers, often by asserting that they violate state law principles of unconscionability. Several federal courts have accepted this position and invalidated class action waivers on state law unconscionability grounds. The Second Circuit’s decision is perhaps the first to invalidate an arbitral class action waiver strictly on public policy grounds, without invoking common law unconscionability principles.

Section 2 of the FAA provides that an arbitration agreement “shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract.” In holding that this contract violated Section 2, the decision highlights that the FAA inhibits as well as promotes agreements to arbitrate: It makes arbitration agreements no more enforceable than other contracts, and thus, their enforcement must be denied when general principles of contract invalidity (e.g. illegality, unconscionability, violation of public policy) so indicate.

Plaintiffs’ claims arose under the federal antitrust laws, alleging unlawful tying arrangements. The Court found that such claims were individually too small to litigate in view of the expense of prosecution relative to the amounts of individual damages. The class action waiver thus effectively immunized the corporate defendant from liability. Thus, the arbitral class action waiver operated, in this case, as a prospective waiver of the substantive rights to bring civil claims for treble damages under the antitrust laws.

Nearly 24 years have passed since the Supreme Court of the United States held, in the Mitsubishi case [Mitsubishi Motors Corp. v. Soler Chrysler-Plymouth, 473 U.S. 614 (1985)] , that an agreement to arbitrate private civil damages claims under the federal antitrust laws was not rendered unenforceable under the FAA merely by virtue of the antitrust subject matter. Responding to and rejecting the contention that arbitration was inherently a procedure that would render prosecution of private antitrust claims ineffectual, the Supreme Court in a famous dictum in Mitsubishi stated that “in the event the choice-of-forum and chose-of-law clauses operated in tandem as a prospective waiver of a party’s right to pursue statutory remedies for antitrust violations, we would have little hesitation in condemning the agreement as against public policy.”

The Second Circuit’s decision essentially elevates the Mitsubishi dictum to a rule of decision, applicable to the particular antitrust claims asserted in this case, and applicable by virtue of the very specific showing made by plaintiffs that individual claims would not be pursued in arbitration in light of the costs for legal representation and expert assistance.

By using violation of public policy, rather than unconscionability, as the basis in contract law for denying enforcement, the Court had no occasion to consider the relative size, sophistication, or bargaining power, of the plaintiff merchants, and also had no need to consider whether the merchants had a meaningful economic choice simply not to participate in American Express credit card programs. But those considerations will likely continue to be important when consumers challenge arbitral class action waivers in cellular phone, cable television, and other consumer services contexts – where the underlying claims of fraudulent or improper service fees are not necessarily imbued with the same public interest as claims under the federal antitrust laws.

Thus, it is difficult to predict whether the decision will result in more class arbitrations, or a shift away from arbitration by consumer services companies like AmEx. In this case, the Second Circuit has remanded to the District Court for further proceedings, only mentioning that American Express might elect to withdraw its motion to compel arbitration. In view of the difficulties of prosecuting federal antitrust claims without wide-ranging discovery from the adverse party and from non-parties, a defendant in the position of AmEx might continue see advantages to an arbitral forum even for class actions. The District Court might then have to decide whether the invalidated class action waiver is severable from the remainder of the arbitration clause, permitting AmEx to require plaintiffs to pursue their class claims in an arbitral forum.

I report today on an unusual case, involving a rarely-encountered issue. The case, decided by a U.S. District Judge in New York in the last days of 2008, is Vistra Trust Co. v. Stoffel, 2008 U.S. Dist. LEXIS 106493 (S.D.N.Y. Dec. 29, 2008). The issue: the right of a litigant to transfer a case filed in state court to a federal court (in federal practice parlance, “removal”) when the case involves an arbitration agreement or award governed by the U.N. Convention on Recognition and Enforcement of Foreign Arbitral Awards (“New York Convention”).

In Vistra, a family trust brought fraud claims against its former trustee, and two entities related to the trustee, in the New York State Supreme Court. The trustee, claiming the disputes were arbitrable, and that arbitrations involving the same issues were pending in Switzerland, sought to remove the case to the U.S. District Court under Chapter Two of the Federal Arbitration Act (“FAA”), which implements the New York Convention. Presumably the trustee’s intention was to move before the U.S. court to compel arbitration, and for dismissal or a stay of the action pending arbitration. But the result in the case is that the removal was held to be improper, because the consent of the related entities to the removal was not obtained by the defendant trustee. And so the case has been sent back (“remanded”) to the New York State court.

Some background is in order: Chapter 1 of the FAA, governing domestic arbitrations, does not confer jurisdiction on U.S. federal courts. Federal jurisdiction in a domestic case to enforce an arbitration agreement or award is based on two requirements. First, the matter must involve interstate or foreign commerce (a requirement usually met given federal law giving broad interpretation to such “commerce” ). Second, the case must meet traditional requirements for federal jurisdiction: either a question of United States law (other than a question under the FAA) or diversity of citizenship. Chapter 2 of the FAA has a jurisdiction-conferring provision that Chapter 1 lacks: It provides that a case “falls under the [New York] Convention” when it involves international commerce, and further states that a case that “falls under the Convention. . . arises under the laws and treaties of the United States.” That is to say, such a case qualifies for federal jurisdiction based on a question of federal law, even if the only question presented is the application of the Convention or Chapter Two of the FAA.

Section 205 of the FAA governs removal of New York Convention cases from state to federal court. It provides that such a case, i.e. one “that relates to an arbitration agreement or award falling under the Convention” may be removed to the federal court by “the defendant or the defendants.” That section goes on to state that “[t]he procedure for removal of causes otherwise provided by law shall apply.”

Case law interpreting the same phrase “the defendant or the defendants” found in the general removal statute, has held that the statute requires that multiple defendants give unanimous consent to the removal, absent some narrow exceptions (e.g. separate and independent claims, or defendants named as parties in the pleading but never served with process).

In Vistra, the Defendants argued that the same words in the arbitration statute should not be construed to require unanimity – for the reason that it was inferable, from the very existence of a special removal statute for New York Convention cases, that Congress sought to channel Convention cases into the federal courts to encourage uniformity of application. But the Court found no concrete evidence of such Congressional intent. And indeed, the Court noted that in the Foreign Sovereign Immunities Act, cases brought in the state court are specifically made removable by the foreign state, even if other non-state defendants are involved, whereas no such right of any foreign private entity or person was established when the New York Convention was implemented by Chapter Two of the FAA.

The result of the remand to State Court is that the same motion to compel arbitration and to stay or dismiss the action will, presumably, be made in that forum. The New York State court is bound to apply the Convention and Chapter Two of the FAA.

That outcome is not necessarily unsatisfactory, from the standpoint of consistent enforcement of the Convention. In New York, at least, where a special part of the State Supreme Court is devoted to complex commercial cases, and cases involving international commerce are by no means infrequent, the judges may be expected to have considerable familiarity with the FAA and the Convention. A source of concern to practitioners, however, and one of the reasons removal to federal court of cases initiated in the State court involving the Convention is frequently sought, is that New York, like other states, has its own arbitration statute. It is generally speaking a pro-arbitration statute that does not impose requirements for enforcement of an arbitration agreement that are materially different from federal law. Pre-emption of state arbitration law by the FAA is not categorical, and the general principle is that where state law does not impose more stringent requirements for enforcement of an agreement or award than does federal law, the state and federal statutes shall co-exist and both sha be applied. But in the details of state law concerning enforcement of arbitration agreements – on issues not specifically addressed by statute such as rights and obligations of non-signatories, the scope of arbitrable issues, etc., there may be important deviations from judge-made federal law that has evolved in cases involving the FAA generally and the New York Convention in particular. Thus in the state courts some practitioners will be tempted to seek advantage of requirements under state law, and to argue against pre-emption. This tends to add unnecessary issues, complexity, confusion, and cost.

Despite these concerns, there appears to be no organized initiative in the U.S. arbitration community to promote legislative change that would exclude state court jurisdiction in New York Convention cases. However, cases like Vistra in which the consent of all defendants cannot be obtained should be relatively rare, and in most instances a foreign defendant served in a state court action that should be arbitrated will be able to remove the case and have the arbitrability determination made by a U.S. District Court Judge.

“Do-Overs”: A New Installment in the Law of Reconstituted Arbitral Tribunals