Supplemental Jurisdiction Over Permissive Counterclaims and Set Offs: a Misconception

• Citation: Vol. 64 No. 2
• Publication year: 2013

Supplemental Jurisdiction over Permissive Counterclaims and Set Offs: A Misconception

Douglas D. McFarland

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Supplemental Jurisdiction over Permissive Counterclaims and Set Offs: A Misconception

by Douglas D. McFarland^*

I. Historical Introduction

In the years prior to 1990, courts extended federal jurisdiction over joined claims and parties in an orderly system. Pendent jurisdiction allowed a plaintiff to join a state law theory of recovery to a federal question theory in the complaint when both arose from a "common nucleus of operative fact."¹ Ancillary jurisdiction allowed a defendant to join a state law claim to a federal claim in a civil action when both arose from the same "transaction or occurrence."² Since a compulsory counterclaim arose from the same "transaction or occurrence" and a permissive counterclaim did not,³ courts had no difficulty in holding

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that compulsory counterclaims always qualified and permissive counterclaims never qualified for ancillary jurisdiction.⁴ The law was consistent, parallel, and nearly universally accepted.⁵

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II. Congress Creates Supplemental Jurisdiction

Congress entered this area of the law in 1990.⁶ It melded both pendent jurisdiction and ancillary jurisdiction into supplemental jurisdiction:

[I]n any civil action of which the district courts have original jurisdiction, the district courts shall have supplemental jurisdiction over all other claims that are so related to claims in the action within such original jurisdiction that they form part of the same case or controversy under Article III of the United States Constitution. Such supplemental jurisdiction shall include claims that involve the joinder or intervention of additional parties.⁷

The codification in section 1367(a) used neither the common nucleus of operative fact test from pendent jurisdiction nor the transaction or occurrence test from ancillary jurisdiction as the test for the reach of supplemental jurisdiction; instead, it used the new phrase "same case or controversy under Article III."⁸

In swapping phrases, did Congress in 1990 change the law governing supplemental jurisdiction over counterclaims? While little doubt exists that "case or controversy under Article III" encompasses both "common

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nucleus of operative fact"⁹ and "same transaction or occurrence,"¹⁰ the real question is whether "case or controversy under Article III" has expanded the reach of supplemental jurisdiction because it is broader than these constituent parts.¹¹ The legislative history shows Congress had no such broadening intent.¹² The intent was merely to codify the existing law of pendent and ancillary jurisdiction and to add pendent party jurisdiction.¹³ Many federal courts since 1990 have decided that

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the statute made no change in the law: compulsory counterclaims still automatically qualify for supplemental jurisdiction, and permissive counterclaims still do not.¹⁴

III. Two Cases Misinterpret Transaction or Occurrence Creating a Misconception of Supplemental Jurisdiction over Permissive Counterclaims

The first challenge to this settled law was raised in 1996 in Channell v. Citicorp National Services, Inc.¹⁵ The lessee of a car had an accident that wrecked the leased car. The lease finance company demanded the deficiency balance due on the lease. The lessee took the offensive by commencing a class action for violations of the Consumer Leasing Act.¹⁶ The defendant lease finance company counterclaimed for the balance due on the lease.¹⁷

The United States Court of Appeals for the Seventh Circuit opinion first concluded the counterclaim was permissive and not compulsory.¹⁸ In doing so, the court relied on poor authority and made no attempt at its own reasoned analysis.¹⁹ Next, the opinion concluded that only "a

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loose factual connection" was required for supplemental jurisdiction since § 1367(a) extended jurisdiction to the limits of Article III.²⁰ The court then found this loose factual connection because both the plaintiff's Consumer Leasing Act claim and the defendant's debt counterclaim arose from the same lease:

Each class member's claim against Citicorp depends on the lease, and indeed on the same clause of the lease that creates Citicorp's claim for a termination charge. The acts creating the claims differ-the claims against Citicorp stem from the signing of the lease, while the claims against the class stem from the early termination of the lease. But the parties, the lease, the clause, and even the terminations are constants . . . . Signing and termination alike therefore were integral to this case[,] . . . and these events are ... a single case or controversy.²¹

The court put its two conclusions together to assert, for the first time, the proposition that supplemental jurisdiction reached a permissive counterclaim.²²

In other words, the court concluded side-by-side that claims arising from the same lease did not arise from the same transaction or occurrence, yet claims arising from the same lease were part of the same case or controversy.²³ This could not be. The two conclusions were plainly inconsistent.²⁴ The court's belief that the two conclusions could stand together was based on a grudging misinterpretation of "transaction or occurrence.²⁵

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"Transaction or occurrence" demands a broad, flexible, and generous interpretation.²⁶ It is entirely fact-based and fact-defined: legal

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theories are irrelevant,²⁷ and policy considerations are irrelevant,²⁸ to its scope. It is a broad phrase of inclusion.²⁹

Because a transaction or occurrence is a fact-based, broad phrase of inclusion, the Seventh Circuit should easily have recognized both claim and counterclaim arose out of the same transaction or occurrence. One lease gave rise to one set of facts. Competing claims concerning the same clause of the same lease doubtless were part of the same "affair, altercation, or course of dealings between the parties."³⁰ Channell unremarkably asserted supplemental jurisdiction over a compulsory counterclaim, not a permissive counterclaim.³¹ This decision remained largely isolated for a decade.

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Then, in 2004, the United States Court of Appeals for the Second Circuit decided Jones v. Ford Motor Credit Co.³² Plaintiff borrowers, on behalf of a class, claimed the defendant credit company violated the Equal Credit Opportunity Act³³ when it allowed retail auto dealers to set the interest rate on auto loans in a racially discriminatory manner.³⁴ The defendant counterclaimed for the debts owed on the same loans.³⁵

The Second Circuit first decided in dictum that the counterclaims were permissive and not compulsory because they did not arise from the same transaction or occurrence.³⁶ The court, relying heavily on Channell, then nevertheless decided "[t]he counterclaims and the underlying claim bear a sufficient factual relationship (if one is necessary) to constitute the same 'case' within the meaning of Article III and hence of section 1367."³⁷ That was so because "[b]oth the ECOA claim and the debt collection claims originate from the Plaintiffs' decisions to purchase Ford cars."³⁸ The court, therefore, said the Second Circuit, had supplemental jurisdiction over the permissive counterclaims.³⁹

The Second Circuit in Jones labored under the same misconception as the Seventh Circuit in Channell. Not only did both claim and counterclaims have a loose factual connection of "the Plaintiffs' decisions to buy Ford cars," but also a tight factual connection arising from the identical loan documents.⁴⁰ Both sides of the case arose from the same transac-

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tion or occurrence.⁴¹ The Jones opinion perhaps recognized this difficulty and attempted to reason around the identical factual origin of both claim and counterclaims as follows:

Ford Credit's debt collection counterclaims are related to those purchase contracts, but not to any particular clause or rate. Rather, the debt collection counterclaims concern the individual Plaintiffs' nonpayment after the contract price was set. Thus, the relationship between the counterclaims and the ECOA claim is "logical" only in the sense that the sale, allegedly on discriminatory credit terms, was the "but for" cause of the non-payment . . . . The essential facts for proving the counterclaims and the ECOA claim are not so closely related that resolving both sets of issues in one lawsuit would yield judicial efficiency.⁴²

The court seems to suggest that the facts of non-payment of a loan are not sufficiently related to the facts of creation of the loan.⁴³ Did the court think this distinction made any sense? The claim and counterclaim arose from the same loan document.⁴⁴ Certainly evidence of the terms of the underlying loan would be at the core of a collection claim on the very same loan. One contract gave rise to one transaction or occurrence.⁴⁵ As with Channell, Jones was unremarkably asserting supplemental jurisdiction over a compulsory counterclaim.

Why Jones pushed so hard to find the counterclaim was only permissive is even more puzzling since the result was bootless. The answer almost certainly lies in the court's mention that allowing such counterclaims into federal court "might undermine the ECOA enforcement scheme."⁴⁶ In other words, allowing a compulsory counterclaim into federal court to collect the debt might discourage borrowers from asserting their federal rights under various consumer protection lending

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statutes. Not only was such a policy consideration irrelevant to distinguishing between compulsory and permissive counterclaims,⁴⁷ but also it was completely pointless to rule the counterclaim was only permissive (so it could not be brought into federal court to undermine federal policy) and, in the next paragraph, to rule supplemental jurisdiction allowed the "permissive" counterclaim into federal court.

The end result is that both of the two seminal cases creating the line of...