Res Judicata Strikes Twice
The Sixth Circuit's gloss on the scope of what constitutes a sufficient reservation of rights to bar application of res judicata, if adopted and extended, has a potentially material and adverse impact on the ability to maximize recovery for creditors as it could significantly extend the scope of the application of res judicata to a confirmation order. Second, in an extension of existing case law, the Sixth Circuit applies the res judicata effect of a confirmation order to bar prosecution of a claim by a non-debtor against another non-debtor on the basis that the claim, emanating from facts and circumstances preceding and precipitating the bankruptcy case, was within the "related to" jurisdiction of the bankruptcy court, and a failure to commence, or disclose, the cause of action prior to the entry of the confirmation order triggered application of the doctrine of res judicata to bar the action post-confirmation. The potential implications to creditors who may have claims against non-debtors that are related to a debtor's bankruptcy case is staggering.
Nationwise Automotive Inc. filed its chapter 11 case on Aug. 18, 1995; its disclosure statement was approved on Dec. 12, 1995; and its liquidating reorganization plan was confirmed on Feb. 16, 1996. Following confirmation of the reorganization plan, Nationwise changed its name to NW Liquidating Inc. and continued "functioning as the debtor-in-possession of the bankruptcy estate and presiding over the liquidation of the corporation's assets with all the powers and duties of a trustee." Browning v. Levy, 283 F.3d at 768.
On Aug. 23, 1995, two individual employees (the plaintiffs) of Nationwise and participants in Nationwise Automotive Inc.'s Employee Stock Ownership Plan (ESOP) filed a lawsuit in district court against Saul Levy, a major shareholder of Nationwise, based on claims relating to a 1992 settlement between Levy and the ESOP regarding control over Nationwise. Id. at 767.
The ESOP was represented in Nationwise's chapter 11 case, filed a proof of claim on behalf of the participants in the ESOP, and participated in a variety of contested matters during the bankruptcy case. Id. at 768. In 1997, after confirmation of Nationwise's reorganization plan, NW and the ESOP intervened in the plaintiffs' lawsuit against Levy and joined as a defendant Levy's counsel (who also represented Nationwise as special counsel in its chapter 11 case3) in asserting breach of fiduciary duty and related claims. Thereafter, the plaintiffs also asserted claims against Levy's counsel. Id. at 767.
The district court granted summary judgment in favor of Levy's counsel and against the plaintiffs, NW and the ESOP, on the grounds that the claims were barred by res judicata and judicial estoppel.4
On appeal, NW argued5 that (1) Levy's counsel concealed information necessary for NW to know about its claim prior to the confirmation order, (2) the elements of res judicata were not established, and (3) Nationwise specifically reserved in its reorganization plan the right to prosecute all causes of action. The Sixth Circuit rejected NW's concealment argument6 and found that each of the elements of res judicata were present.
The Res Judicata Analysis: Linking the Events Preceding the Bankruptcy Case and the Undisclosed Claim
With respect to the elements of res judicata, the Sixth Circuit found:
- Final Judgment: Premised on the principle that a confirmation order constitutes a final judgment in bankruptcy proceedings, the Sixth Circuit concluded that because NW's claim should have been raised during the bankruptcy case, the confirmation order constitutes a final judgment on the claim;
- Privity or Identity of Parties: NW was the successor in interest to Nationwise, and because Levy's counsel was employed as special counsel for Nationwise in the bankruptcy case, Levy's counsel was a party in the bankruptcy proceeding for purposes of res judicata;
- The Claim Should Have Been Litigated in the Prior Proceeding. Because NW's claims fell within the bankruptcy court's related-to jurisdiction, the claims should have been litigated, or reserved, in the bankruptcy proceeding; and
- Identity of Claims. The bankruptcy case and the claims asserted against Levy's counsel were both based on the facts and circumstances preceding and precipitating Nationwise's chapter 11 case.
The Sixth Circuit's res judicata analysis rests on a delicate thread connecting (x) the overlap between the facts giving rise to Nationwise's chapter 11 case and the facts giving rise to the claims against Levy's counsel and (y) the conclusions that the claims against Levy's counsel "should have" been brought in the chapter 11 case, there was an "identity of claims" between the chapter 11 case and the claims against Levy's counsel, and the confirmation order constituted a "final order" on claims that should have been brought prior to confirmation. By coupling the asserted claims against Levy's counsel with the commencement of Nationwise's chapter 11 case, the Sixth Circuit's decision echoes, in part (see supra at n.5), the earlier res judicata cases precluding post-confirmation lender liability claims (see supra at n.2) and highlights the critical facts in the case (e.g., a linkage between the events precipitating a chapter 11 case and the claims with respect to which res judicata is being applied) that arguably limit the precedential value of the holding.
Reservation of Rights: Is Anything Short of a List of Potential Defendants and Causes of Action Sufficient Disclosure?
Nationwise's confirmed reorganization plan included the following provision:
In accordance with §1123(b) of the Bankruptcy Code, the company shall retain and may enforce any claims, rights and causes of action that the debtor or its bankruptcy estate may hold against any person or entity, including, without limitation, claims and causes of action arising under §542, 543, 544, 547, 548, 550 or 553 of the Bankruptcy Code.
Browning v. Levy, 283 F.3d at 774-75. NW and the ESOP argued that this language expressly reserved the claims against Levy's counsel and thus precluded application of res judicata to bar their post-confirmation lawsuit. The Sixth Circuit rejected the argument, reasoning:
NW's blanket reservation was of little value to the bankruptcy court and the other parties to the bankruptcy proceeding because it did not enable the value of NW's claims to be taken into account in the disposition of the debtor's estate. Significantly, it neither names [Levy's counsel] nor states the factual basis for the reserved claims. We therefore conclude that NW's blanket reservation does not defeat the application of res judicata to its claims against [Levy's counsel].
The Sixth Circuit's reasoning is not without vulnerability. Nationwise's reorganization plan was a liquidation plan. The value of all claims reserved under the plan were necessarily taken into account by creditors; until fully paid, creditors would be the beneficiaries of the successful prosecution of such claims. Thus, contrary to the Sixth Circuit's conclusion, the reservation of rights in the reorganization plan was presumptively extremely important to creditors to insure maximization of the Nationwise estate. In addition, no precedent is provided for the proposition that a reservation of rights necessary to preclude application of res judicata requires disclosure, by name, of each and every possible defendant, or of a daily chronology of the debtor's legal, financial and operating history.7 The reservation of rights language clearly put parties on notice that any claims that the estate had would be prosecuted for the benefit of the estate.8 Third, the Sixth Circuit acknowledged that the case involved no bad motive on the part of the debtor; accordingly, it is not an example of a debtor "hiding the ball" for its benefit at the expense of creditors. See supra at n.5. Thus, unlike the predecessor res judicata cases, which at their core precluded a debtor from usurping for its benefit claims of the estate to the detriment of creditors, the Sixth Circuit gives voice to an application of res judicata that is prejudicial to creditors and provides a windfall to the potential defendant, and does so without offering any overriding justification.
Related-to Jurisdiction: Must Every Non-Debtor Who Has a Claim Within the Court's Related-to Jurisdiction Disclose the Claim, or Commence an Adversary Proceeding, Prior to Confirmation?
Like NW, the ESOP9 also argued that the facts required to assert the claims against Levy's counsel were not known to the ESOP, and the elements of res judicata were not present as applied to the ESOP. The Sixth Circuit rejected the concealment argument as it did NW's identical argument. With respect to the "final judgment" and "identity of claims" elements of res judicata, the Sixth Circuit adopted the reasoning it applied to NW. With respect to the "identity of parties" and "should have been litigated" elements of res judicata, the Sixth Circuit provided a separate analysis. This analysis, like the Sixth Circuit's holding on the reservation of rights issue, has potential adverse consequences for creditors of distressed debtors.
The Sixth Circuit concluded that for purposes of the "identity of parties" element, the ESOP was a party to the chapter 11 proceeding because, "for the purposes of res judicata, all shareholder-creditors are considered 'participants' in the bankruptcy proceeding." Browning v. Levy, 283 F.3d at 777. Significantly, the Sixth Circuit rejected as irrelevant ESOP's argument that the identity-of-parties element could only be met if there was meaningful participation in the bankruptcy proceeding. This conclusion by the Sixth Circuit places in harm's way, at least for purposes of res judicata, every party in interest10 in a bankruptcy case.
Building on its expansive interpretation of "identity of parties," the Sixth Circuit concluded that any claim that falls within the bankruptcy court's related-to jurisdiction satisfies the "should have been litigated" element.11 In short, the Sixth Circuit concluded that a non-debtor's claims against another non-debtor are barred from prosecution by a confirmation order if the claims could have been litigated in the bankruptcy proceeding under the court's related-to jurisdiction and were not disclosed or reserved in the chapter 11 proceeding.
This conclusion has far-reaching implications for creditors and other parties in interest. To the extent that a creditor or other party in interest has a claim against a third party arising out of the facts and circumstances giving rise to the bankruptcy proceeding, and the bankruptcy court has related-to jurisdiction over such claims, then under the Sixth Circuit's ruling those claims must be disclosed, or commenced, in the bankruptcy case prior to the confirmation order, or risk being barred by res judicata. Significantly, it is not a prerequisite that the creditor or other interested party be meaningfully involved in the bankruptcy proceeding; participation by status as a party in interest is sufficient. The types of third-party claims that could potentially fall within this scenario include (1) claims among holders of different tranches of debt, (2) breach of fiduciary duty related claims and (3) torturous interference claims, to the extent that such claims are inextricably linked to the facts and circumstances leading to the bankruptcy case. As a result, any creditor or other interested party, when confronted with a bankruptcy proceeding, must be vigilant in prosecuting not only its claim against the debtor, but also its claims against third parties to the extent such claims could in any manner affect the debtor's bankruptcy estate.
The doctrine of res judicata is intended to promote finality and preclude the proverbial "second bite of the apple." In Browning v. Levy, the Sixth Circuit has extended the doctrine to potentially preclude even the first bite of the apple. To avoid the harsh results of the decision, a predictable response is an increase in litigation commenced prior to plan confirmation, a delay in the plan formation and confirmation process, and ultimately a reduction in creditor recoveries as a result of such increase in litigation and delay. The irony of the Sixth Circuit's decision is that the "breathing room" that is intended to be provided to a debtor upon commencement of a bankruptcy case may be short-lived if the facts and circumstances giving rise to the bankruptcy filing provide a foundation for the debtor or other interested parties prosecuting causes of action against third parties.
1 The doctrine of res judicata is commonly understood as a bar on relitigation of claims that were or could have been asserted in an earlier proceeding. Brown v. Felsen, 442 U.S. 127 (1979). In the bankruptcy arena, the doctrine of res judicata and the related doctrines of equitable estoppel and judicial estoppel have been applied in a variety of contexts. See Russell, Bankruptcy Evidence Manual, 2001 Ed., §§1-21, 51-64. Return to article
2 The principle that a confirmation order precludes litigation of claims that could have been litigated during the bankruptcy case, and not otherwise expressly and specifically reserved, has emerged from a line of cases involving lender liability claims or similar claims asserted after confirmation of a reorganization plan, but not disclosed prior to confirmation. See, e.g., D & K Properties Crystal Lake v. Mutual Life Ins. Co. of New York, 112 F.3d 257 (7th Cir. 1997); Sure-Snap Corp. v. State Street Bank and Trust Co., 948 F.2d 869 (2d Cir. 1991); In re Heritage Hotel P'ship. I, 160 B.R. 374, 377 (9th Cir. BAP 1993), aff'd., 59 F.3d 175 (9th Cir. 1995); and In re Hoffman, 99 B.R. 929 (N.D. Iowa 1989).
To satisfy the "final judgment" leg of the res judicata test, each of the foregoing cases rely in part on the conclusion that as a result of the failure to disclose the cause of action at issue, the confirmation order operates (or should be deemed to operate) as a final judgment of the claim at issue. The underlying rationale for this conclusion was succinctly stated by the court in In re Hoffman:
The court agrees with the creditor when it says that the debtor's failure to disclose the possibility of this lawsuit is like failing to disclose a parcel of real estate and then subsequent to plan confirmation saying that the real estate vests solely in the debtor. Such a result would be clearly inequitable and unjust. The provisions of §1141 are not intended to encourage debtors to not disclose information, but are to resolve questions of property ownership subsequent to plan confirmation.Id. at 936-37. Return to article
3 The Sixth Circuit's opinion does not address whether Levy's counsel requested compensation and reimbursement of expenses in the bankruptcy case and, if so, whether such a request had been approved and whether such approval was res judicata as to any claims against Levy's counsel. See, e.g., Osherow v. Ernst & Young LLP (In re Intelogic Trace Inc.), 200 F.3d 382, 391 (5th Cir. 2000). Return to article
4 The doctrine of judicial estoppel applies to preclude a party who has taken a particular position in a judicial proceeding from later taking a contrary or inconsistent position. New Hampshire v. Maine, 532 U.S. 742 (2001). The doctrine is intended to protect the integrity of the judicial process and, as such, unlike its cousin equitable estoppel, detrimental reliance by an opposing litigant is not required. Browning Mfg. v. Mims (In re Coastal Plains Inc.), 179 F.3d 197, 205 (5th Cir. 1999) (cases cited).
A number of cases have applied judicial estoppel and/or equitable estoppel to bar post-confirmation litigation of claims known, but not disclosed, prior to confirmation. The judicial estoppel cases include Hamilton v. State Farm Fire & Cas. Co., 270 F.3d 778, 784-85 (9th Cir. 2001); In re Coastal Plains, 179 F.3d 197, 208 (5th Cir. 1999), cert. denied, 528 U.S. 1117 (2000); Payless Wholesale Distribs. Inc. v. Alberto Culver (P.R.) Inc., 989 F.2d 570, 571-72 (1st Cir.), cert. denied, 510 U.S. 931, 114 S.Ct. 344, 126 L.Ed.29 309 (1993); Hay v. First Interstate Bank of Kalispell N.A., 978 F.2d 555 (9th Cir. 1992); and Oneida Motor Freight Inc. v. United Jersey Bank, 848 F.2d 414, 419 (3rd Cir.), cert. denied, 488 U.S. 967 (1988). The judicial estoppel and equitable estoppel cases, like their res judicata counterparts, heavily rely on an unwillingness to condone a debtor's behavior that would result in a benefit to a debtor at the expense of creditors. For example, in Payless Wholesale Distribs. Inc., the First Circuit observed:
The basic principle of bankruptcy is to obtain a discharge from one's creditors in return for all one's assets, except those exempt, as a result of which creditors release their own claims and the bankrupt can start fresh. Assuming there is validity in Payless's present suit, it has a better plan. Conceal your claims, get rid of your creditors on the cheap, and start over with a bundle of rights. This is a palpable fraud that the court will not tolerate, even passively [citations omitted]. Payless, having obtained judicial relief on the representation that no claims existed, cannot now resurrect them and obtain relief on the opposite basis.Payless Wholesale Distribs. Inc., 989 at 571. Return to article
5 NW also argued that the district court erred in applying judicial estoppel. The Sixth Circuit agreed, reasoning that judicial estoppel did not apply to bar NW's claim as NW had no motive to conceal the claim. Browning v. Levy, 283 F.3d at 775-77. Curiously, the Sixth Circuit did not conclude that such lack of good faith was relevant to the res judicata analysis. In so failing to consider the debtor's intent and consequences to creditors of the debtor's actions, the Sixth Circuit departed from the core reasoning of the preceding res judicata cases. See supra at n.2. Return to article
6 The court based its conclusion in part on the fact that the complaint that added Levy's counsel as a defendant relied substantially on allegations of fact that were included in the plaintiff's original complaint filed in 1995. Browning v. Levy, 283 F.3d at 771. Return to article
8 While the reservation of rights language was broad, no doubt future cases will involve litigation over more detailed reservation language. In addition, the opinion does not address the impact of typical plan provisions detailing objection to claims procedures, and provisions preserving affirmative defenses, rights of set-off and recoupment, and counterclaims. Return to article
9 On appeal, the plaintiffs did not distinguish their position from the ESOP. Accordingly, the Sixth Circuit analyzed the position of the plaintiffs and the ESOP as one. Browning v. Levy, 283 F.3d at 769. Return to article
10 Section 1109 of the Bankruptcy Code provides that a party in interest includes "the debtor, the trustee, a creditors' committee, an equity security-holders' committee or any indenture trustee." 11 U.S.C. §1109(b). Return to article
11 The Sixth Circuit reasoned that "related-to" jurisdiction existed over the ESOP's claims against Levy's counsel because any recovery by the ESOP from Levy's counsel would reduce the ESOP's claims against Nationwise, thereby affecting the bankruptcy estate. However, as Nationwise's confirmed reorganization plan was a liquidating plan, it is not clear from the opinion whether the ESOP, representing the interests of shareholders of Nationwise, would be entitled to any recovery from the liquidation. Browning v. Levy, 283 F.3d at 778. Return to article