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AMERICAN
BANKRUPTCY
INSTITUTE
The Essential Resource for Today’s Busy Insolvency Professional
Res Judicata: Complicated Game of Who’s Who
Written by:
Dena S. Kessler
Baker & Hostetler LLP; Washington, D.C.
dkessler@bakerlaw.com
F
or those who promptly forgot
the elements of res judicata the
moment they finished their Civil
Procedure exams during the first year of
law school, it may be time to crack open
those outlines. A case decided earlier
this year by the Third Circuit Court of
Appeals addressed the preclusive effect
of a confirmed chapter 11 plan in a socalled chapter 22 proceeding. The decision will likely have precedential value
beyond the Third Circuit.
At its core, the issue was whether
the debtor assuming a lease in the first
case precluded the plan administrator in
the second case from treating it as anything other than a true lease. The Third
Circuit ruled in March that res judicata did not apply in a debtor’s second
chapter 11 case when the interests of
the debtor in the second case were not
aligned with the interests of the debtor
in the first case.1 While the decision was
based on the unique facts of the case, it
illustrates a larger issue that can create
confusion and uncertainty for debtors
and creditors alike: What effect, if any,
do decisions in a prior bankruptcy case
have on any subsequent reorganization
case or proceedings that involve the
same company?
Background of Ward 1 and 2
The case was that of Montgomery
Ward LLC, a historic Chicago-based
retailer. Montgomery Ward filed its
chapter 11 petition in 1997 in the U.S.
Bankruptcy Court for the District of
Delaware (Ward 1). The case was concluded by confirmation of a reorganization plan. Only 18 months after confirmation, reorganized Montgomery Ward
was required to return to bankruptcy in
2000 before the same court (Ward 2).
1 In re Montgomery Ward LLC, 634 F.3d 732 (3d Cir. 2011).
About the Author
Dena Kessler in an associate at Baker
Hostetler in Washington, D.C.
In Ward 1, the debtor in possession
(DIP) sought and obtained authority to
assume a lease of a building where it
operated a department store in Joliet,
Ill. The court ultimately confirmed the
plan, which incorporated the prior lease
assumption, and the retailer continued
operating in the Joliet building.
In Ward 2, the DIP sought to wind
down its operations and liquidate its
assets, and thus sought to reject the
lease. The Ward 2 plan administrator
argued that the lease was not a true lease
but was actually a structured financing.
If the plan administrator were to prevail,
the creditor would be limited to seeking
decision. This decision was ultimately
overruled by the Third Circuit.
Elements of Res Judicata
Res judicata, also known as claim
preclusion, promotes judicial economy
by giving finality to parties who have
already litigated a claim. Courts have
uniformly stated that res judicata prevents a party from relitigating a claim,
or from pursuing a claim or defense
that could have been raised in an earlier
proceeding involving the same parties
or their privies, and that resulted in a
final judgment on the merits.2 In short,
a litigant who failed to appeal an unsatisfactory decision or did not raise all
available claims cannot get another bite
at the apple in subsequent proceedings.
In the bankruptcy context, a chapter 11
plan confirmation order is a final judgment on the merits and can bar a party,
Feature
satisfaction of its claim from the collateral securing the alleged financing (here,
the department store building) and be
denied a lease rejection claim.
The creditor argued that res judicata prevented the plan administrator from challenging the nature of
the lease because the Ward 1 debtor
treated the lease as a true lease and
assumed it under 11 U.S.C. § 365,
which assumption was incorporated
in the confirmed plan. The bankruptcy court agreed, finding that confirmation of the Ward 1 plan barred
the Ward 2 plan administrator from
challenging the nature of the lease.
According to the bankruptcy court,
res judicata applied because the Ward
1 debtor could have challenged the
nature of the lease, and both the Ward
2 debtor and plan administrator were
successors in interest to the Ward 1
debtor and were thus bound by that
its successors or its privies from relitigating a matter that was raised or could
have been raised regarding the plan or
its
confirmation.3
Who’s Who for Res Judicata
in Bankruptcy?
Of the three elements involved in a
res judicata analysis,4 the Third Circuit
narrowed its focus solely on whether the
Ward 2 plan administrator was the same
party as, or was in privity with, the Ward
1 debtor that assumed the lease. The
court found that the plan administrator
2 Liona Corp. Inc. v. PCH Assocs. Inc. (In re PCH Assocs.), 949 F.2d 585,
594 (2d Cir. 1991).
3 Peltz v. Worldnet Corp. (In re USN Communications Inc.), 280 B.R. 573,
586 (Bankr. D. Del. 2002).
4 Res judicata prevents relitigating an issue if “there has been (1) a final
judgment on the merits in a prior suit involving (2) the same claim and
(3) the same parties or their privies.” E.E.O.C. v. U.S. Steel Corp., 921
F.2d 489, 493 (3d Cir. 1990). Other courts break the elements into four
steps. See, e.g., Ries v. Paige (In re Paige), 610 F.3d 865, 870 (5th Cir.
2010) (“[T]he parties must be identical in both suits, the prior judgment
must have been rendered by a court of competent jurisdiction, there
must have been a final judgment on the merits and the same cause of
action must be involved in both cases.”).
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was neither the same party nor in privity
with the Ward 1 debtor and was therefore not prevented from challenging the
nature of the lease previously assumed
by the Ward 1 debtor.
At first glance, this outcome may
seem counterintuitive. If it is the same
company that filed both chapter 11 cases,
it may be tempting to conclude that
the debtors in both cases are the same
entity for res judicata purposes. Even
if they are considered different entities,
one might also think they are in privity because they have the same interests
based, at a minimum, on being fiduciaries to the same or similar creditors.
As with most “black letter” legal
principles, it is never that clear. As
the Third Circuit noted, there are three
distinct entities in a chapter 11 case,
and each entity—along with any party
representing its interests—should be
viewed separately: (1) the prebankruptcy debtor, (2) the estate and (3) the
post-bankruptcy business.5 The Ward 2
debtor was not the same entity as the
Ward 1 debtor; rather, it was a successor in interest to the Ward 1 debtor and
the reorganized Montgomery Ward. 6
Similarly, a DIP or plan administrator
is a different entity with different incentives and obligations than the prebankruptcy debtor.7 While a DIP succeeds to
a prebankruptcy debtor’s interests, the
DIP is a different entity and is imbued
with certain powers, rights and fiduciary
responsibilities that the prebankruptcy
debtor did not have.8
Privity: Who’s Got It,
and Who Doesn’t?
While the Third Circuit recognized
that two distinct estates are created from
successive chapter 11 filings, as well
as the distinction between the interests
of a prebankruptcy debtor and trustee,
the court noted that this alone does not
always prevent application of res judicata under such circumstances. Despite the
general rule that res judicata only applies
when the same parties are involved in the
initial and subsequent litigation, the court
recognized that res judicata can apply to
nonparties if privity 9 existed between
5 Elizabeth Warren, “A Theory of Absolute Priority,” 1991 Ann. Surv. Am.
L. 9, 12 (1992).
6 Montgomery Ward, 634 F.3d at 737.
7 In re WorldCom, 401 B.R. 637, 649 (Bankr. S.D.N.Y. 2009).
8 For example, the right to bring an avoidance action does not belong to
the prebankruptcy debtor. Instead, the trustee’s ability to bring such
an action on behalf of the estate is created when the debtor files its
petition. Bethlehem Steel Corp. v. Moran Towing Corp., 390 B.R. 784,
791-92 (Bankr. S.D.N.Y. 2008).
9 The court used the term “privity” in a broad sense “to say that the
relationship between the one who is a party on the record and another
is close enough to include that other within res judicata.” Montgomery
Ward, 634 F.3d at 738 n. 6 (citing Nationwide Mut. Fire Ins. Co. v.
Hamilton, 571 F.3d 299, 311 n. 13 (3d Cir. 2009)).
the prior and present litigants 10—socalled “nonparty preclusion.” Thus, even
though the Ward 2 plan administrator
was not a party in the Ward 1 proceedings, if the Ward 1 debtor and the Ward
2 plan administrator were somehow in
privity, res judicata would apply and
prevent the plan administrator from challenging the nature of the lease.
In its privity analysis, the Third
Circuit cited Taylor v. Sturgell, 11 in
which the Supreme Court engaged in a
lengthy discussion of when res judicata
creates nonparty preclusion by preventing a claim by a litigant in the second
action who was not a party to the initial
litigation. The Taylor court acknowledged that res judicata is generally only
applicable to situations where the parties
in the first and second case are identical, but identified six exceptions to this
rule: (1) a nonparty agrees to be bound
by a prior judicial determination between
other parties; (2) there is a “substantive
legal relationship” between a nonparty
and the initial litigant; (3) a nonparty
was adequately represented in the prior
litigation by someone with the same
interests; (4) a nonparty assumed control
of the prior litigation; (5) a nonparty is
the proxy or agent of a party to the prior
litigation; and (6) a special statutory
scheme, such as bankruptcy, expressly
forecloses subsequent litigation.12
The Third Circuit focused on the second exception: whether the plan administrator in Ward 2—the nonparty—had “a
substantive legal relationship” with the
Ward 1 debtor who assumed the lease.
Ultimately, the Third Circuit found that
there was no substantive legal relationship, and thus no privity, between the
Ward 1 debtor and Ward 2 plan administrator. In its analysis, the court determined that each party’s motivations
was so diverse that privity did not exist.
Specifically, the Ward 1 debtor wanted
to continue operating its store in furtherance of a successful reorganization,
so it was incentivized not to challenge
the lease. The plan administrator, on the
other hand, was tasked with liquidating
the company and providing the highest
possible return to creditors and thus had
an incentive to challenge the nature of
the lease. Successfully challenging the
lease would result in the avoidance of a
large lease rejection claim and increase
recoveries for the class of unsecured
creditors. This misalignment of interests
10 Montgomery Ward, 634 F.3d at 737-38.
11 553 U.S. 880 (2008).
12 Taylor, 553 U.S. at 893-895.
meant that the Ward 1 debtor’s failure to
challenge the lease was not binding on
the Ward 2 plan administrator.
Lessons for Practitioners
Practitioners should be cautious not
to presume that res judicata will never
act as a barrier to a DIP or plan administrator attempting to relitigate an issue or
challenge a ruling in a prior proceeding.
Though the Third Circuit found no privity in this particular set of facts, there are
other situations where the interests of the
DIP and other successors in interest are
similar enough for res judicata to apply.
For example, in the case of conversion from chapter 11 to chapter 7, the
chapter 7 trustee often is in privity with
the earlier DIP.13 Further, because a DIP
is a successor to the property interests
of a prebankruptcy debtor, the DIP is in
privity with the prebankruptcy debtor for
purposes of those property interests.14
The trick is to think critically about each
party’s interests and incentives and to
consider whether they are aligned or
whether they conflict.
While res judicata is designed to
reduce the need for future litigation,
privity questions in the context of bankruptcy can be especially tricky, potentially prompting even more litigation. The
Third Circuit’s decision adds valuable
guidance on this thorny issue. n
Reprinted with permission from the ABI
Journal, Vol. XXX, No. 6, July/August 2011.
The American Bankruptcy Institute is a
multi-disciplinary, nonpartisan organization
devoted to bankruptcy issues. ABI has
more than 13,000 members, representing
all facets of the insolvency field. For more
information, visit ABI World at www.
abiworld.org.
13 In re Fordu, 201 F.3d 693, 706 n. 17 (6th Cir. 1999).
14 See In re Ahead By a Length Inc., 100 B.R. 157, 165 (Bankr. S.D.N.Y.
1989) (“Although it is true that a bankruptcy trustee is a successor to
the debtor’s property and for many purposes is deemed to be in privity
with the debtor, that privity is not complete.”); see also In re McNamara,
281 B.R. 799, 802-3 (Bankr. D. Conn. 2002). A trustee is also generally
in privity with the debtor regarding (and is bound by) judgments already
entered against the debtor. See, e.g., Teltronics Services Inc. v. L.M.
Ericsson Telecommunications Inc., 642 F.2d 31 (2d Cir. 1981).
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