The Fifth Circuit concluded that an uncontested proof of claim in a “no asset” chapter 7 case cannot be grounds for invocation of res judicata against a third party.
In addition to Section 502, there may be other grounds for reaching the same result, as discussed at the end of this analysis.
The Facts
A company filed a chapter 7 petition after being sued for architectural copyright infringement. Initially, the trustee believed there would be no assets and notified creditors that it was unnecessary to file proofs of claim. The trustee later decided there might be distributable assets and notified creditors that they should file claims within 90 days.
The plaintiff in the copyright suit filed a proof of claim for $83 million. Later, however, the trustee filed a “no asset report” and notified creditors accordingly. No one ever filed an objection to the copyright claim.
The copyright plaintiff demanded that the debtor’s insurer pay the face value of a $6 million insurance policy. When the insurance company refused, the plaintiff filed suit in district court for breach of contract, claiming to be a beneficiary of the insurance policy. The plaintiff contended that the debtor’s liability on the policy was res judicata because the proof of claim was deemed allowed under Section 502(a), which provides that a proof of claim is “deemed allowed, unless a party in interest . . . objects.”
The district court granted summary judgment for the insurance company dismissing the complaint and was upheld in the Fifth Circuit’s March 24 opinion by Circuit Judge Edith H. Jones. She said the case presented “an intriguing question of statutory interpretation.”
Judge Jones’ Ratio Decidendi
Judge Jones said that “the necessity for creditors to file and the courts to adjudicate claims depends on the existence of assets in the debtor’s estate.” She also said the “Bankruptcy Rules plainly contemplate pretermitting claims allowance and objection procedures when there are no distributable assets.”
Beyond the statute, Judge Jones said the official forms and accompanying instructions “explain that proofs of claim need only be filed in asset-holding bankruptcy cases.”
Because objections to claims are not mandatory under Bankruptcy Rule 3007(a), Judge Jones concluded that no “party in interest,” including the insurance company, “had any reason to ascertain that [the plaintiff] had filed a proof of claim, much less object to the superfluous claim.”
“Section 502 would be significantly transformed,” Judge Jones said, if it required that parties in interest “monitor, object to, and litigate proofs of claim that need not even be filed.” Were that true, “sureties, guarantors, general partners, and other entities that might share liability for claims against debtors would risk suffering adverse judgments in the form of ‘deemed allowed’ claims.”
Judge Jones distinguished a Ninth Circuit opinion that gave preclusive effect to a “deemed allowed” claim because it did not involve a no-asset case.
Judge Jones held that a “deemed allowed” claim does not have res judicata effect in a no-asset case when creditors were not told to object to claims and “no bankruptcy purpose would have been served by the bankruptcy court’s adjudicating” the claim.
The opinion had another holding of note. The insurance company argued that the bankruptcy court lacked jurisdiction to adjudicate the claim because it would have had no conceivable impact on the nonexistent estate.
Judge Jones held that the bankruptcy court had subject matter jurisdiction, although the Bankruptcy Code gave the court discretion over the claim-allowance process since it was a no-asset case.
What About Asset Cases?
Judge Jones’ opinion might be interpreted to imply that a deemed allowed claim does have res judicata effect whenever there are assets for distribution. However, the opinion does not say that explicitly.
When there are minimal assets, mounting claim objections might not be justifiable economically from the trustee’s vantage point. Further, third parties may lack notice of potential res judicata effects. Indeed, a third party like an insurance company might not even know that a potentially insured claim was filed. Although an insurance company might have a defense under the policy for lack of notice of the claim, other potentially liable third parties might not have similar rights.
If deemed allowed claims have res judicata effect in asset cases, Section 502 would become a trap for the unwary third party liable on a claim against a debtor.
In asset or no-asset cases, another court presented with the same facts might explore whether res judicata is even applicable to deemed allowed claims, since claim preclusion requires a final order. It is at least questionable whether the absence of an objection is equivalent to a final order, given that there was no judicial action affirming the validity of the claim.
Finality is another issue. In chapter 7 cases, there may be no deadline for claim objections. Indeed, a closed case conceivably could be reopened to permit a claim objection.
Therefore, it might be said that a deemed allowed claim is neither an order nor is it final, thus precluding the invocation of res judicata.
Judge Jones’ opinion does not discuss the elements of res judicata, but she appears to assume that the doctrine applies. Another court might explore whether res judicata is applicable when the party allegedly in privity with the debtor lacks notice or an opportunity to defend.