Trimming back the doctrine of res judicata, the Second Circuit held that a prior litigation between the same parties, involving the same facts, may not invoke res judicata when the prior proceeding was a bankruptcy. The outcome may have been influenced by the appeals court’s desire to prevent a technicality from insulating lawyers from liability when the bankruptcy judge was never aware of the lawyers’ alleged conflicts of interest.
The April 14 opinion by Circuit Judge Peter W. Hall shows the peril that befalls lawyers who attempt to maximize income by taking on too many roles and switching clients midstream.
The Facts Are Necessary to Understand the Result
The appeal came to the Second Circuit from an order granting a motion to dismiss. Judge Hall therefore construed the allegations in a light most favorable to the plaintiffs. The following factual summary should also be understood as allegations, not findings of fact.
A law firm was hired by a company’s executives to devise a strategy for them to buy the company and keep it out of the clutches of secured lenders. When an out-of-court transaction became infeasible, the lawyers advised the executives to buy the business through a bankruptcy sale in chapter 11. The lawyers helped the executives incorporate their acquisition vehicle.
The lawyers told the executives that they were interested in representing the company in chapter 11. Without obtaining a waiver from the executives, the company retained the lawyers as their reorganization counsel. The executives included the chief executive and the inside general counsel, who presumably made the decision for the company to hire the lawyers they were using.
Perhaps while representing both the company and the executives, the firm prepared an asset-purchase agreement and advised the executives on how they could maximize the chance that the bankruptcy court would anoint them as the top bidder. The firm also helped the executives arrange financing for the acquisition.
Shortly before bankruptcy, the lawyers told the executives to retain their own counsel, who turned out to be a former partner. By that time, Judge Hall said, most of the acquisition agreement had been drafted.
When the company filed chapter 11, the lawyers did not disclose their prior representation of the executives.
Once in bankruptcy, the company’s secured lender sought to buy the business in exchange for debt. In his lawsuit against the lawyers that led to the appeal, the former chief executive of the debtor contended that the lawyers did not fully disclose their connections with the lender.
In substance, the chief executive alleged that the lawyers used knowledge they gained about him to swing the bankruptcy sale in favor of the lender.
Although the company officers initially won the auction, the chief executive blamed the lawyers’ inaction for causing the loss of financing that prevented him from closing the acquisition. The bankruptcy court eventually approved a sale to the lender, which was followed later by confirmation of a plan.
Judge Hall said that the bankruptcy judge was not aware of the lawyers’ potential conflicts until a year after confirmation.
After the sale to the lender closed and the company confirmed a chapter 11 plan, the debtor’s former chief executive sued the lawyers in federal district court in Brooklyn, N.Y., alleging breach of fiduciary duty, failure to obtain a waiver for dual representation, and common law fraud, among other things. The former executive was not seeking to unravel the sale. Rather, he sought monetary damages to put him financially in the same position as though he had been the successful buyer.
Dismissal in District Court
In district court, the lawyers filed a motion to dismiss and won. They contended that the sale-approval and confirmation orders were res judicata, barring the later suit for ethical misconduct occurring before and during the chapter 11 case.
Employing res judicata to dismiss the suit, the district judge characterized the complaint as a “thinly disguised collateral attack” on the bankruptcy orders. The district judge believed that granting relief to the executives would require him “to effectively overrule” the bankruptcy court’s orders.
Res Judicata Is Awkward in Bankruptcy
Judge Hall recited the usual rules about res judicata, sometimes called claim preclusion. It requires a final decision on the merits, the same parties or their privies, competent jurisdiction in the prior court, and the same causes of action that were or could have been brought.
In substance, the lawyers contended that the suit was barred by res judicata because their ethical misconduct could have been raised in bankruptcy court to block the sale to the lender. Although conceding that the executives could have raised the lawyers’ alleged conflicts in bankruptcy court, Judge Hall said that “the standard res judicata analysis can be an awkward fit when applied to bankruptcy proceedings.”
In ordinary civil litigation, courts focus on whether claims could have been brought in a prior action, Judge Hall said. In bankruptcy, the judge said, the question is whether the new suit “seeks to bring claims that could have been raised and litigated within the scope of the bankruptcy proceeding,” citing Second Circuit precedent. [Emphasis added.] From that point on, the opinion became an exploration of the subtle differences between the res judicata standards for bankruptcy and non-bankruptcy cases.
Evidently, Judge Hall would have invoked res judicata had the chief executive based his lawsuit on the notion that there was collusion between the law firm and the eventual buyer, an issue that would have gone to the heart of the bankruptcy court’s decision to approve the sale to the lender. Instead, he said that collusion was not the “gravamen” of the complaint. Rather, he said, the complaint focused only on the misconduct of the lawyers alone and not in conjunction with the lender.
Judge Hall said the executives could have raised the lawyers’ misconduct during the sale-approval proceedings. Nonetheless, he said that disqualifying the lawyers “would not have provided [the chief executive] a fair forum in which to litigate fully the claims [he] now brings against them.” In other words, even successfully blocking the sale to the lender “would not have been equivalent to asserting the present claims.”
Significantly, Judge Hall said that the “circumstances did not demand that plaintiffs raise their claims in the bankruptcy proceeding.” What those circumstances were is not entirely clear. Does the opinion mean that a bidder is not required to raise allegations of misconduct during the sale process? That hardly seems likely, but the opinion might be cited for that principle.
Ordinarily, a counterclaim not raised in prior litigation can be barred by res judicata in a non-bankruptcy context. When the prior litigation was in bankruptcy, perhaps the decision means that res judicata will not apply when a non-debtor would have been required to initiate an adversary proceeding against another non-debtor to obtain monetary damages or other relief that would not have been available by merely opposing relief sought in the pending contested matter.
In any event, Judge Hall disagreed with the district court’s conclusion “that the [executives] could have, and should have, raised their present claims in the bankruptcy proceeding.” That statement is puzzling, because the executives could have raised claims against the lawyers in bankruptcy court. Indeed, wearing their fiduciary hats as executives of a bankrupt company, perhaps they should have raised the ethical questions before the bankruptcy judge. Whether the bankruptcy court may have deflected jurisdiction beyond sanctioning the lawyers is another question.
Judge Hall ended the opinion by saying that giving monetary damages to the executive in the new lawsuit “will have no effect on the continuing validity of the bankruptcy court’s order approving the sale.”
What Happens Next?
Having the lawsuit reinstated does not mean the former chief executive will eventually win. Arguably, he was happy with dual representation and lack of disclosure when bankruptcy seemed to be working in his favor. Perhaps the doctrine of unclean hands or some other equitable defense will bar a recovery, because the executive was working in conjunction with the company’s inside counsel to buy the business, and the inside attorney should have been aware of the ethical question and failure to disclose the pre-bankruptcy representation of the insider buyout group.
Courts will likely read the decision narrowly to avoid collateral attacks on sale orders by disgruntled bidders. The opinion may be confined to its precise facts: Res judicata will not apply where an unsuccessful bidder sues its own lawyer for a conflict, and the bankruptcy court ordinarily would not dispense monetary damages to the non-debtor client.
If nothing more, the case is a fine example of ethical problems that confront lawyers when they wear too many hats, and especially when there was no informed consent and waiver by the clients.