The Second Circuit has pitched the rules of res judicata to favor debtors and their successors, as shown by Bankruptcy Judge Robert D. Drain in a Feb. 15 opinion.
In Brown Media Corp. v. K&L Gates LLP, 854 F.3d 150 (2d Cir. April 14, 2017), 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.
In the aftermath of the chapter 11 plan of Frontier Insurance Group Inc., confirmed in 2005, Judge Drain ruled that the debtor’s successor owned valuable real estate, even though a pre-bankruptcy agreement provided that the creditor would become the owner of the asset 10 years after confirmation. Building on Brown Media, he ruled that a creditor with a claim to ownership “may lose that interest if, knowing the debtor’s contrary claim, [the creditor] lets a plan be confirmed without contesting the debtor’s position.”
The principle, however, is a double-edged sword because, as Judge Drain said, “a post-confirmation debtor may be precluded from subsequently claiming an asset that was not sufficiently claimed during the chapter 11 case.”
The heart of Judge Drain’s 32-page opinion is an analysis of whom the parties understood the owner to be when the chapter 11 case was pending. His analysis focused to a significant extent on the contents of the plan, the disclosure statement, and the creditor’s proof of claim.
Judge Drain’s case involved an industrial development authority, or IDA, that held title to real estate during the debtor’s chapter 11 case. The debtor’s headquarters was located on the property. The IDA held title for a number of years as part of a tax-abatement arrangement.
At the expiration of the tax-abatement agreement almost 10 years after confirmation, the pre-bankruptcy agreements with the IDA called for the IDA to transfer title to the creditor, a non-bankrupt insurance subsidiary in liquidation in state court.
Judge Drain ruled that the creditor lost any claim it had to ownership by failing to assert the claim prior to confirmation. Instead of claiming eventual ownership, the creditor only asserted a $43 million unsecured claim that made no assertion of ownership of the real estate.
On the other hand, the debtor’s plan established the debtor’s ownership because (1) the debtor had scheduled the property among its assets, and (2) the plan conveyed ownership of all estate property to the debtor’s successor on confirmation. Judge Drain said that scheduling the property among the debtor’s assets put the creditor on notice of the debtor’s claim to ownership.
Because the creditor “did nothing to preserve [its] interest” in the property, Judge Drain said that the creditor’s “failure to claim a contrary interest became binding on” the creditor as a consequence of confirmation of the plan.
Given the peculiar, contorted, complex facts of the case, Judge Drain’s opinion may have limited precedential value. Indeed, the judge himself said that the “unique fact pattern . . . highlights why the doctrine [of res judicata] should be applied flexibly when a debtor fails to disclose an asset.”
Judge Drain’s case and Brown Media share a common feature. The Second Circuit seemed motivated to massage the rules of res judicata to prevent a law firm from escaping liability for an undisclosed conflict of interest and failure to disclose. Judge Drain explained that his opinion would prevent the creditor from realizing an “improper windfall.”
To read ABI’s discussion of Brown Media, click here.