Corestates Extends Claim Preclusion to Competing Creditors

The Third Circuit's recent decision in the case of CoreStates Bank, N.A. v. Huls America, Inc., 1999 WL 289426 (3d Cir. 1999) could have significant impact on when competing creditors to a bankruptcy debtor should assert their claims against each other. In CoreStates, the Third Circuit barred one creditor, CoreStates Bank, N.A. ("CoreStates"), from bringing an action against another creditor, Huls America, Inc. ("Huls"), subsequent to the entry of a bankruptcy plan confirmation order of the debtor, United Chemical Technologies, Inc. ("UCT").

In its May 11, 1999 decision, the court concluded that under principles of claim preclusion that CoreStates should have raised its claim against Huls during UCT's contested plan confirmation hearing where all three were parties.

Although the Third Circuit took great pains to emphasize that its decision was limited to the facts of the case and that CoreStates's present claims were "precluded because of the coincidence of several unusual circumstances," this holding is certainly broad enough to warrant caution on the part of a creditor objecting to a debtor's reorganization plan.

Consequently, creditors should now be careful to closely examine whether possible claims against other creditors of the Debtor should be raised during a contested plan confirmation hearing or be at risk of having their claims subsequently forfeited under principles of claim preclusion.

In general, the doctrine of claim preclusion or res judicata, as it is also commonly known, is a type of judicial-made equitable remedy that is intended to discourage piecemeal litigation and improve efficiency of the adversarial system by attempting to ensure that a claimant assert all its claims against a party arising under a particular set of factual circumstances in one action.

For claim preclusion to apply there must be a final judgment on the merits in a prior suit involving the same parties or their privities and a subsequent suit based on the same cause of action. Once claim preclusion is found to be applicable, the consequences of failing to comply with claim preclusion principles are severe - namely a litigant's subsequent action is barred.

Historically, the Third Circuit has recognized the doctrine of claim preclusion in bankruptcy cases is fundamentally different from typical civil actions in light of the unique nature of bankruptcy subject matter jurisdiction, as well as the multiple issues decided and multiple parties participating throughout the pendency of a representative bankruptcy case.

Thus, as the court stated at the outset of its decision, claim preclusion can only apply to a judgment in a bankruptcy case if the current claim would have been within the jurisdiction of the Bankruptcy Court hearing the case and the party to be precluded had raised a "claim" in the bankruptcy case. Finally, the facts underlying the current claim must be "essentially similar" to those underlying the claim made in the bankruptcy case as viewed under the "totality of the circumstances." It is only if all three requirements are met that the current claim would be precluded.

CoreStates and Huls were both substantial pre-petition, secured creditors of the debtor, UCT, with CoreStates having loaned UCT approximately $1.1 million to finance UCT's acquisition of a Huls owned facility that manufactured specialty chemicals. As seller, Huls also extended several million dollars in financing to UCT to assist in the acquisition.

In conjunction with its financing, CoreStates required UCT and Huls to execute a Subordination Agreement under which Huls agreed, among other things, to subordinate its rights as a creditor to CoreStates and not retain any payments made by UCT until UCT's indebtedness to CoreStates had been paid in full. Significantly, in the event of a UCT bankruptcy filing, the Subordination Agreement further provided that Huls would hold any payments it received pursuant to the bankruptcy proceedings in trust for CoreStates and would thereafter immediately turnover any such payments to CoreStates to be applied to UCT's indebtedness to CoreStates.

UCT's subsequent chapter 11 bankruptcy filing was necessitated by an explosion at UCT's facility. Several months after filing, UCT submitted its first Plan of Reorganization, which met with objections from a number of UCT's creditors, including both CoreStates and Huls. Thereafter, following negotiation with interested parties, UCT filed an Amended Plan which had the consent of all parties except CoreStates.

Under the Amended Plan, Huls was to receive an immediate cash payment of $600,000 in full satisfaction of its more than $3.2 million in claims. CoreStates objected to this proposed payment to Huls arguing that it constituted unfair discrimination among creditors, since it allowed for immediate payment to Huls, a junior creditor. Notably, CoreStates did not set forth the argument that under the Subordination Agreement Huls was not permitted to receive any direct payments from UTC directly under the plan but was required, instead, to turnover the payment to CoreStates. Rather, the record suggests that CoreStates' counsel orally raised the Subordination Agreement requirements with the Bankruptcy Court but that no papers were filed by CoreStates.

The Bankruptcy Court thereafter confirmed UCT's Plan over the objection of CoreStates. A subsequent appeal resulted in the reversal of the Bankruptcy Court's confirmation order but for reasons unrelated to the payment to Huls. CoreStates had raised the issue regarding the Subordination Agreement in its appeal brief but the District Court found that CoreStates had not raised the terms of the Agreement as a basis for objecting to the Amended Plan in the Bankruptcy Court and, therefore, did not consider the issue on appeal.

While the appeal was pending, UCT paid the $600,000 to Huls in accordance with the Amended Plan. After the confirmation order was reversed, CoreStates made a written demand to Huls to turnover the $600,000 payment but Huls refused. UCT subsequently filed a Second Amended Plan, which cured the defects noted by the District Court. The Seconded Amended Plan, however, did not alter the required payment to Huls. Thereafter, the Bankruptcy Court confirmed UCT's Second Amended Plan, also over CoreStates's objection. Notably, CoreStates once again did not formally object to the payment to Huls on the grounds such a payment violated the terms of the Subordination Agreement.

CoreStates did not appeal the Bankruptcy Court order confirming the Second Amended Plan, but instead filed an action in federal court against Huls seeking to compel Huls to turnover the payment in accordance with the terms of the Subordination Agreement. Huls's motion to dismiss the complaint based on claim preclusion was granted by the District Court, with the District Court concluding that CoreStates could have asserted the issue regarding the Subordination Agreement in conjunction with its objection UCT's Plan, but failed to do so.

CoreStates appealed to the Third Circuit arguing that an order confirming a contested bankruptcy plan of reorganization could not be used as the basis for claim preclusion when the claim being precluded was at best a "non-core" proceeding. Furthermore, CoreStates argued a plan confirmation order should not be applied to the claims of a creditor who objects to the bankruptcy plan. In its decision, the Third Circuit rejected both arguments and affirmed the dismissal.

CoreStates preliminary argument was that claim preclusion could not apply to its claims against Huls because CoreStates's claims were at best within the non-core "related to" jurisdiction of the Bankruptcy Courts. Section 157 of Title 28 of the United States Code grants Bankruptcy Courts the authority to hear both core and non-core proceedings. Core proceedings are those actions which invoke a substantive right under the Bankruptcy Code or could only arise in the context of a bankruptcy case. Non-core proceedings are those actions which are not core but are otherwise "related to" a bankruptcy case. A claim would be considered non-core only if it could conceivably have an effect on the administration of the bankruptcy estate such as by altering the debtor's rights or liabilities.

By way of history, the distinction between core versus non-core jurisdiction of the Bankruptcy Court was created by Congress in response to the United States Supreme Court decision of Northern Pipeline Constr. Co. v. Marathon Pipe Line, Co., 458 U.S. 50 (1982), which found the former Bankruptcy Act's grant of jurisdiction over proceedings "related to" bankruptcy cases to non-Article III Bankruptcy Judges unconstitutional. According to the Supreme Court, non-Article III judges, such as Bankruptcy Judges, can hear cases involving public, congressionally created rights, such as those rights provided under the Bankruptcy Code. However, Bankruptcy Judges cannot hear cases based on private common-law rights, which are properly heard only before Article III, life-tenured judges, such as District Judges.

In response to the Marathon decision, Congress enacted the Bankruptcy Code which provided among other things that Bankruptcy Courts could not enter final judgments in non-core proceedings unless all parties consented. In the absence of consent, the Bankruptcy Court was required to submit proposed findings of fact and conclusions of law to the District for entry of final judgment. Because of this distinction, both the Fifth and Seventh Circuits have held that a plan confirmation order cannot be used as a basis for claim preclusion if the present claim could only be raised under a Bankruptcy Court's non-core "related" jurisdiction.

The Third Circuit, siding with the Second, Sixth and Ninth Circuits previously considering the issue, concluded the claim preclusion doctrine applies regardless of the type of bankruptcy jurisdiction. The reasoning behind such a decision is grounded in the fact that, although a Bankruptcy Court cannot finally determine a non-core proceeding, the Bankruptcy Court together with the District Court can ensure full and fair litigation of the non-core claim. Accordingly, whether a current claim would fall with the core or non-core jurisdiction of the Bankruptcy Court will not shield a claimant from the consequences of the doctrine.

In rejecting CoreStates's argument that the dispute was entirely between Huls and CoreStates, the Third Circuit concluded that CoreStates's claims under the Subordination Agreement were at the very least "related to" non-core claims since the resolution of the dispute conceivably would have impacted UCT's options in proposing a plan to which Huls consented.

CoreStates also argued that the plan confirmation order could not be applied for claim preclusion purposes to disputes between creditors of a debtor. However, the Third Circuit found that a party who files an objection to a plan of reorganization can state a claim against another creditor for claim preclusion purposes when the objection impacts a creditor's rights under the proposed plan.

Essentially, the Third Circuit believed that CoreStates, by filing an objection to the Debtor's different treatment of Huls's claim under the Amended Plan, "put Huls's rights in the bankruptcy estate into question" and therefore asserted a claim against Huls in the bankruptcy case. Accordingly, by objecting to the terms of the Plan which called for the payment to Huls, CoreStates's objection effectively "subsumed" the Subordination Agreement, even though the Agreement was not advanced "in terms." Because the Third Circuit believed that CoreStates's objection and the subsequent cause of action against Huls were "essentially the same" it concluded that CoreStates's subsequent action under the Subordination Agreement was forfeited.

In a noteworthy dissent, Circuit Judge Stapleton criticizes the majority decision as "fashion[ing] an unprecedented 'entire controversy doctrine' for bankruptcy litigation," with "parameters of [the] new doctrine . so broad and ill defined" that "much mischief" will be done by the decision. As Judge Stapleton views the CoreStates decision, a claim between creditors brought subsequent to entry of an order confirming a contested bankruptcy plan of reorganization will now be barred if the facts underlying the objections raised in the confirmation hearing are "essentially similar" to the facts underlying the subsequent claim.

According to Judge Stapleton, such a holding ignores the fact that under traditional principles of claim preclusion, the scope of preclusion arising from a judgment is determined by the claim underlying the judgment and is limited solely to the rights asserted between the claimant and the party against whom the claim is asserted. Thus, Judge Stapleton concludes that while a bankruptcy plan confirmation order may be viewed as a judgment in favor of creditors on their claims against the debtor and, to the extend disallowed, as a judgment in the debtor's favor on the disallowed claims, under traditional principles of claim preclusion, a plan confirmation order would not bar a subsequent claim between creditors who have not raised claims against each other in the bankruptcy proceeding.

Under Judge Stapleton's reasoning, if CoreStates had asserted a claim against Huls in the bankruptcy case, principles of claim preclusion would properly be applied with reference to that claim. However, Judge Stapleton is quick to point out that CoreStates never asserted a claim against Huls. Therefore, while recognizing that "principles of claim preclusion in the context of a bankruptcy proceeding requires flexibility and must take into account the nature of the bankruptcy process," Judge Stapleton refused to agree that a plan confirmation order should be extended to extinguish CoreState's subsequent claim against Huls.

Only time will tell if the "mischief" envisioned by Judge Stapleton will come to pass from the Third Circuit's decision in CoreStates. As noted, the Third Circuit appears to have deliberately taken extra effort to tailor its decision to the perceived unique set of circumstances surrounding UCT's contested plan confirmation hearing and the dispute between CoreStates and Huls. In particular, the Third Circuit highlights the fact that $600.000 payment had been made to Huls before the Plan was ultimately confirmed, which resulted in CoreStates's claim against Huls accruing before the confirmation hearing concluded. Additionally, the Court relies upon the fact that the dispute surrounding the payment was squarely put in issue during the plan confirmation hearing, albeit in the form of an objection to the perceived discriminatory treatment to Huls.

Unfortunately, a close reading of CoreStates does not support such a limited reading of its holding. Objections to plans of reorganization, by their very nature, often involve disputes regarding the treatment of creditors under the plan. Moreover, the fact that UCT made its payment to Huls before confirmation was but one factor considered by the District Court in dismissing CoreStates's action. The District Court also relied upon the fact that the terms of the Amended Plan were known to all parties several months before the initial confirmation hearing as well.

In light of the CoreStates decision, creditors should now be more cautious when objecting to a plan of reorganization if the basis for their objection might impact upon the rights of other creditors. Depending on the circumstances, it may be prudent to raise claims against other creditors in the context of the contested plan confirmation hearing in order to avoid the risk that prevailing creditors will use the plan confirmation order as a weapon to preclude subsequent claims between creditors.

This Article is reprinted with permission from the November 1, 1999 issue of the New Jersey Law Journal. © 1999 American Lawyer Media.

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