In drafting a bankruptcy plan, causes of action often appear to be an overlooked step-child. Type A bankruptcy lawyers like us spend hours carefully drafting or dissecting the language on assets, liabilities, potential preferences, plan effective dates, and the like, while spending very little time fleshing out and providing for causes of action held by the estate. While the debtor is required to list causes of action on its schedules and § 1123(b)(3)(B) allows the plan to provide for the retention and enforcement of these causes of action, more often than not, the plan simply provides that the debtor will retain these causes of action, they are not pursued, and they simply die a natural death by means of a statute of limitation.
Sometimes, however, a cause of action is litigated post-bankruptcy and an enterprising defense lawyer will assert that the bankruptcy plan is res judicata. When the judge agrees and dismisses the case with prejudice, the reorganized debtor looks to the bankruptcy lawyer and asks “did you screw up?” Not a good place to be.
Res Judicata in the Bankruptcy Context
With care, this potential pitfall can be avoided. But first, some discussion of the doctrine of res judicata is necessary to understand the issue.
The doctrine of res judicata is designed to require parties to bring the full controversy before the court for resolution. Here in the Eleventh Circuit, the party seeking to apply res judicata must show (1) the prior decision was rendered by a court of competent jurisdiction; (2) a final judgment on the merits; (3) both cases involve the same parties or their privies; and (4) both cases involve the same causes of action. See In re Piper Aircraft Corp., 244 F.3d 1289, 1296 (11th Cir. 2001). The doctrine extends not only to the legal theory presented in the previous litigation, but also to all legal theories and claims arising out of the same “operative nucleus of fact.” See Olmstead v. Amoco Oil Co., 725 F.2d 627, 632 (11th Cir. 1984).
In bankruptcy, the same rule applies to confirmation orders. A bankruptcy court’s order of confirmation is “an absolute bar to the subsequent action or suit between the same parties . . . to every [claim] which might have been presented. In re Justice Oaks II, Ltd., 898 F.2d 1544, 1552 (11th Cir. 1990). The only exception to this general rule is when the cause of action is specifically reserved in the plan of reorganization or in the confirmation order. See D & K Props. Crystal Lake v. Mut. Life Ins. Co., 112 F.3d 257, 260 (7th Cir 1997) (“res judicata does not apply when a cause of action has been expressly reserved for later adjudication”); Browning v. Levy, 283 F.3d 761 (6th Cir. 2002) (“Res judicata does not apply where a claim is expressly reserved by the litigant in the earlier bankruptcy proceeding.”).
Thus, the case law addressing the issue hinges on whether the plan proponent “expressly reserved” the cause of action.
Drafting Retention Provisions
The first point is the plan must expressly state that the reorganized debtor will retain the causes of action. While blindingly obvious, an express reservation of the causes of action is a required starting point.
It is clear that a blanket reservation of all causes of action will not be effective. “The identification must not only be express [i.e., expressly stated] but also the claim must be specific. A blanket reservation that seeks to reserve all causes of action reserves nothing.” D & K Props. at 261.
One potential method to reserve causes of action is by a categorical listing of causes of action. This is especially common when the causes of action arise under Bankruptcy Code provisions such as §§ 544, 547, and 548 and in large cases where there are numerous causes of action. An excellent representative case is In re Pen Holdings, Inc., 316 B.R. 495 (Bankr. M.D. Tenn. 2004). The reorganized debtor brought a preference action after confirming a plan which retained all “Avoidance Actions.” That term was defined as:
“actions and rights of action under Section 510, 541, 544, 545 and 546 of the Bankruptcy Code, all preference claims pursuant to Section 547 . . . , all fraudulent transfer claims pursuant to Section 544 or 548 . . . , all claims recoverable under Section 550 and 553 . . . , all other claims under Chapter 5 of the Bankruptcy Code, and all claims (including claims arising in common law or in equity) against any person on account of any debt or other claim owed to or in favor of the Debtor.”
The plan provided that all causes of action shall vest in the reorganized debtor, and would be distributed in accordance with the terms of the plan. The plan also provided for retention of jurisdiction by the bankruptcy court. The liquidation analysis did not list Avoidance Actions separately, but did include a line item for “other assets” valued at $924,000.
After confirmation, the reorganized debtor filed 173 adversary proceedings to avoid preferential transfers. The defendants asserted that the claims were barred by res judicata.
Pen Holdings emphasized that courts require the plan proponent to specifically describe the causes of action to enable the other parties to the bankruptcy to value the claims and take these amounts into account in voting on the disposition of the debtor’s estate. When the listing is not sufficiently specific, the other parties are unable to make a rational decision. The penalty for the plan proponent’s failure to sufficiently identify the causes of action is to lose the cause of action under res judicata. But compare In re Diabetes America, Inc., 485 B.R. 340, 355 (Bankr. S.D. Tex. 2012) (purpose of retention language under § 1123(b)(3) is to provide notice to potential defendants in order to allow them to calculate liabilities and benefits under a plan).
In the end, Pen Holding held that the preference litigation was sufficiently reserved, but noted that it was “a close case.” In so holding, it noted that “it is not practicable, especially in larger cases, for the debtor to identify by name in the plan or disclosure statement every entity that may have received a preferential payment.” The court also pointed to the Statement of Financial Affairs, which included a list of payment made within the preference period totaling $160,000,000. Other courts to consider avoidance actions agree with Pen Holding’s rationale. See, e.g., Matter of P.A. Bergner & Co., 140 F.3d 1111, 1117 (7th Cir. 1998); In re Kmart Corp, 310 B.R. 107, 124 (Bankr. N.D. Ill. 2004).
Thus, in bankruptcy avoidance actions, it appears to be the rule that categorical retention is sufficient, but certainly the best practice would be to identify as specifically as possible the value of the retained causes of action and disclose that value and the underlying reasoning to creditors.
Pen Holding also illustrated that non-bankruptcy causes of action may be treated differently. It contrasted the “immense” “universe of causes of action that become assets of Chapter 11 estates” with the more limited (and knowable through the Statement of Financial Affairs) universe of avoidance actions. In Browning v. Levy, 283 F.3d 761 (6th Cir. 2002), the Sixth Circuit reviewed a defense of res judicata against state law claims of breach of fiduciary duty, legal malpractice, and other claims. The debtor argued that it expressly reserved “any claims, rights, and causes of action that the Debtor or its bankruptcy estate may hold against any person or entity, including without limitation, claims and causes of action arising under section 542, 543, 544, 547, 548, 550, or 553 of the Bankruptcy Code.” The Sixth Circuit disagreed, stating that “[s]ignificantly, it neither names [the defendant] nor states the factual basis for the reserved claims” and held that res judicata barred the claims.
Of course, the best practice is to list each cause of action and describe the underlying facts. In retaining state law or non-bankruptcy claims, this may even be necessary , at least for the class of claims or the major claims. In that case, it should be sufficient to briefly describe the facts and estimate the claims’ values. But, as the courts have recognized, it can often be impracticable to do so, especially with bankruptcy claims. Thus, at least for avoidance claims, using a categorical approach has been respected by most courts, especially when the plan, disclosure statement, or liquidation analysis contains enough information for third parties to make a reasoned decision on the debtor’s retention of those assets. For all causes of action, it is better to put too much information in a plan or disclosure statement than face the argument that res judicata applies because the bankruptcy pleadings were defective.