Third Circuit Court of Appeals Provides Guidance on Relationships (of the Substantive Legal Variety)

Contributed by Blaire Cahn
In the recent case of In re Montgomery Ward, LLC, Nos. 09-1736, 09-1745, 09-1735, 09-1746, 2011 WL 801981 (3d Cir. March 9, 2011), the United States Court of Appeals for the Third Circuit addressed the application of res judicata in the context of a “chapter 22.”  Montgomery Ward, LLC, previously one of the largest retail merchandising organizations, first filed for bankruptcy protection on July 7, 1997.  Less than 18 months after it emerged from its first chapter 11 case, it filed again on December 28, 2000, this time with the aim of liquidating its assets. 
At the center of the dispute in this case is a leasing arrangement between Montgomery Ward and Jolward Associates Limited Partnership.  Montgomery Ward leased a parcel of land to Jolward, and Jolward agreed to construct a department store.  Jolward subsequently leased the land and the department store back to Montgomery Ward, and Montgomery Ward received an option to purchase the department store at the end of the lease.  Jolward’s interests were later assigned to State Farm Life Insurance Co. 
In Montgomery Ward I, State Farm filed a proof of claim in connection with the leasing arrangement.  The debtor assumed the leasing arrangement but disputed the amount of State Farm’s claim.  The dispute was later settled with State Farm receiving payment for the full amount of its claim.  State Farm’s interests in the leasing arrangement were later acquired by Dika-Ward LLC.  As part of Montgomery Ward II, the debtor rejected the leasing arrangement, and Dika-Ward filed a proof of claim for rejection damages.  Both the Montgomery Ward II debtor and the plan administrator objected to Dika-Ward’s claim.  The plan administrator challenged the leasing arrangement on the basis that it was a financing arrangement rather than a true lease; as a financing arrangement, the plan administrator argued, Dika-Ward’s sole remedy was against the collateral that secured the financing (i.e., the department store that the debtor already had decided was not needed when it rejected the leasing arrangement).
Because the Montgomery I debtor in possession had treated the arrangement as a true lease, though, Dika-Ward argued that the Montgomery Ward II plan administrator was barred by res judicata from challenging the nature of the lease/sublease arrangement.  Although res judicata does not generally apply when the party to be bound was not a party in the first proceeding, did the legal relationship between the Montgomery Ward I debtor and the Montgomery Ward II plan administrator warrant making an exception to the general rule?  No, according to the Third Circuit.  While a relationship between a successor in interest and its predecessor may trigger an application of res judicata, the Third Circuit found that the incentives of the Montgomery Ward II plan administrator and the Montgomery Ward I debtor in possession were misaligned.  Therefore, these parties did not possess the type of substantive legal relationship necessary to render the imposition of res judicata appropriate. 
The Third Circuit compared the relationship between the Montgomery Ward II plan administrator and the Montgomery Ward I debtor in possession to that of a bankruptcy trustee and a pre-bankruptcy debtor, noting that the bankruptcy trustee is not simply a successor in interest to the pre-bankruptcy debtor.  A bankruptcy trustee has an obligation to represent the interests of the debtor’s creditors, and that interest may differ from the interests of the debtor.  For example, the court pointed to a 1983 bankruptcy court decision  in which the debtor in possession had failed to pursue a preference action against one of its vendors.  When a chapter 7 trustee was appointed and brought the preference action, the bankruptcy court found that the debtor’s failure to bring the preference action did not preclude the trustee from doing so.  The interests of the trustee, as a representative of the debtor’s general unsecured creditors, differed from the interests of the debtor in possession in preserving its business relationship with the vendor.
Both the Third Circuit’s comparison and the example it cites seem to overlook the fiduciary duty that a debtor in possession has to act in the best interest of its estate.  Perhaps, though, both cases implicitly recognize that what is in the best interests of a debtor’s estate may change depending upon whether a debtor is reorganizing or liquidating.  Because Montgomery Ward II was liquidating, the plan administrator was focused on bringing additional funds into the estate to maximize recoveries for creditors.  Conversely, the debtor in Montgomery Ward I was focused on maintaining the operations of Montgomery Ward and, therefore, had an incentive not to challenge the lease.  The Third Circuit found that these differing motivations were sufficient to protect the Montgomery Ward II plan administrator from application of res judicata, and, therefore, the plan administrator could argue that the leasing arrangement was in fact a structured financing. 
Notably, the Third Circuit did not address what the result would have been if the Montgomery Ward II debtor in possession, and not the plan administrator appointed under the Montgomery Ward II liquidating plan, had brought the recharacterization action.  Clearly, the Montgomery Ward II debtor in possession would have been a successor in interest to the Montgomery Ward I debtor in possession, and application of res judicata likely would have applied.   Montgomery Ward suggests that the assignment of the rights to a different entity preserved the ability to bring the recharacterization action.  It is somewhat ironic that the Third Circuit allowed the form in which the action was preserved to prevail so the Montgomery Ward II plan administrator could look past the form of the leasing arrangement and seek to recharacterize it.