The Res Judicata Worth of Illegal Bankruptcy Reorganization Plans
Volume 82, No. 2, Summer 2009
By David Gray Carlson [PDF]

In the mad chaos of the American bankruptcy system, courts unwittingly confirm illegal reorganization plans, especially in the highly frenetic context of a Chapter 13 case. What is the worth of these plans?

Each reorganization chapter includes a sweeping statement to the effect that confirmed plans are binding. According to the Chapter 11 provision:

(a) [T]he provisions of a confirmed plan bind the debtor . . . and any creditor . . . whether or not the claim or interest of such creditor . . . is impaired under the plan and whether or not such creditor . . . has accepted the plan.
(b) Except as otherwise provided in the plan or the order confirming the plan, the confirmation of a plan vests all of the property of the estate in the debtor.
(c) [E]xcept as otherwise provided in the plan or in the order confirming the plan, after confirmation of a plan, the property dealt with by the plan is free and clear of all claims and interests of creditors . . . in the debtor.

The parallel provision in Chapter 13 is:

(a) The provisions of a confirmed plan bind the debtor and each creditor, whether or not the claim of such creditor is provided for by the plan, and whether or not such creditor has objected to, has accepted, or has rejected the plan.
(b) Except as otherwise provided in the plan or the order confirming the plan, the confirmation of a plan vests all of the property of the estate in the debtor.
(c) Except as otherwise provided in the plan or in the order confirming the plan, the property vesting in the debtor under subsection (b) of this section is free and clear of any claim or interest of any creditor provided for by the plan.

These provisions are so sweeping and categorical that they cannot be, and are not, taken literally. Suppose the debtor writes a plan in Chapter 11 or 13 that permits him to murder a creditor in revenge. The creditor does not object through inattention or despair. The plan is confirmed, and the creditor never appeals. Surely this plan term does not bind the creditor. Common sense requires that exceptions mitigate the absoluteness of § 1141(a) and § 1327(a).

The finality sections—§ 1141(a) and § 1327(a)—“generally codif[y] the doctrine of res judicata with respect to confirmed” reorganization plans. What is res judicata? Roughly translated from Latin, this term means, “Plaintiff! Get lost!” Res judicata exalts finality over justice and the rule of law. To be sure, one can find words in praise of finality. Res judicata “relieve[s] parties of the cost and vexation of multiple lawsuits . . . [and] encourage[s] reliance on adjudication.” But certainty and thrift are virtues only in the cause of some underlying virtue. Where efficiency and cost cutting emanate from the mouth of a villain, they are vices. For this reason, courts often say that “‘the principle of res judicata should be invoked only after careful inquiry because it blocks unexplored paths that may lead to truth.’”

Modernly, res judicata is called “claim preclusion.” It is to be distinguished from collateral estoppel, recently renamed “issue preclusion.” The difference between them is that claim preclusion bars any claim that could have been litigated. Issue preclusion bars any claim based on facts that were actually litigated. Possibility and history distinguish these two doctrines.

Res judicata is a mere defense to a claim under applicable nonbankruptcy law. Accordingly, the Supreme Court has ruled that a state law cause of action cannot be removed to federal court solely because of a res judicata defense arising from confirmation of a bankruptcy reorganization plan. Absent diversity of citizenship, removal requires the assertion of a federal cause of action, not the presence of a federal defense. But so what? If the debtor needs a federal remedy to protect against acts in violation of a reorganization plan, she can reopen the old bankruptcy proceeding to get a protective order. Here (not for the first time), the Supreme Court has taught us nothing of value about bankruptcy litigation.

A standard account of res judicata in the context of bankruptcy reorganization can be found in Corbett v. MacDonald Moving Services, Inc.:

To determine whether the doctrine of res judicata bars a subsequent action, we consider whether 1) the prior decision was a final judgment on the merits, 2) the litigants were the same parties, 3) the prior court was of competent jurisdiction, and 4) the causes of action were the same. In the bankruptcy context, we ask as well whether an independent judgment in a separate proceeding would “impair, destroy, challenge, or invalidate the enforceability or effectiveness” of the reorganization plan. This last inquiry may also be viewed as an aspect of the test for identity of the causes of action.

The weak point in the citadel of res judicata is “competent jurisdiction.” It turns out that bankruptcy courts do lack jurisdiction to do many things under the guise of plan confirmation. When jurisdiction fails, justice and fairness may penetrate the citadel. But jurisdiction, it turns out, is not the only limit on res judicata in the context of bankruptcy reorganization. What other limits to the res judicata worth of confirmed plans might there be?

In Corbett, a Chapter 11 plan discharged a third party of suretyship liability, in spite of Bankruptcy Code § 524(e), which provides that the “discharge of a debt of the debtor does not affect the liability of any other entity on . . . such debt.” The assured creditor attempted a collateral attack on the plan on the theory that the bankruptcy court had no subject matter jurisdiction to discharge nondebtors—the talisman that is wont to scare off res judicata. The appellants contended:

[T]he district court’s reasoning . . . creates a circularity problem: if the bankruptcy court potentially lacked subject matter jurisdiction to discharge [the guarantor], then how can one determine that the bankruptcy court was a “court of competent jurisdiction” for purposes of res judicata without considering the merits of the jurisdictional challenge? There may be circumstances in which a bankruptcy court lacks competent jurisdiction, such as where it acts as a traffic court or a court of domestic relations. But we are not faced with a situation in which a bankruptcy court has expunged the points on a debtor’s driver’s license or annulled her marriage, nor are we evaluating a question of jurisdiction over a person or a res. Here, the bankruptcy court exercised powers that are within its competent jurisdiction: e.g., confirm a plan of reorganization; classify claims; discharge claims; and provide the means for implementing a reorganization plan. The bankruptcy court may or may not have had subject matter jurisdiction to discharge [the guarantor]; but even if it did not, the bankruptcy court was competent to confirm a plan of reorganization, and the aggrieved party was free to appeal.

As I read Corbett, a bankruptcy court can remove points on a driver’s license or award custody in a divorce, so long as it is done as part of a Chapter 11 plan. The Corbett formulation exalts form (was it done in a plan?) over substance and suggests no limit at all to the res judicata principle.

Yet, in spite of Corbett’s intimation that anything goes so long as it is done in a plan, courts have discovered all sorts of implicit limits to § 1141(a) and especially to § 1327(a). My purpose in this Article is to survey these limitations. My analysis covers Chapters 11 and 13 (with the assumption that whatever goes for Chapter 13 also goes for Chapter 12). Readers, however, will get the impression that greater weight is given to Chapter 13 cases. This is because there are hundreds of thousands of Chapter 13 cases per year and only a few thousand Chapter 11 cases. Also, Chapter 13 procedure is so accelerated that the opportunity for error is much increased. Chapter 13, “the last great bankruptcy frontier,” still remains largely untheorized. Nevertheless, although courts do not always agree, I will maintain that the law of Chapter 13 generally applies to Chapter 11 as well. Sections 1141 and 1327 each articulate the same policy.

What do I make of the various exceptions to res judicata that courts have discovered? Clearly Congress could not have intended to make every confirmed plan binding no matter what. Courts are certainly justified in discovering implicit exceptions hidden in broad statements of law. To borrow an old chestnut from jurisprudence, New York had a rule that the legatee of a proper will inherits absolutely. But, in Riggs v. Palmer, the New York Court of Appeals discovered that there is an exception for murderers. In fact, the Riggs experience is repeated frequently in the bankruptcy courts as judges discover just how unfair res judicata can be, and how untenable Congress’s broad declaration of bindingness is. Debtors (and others) often try to get away with murder, but the courts will not stand for res judicata in a variety of circumstances.

With the aim of elucidating the various exceptions to the principle of finality so absolutely proclaimed in Bankruptcy Code § 1141(a) and § 1327(a), Part II begins with a short overview of bankruptcy reorganization and what it takes to confirm a plan. Surprisingly, the matter is in doubt for Chapter 13 cases, thanks to a venerable Third Circuit case, which I will suggest was effectively overruled in 2008. Part III covers the exceptions to finality by subject matter. These include plan terms that: (1) eliminate a lien (without a prior adversary proceeding avoiding the lien); (2) set claims in spite of contrary proofs of claim; and (3) declare debts as discharged, setoffs as nonexistent, and home mortgages as illegally crammed down.

Many of these exceptions are based on not following some procedural rule in the Bankruptcy Code or the Federal Rules of Bankruptcy Procedure. Accordingly, Part IV considers whether the due process clause of the Fifth Amendment requires that these rules be followed, even though the affected creditor has been notified of the confirmation hearing. I will argue that, as the Supreme Court has defined it, the procedural rules have a constitutional dimension which overrides the res judicata effect of a plan.
Judgments can often be revoked. If they are, the judgment loses its res judicata worth. Part V considers the circumstances under which an illegal plan can be revoked. Part VI considers whether plan modification, which Chapters 11 and 13 both invite, can be used to correct legal errors in a confirmed plan. Finally, Part VII summarizes the conclusions that I have reached that are new or at some level surprising.

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