In Re: Kaplan

Opinions of the United
1998 Decisions States Court of Appeals
for the Third Circuit
6-9-1998
In Re: Kaplan
Precedential or Non-Precedential:
Docket 97-1394
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Filed June 9, 1998
UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
No. 97-1394
IN RE: MANUEL KAPLAN,
Debtor
MANUEL KAPLAN; ARTHUR LIEBERSOHN, Trustee
v.
FIRST OPTIONS OF CHICAGO, INC.
Manuel Kaplan,
Appellant
ON APPEAL FROM THE
UNITED STATES DISTRICT COURT
FOR THE EASTERN DISTRICT OF PENNSYLVANIA
(Civil Action No. 95-cv-06040)
Argued December 12, 1997
Before: NYGAARD and ALITO, Circuit Judges, and
DEBEVOISE, District Judge*
(Opinion filed: June 9, 1998)
_________________________________________________________________
*The Honorable Dickinson R. Debevoise, Senior United States District
Judge for the District of New Jersey, sitting by designation.
Gary A. Rosen (Argued)
Connolly, Epstein, Chicco, Foxman,
Engelmyer & Ewing
1515 Market Street
9th Floor
Philadelphia, PA 19102
Attorney for Appellant
Manuel Kaplan
Stephen P. Bedell
Timothy G. McDermott (Argued)
Gardner, Carton & Douglas
321 North Clark Street, Suite 3000
Chicago, Illinois 60610
William A. Slaughter
Ballard, Spahr, Andrews & Ingersoll
1735 Market Street
51st Floor
Philadelphia, PA 19103
Attorneys for Appellee
First Options of Chicago, Inc.
OPINION OF THE COURT
ALITO, Circuit Judge:
In this bankruptcy appeal, Debtor-Appellant Manuel
Kaplan contests an order allowing First Options of
Chicago's proof of claim. Kaplan argues that we should
reverse the order allowing the claim because First Options
materially breached the contracts under which the claim
arose. Concluding that First Options did not breach the
parties' contracts, the bankruptcy and district courts
allowed the claim. For the reasons stated below, we reverse
and remand.
I.
From 1981 to 1989, Manuel Kaplan was a professional
options trader on the Philadelphia Stock Exchange. In
2
1984, Kaplan began trading through MK Investments, Inc.
("MKI"), which was a market maker on the exchange.1
Kaplan became MKI's sole shareholder in 1986.
To facilitate its trading business, MKI entered into
various contracts with First Options. Under these
contracts, First Options agreed to act as MKI's clearing
firm, providing a variety of support functions, such as
generating account statements, keeping records, investing
short-term funds, providing office space and margin,2 and
guaranteeing MKI's obligations to the exchange. Since First
Options assumed the role of MKI's guarantor, the parties'
contracts granted First Options certain powers over MKI's
trading account.
While the business relationship between MKI and First
Options was initially profitable, MKI's account with First
Options suffered approximately $12 million in losses during
the stock market crash of 1987. These losses left MKI's
account with a deficit of approximately $2 million. As MKI's
guarantor, First Options was liable for this deficit. First
Options therefore attempted to minimize its exposure by
liquidating the remaining positions in MKI's trading
account. This liquidation created a dispute between the
parties as Kaplan asserted that First Options' actions in
liquidating the account needlessly compounded MKI's
losses, rather than alleviating its deficit.
After the 1987 market crash, MKI and First Options
negotiated a Workout Agreement under which the parties
settled their dispute and arranged for MKI to resume its
trading activities. This Workout Agreement consisted of four
documents: (1) a Letter Agreement executed by Kaplan, his
_________________________________________________________________
1. A market maker is "a dealer who holds himself out . . . as being
willing to buy or sell securities for his own account on a continuous
basis." Philadelphia Stock Exch. By-Laws S 23-2. See also Philadelphia
Stock Exch. Guide (CCH) P 1552.
2. Under this margin arrangement, First Options extended credit to MKI
for trading purposes. By virtue of this leverage, MKI was able to carry
significantly larger positions than would have been available if it had
been limited to its own capital. As a result of this lender-borrower
relationship, a clearing firm ordinarily has a security interest in the
positions in its customers' trading accounts.
3
wife (Carol Kaplan), First Options, and MKI; (2) a Guaranty
executed only by MKI; (3) a Subordinated Loan Agreement
executed by First Options and MKI; and (4) a Subordinated
Promissory Note executed by MKI.3 Under the terms of
these documents, MKI agreed to repay more than $5 million
to cover its trading deficits and various other amounts that
First Options had advanced. MKI also agreed to deposit
$900,000 in new capital into its trading account, to turn
over various other assets to First Options, and to clear its
future trading activity exclusively through First Options.
The Letter Agreement also provided that the Kaplans would
file income tax returns to obtain any individual tax refunds
due from 1987 and remit those refunds to First Options.4 In
turn, First Options allowed MKI to roll over its debt and
agreed once again to provide the clearing services and
leverage necessary for MKI's trading business.
In April 1988, MKI resumed trading pursuant to the
terms of the Workout Agreement. Through successful
trading, MKI increased the value of its account to
approximately $2 million. However, before the market
opened on January 16, 1989, Coastal Corporation
unexpectedly announced a takeover bid for Texas Eastern
Corporation ("TET"), a stock in which MKI had a significant
short position.5 This position exposed MKI to potential
losses if the price of TET stock increased.6 Unfortunately for
MKI, this potential was realized as Coastal's bid caused
_________________________________________________________________
3. Several of these documents involved other parties not relevant to this
appeal.
4. As this court has previously determined in a related appeal, Mr. and
Mrs. Kaplan executed this Letter Agreement in their individual
capacities, but executed the remaining documents only on behalf of MKI.
See Kaplan v. First Options of Chicago, Inc., 19 F.3d 1503, 1513-14 (3d
Cir. 1994).
5. A trader assumes a short position when he agrees to sell at a future
date assets that he does not yet own. See Richard W. Jennings, et al.,
Securities Regulation 8 (7th ed. 1992); Richard A. Brealey & Stewart C.
Myers, Principles of Corporate Finance 636 (4th ed. 1991).
6. The parties agree that MKI's position was short approximately 150,000
to 170,000 shares of TET stock. Consequently, each dollar increase in
the price of TET stock would have increased MKI's loss by $150,000 to
$170,000.
4
TET's price to jump from $30 to $45 before the opening of
trading on January 16. At the $45 price, MKI would have
lost more than $1.5 million if it had purchased enough TET
shares to cover its short position. However, because MKI
was not required to cover its short position immediately, it
had an opportunity to evaluate the risk of further market
fluctuations. Any reduction in the price of TET in the days
following Coastal's bid would have allowed MKI to regain its
lost value, while any further increase would have inflicted
additional losses.
The parties disagree over whether Kaplan took
appropriate steps to analyze and alleviate the risk that the
TET position posed to MKI's account. However, the parties
agree that MKI was unable to reduce its short position
significantly on January 16 despite actively trading in TET
options and stock. First Options contends that the parties
agreed to meet on the morning of January 17 to reassess
MKI's position. Kaplan does not recall such an agreement
and did not attend the meeting. When Kaplan failed to
arrive at the meeting, First Options instructed one of MKI's
traders to purchase the 150-170,000 shares of TET stock
or stock options necessary to cover MKI's short position.
While this action eliminated any further risk from the TET
position, it also locked in MKI's existing losses and deprived
MKI of the benefit of any future decline in TET's price.
First Options personnel confronted Kaplan when he
arrived at the exchange later on the morning of January 17.
The bankruptcy court noted that this exchange "went
badly." Following this conversation, First Options ordered
Kaplan to leave the premises and took control of MKI's
trading account. First Options disconnected MKI's phone
lines, removed MKI's traders from the floor of the exchange,
canceled MKI's outstanding orders and instructed brokers
not to take orders placed by MKI.
MKI's account still had a net value of approximately
$500,000 when First Options assumed control on January
17. However, the account's value declined as First Options
liquidated the remaining assets over the following months.
By the time First Options finished liquidating the account,
it had a final deficit of approximately $65,000.
5
Kaplan filed a bankruptcy petition under Chapter 11 in
February 1993. He subsequently converted his petition to
Chapter 7. First Options asserted a proof of claim to obtain
the income tax refunds mentioned in the parties' Letter
Agreement. In response, Kaplan asserted several
counterclaims and defenses against First Options. Kaplan
argued that First Options' actions in seizing and liquidating
MKI's accounts breached the Workout Agreement and the
implied obligations of good faith and fair dealing. To remedy
these breaches, Kaplan sought damages and a ruling
excusing his obligation to surrender his tax refund to First
Options. The bankruptcy court rejected Kaplan's claims
and defenses, holding that the parties' agreements explicitly
authorized First Options' actions in seizing and liquidating
MKI's account. The district court affirmed.
II.
As an initial matter, First Options asserts that we must
consider whether Kaplan has standing to assert his
counterclaims. First Options argues that Kaplan's
counterclaims are improper because he seeks to recover
personally for damages suffered by MKI. Kaplan responds
that First Options owed direct contractual duties to him
individually and that his claims are thus for personal
rather than derivative injuries. The bankruptcy court did
not address the standing issue, and the district court
declined to address it because the court concluded that
Kaplan's counterclaims failed on the merits. See In re
Kaplan, Civ. Action No. 95-95-6040 at 9 (E.D. Pa. Apr. 21,
1997).
The derivative injury rule holds that a shareholder (even
a shareholder in a closely-held corporation) may not sue for
personal injuries that result directly from injuries to the
corporation. See Singletary v. Continental Ill. Nat'l Bank &
Trust Co., 9 F.3d 1236, 1240 (7th Cir. 1993); 7 Mid-State
_________________________________________________________________
7. Since the contract between Kaplan and First Options contains an
Illinois choice-of-law provision, the district and bankruptcy courts
correctly applied Illinois law to the contract claims at issue. See
Admiral
Corp v. Cerullo Elec. Supply Co., 32 F.R.D. 379, 381 (M.D. Pa. 1961)
(stating that when a contract directs the usage of Illinois law, "the
conflict of laws rules of Pennsylvania . . . [require a court] to look to
the
law of Illinois to determine the rights and obligations of the parties in
interpreting the contract.").
6
Fertilizer v. Exchange Nat'l Bank, 877 F.2d 1333, 1335 (7th
Cir. 1989); Pitchford v. Pepi, Inc., 531 F.2d 92, 97 (3d Cir.
1975). In holding that Kaplan is not personally liable for
MKI's obligations to First Options, this court has previously
recognized the separate corporate existence of MKI. See
Kaplan v. First Options of Chicago, Inc., 19 F.3d 1503,
1513-14 (3d Cir. 1994). Accordingly, since Kaplan chose to
structure his business in the corporate form and received
the benefits of that form by avoiding liability for MKI's
debts, the derivative injury rule prevents him from piercing
the corporate veil in reverse in order to recover individually
for MKI's losses. See Kagan v. Edison Bros. Stores, Inc., 907
F.2d 690 (7th Cir. 1990) (holding that plaintiffs could not
obtain both "limited liability for debts incurred in the
corporate name, and direct compensation for its losses.").
The derivative injury rule, however, will not bar Kaplan's
claims if he seeks to recover for injuries that were inflicted
on him individually rather than on the corporation. See
Kroblin Refrigerated XPress, Inc. v. Pitterich, 805 F.2d 96,
104 (3d Cir. 1986). Since Kaplan signed the Workout
Agreement in his individual capacity and thereby promised
to give First Options his income tax refund, the central
question with respect to the standing issue concerns the
nature of the consideration, if any, that Kaplan himself
received in exchange for this personal commitment. If he
received promises in his individual capacity, he may sue for
the breach of those promises. Id. Likewise, if First Options
materially breached its promises to Kaplan, he may assert
that breach as a defense to First Options' proof of claim.
See generally Regan v. Garfield Ridge Trust & Savings
Bank, 581 N.E.2d 759, 765 (Ill. App. Ct. 1991); Restatement
(Second) of Contracts SS 237, 241 (1979).
A review of the parties' contracts and their positions in
this litigation makes it clear that First Options gave Kaplan
some commitment as consideration for his promise to remit
his tax refund.8 But, while it is clear that Kaplan received
_________________________________________________________________
8. If Kaplan had not received some consideration, his promise to pay
would be an unenforceable gratuitous gift. See Serpe v. Williams, 776 F.
Supp. 1285, 1288 (N.D. Ill. 1991) ("Mutuality of obligation means either
both parties are bound to the agreement or neither party is bound. . . .
7
some consideration for his promise to give up his tax
refund, the parties disagree about exactly what
commitment Kaplan received. An argument could be made
that Kaplan received only a release from personal liability
for MKI's pre-workout debts. Two provisions of the Workout
Agreement specifically mention Kaplan in his individual
capacity. In one of these provisions, Kaplan promises to
give First Options his tax refund. In the other, First Options
releases Kaplan from any personal liability for MKI's pre-
workout deficits.9 Since these are the only provisions in the
agreements that mention Kaplan in his individual capacity,
First Options apparently concludes that Kaplan received
only the release as consideration for his commitment to
surrender his tax refund. If we were to accept this
argument, we would hold that Kaplan has standing to
enforce the release, but does not have standing to assert
claims for a breach of First Options' promise to provide
services to MKI or to assert the breach of those promises as
a defense to First Options' proof of claim.10
_________________________________________________________________
Both parties must be liable to the other for failure to perform his or her
obligation."); Restatement (Second) of Contracts S 71 ("To constitute
consideration, a performance or a return promise must be bargained
for."). However, neither party asserts that Kaplan's promise is anything
but an enforceable commitment.
9. Kaplan has consistently asserted that he is not personally liable for
MKI's debts, but this provision released him from any challenge to that
position.
10. Kaplan argues that, even if he lacks standing to seek recovery from
First Options in his personal capacity, he has standing to assert the
material breach of the parties' agreements as a defense to First Options'
proof of claim. However, we believe that the considerations that govern
Kaplan's standing to bring his counterclaims also determine his standing
to assert the defense of a material breach of the parties' contract. If a
release from liability was the only consideration that Kaplan received for
his tax refund and if First Options honored that release, Kaplan cannot
assert the breach of other promises to other entities as a defense to his
obligation to surrender his refund. However, if the parties intended for
Kaplan to give up his refund to benefit MKI, Kaplan is a direct party to
the contract and may assert a material breach of the promise to benefit
MKI as a defense to First Options' efforts to enforce the contract. See
generally Restatement (Second) of Contracts S 305(1) (noting that a
promisor in a third-party contract has a duty to the promisee to perform,
even though he also has a similar duty to the intended beneficiary).
8
We conclude, however, that the plain text of the parties'
agreements refutes this interpretation. The parties concur
that they executed the Workout Agreement for two
purposes: to resolve their dispute over MKI's pre-workout
debts and to enable MKI to get back into business. The
bankruptcy court noted that the parties intended for the
Workout Agreement to enable MKI to resume trading, see In
re Kaplan, Bankr. No. 93-10625DAS at 4 (Bankr. E.D. Pa.
March 7, 1995), and that interpretation is clearly supported
by the text of the Letter Agreement. The Agreement
acknowledges MKI's debt to First Options and provides a
detailed scheme under which MKI agreed immediately to
pay down the debt by surrendering a list of assets to First
Options. See Joint App. at 75a-90a. Kaplan's promise to
surrender his tax refund is placed in the midst of this list
of assets to be surrendered, and Kaplan's refund is also
specifically earmarked to pay down MKI's debt. See id. at
77a. MKI further promised to infuse new capital into its
trading account and agreed to pay the remainder of its debt
from future trading profits. See id. at 76a-83a, 85a. In
exchange for these assets and promises, First Options
agreed once again to provide the clearing services necessary
to enable MKI to resume trading. See id. at 84a-85a. Based
on these provisions, it is clear to us that the parties
intended for Kaplan to surrender his refund in order to get
MKI back on its feet. In other words, the Agreement
demonstrates that Kaplan exchanged his refund in part for
First Options' promise to provide clearing services and
leverage to assist MKI in its effort to resume trading.
Under this interpretation, MKI is an intended third-party
beneficiary to Kaplan's commitment, and First Options'
corresponding promises to provide services to MKIflow
both to MKI and to Kaplan individually. See generally Olson
v. Etheridge, 686 N.E.2d 563, 566 (Ill. 1997) (noting that a
contract entered into for the direct benefit of a third person
is enforceable in Illinois); Restatement (Second) of Contracts
S 302(1)(b); 17A Am. Jur. 2d ContractsS 440 (1991).
Accordingly, since Kaplan is a direct party to the
Agreement, he has standing to sue for the breach of First
Options' commitment to provide services to MKI. See Olson,
686 N.E.2d at 566 (recognizing that both a promisee and an
intended third party beneficiary may sue to enforce a
9
contract); Buschmann v. Professional Men's Ass'n, 405 F.2d
659, 662 (7th Cir. 1969) ("It is well settled that an
individual cause of action can be asserted when the wrong
is both to the stockholder as an individual and to the
corporation."); Restatement (Second) of Contracts S 305
comment a (noting that a promisee may recover damages
that flow from a promisor's failure to perform to the
intended beneficiary); 17A Am. Jur. 2d Contracts S 436
(recognizing that a promisor owes overlapping duties to a
promisee and a third party beneficiary).11
III.
First Options raises another bar to our consideration of
the merits of Kaplan's claims. First Options asserts that
Kaplan's claims are barred by res judicata and collateral
estoppel because he controlled MKI when First Options and
MKI arbitrated similar claims before the Philadelphia
Exchange. First Options raised this argument before the
bankruptcy court in a motion to dismiss. The bankruptcy
court12 noted that under Pennsylvania's control-of-litigation
rule, a party may be bound by the results of litigation even
if that party, although not a litigant or in privity with a
litigant, was "virtually substituted for the actual party in
the management and control of the litigation." In re Kaplan,
Bankr. No. 93-10625DAS at 18-20 (Bankr. E.D. Pa. Mar. 7,
1995) (quoting Williams v. Lumberman's Ins. Co. of
Philadelphia, 1 A.2d 658, 660-61 (Pa. 1938)). However, the
bankruptcy court denied First Options' motion to dismiss
because it concluded that applying the control-of-litigation
rule to this case would eviscerate the rule that a
_________________________________________________________________
11. Our conclusion that MKI is an intended third-party beneficiary to
Kaplan's promise is sufficient to resolve First Options' assertion that
Kaplan lacks standing. Accordingly, we need not determine what
damages Kaplan may recover if it proves that First Options breached its
promises. See generally Banker's Trust Co. v. Steenburn, 409 N.Y.S.2d
51, 65-69 (N.Y. Sup. Ct. 1978) (discussing one of several measures of a
third party promisee's damages); Restatement (Second) of Contracts
SS 305, 307, 310 (same).
12. Because the district court concluded that Kaplan's counterclaims
lacked substantive merit, it did not address this issue. See Kaplan, Civ.
Action No. 95-6040 at 9.
10
shareholder is generally not precluded by a corporation's
prior litigation.13 See id.We need not decide whether the bankruptcy court
correctly interpreted Pennsylvania law14 because we hold
that the preclusive effect of MKI's prior litigation is
governed by federal, not Pennsylvania, law.
To understand the choice-of-law issue that this case
presents, we must examine how the parties came to this
stage of their litigation. In their previous appeal, the parties
petitioned the federal district court to confirm or vacate the
Philadelphia Exchange's arbitration award. Since the
Federal Arbitration Act does not independently confer
subject matter jurisdiction on the federal courts, see, e.g.,
General Atomic Co. v. United Nuclear Corp., 655 F.2d 968,
970-71 (9th Cir. 1981) (citing cases that stand for this
proposition); TM Marketing, Inc. v. Art & Antiques Assocs.,
L.P., 803 F. Supp. 994, 997-98 (D. N.J. 1992) (same), the
parties invoked the district court's diversity jurisdiction.
See Kaplan, 19 F.3d at 1509. The district court confirmed
the arbitration award against MKI, and it is that judgment
_________________________________________________________________
13. The bankruptcy court also concluded that, for purposes of the
motion to dismiss, First Options failed to show that Kaplan controlled
MKI's prior arbitration.
14. Pennsylvania's appellate courts have repeatedly held that a judgment
against a corporation is not binding on a shareholder or officer of the
corporation in subsequent litigation. See, e.g., Hornstein v. Kramer Bros.
Freight Lines, Inc., 133 F.2d 143, 145-46 (3d Cir. 1943); Amalgamated
Cotton Garment and Allied Indus. Fund v. Campolong, 463 A.2d 1129,
1130-31 (Pa. Super. Ct. 1983); Philadelphia Auburn-Cord Co. v. Shockcor,
2 A.2d 501, 501 (Pa. Super. Ct. 1938); Macan v. Scandinavia Belting Co.,
107 A. 750, 752-53 (Pa. 1919). While Pennsylvania's courts have also
adopted the control of litigation rule, First Options cites no
Pennsylvania
authority that has applied the rule to a closely held corporation. Rather,
Pennsylvania seems to have rejected the position taken in the
Restatement (Second) of Judgments that a judgment against a closely
held corporation is conclusive against the corporation's stockholders. See
Restatement (Second) of Judgments S 59(3) (1982); Macan, 107 A. at 752-
53 (refusing to hold that a corporation's prior litigation was res
judicata
against the corporation's largest shareholder because "[a] corporation
has a separate entity or existence, irrespective of the persons who own
its stock, and this rule is not altered by the fact that the greater
portion
or even the entire issue of stock happens to be held by one person.").
11
that First Options claims has a preclusive effect on
Kaplan's instant litigation.
In contrast to the parties' first case, this litigation was
brought under the federal bankruptcy laws, and therefore
the district court had jurisdiction under 28 U.S.C. S 158(a).
Accordingly, this case presents the question of which law
governs the preclusive effect of a prior federal court
judgment rendered under diversity jurisdiction on a
subsequent case arising under the bankruptcy laws. The
Supreme Court addressed that question in Heiser v.
Woodruff, 327 U.S. 726, 66 S.Ct. 853 (1946). The Court
applied the federal law of res judicata to determine the
preclusive effect of a prior diversity judgment, stating that
"[i]t has been held in non-diversity cases since Erie v.
Tomkins, that the federal courts will apply their own rule of
res judicata." Id. at 733. Accordingly, we will apply federal
preclusion principles to this case.15
_________________________________________________________________
15. This conclusion is supported by the rationale advanced by the
majority of circuits in holding that federal law governs the preclusive
effect of a diversity judgment in a subsequent diversity suit. These
courts
have reasoned that preclusion rules are procedural rather than
substantive, and therefore the Erie doctrine does not require federal
courts to apply state law. See, e.g., Hunt v. Liberty Lobby, Inc., 707
F.2d
1493, 1496 (D.C. Cir. 1983). Moreover, these courts have noted that the
federal courts have a significant interest in determining the preclusive
effect of federal judgments. See, e.g., Johnson v. SCA Disposal Services
of New England, Inc., 931 F.2d 970, 974 n.11 (1st Cir. 1991). As the
Second Circuit stated in Kern v. Hettinger, 303 F.2d 333, 340 (2d Cir.
1962):
One of the strongest policies a court can have is that of
determining
the scope of its own judgments. . . . It would be destructive of
the
basic principles of the Federal Rules of Civil Procedure to say
that
the effect of a judgment of a federal court was governed by the law
of the state where the court sits simply because the source of
federal
jurisdiction is diversity. . . . [I]t would be a strange doctrine
to allow
a state to nullify the judgments of federal courts constitutionally
established and given power also to enforce state created rights.
See also, RecoverEdge L.P. v. Pentecost, 44 F.3d 1284, 1290 n.11 (5th
Cir.1995); Havoco of America, Ltd. v. Freeman, Atkins & Coleman, Ltd.,
58 F.3d 303, 307 (7th Cir. 1995); Shoup v. Bell and Howell, Co., 872
F.2d 1178, 1179 (4th Cir. 1989); Petromanagement Corp. v. Acme-Thomas
12
Although several federal courts have held that a
shareholder is bound by his corporation's prior litigation if
he participated substantially in the suit, see , e.g., In re
Teltronics Servs., Inc., 762 F.2d 185, 191 (2d Cir. 1985) ("A
judgment against a corporation bars later litigation on the
same cause of action by an officer, director, or shareholder
of the corporation if the individual participated in and
effectively controlled the earlier case."), we decline to apply
this rule in the context of this case.
It is cardinal rule that "[a]rbitration is a matter of
contract, and parties are bound by arbitration awards only
if they agreed to arbitrate a matter." E.g., Teamsters Local
Union No. 764 v. J.H. Merritt and Co., 770 F.2d 40, 42 (3d
Cir. 1985). Applying this rule, we concluded in a previous
appeal that Kaplan did not consent to the jurisdiction of the
Exchange's arbitration panel, and we therefore rejected
First Options' attempt to confirm the panel's decision
against Kaplan in his individual capacity. See Kaplan, 19
F.3d at 1510-23. This conclusion was affirmed by the
Supreme Court. See First Options of Chicago, Inc. v. Kaplan,
514 U.S. 938, 947 (1995). See also id. at 942 ("a party who
has not agreed to arbitrate will normally have a right to a
court's decision about the merits of its dispute.").
First Options, however, now asks us to hold that,
although it has already been conclusively adjudicated that
Kaplan withheld consent to be bound personally by the
arbitration award or the prior judgment confirming the
arbitration award against MKI, he is nevertheless bound
because he controlled the prior litigation on MKI's behalf.
We reject First Options' argument. Generally applicable res
judicata rules must sometimes be adapted to fit the
_________________________________________________________________
Joint Venture, 835 F.2d 1329. 1333 (10th Cir. 1988); Precision Air Parts,
Inc. v. Avco Corp., 736 F.2d 1499, 1503 (11th Cir. 1984); Silcox v. United
Trucking Serv., Inc., 687 F.2d 848, 852 (6th Cir. 1982); Restatement
(Second) of Judgments S 87 comment b, at 317-18 (1982); Ronan E.
Degnan, Federalized Res Judicata, 85 Yale L.J. 741, 769-70 (1976).
However, while these authorities persuasively support our conclusion in
this case, we note that this circuit has not yet decided which preclusion
law it will apply in the successive-diversity context. See Venuto v. Witco
Corp., 117 F.3d 754, 758 (3d Cir. 1997).
13
arbitration context. See Dean Witter Reynolds, Inc. v. Byrd,
470 U.S. 213, 222-23 (1985); NLRB v. Yellow Freight
Systems, Inc., 930 F.2d 316, 319-21 (3d Cir. 1991); General
Comm. of Adjustment v. CSX Corp., 893 F.2d 584, 593 n.10
(3d Cir. 1990) ("traditional principles of stare decisis and
res judicata are given significantly less weight in arbitration
proceedings"); Leddy v. Standard Drywall, Inc., 875 F.2d
383, 385 (2d Cir. 1989); Kovats v. Rutgers, 749 F.2d 1041,
1048 (3d Cir. 1984).16 Moreover, we believe that First
Options' argument is inconsistent with the rule that the
scope of the obligation to arbitrate -- and to accept arbitral
decisions -- is defined by contract. An arbitration
agreement may limit its preclusive effects. See Restatement
(Second) of Judgments S 84(4). Where, as in this case, a
corporation agrees to arbitration but the corporation's
principal and sole shareholder withholds such consent, we
presume, in the absence of any contractual provision
addressing the issue of res judicata in so many words, that
the parties agreed that the principal and sole shareholder,
who would necessarily control the corporation's
participation in any arbitration proceeding or litigation,
would not be bound by any arbitral award or judgment
based on the theory that he or she controlled the relevant
proceeding. Any other rule would render essentially
meaningless the principal and sole shareholder's
withholding of consent to be bound personally by the
arbitral award or judgment. For these reasons, we hold that
Kaplan's instant claims are not barred by res judicata.
IV.
We turn now to the merits of Kaplan's counterclaims.
Kaplan asserts that First Options had no contractual right
to assume control of MKI's account, evict MKI from its
offices, or prevent him from running MKI's affairs. Kaplan
_________________________________________________________________
16. Cf. McDonald v. City of West Branch, 466 U.S. 284, 287 (1984)
(holding that federal courts may not apply res judicata or collateral
estoppel to an unreviewed arbitration award in a case brought under 42
U.S.C. S 1983); Kremer v. Chemical Contstr. Corp., 456 U.S. 461, 477
(1982) ("Arbitration decisions . . . are not subject to the mandate of
[the
Full Faith and Credit Statute].").
14
also asserts that First Options improperly dissipated MKI's
assets in the process of liquidating its account. He argues
that these actions breached both the express provisions of
the parties' agreements and First Options' implied covenant
of good faith and fair dealing. Kaplan argues that these
breaches entitle him to damages and also discharge his
obligation to surrender his income tax return.
We begin by considering Kaplan's breach of contract
claim. We analyze a claim for breach of contract byfirst
examining the plain language of the parties' agreements.
See American Flint Glass Workers Union v. Beaumont Glass
Co., 62 F.3d 574, 581 (3d Cir. 1995). Accordingly, we must
look to the language of the parties' contracts to discover the
extent of First Options' rights.
First Options argues that several provisions in the
parties' agreements grant it unfettered discretion to
liquidate MKI's account.17 Thefirst of these provisions
states:
The undersigned [MKI] agrees to keep good, in every
account in which the undersigned has an interest, a
margin satisfactory to you [First Options] from time to
time, and in the event that any such margin shall in
your discretion be deemed insufficient, you shall have
the right, whenever in your discretion you deem it
necessary, to sell any or all of the undersigned's
securities and other property, to buy any or all
securities and other property of which the undersigned
may be short, and to close out any or all outstanding
contracts, all without demand for margin or additional
margin.
The remaining provisions are similar:
4. Clearing Member [First Options] and Clearing
Corporation are each hereby severally authorized
_________________________________________________________________
17. These provisions are embodied in several contracts executed before
and after the 1987 workout: (a) the Combined Market Makers',
Specialists' or Registered Traders' Account Agreement dated June 1,
1987 and (b) the Market Maker's Agreements dated November 15, 1984
and June 1, 1987. As the bankruptcy court found, the two Market
Maker's Agreements are identical.
15
by Member [MKI], whenever it considers it
necessary for its protection, . . . to sell out or buy
in any position or other asset in the Account, to
cancel any open uncleared transaction, to exercise
any option, and to close out the Account in whole
or in part.
5. Any exercise, purchase, sale, buy in, sell out,
netting, liquidation or cancellation made under this
agreement, of the Account or any position or other
assert therein may be made by . . . Clearing
Member, . . .; according to its judgment and
discretion, at public or private sale and without
notice to Member.
As the bankruptcy court concluded, these provisions grant
broad powers to First Options. Specifically, the provisions
authorize First Options to buy assets in which the account
has a short position, sell assets in the account, and close
out the account entirely. Any of these actions may be taken
whenever First Options deems it necessary for its
protection. Accordingly, Kaplan's argument that First
Options was not authorized to liquidate the account once
the TET risk was eliminated is incorrect.
However, the parties' agreements do not grant First
Options unlimited authority. As Kaplan asserts, the
foregoing provisions do not authorize First Options to
purchase new securities unless those securities are
purchased to cover a short position. While the agreement
states that First Options may "sell out or buy in any
position or other asset in the Account," that phrase must
be read in light of the parties' use of language in the
agreement. The parties apparently use the phrases"sell
out" and "buy in" to mean the acts of selling assets in the
account and purchasing assets to cover the account's short
positions. Thus, a "buy in" refers to the power to "buy any
or all securities and other property of which the
undersigned may be short."
Kaplan asserts that First Options "churned" the MKI
account by opening new positions--i.e., purchasing new
securities for which MKI did not have a short position at
the time First Options assumed control. To the extent that
First Options did this, it exceeded its contractual authority.
16
As discussed above, First Options did have the right to
take control of and liquidate the MKI account. However,
First Options' rights did not amount to the unfettered
discretion of absolute ownership. Rather, the agreements
state specifically what actions First Options could take to
liquidate the account. The agreement's language is simply
not broad enough to permit First Options to manage the
account without limitation--buying and selling securities
unrelated to positions in the account until the account's
equity was dissipated. Kaplan offered evidence that First
Options opened new positions that were unrelated to any
preexisting short position.18 Accordingly, we will remand the
case to allow the bankruptcy court to compare the evidence
of First Options' actions to the actions specifically
authorized in the agreement.
V.
Kaplan asserts that First Options' conduct not only
violated the express provisions of the parties' agreements,
but also breached the covenant of good faith and fair
_________________________________________________________________
18. The bankruptcy court stated that Kaplan failed to present sufficient
evidence of such "opening trades" and failed to allege that these trades
decreased the value of MKI's account. See In re Kaplan, Bankr. No. 93-
10625DAS at 18. This conclusion may well be true. We express no
opinion as to the sufficiency of Kaplan's evidence because the parties
have not addressed the issue, First Options has not asserted it as an
alternative basis for affirmance, and we believe that the bankruptcy
court is better suited to compare the evidence with the parties' contracts
since it presided over the trial and is familiar with the complex stock-
trading documentation at issue. Given our conclusion that First Options
did not enjoy unlimited discretion under the parties' contracts, we
remand to allow the bankruptcy court to compare the evidence
supporting Kaplan's various allegations to the specific actions permitted
by the parties' contracts. This comparison need not be limited to opening
trades but could involve any unauthorized activities.
Lastly, we note that the bankruptcy court's statement regarding
Kaplan's evidence assumes that, once Kaplan proves a breach of the
parties' promises, his damages are to be measured by the value of MKI's
account. As previously noted, we do not decide the proper measure of
Kaplan's damages, and we therefore express no opinion on the validity
of this assumption. See supra n.10.
17
dealing implied in every contract. The district court
correctly stated the law on the implied covenant of good
faith and fair dealing:
[U]nder Illinois law, a covenant to deal fairly and in
good faith is implied in every contract. Saunders v.
Michigan Ave. Nat'l Bank, 278 Ill. App. 3d 307, 622
N.E.2d 602, appeal denied, 167 Ill.2d 569, 667 N.E. 2d
1063 (1996); Northern Trust Co. v. VII Michigan Assoc.,
276 Ill. App. 3d 355, 657 N.E.2d 1095 (1995); Abbott v.
Amoco Oil Co., 249 Ill.App.3d 774, 619 N.E.2d 789(1993), appeal denied, 153 Ill.2d 968 (1985). Moreover,
this duty requires the party vested with discretion
under the contract `to exercise that discretion
reasonably and with proper motive, . . . not . . .
arbitrarily, capriciously, or in a manner inconsistent
with the reasonable expectations of the parties.'
Saunders, 662 N.E.2d 602 (quoting Dayan v.
McDonald's Corp., 125 Ill.App.3d 972, 991, 466 N.E.2d
958, 972 (1984)).
In re Kaplan, Civ. Action No. 95-95-6040 at 20.
The bankruptcy and district courts rejected Kaplan's bad
faith claim because they concluded that First Options'
actions in closing the account were specifically authorized
by the parties' agreements. The bankruptcy court stated
that First Options' "right to take control of the Account was
practically unfettered and in its sole discretion" and that
"[n]othing in the Workout Agreement purported to limit or
qualify in any way [First Options'] rights under the Account
Agreements." In re Kaplan, Bankr. No. 93-10625DAS at 14-
15, 24. Accordingly, although the bankruptcy court stated
that First Options' actions were "unorthodox and not
consistent with industry practice" and "were possibly
tainted by personal animus," it concluded that Kaplan's
claim lacked merit. Id., at 24-25.
We agree with the lower courts' conclusion that the
language of the parties' agreements protects First Options'
interest in the account by granting it extraordinarily broad
discretion to eliminate risk and close the account. However,
the agreements do not give First Options the right to act in
bad faith or in a commercially unreasonable manner. The
18
relationship between a margin account customer and
broker is generally that of a pledgor and pledgee. See In re
Rosenbaum Grain Corp., 103 F.2d 656, 661 (7th Cir. 1939);
Restatement of Security S 12 (1941). Accordingly, while the
pledgee may have a discretionary right to liquidate the
margined securities, it must do so in good faith and in a
commercially reasonable manner. See Modern Settings, Inc.
v. Prudential-Bache Sec. Inc., 936 F.2d 640, 644 (2d Cir.
1991) (holding that the discretionary right to liquidate a
securities account must be exercised in good faith); (citing
Cauble v. Mabon Nugent & Co., 594 F. Supp. 985, 992
(S.D.N.Y. 1984)). Accordingly, First Options' argument that
it has "absolute discretion to control risk stemming from
the accounts of its customers, including MKI" is incorrect
insofar as it claims a right to liquidate MKI's account in
bad faith or in a commercially unreasonable manner.19
It is true that the obligation of good faith and fair dealing
cannot be used to negate specific contractual powers, even
if the exercise of those powers causes harsh results. See
Olmos v. Golding, 736 F. Supp. 1472, 1479 n.5 (N.D. Ill
1989); Continental Bank, N.A. v. Everett, 964 F.2d 701, 705
(7th Cir. 1992). "Parties are entitled to enforce the terms of
negotiated contracts to the letter without being mulcted for
lack of good faith: express covenants abrogate the operation
of implied so courts will not permit implied agreements to
overrule or modify the express contract of the parties." RTC
v. Holtzman, 618 N.E.2d 418, 424 (Ill. App. Ct. 1993).
"When a contract is silent, principles of good faith . . . fill
the gap. They do not block the use of terms that actually
appear in the contract." Kham & Nates Shoes No.2, Inc. v.
First Bank, 908 F.2d 1351, 1357 (7th Cir. 1990). However,
in this case the language of the parties agreements provides
that First Options may, in its discretion, buy in, sell out, or
close out the account. Since one purpose of the implied
_________________________________________________________________
19. The Seventh Circuit has stated that Illinois does not recognize an
action for breach of the implied covenant independent of a breach of
contract claim. Continental Bank, 964 F.2d at 705. However, as
discussed above, Kaplan has brought a viable breach of contract claim
alleging that First Options churned the account by opening and closing
new positions not represented in the account at the time First Options
assumed its management.
19
covenant of good faith is to "check the exercise of a party's
discretion under a contract," Bane v. Ferguson, 707 F.
Supp. 988, 994 (N.D. Ill 1989), aff'd, 890 F.2d 11 (7th Cir.
1989); see also Dayan, 466 N.E.2d at 972, First Options'
discretion to take these actions is subject to the
requirement that it exercise that discretion in good faith.
Moreover, while it is true that the implied covenant will not
negate or modify express terms, the terms in the parties'
contracts leave great room for discretion and thus for the
application of the implied covenant.
First Options points out that the bankruptcy court's
opinion contains some language indicating that it did not
act in bad faith. However, those statements are in tension
with the court's statements that First Options' actions were
unorthodox and possibly tainted by personal animus and
with the statement that Kaplan's expectations were"not
necessarily unreasonable." As noted above, the duty of good
faith and fair dealing requires that a party exercise its
discretion "reasonably and with proper motive, . . . not . . .
arbitrarily, capriciously, or in a manner inconsistent with
the reasonable expectations of the parties." In re Kaplan,
Civ. Action No. 95-95-6040 at 20. Accordingly, since First
Options enjoyed a qualified discretion to take control of and
liquidate MKI's account, we will remand to allow the lower
courts to consider whether First Options exercised its
discretion in good faith.
VI.
For the foregoing reasons, we reverse the judgment of the
district court and remand for further proceedings
consistent with this opinion.
A True Copy:
Teste:
Clerk of the United States Court of Appeals
for the Third Circuit
20