Wake Forest Law Review

By Mickey Herman

On Thursday, March 30, 2017, the Fourth Circuit issued a published opinion in LVNV Funding, LLC v. Harling, a bankruptcy case. Creditor-appellant, LVNV Funding, LLC (“LVNV”) appealed the bankruptcy court’s decision to sustain Rhodes’ and the Harling’s (collectively “Debtors”) objections to LVNV’s unsecured claims, which were raised after the confirmation date. After rejecting LVNV’s argument that such objections were precluded by the doctrine of res judicata, the Fourth Circuit affirmed the bankruptcy’s judgments.

Facts & Procedural History

In July 2014, Jeffrey Rhodes filed for bankruptcy relief under Chapter 13. Rhodes’ Chapter 13 plan was confirmed in October 2014. In June 2015, Derek and Teresa Harling similarly filed for relief under Chapter 13. Their plan was confirmed in August 2015. The Debtors’ Chapter 13 plans both “provided for treatment of unsecured creditors as a single class,” the members of which would be paid pro rata to the extent that funds remained after payment of all other claims. They also reserved to the Debtors the right to object to claims after plan confirmation.

LVNV filed proofs of claim in each case before the plans were confirmed, and neither the Debtors, nor their trustees, acted on the claims before their plans’ respective confirmations. Following their plans’ confirmations, the Debtors—relying on the reservation of rights clauses—objected to LVNV’s proof of claims, arguing that they were barred by the statute of limitations. Although LVNV conceded that its claims would ordinarily be so barred, it characterized the confirmation orders as final judgments and argued that the Debtors’ objections were precluded under the doctrine of res judicata. The bankruptcy courts disagreed with LVNV and sustained the Debtors’ objections. LVNV appealed, and the Fourth Circuit consolidated the Debtors’ cases.

Analysis

The court began by summarizing the role of res judicata in bankruptcy cases. Because “[a] debtor’s bankruptcy case ‘involves an aggregation of individual controversies,’” the court emphasized that it “may contain many ‘final decisions’ that do not necessarily fit squarely into the conventional formulation of res judicata.” Still, the court emphasized, confirmation orders “have a preclusive effect on those issues litigated at confirmation.” Resolution of the issue, therefore, required the court to consider what issues were determined by the confirmation orders and whether the courts “adjudicate[d] the merits of any individual unsecured creditor’s claim.”

The court first addressed the statutory structure of the Bankruptcy Code. After summarizing the distinctions between treatment of unsecured and secured claims, it emphasized that “[n]o provision of the . . . Code provides for the determination of the merits of an individual unsecured claim within the class of unsecured claims as part of plan confirmation.”

It turned next to the question of whether the elements of res judicata were met in the instant case. “Res judicata applies where three conditions are met: (1) there is a prior judgment, which was final, on the merits, ‘and rendered by a court of competent jurisdiction in accordance with the requirements of due process’; (2) the parties to the second matter are identical to, or in privity with, the parties in the first action; and (3) ‘the claims in the second matter are based upon the same cause of action involved in the earlier proceeding.’” Noting that both parties agree that the confirmation orders constitute final judgments “as to their subject matter” and that the parties were before the court when such confirmations were ordered, the court concluded that the first two elements of the doctrine were met.

The court concluded its analysis by considering “whether the ‘cause of action’ in the later proceeding—the validity of the Debtors’ objections to LVNV’s claims—was any part of the cause of action in the first proceeding, plan confirmation.” Ultimately, the court determined that the causes of action differed in that while the Debtors’ objections focused on LVNV’s claims, the plan confirmations only considered unsecured creditors as a class. This result is necessitated by the structure of the Bankruptcy Code, in which “Congress had made Chapter 13 plan confirmation and claim-allowance on contested unsecured claims to be separate and distinct actions within a . . .  proceeding.”

Conclusion

Rejecting the contention that plan confirmation constitutes a final judgment as to an individual unsecured creditors claim, the Fourth Circuit affirmed, holding that the Debtors’ objections to LVNV’s claims were not barred by the doctrine of res judicata.

By Amanda Whorton

On March 11, 2016, the Fourth Circuit issued a published opinion in the civil case Providence Hall Associates v. Wells Fargo Bank. The court affirmed the district court’s dismissal of Providence Hall Associates’ (“PHA”) lawsuit against Wells Fargo Bank (“Wells Fargo”), holding that it was precluded by res judicata.

The Three Agreements and Bankruptcy Proceedings

PHA, a Virginia limited partnership, entered into three agreements with Wells Fargo. These transactions were a $2.5 million loan, a $500,000 line of credit, and an interest-rate-swap agreement. PHA defaulted on its loans and filed for Chapter 11 bankruptcy in March 2011. Wells Fargo filed a proof of claim in the bankruptcy proceeding for almost $3 million. PHA objected and filed an adversary complaint, alleging that Wells Fargo falsely represented that it would refrain from collecting the principal balance of the line of credit. PHA asserts that this caused it to default and enter bankruptcy.

The U.S. Trustee obtained court approval to sell two of PHA’s properties to satisfy its debts to Wells Fargo. In the Trustee’s sale motions, it requested that the proceeds be distributed to Wells Fargo. In November 2012, after PHA’s debts to Wells Fargo had been satisfied from the proceeds of the sales, the Chapter 11 bankruptcy proceeding was dismissed.

Over a year after the dismissal, PHA filed a suit in Virginia state court repeating the claims it made in the bankruptcy adversary complaint. Wells Fargo removed the suit to federal court and filed a motion to dismiss, which the district court granted on res judicata grounds, stating that the bankruptcy court’s sale orders precluded PHA from bringing this subsequent action.

Doctrine of Res Judicata

Res judicata, or claim preclusion, bars relitigation of issues that were or could have been raised in a previous action when the previous action constituted a final judgment on the merits and was between the same parties or their privies. Three elements of res judicata have to be met in order for it to bar a subsequent action: (1) final judgment on the merits, (2) identical causes of action between the prior and subsequent suits, and (3) identical parties or their privies in the two suits. The court also took into account two practical considerations, which include (1) whether a party or its privy knew or should have known of the claims during the first action, and (2) whether the court that ruled in the first action was an effective forum to litigate the claims.

The Sale Orders Meet the Three Elements of Res Judicata and the Two Practical Considerations

The Fourth Circuit found cases from its sister circuits persuasive in holding that the first prong of the res judicata analysis was met. Bankruptcy sale orders are considered final orders on the merits in the Fifth, Sixth, and Seventh Circuits. The Fourth Circuit further reasoned that the trustee, acting as PHA’s representative, would not have moved to sell the property to satisfy the debt if PHA did not in fact owe the amount that Wells Fargo claimed it was due. These motions to sell effectively conceded the validity of Wells Fargo’s claims and the proceeds of those sales satisfied PHA’s debts. The court reasoned that it would not serve judicial economy and promote finality if PHA was allowed to challenge in a new proceeding the transactions after the sales were made, the debt was satisfied, and the bankruptcy proceeding closed. Furthermore, the fundamental purpose of a Chapter 11 bankruptcy proceeding is the rehabilitation of the debtor. This is served by holding that PHA’s bankruptcy case ended in a final judgment on the merits.

The court held that the second prong of res judicata was also met. The Fourth Circuit uses the transactional approach with this prong: res judicata will bar a new claim if it is based on the same underlying transaction involved in the earlier suit. The court reasoned that the sale orders arose out of the same nucleus of operative facts as PHA’s claims in the current case, which are the three agreements between PHA and Wells Fargo.

The third prong was met, the Fourth Circuit reasoned, because the trustee was in privity with PHA as its representative in the bankruptcy proceeding. The trustee was able to therefore effectively litigate on PHA’s behalf.

The Fourth Circuit Affirmed the District Court

The Fourth Circuit held that PHA’s claims were barred by res judicata and affirmed the district court’s dismissal of PHA’s suit.

By Sarah Saint

In the March 11 civil case Providence Hall Associates Limited Partnership v. Wells Fargo Bank, the Fourth Circuit affirmed the district court’s decision to give res judicata effect to sale orders issued during Providence Hall Associates’ (“PHA”) Chapter 11 bankruptcy and thus dismiss PHA’s lawsuit against Wells Fargo Bank.

Procedural History of the Res Judicata Effect

PHA, a Virginia-based limited partnership, entered three transactions with Wells Fargo’s predecessor-in-interest prior to bankruptcy: (1) a $2.5 million loan, (2) a $500,000 line of credit, and (3) an interest-rate-swap agreement. The loan and line of credit had a cross-default clause–a default on one is a default on both–and were secured by deeds of trust, mortgages, and assignments of rent for PHA real estate holdings. When PHA defaulted on the loans, it filed a petition for Chapter 11 bankruptcy. Shortly after, PHA defaulted on the interest-rate-swap agreement.

Wells Fargo filed a proof of claim in the Chapter 11 case, to which PHA objected, alleging that Wells Fargo falsely represented that it would forbear the collection of the principal balance of the line of credit, which caused PHA to enter bankruptcy. The United States Trustee then moved to convert the Chapter 11 case to a Chapter 7 proceeding or, alternatively, dismiss it because PHA had failed to file monthly reports. Wells Fargo filed a memorandum in support of the motion, repeating that PHA’s principals used Wells Fargo’s cash collateral to pay distributions to themselves. The bankruptcy court decided to appoint a Chapter 11 trustee instead of converting or dismissing the case.

The trustee obtained court approval to sell two of the bankruptcy estate’s properties to satisfy the debts owed to Wells Fargo and bring PHA out of bankruptcy. The sale motions recognized PHA’s obligations to Wells Fargo, and the bankruptcy court noted that PHA was in debt to Wells Fargo in granting the motions. The proceeds of the sales satisfied PHA’s debts to Wells Fargo, and a principal of PHA filed a motion to dismiss the Chapter 11 proceeding, which was granted with the trustee’s consent.

Over a year later, PHA filed suit in Virginia state court, which Wells Fargo removed to federal court, alleging the same claims in the bankruptcy adversary complaint and new theories of lender liability. PHA specifically claimed that the interest-rate-swap transaction was a sham because the rate was illegally manipulated. Wells Fargo then filed a motion to dismiss, which the district court granted on res judicata grounds. PHA subsequently appealed.

Standard of Review and Rules of Law

The Fourth Circuit reviewed de novo the district court’s dismissal based on res judicata. The doctrine of res judicata maintains that a final judgment on the merits precludes the parties from relitigating issues that were or could have been raised in that earlier action. Three elements must be satisfied for res judicata to apply: (1) a final judgment on the merits in a prior suit; (2) an identity of the claim in both the prior and present suit; and (3) an identity of parties or their privies in both the prior and present suit. Additionally, two practical considerations should be taken into account: whether the party knew or should have known of its claims at the time of the first action and whether the court that ruled in the first suit was an effective forum to litigate the other relevant claims.

Prong 1: A Final Judgment on the Merits

The district court used cases from the Fifth, Sixth, and Seventh Circuits to determine that the bankruptcy sale order was a final order on the merits. The Fourth Circuit found those circuit decisions persuasive and also concluded that the first prong of the res judicata test was satisfied. Despite PHA’s attempts to distinguish its suit from the Fifth, Sixth, and Seventh Circuit determinations, the Fourth Circuit found that the distinctions were misplaced, unhelpful, unmeaningful and unpersuasive.

The Court dedicated a large portion of its analysis to PHA’s attempted distinction from the Seventh Circuit decision, where the trustee alleged fraud surrounding the sale proceedings while PHA alleged fraud unrelated to the sale proceedings. The trustee in this case moved to sell PHA’s property to satisfy specific obligations arising out of PHA’s transactions with Wells Fargo, which the bankruptcy court approved. The Court reasoned that it would not make sense to allow PHA to challenge the transactions that gave rise to its now-extinguished debt. In fact, it would upend the purpose of res judicata, to promote finality and judicial economy.

Relying on the other Circuit’s decisions, as well as the purpose of Chapter 11 bankruptcy–to rehabilitate the debtor–the Court concluded that sale orders are final orders on the merit. The fact that a bankruptcy court sale order is an in rem proceeding does not remove in personam lender liability claims arising out of the same claims and involving the same parties from the reach of res judicata. PHA contended that a previous Fourth Circuit decision and a district court decision would decline to give preclusive effect to sale orders. The Fourth Circuit rejected the prior Fourth Circuit decision because the discussion about res judicata in that decision was merely dicta and because PHA’s fraud claims arose out of the same underlying transaction as the sale order. The Fourth Circuit also rejected the district court decision because it is not binding authority, because it involved a lift-stay order and not a sale order, and because it does not make sense to liquidate a bankruptcy estate and then allow claims to be brought against the creditor regarding the now-satisfied debts.

Prong 2: Identity of the Claims

Res judicata bars a second suit if it is based on the same underlying transaction that was involved in the first suit and if it could have been brought in the prior action. The Fourth Circuit concluded that the sale orders arose out of the same nucleus of facts as PHA’s prior claims: the circumstances surrounding the three agreements between PHA and Wells Fargo. Accordingly, the second prong of the res judicata test was met.

Prong 3: Identity of the Parties of their Privies

Even though PHA was not a party to the sale order–the trustee was–the trustee was in privity with PHA as a representative of the debtor’s bankruptcy case. Thus, the third prong of the res judicata test was met.

Practical Considerations

PHA argued that it, as a debtor who was no longer a debtor-in-possession, could not have effectively litigated its claims against Wells Fargo. However, in doing so, the Fourth Circuit reasoned that PHA was relying on a faulty premise because the trustee was the party to the sale order and not PHA. Thus, the question is whether the trustee could have effectively litigated in the bankruptcy court. Because PHA offered no argument that the trustee could not effectively litigate in the bankruptcy court, the Fourth Circuit concluded that the two practical considerations were met.

Conclusion

Because the Fourth Circuit found that the three elements of res judicata were met and the two practical considerations were also satisfied, the Fourth Circuit held that the district court properly dismissed PHA’s suit against Wells Fargo and affirmed the district court’s judgment.

By Taylor Ey

Today, the Fourth Circuit issued its public opinion in Covert v. LVNV Funding, LLC, affirming the decision of the District Court of Maryland, Greenbelt.

Procedural History

In 2008, Plaintiffs Covert, Haworth, Haworth, Ayele, and Brown separately filed petitions for Chapter 13 bankruptcy in Bankruptcy Court for the District of Maryland.  Defendants, LVNV Funding, LLC (“LVNC”) had acquired defaulted debt against each plaintiff.  LVLN filed proofs of claim against each plaintiff.  “A proof of claim is a form filed by a creditor in a bankruptcy proceeding that states the amount the debtor owes to the creditor and the reason for the debt.”  The bankruptcy court confirmed a plan that these claims were to be paid in pro rata amounts.

In March 2013, plaintiffs filed a class-action lawsuit, alleging that defendants had violated the federal Fair Debt Collection Practices Act (“FDCPA”) and Maryland law by filing proofs of claim without a Maryland debt collection license.  The district court granted defendants’ motion to dismiss for failure to state a claim under Fed. R. Civ. Pro. 12(b)(6).

The District Court Properly Dismissed Plaintiffs’ Complaint for Failure to State a Claim

Plaintiffs alleged that the defendants were not legally entitled to collect the debt because they did not have a license at the time they filed in bankruptcy court.  Plaintiffs requested injunctive relief and an instruction requiring defendants to return to the plaintiffs all the money paid pursuant to the proofs of claim.  Defendants asserted that plaintiffs failed to state a claim for which relief could be granted, and thus the claims should be dismissed.  The Fourth Circuit held that the district court properly dismissed the claims, but should have done so on res judicata grounds.

The Doctrine of Res Judicata in the Bankruptcy Context

In bankruptcy cases, prior bankruptcy judgment has res judicata effect when three conditions are met: “(1) the prior judgment was final and on the merits, and rendered by a court of competent jurisdiction in accordance with the requirements of due process; (2) the parties are identical, or in privity, in the two actions; and, (3) the claims in the second matter are based upon the same cause of action involved in the earlier proceeding.”  In re Varat Enters., Inc., 81 F.3d 1310, 1315 (4th Cir. 1996).

The Bankruptcy Court Decision Had Res Judicata Effect

The confirmation of a bankruptcy plan was a final judgment on the merits, and thus the bankruptcy judgment met the first element of the test.

Because both plaintiffs and defendants were parties to the proceedings in the bankruptcy court, the second element was met.

The claims before the district court arose “out of the same transaction or series of transactions, or the same core of operative facts” as those in the bankruptcy court action.  Varat, 81 F.3d at 1316. The plaintiffs would need to rely on the same facts as in the bankruptcy case to succeed in the present action.  Therefore, the bankruptcy judgment met the third element of the test.  Because all three elements are met, the plaintiffs’ claims were barred by res judicata.

The District Court’s Reading of the Cen-Pen Exception Was Too Broad

The district court held that plaintiffs’ claims were not barred by res judicata because it applied the Cen-Pen exception.  In Cen-Pen, the Fourth Circuit held that “[i]f an issue must be raised through an adversary proceeding it is not part of the confirmation process and, unless it is actually litigated, confirmation will not have a preclusive effect.”  Cen-Pen Corp. v. Hanson, 58 F.3d 89, 93 (4th Cir. 1995).

According to the Fourth Circuit, the district court misread Cen-Pen as creating a rule that “plan confirmation does not have preclusive effect to any issue that must have been decided through an adversary process.”

In this case, the Fourth Circuit clarified the rule.  First, the exception is limited to the facts; it applies to cases of secured claims after a bankruptcy proceeding.  In contrast, the present case involved a process used to collect an unsecured claim.  Moreover, because the parties in Cen-Pen were not directly involved in the bankruptcy proceeding that court sought to protect those parties’ rights in the subsequent proceeding.  Instead, the parties in this case were on notice as parties to the previous bankruptcy proceeding and did not need protection.

The District Court’s Decision Is Affirmed

Because plaintiffs did not assert any evidence suggesting that they could not have raised their present claims in the previous action, plaintiffs’ claims were barred.  The Fourth Circuit warned that holding otherwise would run counter to bankruptcy law policy.