In a series of opinions issued by the U.S. Bankruptcy Court for the Eastern District of Arkansas in the chapter 11 of Hoffinger Industries Inc. (the debtor),² J.M. Capital Finance Ltd. went from being a secured creditor—which, in exchange for its consent for the debtor to use its cash collateral, received a superpriority administrative expense and replacement liens—to a creditor whose pre-petition secured claim was disallowed and recharacterized as equity (and to the extent that JM Capital had any claim, it was subordinated under §510(c) of the Bankruptcy Code.) This column is not intended to address the equitable subordination or recharacterization aspect of the bankruptcy court’s opinions; rather, it will address the court’s analysis in “reconsidering” the cash collateral order that granted JM Capital (at least that’s what it thought) an allowed secured claim with a superpriority administrative expense and adequate protection liens, and ways that a secured creditor may be able to protect itself from an attack.

Brief Background

JM Capital and the debtor were related entities by which each entity shared, albeit indirectly, some of the same equity-holders. JM Capital’s principal business activity “was to provide financing to the debtor.”³ JM Capital and the debtor collectively represented that JM Capital had lent the debtor $10 million pre-petition, which was secured by liens on certain collateral.

The debtor filed for chapter 11 on Sept. 13, 2001, as a result of a $13.5 million personal-injury judgment in favor of Leesa Bunch.⁴ Shortly after the filing, the debtor filed a motion requesting authorization to use cash collateral and to obtain secured debt. The debtor sought to enter into a $10 million line of credit with another related entity, C.M.A. Corp. JM Capital agreed to subordinate its $10 million pre-petition loan and to permit the use of its cash collateral on the condition that it received replacement liens and a superpriority administrative expense claim.⁵

The court entered an order authorizing the debtor to obtain the $10 million line of credit, authorizing the debtor to use cash collateral, subordinating JM Capital’s pre-petition liens and granting JM Capital a superpriority administrative expense claim and replacement liens. The order included a provision that required the debtor to assert any cause of action or defense against JM Capital within 90 days after the entry of the order, and provided that if the debtor failed to pursue any cause of action within that 90-day window, “the creditors’ committee or other party in interest may assert or otherwise pursue the JM causes of action within 120 days following the entry of the final order... granting the motion and approving the use of cash collateral pursuant to this agreement.”⁶ The opinions do not state whether the cash collateral order expressly allowed the claim as a secured claim.

Ms. Bunch and McMasker Enterprises Inc. (the plaintiffs) did not assert any claims or defenses against JM Capital within the 120-day window. Rather, on Aug. 6, 2004, almost three years after entry of the cash-collateral order, the plaintiffs filed a complaint against JM Capital requesting the court to, among other things, (1) reconsider the liens granted as adequate protection to JM Capital in the Nov. 21, 2001, cash-collateral order, (2) disallow JM Capital’s claim or reclassify the claim as equity, and (3) equitably subordinate JM Capital’s claims to the claims of all other creditors of the debtor.

JM Capital responded by filing a motion for summary judgment.⁷ JM Capital argued that since the plaintiffs did not bring their action within the 120-day window as provided by the cash-collateral order, the plaintiffs were now barred by the doctrine of res judicata. Additionally, it argued that the plaintiffs were time-barred by the one-year limitation period under Rule 60(b) of the Federal Rules of Civil Procedure (Federal Rules), and to the extent that the one-year limitation did not apply, the plaintiffs failed to bring their action within a reasonable time.⁸

The court denied JM Capital’s motion for summary judgment. The court held that the 90-day and 120-day windows established in the cash-collateral order did not prevent creditors from bringing their own causes of action against JM Capital; rather, the time limitations only prevented the debtor and creditors from bringing causes of action belonging to the debtor.⁹ Since the plaintiffs were bringing their own causes of action (equitable subordination and recharacterization), the plaintiffs were not barred by the doctrine of res judicata.¹⁰ Additionally, the court held that it could reconsider JM Capital’s claim, even if previously allowed by a final order, for cause under §502(j) of the Code, and as a result, the court disallowed the secured claim and recharacterized the $10 million “loan” as equity.¹¹

Res Judicata Not Applied to the Cash Collateral Order

The court recognized that the Eighth Circuit employs a three-element test to determine whether res judicata applies to a given cause of action.¹² The elements in the Eighth Circuit are as follows:

1. a court of competent jurisdiction rendered the prior judgment;
2. the prior judgment was a final judgment on the merits; and
3. both cases involve the same cause of action and the same parties.

The bankruptcy court easily concluded that the first element was met, since the cash-collateral order was entered by the court. Second, the court assumed without deciding that the cash-collateral order was a final order on the merits, even though the order was titled “Final Order Authorizing Debtor to Use Cash Collateral Order....” The court, however, held that the third element was not met. In other words, the hearing on cash collateral and the trial on recharacterization/equitable subordination and objection to claim did not involve the same cause of action and the same parties.¹³

The court explained that “if a case arises out of the same nucleus of operative fact, or is based upon the same factual predicate, as a former action...the two cases are really the same ‘claim’ or ‘cause of action’ for purposes of res judicata.”¹⁴ The court then recognized that the factual predicate of a cash-collateral hearing is whether the debtor should be authorized to use cash collateral. The court explained that a hearing on authority to use cash collateral is brought before a court immediately after the filing of the petition, and creditors do not understand the financing relationships between the debtor and its financiers. At a cash-collateral hearing, the court is not called upon to examine the credit history of the debtor, but whether, and to what extent, the debtor can use cash collateral.¹⁵

Section 502(j) and Rule 9024

The court also held that it could reconsider any allowed claim for cause, and then disallow that claim according to the equities of the case. Although cause is not defined by the Code, the court equated a §502(j) motion with a motion for relief from judgment under Federal Rule 60(b), which is incorporated into the bankruptcy arena by Bankruptcy Rule 9024. However, as the court noted, some courts apply the standards outlined in Federal Rule 60(b) for relieving a party from a judgment only when the claim was actually litigated.¹⁶ A bankruptcy court in the Eighth Circuit can reconsider a claim allowed or disallowed without a contest under §502(j) of the Code by considering “whether delay would prejudice the debtors or other creditors, the reason for the delay and its length and impact on efficient court administration, whether the creditor acted in good faith, whether clients should be penalized for counsel’s mistake or neglect, and whether claimants have a meritorious claim.”¹⁷

The court concluded that it could reconsider JM Capital’s secured claim under the less-stringent “without a contest” standard of §502(j) to the extent that the claim was actually allowed by the cash collateral order. First, it appeared to the court that JM Capital did not actually have a fully secured claim. Second, and probably more important to the court, any debt funded by JM Capital to the debtor was used to pay interest on equity and, in effect, decreased its ability to pay large judgments, such as Ms. Bunch’s judgment.¹⁸ The court also found that the plaintiffs had acted in good faith, and since no distributions had been made by the debtor, nobody would be prejudiced. Thus, the court reconsidered JM Capital’s claim and held that it did not have a claim as a secured creditor, or as a creditor at all.¹⁹

A Look at the Code and Rules

The U.S. Supreme Court first formulated the res judicata doctrine in Cromwell v. County of Sac, 94 U.S. 351, 352, 24 L.Ed. 195 (1876):

[T]he judgment, if rendered on the merits, constitutes an absolute bar to a subsequent action. It is a finality as to the claim or demand in controversy, concluding parties and those in privity with them, not only as to every matter which was offered and received to sustain or defeat the claim or demand, but as to any other admissible matter which might have been offered for that purpose.

The policy behind the res judicata doctrine is that “[a]ll facts, allegations and legal theories which support a particular claim, as well as all possible remedies and defenses, must be presented in one action or are lost.”²⁰ Indeed, res judicata is designed to prevent the relitigation of issues that already have or could have been litigated.²¹

Res judicata applies equally in bankruptcy courts as it does in other civil cases.²² However, §502(j) of the Code creates a narrow exception to the common law principle.²³ Under §502(j), a court may reconsider a claim that has been allowed or disallowed for cause. Thereafter, a court may enter an order allowing or disallowing a claim based on the equities of the case.²⁴ Res judicata therefore should apply to orders allowing or disallowing claims, at least to the extent that there is no reason to revisit the issues under §502(j), Bankruptcy Rule 9024 and Federal Rule 60(b).²⁵

Since “cause” is not defined by the Code, many courts have adopted the standards set forth in Federal Rule 60(b) for motions to reconsider filed after 10 days after entry of the order to determine whether cause exists to reconsider the claim.²⁶ Under this approach, a court may reconsider an order allowing or disallowing a claim for the following reasons:

1. mistake, inadvertence, surprise or excusable neglect;
2. newly discovered evidence that by due diligence could not have been discovered in time to move for a new trial under Rule 59(b);
3. fraud (whether...denominated in-trinsic or extrinsic), misrepresentation or other misconduct of an adverse party;
4. the judgment is void;
5. the judgment has been satisfied, released, or discharged...; or
6. any other reasons justifying relief from the operation of the judgment.

Although Federal Rule 60(b) requires a motion to be filed within a reasonable time, the Rule requires a motion based on paragraphs 1, 2 and 3 above to be filed no later than one year after entry of the order. Bankruptcy Rule 9024 does not require “a motion...for reconsideration of an order allowing or disallowing a claim against the estate entered without a contest” to be filed within the one-year limitation. Conversely, an order allowing or disallowing a claim entered after a contested hearing must be brought within one year after entry of the order. Thus, if cause does not exist under §502(j)—and as a result, there are no Rule 60(b) grounds—and the elements for res judicata are met, a party in interest should be barred from relitigating an order allowing a secured claim.

Conclusion

In light of these three opinions issued in Hoffinger Industries, what steps can a secured creditor consenting to the use of its cash collateral do to protect itself from an attack by a party in interest?²⁷ First of all, if grounds exist under §502(j) and Bankruptcy Rule 9024 to vacate an order allowing a claim, res judicata will not apply.²⁸

Second, the Bankruptcy Rules and Code may provide the answer to the question. Under Bankruptcy Rule 9014, motions to prohibit, condition or use cash collateral are contested matters,²⁹ and thus the one-year limitation under Bankruptcy Rule 9024 and Federal Rule 60(b) should apply to a cash-collateral order.

When obtaining an allowed secured claim through the cash-collateral process then, the secured creditor may consider requiring the debtor to (a) serve the motion for authorization to use cash collateral on all creditors, (b) include a provision in the notice of motion that the secured creditor will put on evidence establishing its secured claim, and that the debtor and secured creditor will request the court to make a final adjudication on the merits concerning its claim, and (c) serve all creditors with a proposed order incorporating those provisions.³⁰ In the notice and proposed order, counsel should also consider including a limitations window similar to the window in the Hoffinger Industries cash-collateral order. Additionally, counsel should include in the notice and proposed order that the final order authorizing the use of cash collateral will not only bar any subsequent litigation on causes of action belonging to the debtor, but the order will also bar any causes of action belonging to parties in interest that fail to act within the limitations period established by the order. Finally, the secured creditor should file, prior to the final cash-collateral hearing, a proof of claim evidencing its secured status along with supporting documentation such as promissory notes, mortgages, security agreements and evidence of perfection of lien. These steps will help the creditor contend in subsequent litigation that the order allowing its secured claim is a final order protected by res judicata.

Even if no objections to the motion are filed, res judicata should still apply since the secured creditor put on evidence of its secured claim, the court entered a final order on the merits, a court of competent jurisdiction rendered the opinion, and both cases involve the same cause of action and the same parties. As stated above, res judicata is designed to prevent the relitigation of issues that already have or could have been litigated. If a party in interest fails to object to the allowance of the secured creditor’s claim under the cash-collateral order, res judicata should apply since the party in interest will have had an opportunity to object—unless, of course, a court revisits the issue under the limited grounds authorized by §502(j), Bankruptcy Rule 9024 or Federal Rule 60(b). n

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Footnotes

1 Mr. Misken began representing Hoffinger Industries Inc. in its chapter 11 in August 2004. Mr. Misken did not participate in the cash collateral hearing or the adversary proceeding discussed in this article.
2 Bunch v. JM Capital Fin. Ltd. (In re Hoffinger Indus. Inc), 321 B.R. 515 (Bankr. E.D. Ark. 2005) (Hoffinger I); Bunch v. JM Capital Fin. Ltd. (In re Hoffinger Indus. Inc.), 323 B.R. 681 (Bankr. E.D. Ark. 2005) (Hoffinger II); Bunch v. JM Capital Fin. Ltd. (In re Hoffinger Indus. Inc.), 327 B.R. 389 (Bankr. E.D. Ark. 2005) (Hoffinger III).
3 Hoffinger III, 327 B.R. at 401.
4 Id. at 394.
5 Id. at 406.
6 Hoffinger I, 321 B.R. at 517. “JM causes of action” was defined in the order as “any and all defenses, affirmative defenses, counterclaims, causes of action, rights of set-off the debtor may have against JM or any other objections to the claims or liens of JM whether pre-petition or post-petition, including but not limited to any claims or rights under §§547, 548, 549, 550 and 553....”
7 JM Capital previously filed a motion to dismiss based on the same theories, and the court denied the motion. In the motion for summary judgment, JM Capital sought, as an alternative, for the court to reconsider its previous denial of JM Capital’s motion to dismiss.
8 Id.
9 Hoffinger I, 321 B.R. at 517.
10 Id. at 520.
11 Hoffinger III, 327 B.R. at 411-12.
12 Hoffinger I, 321 B.R. at 518 (citing Canady v. Allstate Ins. Co., 282 F.3d 1005, 1014 (8th Cir. 2002)).
13 Id. at 518.
14 Id. at 519 (citing Ruple v. City of Vermillion S.D., 714 F.2d 860, 861 (8th Cir. 1983)).
15 The court also pointed out that JM Capital did not file a proof of claim until after the 120-period in the cash collateral order expired. As a result, even if the plaintiffs wanted to object to the validity of JM Capital’s claim within the 120-day window, they were unable to do so. In other words, “[w]ithout the claim, the present adversary proceeding and the earlier cash-collateral hearing could not have been based on the same factual predicate.” Therefore, the cash-collateral order was not res judicata to the plaintiffs’ equitable subordination or recharacterization causes of action. The court did not state whether the debtor listed JM Capital on its schedules with a $10 million secured claim. Under Bankruptcy Rule 3003(b)(1), the debtor’s schedules “constitute prima facie evidence of the validity and amount of the claims of creditors, unless they are scheduled as disputed, contingent or unliquidated.”
16 Hoffinger III, 327 B.R. at 411 (citing In re Gomez, 250 B.R. 397, 400 (M.D. Fla. 1999)).
17 Id. (citing Kirwan v. Vanderwerf (In re Kirwan), 164 F.3d 1175, 1177 (8th Cir. 1999)).
18 Hoffinger III, 327 B.R. at 412.
19 Id.
20 18 Moore’s Federal Practice-Civil §131.01 (LexisNexis 2005).
21 Id.
22 See, e.g, Katchen v. Landy, 382 U.S. 323, 334, 86 S.Ct. 467, 475, 15 L.Ed.2d 391 (1966) (“the normal rules of res judicata and collateral estoppel apply to the decisions of the bankruptcy courts”); 641 Avenue of the Americas Ltd. P’ship. v. 641 Assocs. Ltd., 189 B.R. 583, 588 (S.D.N.Y. 1995).
23 In re Gomez, 250 B.R. 397, 400 (Bankr. M.D. Fla. 1999) (stating that §502(j) of the Code creates “a narrow exception to the otherwise unwavering bar which §1327(a) places upon relitigation of claim allowance after confirmation”).
24 Bankruptcy Rule 3008 implements §502(j) of the Code and provides that:
[a] party in interest may move for reconsideration of an order allowing or disallowing a claim against the estate. The court after notice and a hearing shall enter an appropriate order.
25 See 4 King, Lawrence P., Collier on Bankruptcy ¶502.11[3] (15th ed.rev. 2005) (“to the extent a claim has been allowed or disallowed pursuant to an adversary proceeding or other contested litigation process, however, the rules of finality and appeal might apply and thus review may be available under Bankruptcy Rule 9024 but not §502(j)”).
26 See, e.g., Above the Belt Inc. v. Bohannon Roofing Inc., 99 F.R.D. 99, 101 (E.D. Va. 1983). For motions brought within 10 days after entry of the order, courts look at Federal Rule 59(a). Under Federal Rule 59(a), a bankruptcy court may grant a new trial for “any of the reasons for which rehearings have...been granted in suits in equity in the courts of the United States.” Although there is no fixed standard that applies to Federal Rule 59(a) relief, “[t]he general grounds for a new trial are [among others,] the verdict is against the clear weight of the evidence...that the trial was not fair, or that substantial errors occurred in the admission or rejection of evidence....” 12 Moore’s Federal Practice-Civil §59.13.
27 Under BAPCA, a chapter 11 debtor may file a plan within 120 days after the entry of the order for relief. The court may extend that time period for cause, but may not extend the time period beyond 18 months after entry of the order for relief. Thus, unlike the adversary proceeding in Hoffinger Industries mentioned above, a creditor should not be able to attack an allowed claim of a secured creditor three and a half years after entry of a cash collateral order.
28 See, e.g., In re Firrone, 272 B.R. 213, 217 (Bankr. N.D. Ill. 2000).
29 Bankruptcy Rule 4001(a)(1) and (b)(1).
30 Bankruptcy Rule 4001 requires a motion to prohibit, condition or use cash collateral to be served on the creditors’ committee and, if one has not been appointed, upon all creditors listed on the list of creditors. See Spartan Mills v. Bank of America Ill., 112 F.3d 1251, 1257 (4th Cir. 1997) (“due process requires that in order for a proceeding to be accorded finality, notice must be given that is ‘reasonably calculated, under all the circumstances, to apprise interested parties of the pendency of the action and afford them an opportunity to present their objections’”). If the secured creditor is filing the motion to prohibit or condition the use of cash collateral, the secured creditor can include the above mentioned provisions in the motion, notice and order.