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Seventh Circuit Suggests Supreme Court's Recent Ruling May Affect Split of Authority Regarding Application of Res Judicata to Bankruptcy Claims

Wednesday, August 10, 2011

Matrix IV, Inc. v. American Nat’l Bank, No. 08-3917, 2011 BL 196599 (7th Cir. July 28, 2011) The United States Court of Appeals for the Seventh Circuit affirmed a district court’s dismissal of a creditor’s RICO and fraud claims against a lender and an insider company of the debtor, holding that the claims were barred by collateral estoppel because they had been previously litigated in the debtor’s bankruptcy. While ultimately deciding the issue on collateral estoppel grounds, the Seventh Circuit’s decision is notable in its discussion of the Supreme Court’s recent decision in Stern v. Marshall, 131 S.Ct. 2594 (2011), and its suggestion that the decision may affect a lop-sided split of authority among the circuit courts regarding whether a core ruling in a bankruptcy suit is res judicata as to noncore claims.

Bankruptcy Court Rejects Matrix’s Fraud and Equitable Subordination Claims

Following its chapter 11 bankruptcy filing, S.M. Acquisition Co., a plastic-container company doing business as “Stylemaster, Inc.” (“Stylemaster”) formed a new company, which purchased Stylemaster’s assets through the bankruptcy. Strenuously opposing the sale, Matrix IV, Inc. (“Matrix”), a supplier of Stylemaster, alleged that Stylemaster had fraudulently induced it to produce plastic storage containers without any intention of paying for them. According to Matrix, the object of this scheme was to build up Stylemaster’s inventory so that a successor/insider company could purchase the assets at a firesale in bankruptcy. At the same time, Matrix also objected to the claimed lien of American National Bank and Trust Company of Chicago (“ANB”), arguing that ANB’s lien should be equitably subordinated because ANB participated in the fraud by lending Stylemaster money and conspiring to destroy Matrix’s lien. Ultimately, the bankruptcy court rejected all of Matrix’s fraud claims, holding that there was no evidence to support the claim of fraud in the sale process and ABN’s conduct was neither unfair nor inequitable.

District Court Dismisses Matrix’s RICO and Common Law Fraud Claims

After suffering defeat in the bankruptcy case, Matrix filed a suit in district court against ANB and Gateway Park, LLC (“Gateway), a company formed by Stylemaster, alleging RICO and common law fraud claims (“RICO Action”). Matrix’s claims were once again based on the allegation that the defendants had schemed to defraud Matrix by building up Stylemaster’s inventory, refusing to pay Matrix’s invoices and allowing an insider company to buy Stylemaster’s inventory at a firesale price. Ultimately dismissing the RICO Action, the district court held that because Maxtrix’s RICO and common law fraud claims were compulsory counterclaims that could have been brought in the bankruptcy, they were barred by res judicata and collateral estoppel. Matrix then appealed the district court’s ruling to the Seventh Circuit.

Doctrines of Collateral Estoppel and Res Judicata

Rendering its decision on appeal, the Seventh Circuit began by establishing that res judicata, or claim preclusion, bars “not only those issues actually litigated in the prior suit, but all other issues which could have been brought.” Aaron v. Mahl, 550 F.3d 659 (7th Cir. 2008). To this end, the Seventh Circuit found that res judicata has three elements: (1) an identity of the parties or their privies, (2) an identity of the cause of action, and (3) a final judgment on the merits. Alvear-Velez v. Mukasey, 540 F.3d 672 (7th Cir. 2008). In contrast, the Seventh Circuit observed that collateral estoppel, or issue preclusion, is narrower, requiring that: (2) the issue sought to be precluded is the same as that involved in the prior litigation, (2) the issue was actually litigated, (3) the issue was essential to the final judgment, and (4) the party against whom estoppel is invoked was fully represented in the prior action. H-D Mich., Inc. v. Top Quality Serv., Inc., 496 F.3d 755 (7th Cir. 2007).

Seventh Circuit Rules Matrix’s RICO Action Was Barred by Collateral Estoppel

Applying the concepts of collateral estoppel to the present case, the Seventh Circuit concluded that because the claims in the RICO Action were based on the same core of operative facts as the claims Matrix had litigated in the bankruptcy court, the claims were barred by the doctrine of collateral estoppel, irrespective of whether they were based on differing legal theories. See Alvear-Velez, 540 F.3d at 677. While Matrix insisted that the claims could not be the same because the alleged RICO Action included some claims that occurred subsequent to Stylemaster’s bankruptcy, the Seventh Circuit found that nearly all the facts comprising the alleged fraudulent scheme predated Stylemaster's bankruptcy filing and that, without such claims, Matrix had no RICO or common law fraud claim. Also rejecting Matrix’s contention that it never actually presented allegations of conspiracy to defraud before the bankruptcy court, the Seventh Circuit alternatively resolved that Matrix’s objection to the asset sale and equitable subordination defense turned entirely on allegations that a fraudulent scheme was afoot and it was immaterial for res judicata purposes under which legal theory the claims were presented. Finally, the Seventh Circuit found that the bankruptcy court had rendered final judgment on the merits of these claims by confirming the asset sale and dismissing Matrix’s equitable subordination defense. Therefore, based on these findings, the Seventh Circuit held that the elements of collateral estoppel had been established, such that the RICO Action was barred. In so holding, the Seventh Circuit emphasized that its decision was consistent with case law arising in the circuit, including In re Met-L-Wood Corp., 861 F.2d 1012 (7th Cir. 1988), holding that res judicata barred a bankruptcy trustee from filing a RICO suit against the debtor and others based on their involvement in a bankruptcy asset sale after the sale had been confirmed. See also Crop-Maker Soil Services v. Fairmount State Bank, 881 F.2d 436 (7th Cir. 1989).

Affect of the Supreme Court’s Recent Ruling in Stern

Notwithstanding this ruling, the Seventh Circuit proceeded to discuss a lop-sided split of authority among the circuit courts regarding the proper application of the doctrine of res judicata to bankruptcy claims. In this regard, the Seventh Circuit cited its previous decision in Barnett v. Stern, 909 F.2d 973 (7th Cir. 1990), holding that a bankruptcy court’s resolution of a core claim is not res judicata as to a noncore claim that could have been brought in the bankruptcy court, even where the claim arose out of the same transaction and operative facts. At the same time, however, the Seventh Circuit observed that the Barnett opinion did not mention the Met-L-Wood or Crop-Maker decisions, even though its holding would have dictated a different result in those cases. Similarly, the Seventh Circuit noted that the circuit has continued to apply res judicata in the bankruptcy context post-Barnett without reference to core/noncore distinction, see, e.g., ITOFCA, Inc. v. MegaTrans Logistics, Inc., 322 F.3d 928 (7th Cir. 2003), and every other circuit to have addressed the issue has rejected the core/noncore distinction for purposes of deciding the claim-preclusive effect of judgments entered in bankruptcy proceedings. See, e.g., Plotner v. AT&T Corp., 224 F.3d 1161 (10th Cir. 2000). Most notably, however, the Seventh Circuit took note of the Supreme Court’s recent decision in Stern v. Marshall, 131 S.Ct. at 2594, in which the court held that Article III did permit the bankruptcy court to hear and finally decide a counterclaim alleging a state common law tort claim, even though Congress had, in § 157(b)(2)(c), designated this kind of claim as a “core” proceeding. Based on this ruling, the Seventh Circuit suggested that resolving the split of authority regarding the proper application of res judicata as to noncore bankruptcy claims was, perhaps, more complicated than the case law presently admits. Nevertheless, the Seventh Circuit declined to weigh in on the controversy and instead decided the instant case on the narrow grounds that the Barnett decision does not apply to collateral estoppel and the elements of collateral estoppel had been satisfied with respect to Matrix’s claims. Barnett, 909 F.2d at 978 n. 5. Accordingly, the Seventh Circuit ruled that Matrix was collaterally estopped from relitigating the RICO Action.

Seventh Circuit Affirms District Court’s Decision

Ultimately affirming the district court’s decision, the Seventh Circuit held that Matrix was collaterally estopped from relitigating the fraud issues raised by the RICO Action because they were based on the same core of operative facts raised in the Stylemaster’s bankruptcy. The case is, however, most notable in that it raises the issue whether, in light of the Stern decision, non-core claims which are raised or could have been raised in a prior bankruptcy proceeding are barred by res judicata in subsequent proceedings. Disclaimer This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy. ©2014 The Bureau of National Affairs, Inc. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of The Bureau of National Affairs, Inc.

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