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Precedential or Non-Precedential: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

Follow this and additional works at: http://digitalcommons.law.villanova.edu/thirdcircuit_1998

Recommended Citation

"In Re: Kaplan" (1998). 1998 Decisions. Paper 139.

http://digitalcommons.law.villanova.edu/thirdcircuit_1998/139

This decision is brought to you for free and open access by the Opinions of the United States Court of Appeals for the Third Circuit at Villanova

University School of Law Digital Repository. It has been accepted for inclusion in 1998 Decisions by an authorized administrator of Villanova

University School of Law Digital Repository. For more information, please contact Benjamin.Carlson@law.villanova.edu.

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