1998 Decisions

Opinions of the United

States Court of Appeals

for the Third Circuit

6-9-1998

In Re: Kaplan

Precedential or Non-Precedential:

Docket 97-1394

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Recommended Citation

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

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