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D ock e t 97-1394

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. e du/thir dc ir c uit_1998/139Filed 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)

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*The Honorable Dickinson R. Debevoise, Senior Unite d States District Judge for the District of New Jersey, sitting by de signation.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 sho uld reverse the order allowing the claim because First Options materially breached the contracts under which the c laim arose. Concluding that First Options did not breach the parties' contracts, the bankruptcy and district cou rts 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

21984, 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 int o various contracts with First Options. Under these contracts, First Options agreed to act as MKI's cle aring firm, providing a variety of support functions, suc h as generating account statements, keeping records, inv esting short-term funds, providing office space and margin ,2 and guaranteeing MKI's obligations to the exchange. Sin ce First Options assumed the role of MKI's guarantor, the pa rties' contracts granted First Options certain powers over MKI's trading account.

While the business relationship between MKI and Fir st Options was initially profitable, MKI's account wit h First Options suffered approximately $12 million in losse s during

the stock market crash of 1987. These losses left M KI's account with a deficit of approximately $2 million. As MKI's guarantor, First Options was liable for this defici t. First Options therefore attempted to minimize its exposur e by liquidating the remaining positions in MKI's tradin g account. This liquidation created a dispute between the parties as Kaplan asserted that First Options' acti ons 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 part ies settled their dispute and arranged for MKI to resum e its trading activities. This Workout Agreement consiste d of four documents: (1) a Letter Agreement executed by Kapla n, his

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1. A market maker is "a dealer who holds himself ou t . . . as being willing to buy or sell securities for his own accou nt on a continuous basis." Philadelphia Stock Exch. By-Laws S 23-2. Se e also Philadelphia Stock Exch. Guide (CCH) P 1552.

2. Under this margin arrangement, First Options ext ended credit to MKI for trading purposes. By virtue of this leverage, M KI 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 thi s lender-borrower relationship, a clearing firm ordinarily has a secu rity interest in the positions in its customers' trading accounts.

3wife (Carol Kaplan), First Options, and MKI; (2) a Guaranty

executed only by MKI; (3) a Subordinated Loan Agree ment executed by First Options and MKI; and (4) a Subord inated Promissory Note executed by MKI.3 Under the terms o f these documents, MKI agreed to repay more than $5 m illion to cover its trading deficits and various other amo unts that First Options had advanced. MKI also agreed to depo sit $900,000 in new capital into its trading account, t o turn over various other assets to First Options, and to clear its future trading activity exclusively through First O ptions. The Letter Agreement also provided that the Kaplans would file income tax returns to obtain any individual ta x refunds due from 1987 and remit those refunds to First Opti ons.4 In turn, First Options allowed MKI to roll over its de bt 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 marke t opened on January 16, 1989, Coastal Corporation unexpectedly announced a takeover bid for Texas Eas tern Corporation ("TET"), a stock in which MKI had a sig nificant short position.5 This position exposed MKI to poten tial losses if the price of TET stock increased.6 Unfort unately for MKI, this potential was realized as Coastal's bid c aused

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3. Several of these documents involved other partie s not relevant to this appeal.

4. As this court has previously determined in a rel ated appeal, Mr. and Mrs. Kaplan executed this Letter Agreement in their individual capacities, but executed the remaining documents on ly 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 l oss by $150,000 to $170,000.

4TET's price to jump from $30 to $45 before the open ing of

trading on January 16. At the $45 price, MKI would have lost more than $1.5 million if it had purchased eno ugh TET shares to cover its short position. However, becaus e MKI was not required to cover its short position immedi ately, 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 r egain its lost value, while any further increase would have i nflicted

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 p arties agree that MKI was unable to reduce its short posit ion significantly on January 16 despite actively tradin g in TET options and stock. First Options contends that the parties agreed to meet on the morning of January 17 to reas sess MKI's position. Kaplan does not recall such an agre ement 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 s tock or stock options necessary to cover MKI's short pos ition. While this action eliminated any further risk from the TET position, it also locked in MKI's existing losses a nd deprived MKI of the benefit of any future decline in TET's p rice.

First Options personnel confronted Kaplan when he arrived at the exchange later on the morning of Jan uary 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 MK I's trading account. First Options disconnected MKI's p hone lines, removed MKI's traders from the floor of the exchange, canceled MKI's outstanding orders and instructed br okers not to take orders placed by MKI.

MKI's account still had a net value of approximatel y $500,000 when First Options assumed control on Janu ary 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.

5Kaplan filed a bankruptcy petition under Chapter 11 in

February 1993. He subsequently converted his petiti on to Chapter 7. First Options asserted a proof of claim to obtain the income tax refunds mentioned in the parties' Le tter Agreement. In response, Kaplan asserted several counterclaims and defenses against First Options. K aplan argued that First Options' actions in seizing and l iquidating MKI's accounts breached the Workout Agreement and t he 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 cla ims and defenses, holding that the parties' agreements explicitly authorized First Options' actions in seizing and li quidating

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 reco ver personally for damages suffered by MKI. Kaplan resp onds that First Options owed direct contractual duties t o him individually and that his claims are thus for perso nal rather than derivative injuries. The bankruptcy cou rt did not address the standing issue, and the district co urt

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. A pr. 21, 1997).

The derivative injury rule holds that a shareholder (even a shareholder in a closely-held corporation) may no t sue for personal injuries that result directly from injurie s to the corporation. See Singletary v. Continental Ill. Nat 'l Bank & Trust Co., 9 F.3d 1236, 1240 (7th Cir. 1993); 7 Mid -State

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7. Since the contract between Kaplan and First Opti ons contains an Illinois choice-of-law provision, the district and bankruptcy courts correctly applied Illinois law to the contract clai ms at issue. See

Admiral Corp v. Cerullo Elec. Supply Co., 32 F.R.D. 379, 38 1 (M.D. Pa. 1961) (stating that when a contract directs the usage of Illinois law, "the conflict of laws rules of Pennsylvania . . . [requi re a court] to look to

the law of Illinois to determine the rights and obligat ions of the parties in interpreting the contract.").

6Fertilizer v. Exchange Nat'l Bank, 877 F.2d 1333, 1 335 (7th

Cir. 1989); Pitchford v. Pepi, Inc., 531 F.2d 92, 9 7 (3d Cir. 1975). In holding that Kaplan is not personally lia ble 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 1 503, 1513-14 (3d Cir. 1994). Accordingly, since Kaplan c hose to structure his business in the corporate form and re ceived 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 i ndividually for MKI's losses. See Kagan v. Edison Bros. Stores, Inc., 907 F.2d 690 (7th Cir. 1990) (holding that plaintiffs c ould not obtain both "limited liability for debts incurred i n the corporate name, and direct compensation for its los ses.").

The derivative injury rule, however, will not bar K aplan's claims if he seeks to recover for injuries that wer e 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 pr omised to give First Options his income tax refund, the ce ntral question with respect to the standing issue concern s the nature of the consideration, if any, that Kaplan hi mself received in exchange for this personal commitment. If he received promises in his individual capacity, he ma y sue for the breach of those promises. Id. Likewise, if Firs t 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 & Savin gs Bank, 581 N.E.2d 759, 765 (Ill. App. Ct. 1991); Res tatement (Second) of Contracts SS 237, 241 (1979).

A review of the parties' contracts and their positi ons in this litigation makes it clear that First Options g ave Kaplan some commitment as consideration for his promise to remit his tax refund.8 But, while it is clear that Kaplan received

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8. If Kaplan had not received some consideration, h is promise to pay would be an unenforceable gratuitous gift. See Serp e v. Williams, 776 F. Supp. 1285, 1288 (N.D. Ill. 1991) ("Mutuality of ob ligation means either both parties are bound to the agreement or neither party is bound. . . .

7some consideration for his promise to give up his t ax

refund, the parties disagree about exactly what commitment Kaplan received. An argument could be ma de that Kaplan received only a release from personal l iability for MKI's pre-workout debts. Two provisions of the Workout Agreement specifically mention Kaplan in his indivi dual capacity. In one of these provisions, Kaplan promis es to give First Options his tax refund. In the other, Fi rst Options releases Kaplan from any personal liability for MKI 's preworkout deficits.9 Since these are the only provisi ons in the agreements that mention Kaplan in his individual ca pacity, First Options apparently concludes that Kaplan rece ived only the release as consideration for his commitmen t 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 pr ovide services to MKI or to assert the breach of those pr omises as a defense to First Options' proof of claim.10

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Both parties must be liable to the other for failur e to perform his or her obligation."); Restatement (Second) of Contracts S 71 ("To constitute consideration, a performance or a return promise mu st 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 a ny challenge to that position.

10. Kaplan argues that, even if he lacks standing t o seek recovery from First Options in his personal capacity, he has stan ding to assert the material breach of the parties' agreements as a def ense to First Options' proof of claim. However, we believe that the consid erations that govern Kaplan's standing to bring his counterclaims also d etermine his standing to assert the defense of a material breach of the p arties' contract. If a release from liability was the only consideration t hat Kaplan received for his tax refund and if First Options honored that re lease, Kaplan cannot assert the breach of other promises to other entiti es 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 th e promise to benefit MKI as a defense to First Options' efforts to enfor ce the contract. See generally Restatement (Second) of Contracts S 305(1 ) (noting that a promisor in a third-party contract has a duty to th e promisee to perform, even though he also has a similar duty to the inten ded beneficiary).

8We conclude, however, that the plain text of the pa rties'

agreements refutes this interpretation. The parties concur that they executed the Workout Agreement for two purposes: to resolve their dispute over MKI's pre-w orkout debts and to enable MKI to get back into business. The bankruptcy court noted that the parties intended fo r 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 provid es 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 promis e 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 int o its trading account and agreed to pay the remainder of its debt from future trading profits. See id. at 76a-83a, 85 a. In exchange for these assets and promises, First Optio ns 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 par ties intended for Kaplan to surrender his refund in orde r to get MKI back on its feet. In other words, the Agreement demonstrates that Kaplan exchanged his refund in pa rt for First Options' promise to provide clearing services and leverage to assist MKI in its effort to resume trad ing.

Under this interpretation, MKI is an intended third -party beneficiary to Kaplan's commitment, and First Optio ns' corresponding promises to provide services to MKIfl ow both to MKI and to Kaplan individually. See general ly Olson v. Etheridge, 686 N.E.2d 563, 566 (Ill. 1997) (noti ng that a

contract entered into for the direct benefit of a t hird person is enforceable in Illinois); Restatement (Second) o f 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

9contract); Buschmann v. Professional Men's Ass'n, 4 05 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 damag es that flow from a promisor's failure to perform to t he intended beneficiary); 17A Am. Jur. 2d Contracts S 436 (recognizing that a promisor owes overlapping dutie s to a promisee and a third party beneficiary).11

III.

First Options raises another bar to our considerati on of the merits of Kaplan's claims. First Options assert s that Kaplan's claims are barred by res judicata and coll ateral estoppel because he controlled MKI when First Optio ns and MKI arbitrated similar claims before the Philadelph ia Exchange. First Options raised this argument before the bankruptcy court in a motion to dismiss. The bankru ptcy court12 noted that under Pennsylvania's control-of- litigation rule, a party may be bound by the results of litiga tion even if that party, although not a litigant or in privit y with a litigant, was "virtually substituted for the actual party in the management and control of the litigation." In r e Kaplan, Bankr. No. 93-10625DAS at 18-20 (Bankr. E.D. Pa. Ma r. 7, 1995) (quoting Williams v. Lumberman's Ins. Co. of Philadelphia, 1 A.2d 658, 660-61 (Pa. 1938)). Howev er, the bankruptcy court denied First Options' motion to di smiss because it concluded that applying the control-of-l itigation

rule to this case would eviscerate the rule that a

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11. Our conclusion that MKI is an intended third-pa rty beneficiary to Kaplan's promise is sufficient to resolve First Opt ions' assertion that Kaplan lacks standing. Accordingly, we need not det ermine what damages Kaplan may recover if it proves that First Options breached its promises. See generally Banker's Trust Co. v. Steen burn, 409 N.Y.S.2d 51, 65-69 (N.Y. Sup. Ct. 1978) (discussing one of s everal measures of a third party promisee's damages); Restatement (Secon d) of Contracts SS 305, 307, 310 (same).

12. Because the district court concluded that Kapla n's counterclaims lacked substantive merit, it did not address this i ssue. See Kaplan, Civ.

Action No. 95-6040 at 9.

10shareholder is generally not precluded by a corpora tion's

prior litigation.13 See id.

We need not decide whether the bankruptcy court correctly interpreted Pennsylvania law14 because w e hold that the preclusive effect of MKI's prior litigatio n is governed by federal, not Pennsylvania, law.

To understand the choice-of-law issue that this cas e presents, we must examine how the parties came to t his 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 th e Federal Arbitration Act does not independently conf er subject matter jurisdiction on the federal courts, see, e.g., General Atomic Co. v. United Nuclear Corp., 655 F.2 d 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 juri sdiction. See Kaplan, 19 F.3d at 1509. The district court con firmed the arbitration award against MKI, and it is that j udgment

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13. The bankruptcy court also concluded that, for p urposes of the motion to dismiss, First Options failed to show tha t 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 sharehold er or officer of the corporation in subsequent litigation. See, e.g., Ho rnstein 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. Sca ndinavia Belting Co., 107 A. 750, 752-53 (Pa. 1919). While Pennsylvania's courts have also adopted the control of litigation rule, First Optio ns cites no Pennsylvania authority that has applied the rule to a closely he ld corporation. Rather, Pennsylvania seems to have rejected the position ta ken in the Restatement (Second) of Judgments that a judgment a gainst a closely held corporation is conclusive against the corporat ion's stockholders. See Restatement (Second) of Judgments S 59(3) (1982); M acan, 107 A. at 752- 53 (refusing to hold that a corporation's prior lit igation was res judicata against the corporation's largest shareholder becau se "[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 hel d by one person.").

11that First Options claims has a preclusive effect o n

Kaplan's instant litigation.

In contrast to the parties' first case, this litiga tion was brought under the federal bankruptcy laws, and ther efore the district court had jurisdiction under 28 U.S.C. S 158(a). Accordingly, this case presents the question of whi ch law governs the preclusive effect of a prior federal co urt 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 Co urt applied the federal law of res judicata to determin e the preclusive effect of a prior diversity judgment, st ating that "[i]t has been held in non-diversity cases since Er ie v. Tomkins, that the federal courts will apply their o wn rule of res judicata." Id. at 733. Accordingly, we will app ly federal preclusion principles to this case.15

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15. This conclusion is supported by the rationale a dvanced by the majority of circuits in holding that federal law go verns the preclusive effect of a diversity judgment in a subsequent dive rsity suit. These

courts have reasoned that preclusion rules are procedural rather than substantive, and therefore the Erie doctrine does n ot require federal courts to apply state law. See, e.g., Hunt v. Liber ty 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 deter mining 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 C ir. 1991). As the Second Circuit stated in Kern v. Hettinger, 303 F.2 d 333, 340 (2d Cir. 1962):

One of the strongest policies a court can ha ve is that of determining the scope of its own judgments. . . . It wou ld be destructive of

the basic principles of the Federal Rules of Civ il 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 bec ause 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 12 84, 1290 n.11 (5th Cir.1995); Havoco of America, Ltd. v. Freeman, Atki ns & Coleman, Ltd., 58 F.3d 303, 307 (7th Cir. 1995); Shoup v. Bell and Howell, Co., 872F.2d 1178, 1179 (4th Cir. 1989); Petromanagement Co rp. v. Acme-Thomas

12Although several federal courts have held that a

shareholder is bound by his corporation's prior lit igation 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 litigatio n on the same cause of action by an officer, director, or sh areholder of the corporation if the individual participated i n and effectively controlled the earlier case."), we decl ine 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 awar ds only if they agreed to arbitrate a matter." E.g., Teamst ers 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 p revious appeal that Kaplan did not consent to the jurisdict ion of the Exchange's arbitration panel, and we therefore reje cted First Options' attempt to confirm the panel's decis ion against Kaplan in his individual capacity. See Kapl an, 19 F.3d at 1510-23. This conclusion was affirmed by th e Supreme Court. See First Options of Chicago, Inc. v . Kaplan, 514 U.S. 938, 947 (1995). See also id. at 942 ("a p arty who has not agreed to arbitrate will normally have a ri ght 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 adjudicat ed that Kaplan withheld consent to be bound personally by t he arbitration award or the prior judgment confirming the arbitration award against MKI, he is nevertheless b ound because he controlled the prior litigation on MKI's behalf. We reject First Options' argument. Generally applic able res judicata rules must sometimes be adapted to fit the

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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. 1 982); Restatement (Second) of Judgments S 87 comment b, at 317-18 (19 82); Ronan E. Degnan, Federalized Res Judicata, 85 Yale L.J. 741, 769-70 (1976). However, while these authorities persuasively suppo rt our conclusion in this case, we note that this circuit has not yet de cided which preclusion law it will apply in the successive-diversity conte xt. See Venuto v. Witco Corp., 117 F.3d 754, 758 (3d Cir. 1997).

13arbitration 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 de cisis 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.2 d 1041, 1048 (3d Cir. 1984).16 Moreover, we believe that Fi rst Options' argument is inconsistent with the rule tha t the scope of the obligation to arbitrate -- and to acce pt arbitral decisions -- is defined by contract. An arbitration agreement may limit its preclusive effects. See Res tatement (Second) of Judgments S 84(4). Where, as in this ca se, a corporation agrees to arbitration but the corporati on's principal and sole shareholder withholds such conse nt, we presume, in the absence of any contractual provisio n addressing the issue of res judicata in so many wor ds, that the parties agreed that the principal and sole shar eholder, who would necessarily control the corporation's participation in any arbitration proceeding or liti gation, would not be bound by any arbitral award or judgmen t based on the theory that he or she controlled the r elevant proceeding. Any other rule would render essentially meaningless the principal and sole shareholder's withholding of consent to be bound personally by th e arbitral award or judgment. For these reasons, we h old that Kaplan's instant claims are not barred by res judic ata.

IV.

We turn now to the merits of Kaplan's counterclaims

. Kaplan asserts that First Options had no contractua l right to assume control of MKI's account, evict MKI from its offices, or prevent him from running MKI's affairs. Kaplan

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16. Cf. McDonald v. City of West Branch, 466 U.S. 2 84, 287 (1984) (holding that federal courts may not apply res judi cata or collateral estoppel to an unreviewed arbitration award in a ca se brought under 42 U.S.C. S 1983); Kremer v. Chemical Contstr. Corp., 456 U.S. 461, 477 (1982) ("Arbitration decisions . . . are not subjec t to the mandate of [the Full Faith and Credit Statute].").

14also asserts that First Options improperly dissipat ed MKI's

assets in the process of liquidating its account. H e argues that these actions breached both the express provis ions 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 by first examining the plain language of the parties' agreem ents.

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 d iscover 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 provis ions

states:

The undersigned [MKI] agrees to keep good, i n every account in which the undersigned has an inte rest, a margin satisfactory to you [First Options] f rom 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 d eem it necessary, to sell any or all of the undersi gned's securities and other property, to buy any or all securities and other property of which the u ndersigned may be short, and to close out any or all ou tstanding contracts, all without demand for margin or additional margin.

The remaining provisions are similar:

4. Clearing Member [First Options] and Clear ing Corporation are each hereby severally author ized

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17. These provisions are embodied in several contra cts executed before and after the 1987 workout: (a) the Combined Market Makers', Specialists' or Registered Traders' Account Agreeme nt dated June 1, 1987 and (b) the Market Maker's Agreements dated No vember 15, 1984 and June 1, 1987. As the bankruptcy court found, th e two Market Maker's Agreements are identical.

15by Member [MKI], whenever it considers it

necessary for its protection, . . . to sell out or buy in any position or other asset in the Accoun t, to cancel any open uncleared transaction, to ex ercise any option, and to close out the Account in whole or in part.

5. Any exercise, purchase, sale, buy in, sel l out, netting, liquidation or cancellation made un der 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 wi thout

notice to Member.

As the bankruptcy court concluded, these provisions grant broad powers to First Options. Specifically, the pr ovisions authorize First Options to buy assets in which the account has a short position, sell assets in the account, a nd 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 Fir st 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 agre ement states that First Options may "sell out or buy in a ny position or other asset in the Account," that phras e must be read in light of the parties' use of language in the agreement. The parties apparently use the phrases"s ell out" and "buy in" to mean the acts of selling asset s 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 posit ion at the time First Options assumed control. To the exte nt that First Options did this, it exceeded its contractual authority.

16As discussed above, First Options did have the righ t to

take control of and liquidate the MKI account. Howe ver, First Options' rights did not amount to the unfette red discretion of absolute ownership. Rather, the agree ments 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 secu rities unrelated to positions in the account until the acc ount'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 e vidence of First Options' actions to the actions specifical ly authorized in the agreement.

V.

Kaplan asserts that First Options' conduct not only violated the express provisions of the parties' agr eements, but also breached the covenant of good faith and fa ir

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18. The bankruptcy court stated that Kaplan failed to present sufficient evidence of such "opening trades" and failed to all ege that these trades decreased the value of MKI's account. See In re Kap lan, Bankr. No. 93- 10625DAS at 18. This conclusion may well be true. W e 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 th at the bankruptcy court is better suited to compare the evidence with the parties' contracts since it presided over the trial and is familiar wi th the complex stocktrading documentation at issue. Given our conclusio n that First Options did not enjoy unlimited discretion under the partie s' contracts, we remand to allow the bankruptcy court to compare the evidence supporting Kaplan's various allegations to the spec ific actions permitted by the parties' contracts. This comparison need not be limited to opening trades but could involve any unauthorized activitie s.

Lastly, we note that the bankruptcy court's stateme nt regarding Kaplan's evidence assumes that, once Kaplan proves a breach of the parties' promises, his damages are to be measured b y 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 opini on on the validity of this assumption. See supra n.10.

17dealing implied in every contract. The district cou rt

correctly stated the law on the implied covenant of good faith and fair dealing:

[U]nder Illinois law, a covenant to deal fai rly and in good faith is implied in every contract. Sau nders v. Michigan Ave. Nat'l Bank, 278 Ill. App. 3d 3 07, 622 N.E.2d 602, appeal denied, 167 Ill.2d 569, 6 67 N.E. 2d 1063 (1996); Northern Trust Co. v. VII Michi gan 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.2 d 789 (1993), appeal denied, 153 Ill.2d 968 (1985) . Moreover, this duty requires the party vested with dis cretion

under the contract `to exercise that discret ion reasonably and with proper motive, . . . not

. . . arbitrarily, capriciously, or in a manner in consistent with the reasonable expectations of the part ies.' Saunders, 662 N.E.2d 602 (quoting Dayan v. McDonald's Corp., 125 Ill.App.3d 972, 991, 4 66 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 Optio ns' actions in closing the account were specifically au thorized by the parties' agreements. The bankruptcy court st ated that First Options' "right to take control of the A ccount was practically unfettered and in its sole discretion" and that "[n]othing in the Workout Agreement purported to li mit or qualify in any way [First Options'] rights under th e Account Agreements." In re Kaplan, Bankr. No. 93-10625DAS a t 14- 15, 24. Accordingly, although the bankruptcy court stated that First Options' actions were "unorthodox and no t consistent with industry practice" and "were possib ly tainted by personal animus," it concluded that Kapl an'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 extraordinar ily 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

18relationship 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, w hile the pledgee may have a discretionary right to liquidate the margined securities, it must do so in good faith an d in a commercially reasonable manner. See Modern Settings , Inc. v. Prudential-Bache Sec. Inc., 936 F.2d 640, 644 (2 d Cir. 1991) (holding that the discretionary right to liqu idate 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' argum ent that

it has "absolute discretion to control risk stemmin g from the accounts of its customers, including MKI" is in correct insofar as it claims a right to liquidate MKI's acc ount in bad faith or in a commercially unreasonable manner. 19

It is true that the obligation of good faith and fa ir dealing cannot be used to negate specific contractual power s, even if the exercise of those powers causes harsh result s. 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 t he terms of negotiated contracts to the letter without being mu lcted for lack of good faith: express covenants abrogate the operation of implied so courts will not permit implied agreem ents to overrule or modify the express contract of the part ies." RTC v. Holtzman, 618 N.E.2d 418, 424 (Ill. App. Ct. 199 3). "When a contract is silent, principles of good fait h . . . fill the gap. They do not block the use of terms that ac tually appear in the contract." Kham & Nates Shoes No.2, I nc. v. First Bank, 908 F.2d 1351, 1357 (7th Cir. 1990). Ho wever, 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 imp lied

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19. The Seventh Circuit has stated that Illinois do es not recognize an action for breach of the implied covenant independe nt 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.

19covenant 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 Opt ions' discretion to take these actions is subject to the requirement that it exercise that discretion in goo d faith. Moreover, while it is true that the implied covenan t will not negate or modify express terms, the terms in the pa rties' 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 d id not act in bad faith. However, those statements are in tension with the court's statements that First Options' act ions 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 exerci se its discretion "reasonably and with proper motive, . . . not . . . arbitrarily, capriciously, or in a manner inconsist ent with the reasonable expectations of the parties." In re Kaplan, Civ. Action No. 95-95-6040 at 20. Accordingly, sinc e First Options enjoyed a qualified discretion to take cont rol of and liquidate MKI's account, we will remand to allow th e 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