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In re Kaplan

June 09, 1998



Before: Nygaard and Alito, Circuit Judges, and Debevoise, District Judge*fn*

The opinion of the court was delivered by: Alito, Circuit Judge:

(Civil Action No. 95-cv-06040)

Argued December 12, 1997

Opinion filed: June 9, 1998


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.


From 1981 to 1989, Manuel Kaplan was a professional options trader on the Philadelphia Stock Exchange. In 1984, Kaplan began trading through MK Investments, Inc. ("MKI"), which was a market maker on the exchange.*fn1 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,*fn2 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 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.*fn3 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.*fn4 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.*fn5 This position exposed MKI to potential losses if the price of TET stock increased.*fn6 Unfortunately for MKI, this potential was realized as Coastal's bid caused 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 ...

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