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Kmart Corp. v. Capital One Bank

January 4, 2006

IN THE MATTER OF KMART CORPORATION, DEBTOR-APPELLEE
v.
APPEAL OF: CAPITAL ONE BANK; CAPITAL ONE, F.S.B.; AND CAPITAL ONE SERVICES, INC., APPELLANTS



Appeal from the United States District Court for the Northern District of Illinois, Eastern Division. No. 03 C 8625-Rebecca R. Pallmeyer, Judge.

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

ARGUED OCTOBER 28, 2005

Before EASTERBROOK, MANION, and ROVNER, Circuit Judges.

One of the many contested matters in Kmart's bankruptcy was whether the debtor could assume an executory contract with Capital One Bank providing for a co-branded credit card. Kmart wanted to continue the arrangement, while Capital One did not want its brand to be associated with a bankrupt retailer. After a trial, Bankruptcy Judge Sonderby held that Kmart is entitled to assume the contract, and District Judge Pallmeyer affirmed.

Capital One contended during the trial that Kmart was in material breach of its obligations under the agreement. If true, that would have precluded assumption unless the shortcoming had been cured and assurances of future performance given. 11 U.S.C. §365(b)(1). (We cite the Bankruptcy Code as it was before the 2005 amendments, which do not apply to this proceeding.) Kmart contended that it was in compliance and has not relied on the cure-and-assurance route. Judge Sonderby agreed with Kmart's position and allowed it to assume the contract.

About six months later Capital One ended the co-brand deal under §9.2(b) of the contract, which permits early termination in the event of "material breach" by either side. Capital One contended that, even if Kmart was performing its duties in September 2003 (when the bankruptcy court allowed it to assume the contract), it had failed to perform fully between then and March 2004 (when Capital One sent the notice of termination). Capital One Bank replaced the Kmart-brand credit cards with Capital One-brand credit cards. Kmart responded by filing suit in a Michigan state court, demanding damages. Kmart adds that by terminating the contract-rightly or wrongly-Capital One has made this appeal moot. Why decide whether it can assume an executory contract, Kmart asks, when decision cannot affect the parties' future performance under this contract?

Still, there is a controversy: Kmart wants damages for wrongful termination, and that claim is tenable only if the contract was properly assumed under §365. Knock out the bankruptcy court's assumption decision and the claim for damages disappears, because Kmart never had a right to Capital One's future performance. The posture is similar to that of a case in which a district judge issues a preliminary injunction secured by a bond, and after the court dissolves the injunction the parties debate whether the defendant can recover on the bond. Recovery is proper if the injunction should not have been issued; a concrete dispute about damages preserves a justiciable controversy about whether the injunction was valid, even though no prospective relief remains in dispute. See American Can Co. v. Mansukhani, 742 F.2d 314, 320 (7th Cir. 1984).

The complication is that Kmart's suit for damages is a distinct piece of litigation, in another court. Perhaps it should not have been; as long as the dispute about assumption was festering in the bankruptcy proceedings, a claim for damages would have come within the related-dispute jurisdiction established by 28 U.S.C. §§ 157(c)(1), 1334(b). But whether or not the damages claim could or should have been filed in the bankruptcy court, it is not there. This suggests that we should follow the approach of United States v. Munsingwear, Inc., 340 U.S. 36 (1950), and vacate the decision, so that all issues may be litigated in Michigan. The Court assumed in Munsingwear that, when the only effect of deciding Case #1 would be to resolve a single issue in Case #2, then Case #1 is moot and the judgment should be vacated. As the Court wrote, vacatur "clears the path for future relitigation of the issues between the parties and eliminates a judgment, review of which was prevented through happenstance. When that procedure is followed, the rights of all parties are preserved". Id. at 41. Unfortunately, however, the rights of all parties cannot be preserved by vacatur-nor could both parties' entitlements be preserved by dismissing the appeal while leaving the bankruptcy judge's decision in place, as Kmart requests. Either approach will privilege one side over the other.

Because federal bankruptcy jurisdiction is exclusive, the state court in Michigan could not decide whether Kmart was entitled to assume the contract under §365. Treating the federal proceedings as moot would leave only two possibilities. If we were to vacate the bankruptcy court's decision, then Kmart's state-court action also must be dismissed: there would be no (effective) judicial decision allowing Kmart to assume the contract, so Capital One's decision to walk away could not be breach. That would permit the unsuccessful party in litigation under §365 to frustrate the bankruptcy judge's decision, and the other party's rights, by the expedient of refusing to carry out its side of the bargain: breach would end the §365 proceeding and at the same time prevent later claims for damages (because the order allowing the contract to be assumed would have to be vacated once either party definitively refused to perform). If instead we were to dismiss the appeal and leave the bankruptcy judge's decision in force, by analogy to U.S. Bancorp Mortgage Co. v. Bonner Mall Partnership, 513 U.S. 18 (1994) (holding that vacatur is obligatory only if mootness arises from circumstances beyond the parties' control), then Capital One will be stuck with a contract (and must face the prospect of damages for breach) that may not have been assumed properly. Neither the rule "breach itself protects the breaching party from damages, because it requires vacatur of the §365 order" nor the rule "breach ensures victory for the debtor, because the appeal must be dismissed" is palatable. The only sensible thing to do is resolve the appeal on the merits; only then can both sides' rights be respected.

Judges cannot resolve moot cases, however prudent such a step might seem, but as we have observed the ongoing damages litigation shows that a justiciable controversy remains. Article III permits a federal court to resolve an issue that might control some other case. Think of the offensive use of the declaratory-judgment statute, to obtain a declaration that a claim under some other statute, in some other court, is preempted by federal law. See, e.g., Golden State Transit Corp. v. Los Angeles, 493 U.S. 103 (1989). Or think of insurance-coverage litigation. A sues B in state court; C, B's insurer, brings a suit in federal court seeking a declaratory judgment that the policy does not cover the events, so that it need not indemnify B, should B be held liable in the state case. No one supposes that such litigation, a staple under the diversity jurisdiction, exceeds the judicial power under Article III just because the state court may decide in B's favor on the merits and make the federal decision irrelevant. As long as there is a risk that B will be held liable and that C called on to indemnify, there is a live controversy that a federal court may resolve.† Just so here: As long as the Michigan litigation is pending, and there is a risk that Capital One may be called on to pay damages for breach of a contact that, it contends, was not properly assumed in bankruptcy, there is a live controversy in the federal forum.

When opposing assumption in the bankruptcy court, Capital One argued that Kmart is in default because it is no longer a "mass merchandise retailer." A series of "whereas" clauses precedes the contract's main text. One paragraph reads: "WHEREAS, Kmart owns and operates a chain of discount retail stores and is a mass merchandise retailer". (The next clause reads: "WHEREAS, Capital One is engaged in the business of issuing, managing and servicing VISA and MasterCard branded credit card accounts".) When the contract was signed in May 2000, Kmart had about 2,200 stores; by February 2003 it was down to 1,514, and Capital One thinks that this meant that it was no longer the sort of "mass" retailer that would make a good partner even though it was still one of the ten largest retail chains in the nation.

† See Premcor USA, Inc. v. American Home Assurance Co., 400 F.3d 532 (7th Cir. 2003); American States Insurance Co. v. Capital Associates of Jackson County, Inc., 392 F.3d 939 (7th Cir. 2004). When the insurers' duty to defend the state case is not at issue, federal litigation usually should be deferred until the state court has acted. See Lear Corp. v. Jackson Electric Holdings Ltd., 353 F.3d 580, 583 (7th Cir. 2003); Nationwide Insurance Co. v. Zavalis, 52 F.3d 689, 692-93 (7th Cir. 1995). Ripeness is not a problem in our litigation, however; the concern is that it is too late rather than too soon to adjudicate matters.

Such "WHEREAS" language divorced from the contract's substantive clauses implies that this document was drafted by someone who used a form book printed on parchment before the Linotype machine was invented. It does not, however, show that Kmart's scale is a promise, as opposed to a description. It would have been easy to state in one of the contract's substantive clauses that failure to operate at least 2,000 outlets entitled Capital One to walk away. Section 10.2 of the contract contains a long list of representations and warranties that Kmart makes to Capital One; the number of stores that Kmart will operate is not on that list. Nor does the contract otherwise imply that being a "mass merchandise retailer" (whatever that might mean) is a condition that Kmart must satisfy for the contract's five-year duration. The "WHEREAS" clause reads as an identifier-this contract is between Capital One and Kmart the national chain, rather than Kmart the mom-and-pop store in Barrow, Alaska, that has flown beneath the trademark radar. Cf. Atlantic Mutual Insurance Co. v. Metron Engineering & Construction Co., 83 F.3d 897, 899 (7th Cir. 1996); Walker v. Tucker, 70 Ill. 527 (1873).

Capital One's position is that the negotiators had discussions that led it to think that Kmart planned to remain about the same size, and that Capital One relied on this when deciding whether to enter the arrangement. But what the negotiators said to each other is tangential, and what people in Capital One's front office thought is irrelevant. See AM International, Inc. v. Graphic Management Associates, Inc., 44 F.3d 572, 575 (7th Cir. 1995); Skycom Corp. v. Telstar Corp., 813 F.2d 810 (7th Cir. 1987). These discussions do not resolve ambiguities in any of the contract's substantive terms and so would not be admissible under the parol evidence rule even if the contract lacked an integration clause. (Our reference to "the" parol evidence rule reflects the fact that there is widespread agreement on this proposition. The contract lacks a choice-of-law clause, and the parties have not discussed which state's law would govern its interpretation-Capital One's brief cites only one state case, for the incorrect proposition that state law supplies the standard of appellate review in federal court, on which see Mayer v. Gary Partners & Co., 29 F.3d 330 (7th Cir. 1994)-so we do not consider the possibility that an idiosyncratic version of the parol evidence rule might apply.) As it happens, however, the contract has a strong integration clause. Section 13.8 ...


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