Article

Note: West Coast Liquidators (Seller) sold a warehouse to AMB Institutional Alliance Fund, II (Buyer) which was leased by Applause LLC (Tenant). To guarantee Tenant's payment of rent to Buyer as landlord, Seller posted a standby letter of credit in the amount of US$950,000 in favor of Buyer. Tenant subsequently defaulted on its rent payments and filed for protection under Chapter 11 (reorganization) of the US Bankruptcy Code. Buyer drew down the entire amount of the LC.

Buyer initially filed a proof of claim for US$1,317,054.52 which amount represented unpaid future rents associated with Debtor/Tenant's breach of the lease. Seller filed a proof of claim for US$1,084,426.92 which amount represented repayment of the money paid out under the LC plus miscellaneous contract damages. Debtor/Tenant objected to both claims. With respect to the LC, Debtor/Tenant argued that Seller's claim must be limited to the amount that Seller paid on the LC. Debtor/Tenant further argued that 11 U.S.C. § 509(c) required that Buyer's claims must be paid in full before Seller could receive any distribution from Debtor/ Tenant's estate on it claim. Finally, Debtor/Tenant argued that Seller's "claim would need to be reclassified as a general unsecured claim."

Buyer and Debtor/Tenant entered into settlement negotiations regarding the amount of Buyer's proof of claim and subsequently "stipulated to a proof of claim in the amount of $800,000." With respect to Seller's claim, at a hearing on the objection, the bankruptcy court limited the amount of Seller's claim to the face amount of the LC. The court noted that although Seller and Debtor/Tenant lacked contractual privity, Seller was entitled to subrogate its claim. However, it stated that Seller would not be able to assert its claim until Buyer was "paid in full" as required by 11 U.S.C. §509(c). The court concluded that "because [Buyer] and the Debtor settled the claim amount, [Buyer's] claim constituted 'payment in full' under 11 U.S.C. § 509(c)."

Debtor/Tenant disagreed with the ruling on Seller's claim for reimbursement and filed a Motion Pursuant to §502(j) for Reconsideration of the Court's Order. Upon review of the motion, the United States Bankruptcy Court for the Central District of California, San Fernando Valley Division, Tighe, J. vacated its prior order and revised it with respect to Seller's right to subrogation.

In reconsidering its decision, the court noted that, while the payment of the settlement would constitute payment in full of its claim, there would be no actual payment of Buyer's claim because the assets of the estate were insufficient. Therefore, it concluded that the claim of the Buyer took precedence over the subordinated claim to reimbursement by Seller representing the amount paid on the LC for which it had acted as surety.

The court concluded that:

the letter of credit was intended to protect [Beneficiary], Debtor's landlord, so that [Beneficiary] would not have to bear the risk of the Debtor's bankruptcy. But for Debtor's insolvency and bankruptcy, [Beneficiary] would have been paid for the rents due, no matter what its rights against [Applicant] might have been. Consequently, [Applicant] should not, by claiming under subrogation or indemnity for rents paid from the letter of credit, be allowed to reduce the share of the Debtor's assets due to [Beneficiary], for whom the letter of credit was intended to protect from insolvency. This would tend to defeat the very purpose for which the letter of credit was give and therefore cannot be permitted under the equitable or statutory principles governing distribution of the Debtor's assets in this case. Put simply, [Beneficiary] bargained for the letter of credit to protect itself from the credit risk the Debtor [Tenant] posed. [Applicant], making a business decision to close the sale and get the job done, agreed. It makes sense form a policy standpoint that now [Applicant] should not be permitted to dilute [Beneficiary's] recovery. [Applicant] voluntarily assumed the risk that the letter of credit would be drawn upon.

[JEB/aee]

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