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Note: To assure payment of a contract for servicing its accounts for the sale of natural gas, AGF Direct Gas Sales & Servicing, Inc. (Applicant) caused an LC in the amount of US$100,000 to be issued by the Bank of New Hampshire in favor of Baltimore Gas & Electric (Beneficiary). The LC was fully secured by two certificates of deposit owned by Applicant. The bank had also issued other LCs for Applicant which were undersecured.

When Applicant filed for protection under Chapter 7 (liquidation) of the U.S. Bankruptcy Code, Applicant owed Beneficiary US$90,062.93 for the use of its infrastructure and billing services. At the same time, Beneficiary held US$98,483.66 in payments that it had collected from Applicant's customers. Rather than setting off the amount that Applicant owed and then paying the Trustee the difference, Beneficiary made an agreement with the Trustee whereby Beneficiary drew on the letter of credit for the amount it was owed and then paid the Trustee the US$98,483.66, to be held in escrow pending the disposition of the bankruptcy estate.

After Beneficiary drew and was paid, Issuer was granted relief from the automatic stay by the Bankruptcy Court in order to take possession of the certificates of deposit securing the letter of credit. Rather than apply the CDs to reimburse itself, however, Issuer claimed that it was subrogated to the LC Beneficiary's rights against Applicant which would enable it to exercise Beneficiary's right to set off against the collected funds. Apparently, the banker intended to apply the CDs to the other undersecured LCs. The Bankruptcy Court, however, rejected Issuer's claims to subrogation and approved an arrangement for the disbursement of these funds worked out by the Trustee. On appeal to the U.S. District Court for the District of New Hampshire, McAuliffe, J., affirmed.

Issuer argued that it was entitled to either statutory subrogation to the Beneficiary's rights under a provision in the U.S. Bankruptcy code, 11 U.S.C.§ 509 or equitable subrogation under the common law. This provision, 11 U.S.C.§ 509(a), states:

"Except as provided in subsection (b) or (c) of this section, an entity that is liable with the debtor on, or that has secured, a claim of a creditor against the debtor, and that pays such claim, is subrogated to the rights of such creditor to the extent of such payment."

Citing CCF, Inc. v. First Nat'l Bank & Trust Co. (In re Slamans), 69 F.3d 468 (10th Cir. 1995), the court noted that there is disagreement about whether an LC Issuer is eligible for subrogation under this provision but that subrogation would "subvert the fundamental essence of letter of credit law" by violating the independence principle. The court concluded that the bankruptcy court did not err in relying on this decision "for proposition that the issuer of a letter of credit is not entitled to subrogation rights under Section 509."

The court noted in passing that, "however, by virtue of being fully secured on its letter of credit, and of having the bankruptcy court's leave to obtain full repayment from [the debtor's] certificates of deposit, the Bank already has in its hands a more complete remedy than was awarded to any of the issuers in the cases in which courts have granted issuers a right of subrogation."

The bank, however, contended that it was also entitled to equitable subrogation. In considering this argument, the court noted that "[e]quitable subrogation is generally appropriate where: (1) payment was made to protect the subrogee's own interest; (2) repayment by the subrogee was not voluntary; (3) the debt paid was one for which the subrogee was not primarily liable; (4) the entire debt was paid; and (5) subrogation will not injure the rights of others." The court found that Issuer failed to satisfy several of these criteria, including the third point by virtue of the bankruptcy court's conclusion that the independence principle automatically made Issuer independently responsible for the debt.

The court noted that there was no "overriding equitable principle that would require - or even support - a contrary result." It observed that, in issuing the LC, Issuer chose to rely on the CDs instead of other options such as accounts receivable. Such being the case, the court concluded that it is not the job of the courts "to rewrite the contract between the parties to afford [Issuer] greater protection than that for which it bargained. [Issuer] is in the business of selling letters of credit; it could factor in the risk of this situation", quoting Berliner Handels-Und Frankfurter Bank v. East Texas Steel Facilities, Inc. (In re East Texas Steel Facilities, Inc.), 117 B.R. 235, 243 (Bankr. N.D. Texas 1990).

The court noted that "[t]he particular inequity for which equitable subrogation is the solution is not present in this case, and the Bank has given the court no reason to conclude that the doctrine of equitable subrogation has ever been used to provide relief from the collateral predicament in which the Bank finds itself. That is, there is nothing in the jurisprudence of equitable subrogation to suggest that the doctrine is intended to be used as the Bank seeks to use it, to rectify its failure to fully protect itself on collateral letters of credit issued to parties other than [Beneficiary] by making a claim on [Applicant] assets held, or once held, by [Beneficiary], to which other parties have legitimate claims."

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