Article

Factual Summary: To induce a bonding company to issue a supersedeas bond staying execution of a judgment against him pending appeal in an action brought by a former medical partner for breach of fiduciary duty and fraud, Judgment Debtor/Applicant obtained a standby LC from Issuer payable to Beneficiary/Bonding Company.

The Judgment Debtor/Applicant lost the appeal and subsequently filed for bankruptcy protection. Judgment Creditor petitioned the Bankruptcy Court and obtained an order indicating that the award in the judgment was not dischargeable. He then claimed under the bond. Beneficiary/Bond Issuer subsequently drew on the LC, which was honored. In connection with the drawing, Beneficiary assigned its rights against the Judgment Debtor to Issuer. One year later after the time had lapsed to seek discharge of the debt owed it, Issuer sued applicant to be subrogated to the rights of the Judgment Creditor against the Judgment Debtor.

The Bankruptcy Court found that the Issuer was not entitled to have its debt classified as nondischargeable. The intermediate appellate court reversed on appeal, finding Issuer was entitled to subrogation of the non-dischargeable Judgment Creditor's claims. On appeal, reversed and the judgment against Issuer reinstated.

Legal Analysis:

1. Statutory Subrogation: LC Issuer argued that it was entitled as issuer to statutory subrogation to the rights of the Judgment Creditor under 11 USCA Section 509(a) which provides that "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." Issuer contended that it was "liable with the debtor on, or has secured, a claim of a creditor against a debtor." The court agreed that the bonding company which was beneficiary of the credit was liable with the debtor. It disagreed, however, that the issuer of the LC that provided assurance to the bond issuer that it would be repaid was in the same position. Quoting from Tudor Dev. Group, Inc. v. United States Fidelity & Guaranty Co., 968 F.2d 357, 362 (3d Cir. 1992), it stated that "[t]he key distinction between letters of credit and guarantees is that the issuer's obligation under a letter of credit is primary whereas a guarantor's obligation is secondary - the guarantor is only obligated to pay if the principal defaults on the debt the principal owes." The appellate court concluded that "issuers of letters of credit are not 'liable with' the debtor on the obligation owed to the creditor; therefore, letter of credit issuers are not eligible under Section 509 for statutory subrogation in this context," quoting from Slamans v. First Nat'l Bank & Trust Co. (In re Slamans), 69 F.3d 468, 475-76 (10th Cir. 1995). As distinct from the guarantor, the appellate court suggested that the LC issuer is not liable until after some event occurs and, in paying, it is satisfying its own obligation. Although it noted some case law to the contrary and other case law that was supportive, the court concluded that the issuer of a LC was not entitled to statutory subrogation under Section 509.

2. Equitable Subrogation: LC issuer also argued that it was entitled under equitable principles to be subrogated to the rights of the Beneficiary/Bond Issuer. The appellate court rejected this argument. The court noted that under California law a party seeking subrogation must have paid a debt owed to the creditor to protect its own interest, not have acted as a volunteer, not have been primarily liable for the debt, must have paid the entire debt, and must not work an injustice to other creditors. The court concluded that the issuer had a legal duty to pay the LC and, accordingly, acted for its own interest and not as a volunteer, that it paid the entire debt and that there was a plausible argument that the equities were in its favor. The court, however, stated that the issuer was primarily liable on the LC and, so, could not qualify as a surety. Quoting the California Supreme Court in Western Sec. Bank v. Superior Court, 15 Cal. 4th 232, 62 Cal.Rptr.2d, 253, 933 P.2d 507 (Cal. 1997) (citations omitted), the court noted that "the rules applicable to surety relationships do not govern the relationships between the parties to a letter of credit transaction. . . . Nor does the beneficiary of a credit owe any obligations to the issuer; literal compliance with the letter of credit's terms for payment is all that is required."

Dissent:

In a closely reasoned dissent, it was urged that the Issuer was entitled to exercise equitable subrogation. In particular, the dissent noted that the majority concluded that the debt was not one for which the subrogee was not primarily liable. As to the "primary" nature of the LC obligation, the Dissent noted that this rationale "derives from authority which erroneously equates an issuer's primary obligation to pay on a letter of credit with the 'primarily liable' inquiry germane to equitable subrogation." The Dissent suggested that this analysis "collapsed the 'independent' liability of the issuer to pay upon demand with 'primary' liability required under the doctrine of equitable subrogation." Describing this analysis as "flawed", the Dissent stated that "the mere fact that a letter of credit imposed upon the issuer an independent obligation to make payment once a demand is made does not convert the issuer to the 'primary' obligor within the meaning of the equitable subrogation doctrine." It also noted that "to focus solely on [the Insurer's] obligations attendant to the letter of credit is inconsistent with the purposes of equitable subrogation, which is to place the burden for a loss on the party ultimately responsible for the INSTITUTE OF INTERNATIONAL BANKING LAW & PRACTICE 36 loss. As such in the content of equitable subrogation, the proper focus should be on which party is primarily liable for payment of the underlying obligation. In this case, the underlying obligation of [the Judgment Debtor] judgment - an obligation [for which the bond was issued] for which [the Judgment Debtor] should bear a primary responsibility. Therefore, it is [the Judgment Debtor] - not [the Issuer] who should be deemed 'primarily liable' for satisfaction of the judgment."

Comment:

1. This decision is another in the line of cases that over-narrowly construe the notion of subrogation as it applies to letters of credit and, particularly, with respect to insolvency. While there is little that can be said about the policies related to the bankruptcy statute in part because they defer to applicable commercial law, but, there is much to be said about their application to letters of credit.

2. If the statute permits the issuer of a bond or guarantee to be subrogated to the rights of the beneficiary, it is hard to understand why the issuer of a letter of credit would not be in a similar position.

3. The reasons given here, that the LC differs from the guarantee or surtyship undertaking embodied in the bond or guarantee, are not persuasive. There is, of course, a difference between the two. The obligation of the issuer of the LC is abstracted from the defenses that might be available to the guarantor. The reasoning would then seem to be that, because the promise of the guarantor is more porous, it also admits to subrogation to the rights of the principal. Were subrogation to affect adversely the obligations of the issuer of a letter of credit, it should not be permitted. Subrogation, however, only becomes relevant to LCs after they have been honoured. Subrogation does not impact the finality of the obligation of the issuer to the beneficiary. It provides the issuer with another means of recovery of its funds.

4. By reciting the doctrine of independence, surely the courts do not mean to suggest that they would not enforce an assignment of rights from the beneficiary to the issuer. What is the difference between the enforcement of an assignment and the enforcement of subrogation, whether equitable or statutory? To say that the LC is independent with respect to the beneficiary does not provide an adequate answer for the distinction.

5. In some respects, LCs differ from dependent guarantees. These respects are vital to the nature of the LC. In other respects, however, they are similar. Functionally, they serve the same purpose and can be used interchangeably with one another and are so regarded by the market. In both cases, the entity making the undertaking does not expect to bear the cost of payment but to be reimbursed by the person requesting the undertaking. The difference between them goes to the hardness of their promises to the beneficiary. Once that promise is satisfied, it makes little sense to erect an artificial distinction based on a doctrinal point that has a different focus unless it affects the money-like character of that right. Since granting an issuer subrogation to the rights of the beneficiary against the applicant or another third party does not affect the nature of the promise to the beneficiary, subrogation should not be impeded by LC policy.

6. In recognizing that the majority and the cases on which it relies confuse and confound the LC doctrine of independence with the equitable doctrine of primary liability regarding subrogation, The Dissent has the better argument.

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