Subrogation Claims in Bankruptcy

Bankruptcy Code section 509 establishes the requirements for an enforceable subrogation claim in bankruptcy cases. Section 509 applies only when the payment of the Primary Creditor's claim is made after the petition date. In re Four Star Const. Co., 151 B.R. 817, 820 (Bankr. D. Oh. 1993) (citing Collier On Bankruptcy, ' 509.02 at 509-6 (15th ed. 1992)). Where a payment is made prior to bankruptcy, ” 509(a) is inapplicable as the original creditor has been satisfied prepetition through subrogation outside of bankruptcy law.' In re Four Star Const. Co., 151 B.R. at 820 (citing Collier on Bankruptcy, ' 509.02 at 509-7 (15th ed. 1992)). See also In re Tri-Union Development Corp., 314 B.R. 611, 624 (S.D. Tex. 2004) ('Section 509 ' by its terms ' only applies to a co-debtor. If a surety fully funds its suretyship obligation prior to bankruptcy, the subordination provisions of ' 509(c) would not apply.').

Under Code section 509, and subject to certain exceptions, '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' (11 U.S.C. ' 509). Code section 509 requires that the Subrogee's money was used to 'discharge the obligation of another to a third person' and that the Primary Creditor is paid in full by the Subrogee. See Salzman v. Holiday Inns, Inc., 48 A.D.2d 262, 369 N.Y.S.2d 243 (4th Dep't 1975). The primary inquiry is whether one party's money was used to satisfy the obligation of another party in full. Pandora Industries, Inc. v. Paramount Communications Inc. (In re Wingspread Corporation) (Wingspread II), 145 B.R. 784, 790 (S.D.N.Y. 1992); aff'd without written opinion, 992 F.2d 319 (2d Cir. 1993). Usually the Subrogee satisfies the obligation by virtue of a guaranty (Wingspread II, 145 B.R. at 790). If the Subrogee makes the payment from an escrow or other account to cover the amount due, the right to subrogation still exists. See In re Chateaugay Corp., 89 F.3d at 948; Wingspread II, 145 B.R. at 788; Salzman, 48 A.D.2d at 262, 369 N.Y.S.2d at 243.

The existence of a right of subrogation is less clear when the Primary Creditor draws on a letter of credit posted by a third party in satisfaction of the outstanding debt. Courts are split on whether funds drawn under a letter of credit give the issuer of the letter of credit a subrogation claim. Certain courts have found that the issuer of a letter of credit is in a different position than a guarantor of a debt because an obligation of a debtor to reimburse an issuer of a letter of credit is a direct, primary contractual obligation between the issuer and the debtor. A guarantor's obligation is secondary because the guarantee obligation is an indirect obligation which is not triggered until the debtor defaults in its obligations to the Primary Creditor. In re Hamada, 291 F.3d at 650. Accord Tudor Development Group, Inc. v. United States Fidelity & Guaranty Company, 968 F.2d 357, 364 (3d Cir. 1992) (examining letters of credit in relation to equitable subrogation); In re Agrownautics, Inc., 125 B.R. 350, 352-53 (Bankr. D. Conn. 1991) (same, also citing numerous cases in agreement).

Moreover, the letter of credit agreement is independent from the underlying contract and. therefore, the requirement of being 'liable with' the debtor on the debt is not met (In re Hamada, 291 F.3d at 650). Only a minority of courts have found that a letter of credit is within the same family of co-obligations as guarantees and sureties (See, e.g., Young v. Condor Systems, Inc. (In re Condor Systems Inc.), 296 B.R. 5, 15 (9th Cir. BAP 2003) and permitted subrogation where a letter of credit has been drawn upon. See In re National Service Lines, Inc., 80 B.R. 144, 145 (Bankr. E.D. Mo. 1987) (permitting subrogation by a bank which paid a debtor's obligation pursuant to a letter of credit and finding that a letter of credit functions like a guarantor or surety of an obligation).

An Equitable Remedy

At its heart, the law of subrogation, whether at common law or statutory, is an equitable remedy that ' depends upon the equities and attending facts and circumstances of each case.' In re Wingspread Corp., (Wingspread I), 116 B.R. 915, 930 (Bankr. S.D.N.Y. 1990). In fact, '[s]ubrogation is commonly allowed only to the extent necessary to prevent injustice, based on the circumstances of each case, and will not be permitted where it results in unjust enrichment of the subrogee or other inequities.' Harris v. Supreme Plastics, Inc. (In the Matter of Supreme Plastics, Inc.), 8 B.R. 730, 737 (N.D. Ill. 1980) (citing Travelers Indemnity Co. v. Peacock Construction Co., 423 F.2d 1153 (5th Cir. 1970)). For these reasons, certain courts occasionally have found it appropriate to limit the recovery of a Subrogee. For instance, where a Subrogee made payments on a lease during bankruptcy in order to protect his own interest in the property, a court found it proper to limit the Subrogee's claim to an amount corresponding to the extent that it conferred a benefit upon the unencumbered assets of the estate (See Id.).

Even though the right of subrogation is based on a pre-petition agreement, as long as the payment is made after the petition date and would constitute an administrative claim if made by the Primary Creditor, the Subrogee's claim will be entitled to administrative status (Section 507(d) provides that a Subrogee is not entitled to a priority claim in certain circumstances. Section 507(d) recognizes that a Subrogee is entitled to assert an administrative expense claim) . When applying subrogation, the Subrogee 'succeeds to the position of the other in relation to the other's claim or right.' In the Matter of Robbins International, Inc., 275 B.R. 456, 470 (S.D.N.Y. 2002). Accordingly, 'a subrogee is entitled to assert any priority or special right of the subrogor.' Wingspread II, 145 B.R. at 791 (citations omitted). As stated in Wingspread I,

'If Congress had intended that priority status not run with these claims, it could have so provided as it did for other sorts of claims. In fact, the legislative history expressly indicates that priority for administrative claims would be transferred to the subrogee.' 124 Cong. Rec. H. 11,095 (Sept. 28, 1978); S. 17,411 (Oct. 6, 1978). Wingspread I, 116 B.R. at 931-32.

Exceptions

Section 509 contains important exceptions that will cause a subrogation claim to be invalidated. A detailed discussion of those exceptions are beyond the scope of this article. Generally, the exceptions invalidate a subrogation claim if: 1) the holder of the subrogation claim already holds an allowed claim on account of the payment of the Primary Creditor's claim; 2) the subrogation claim was already disallowed; or 3) the subrogation claim was subordinated under Code section 510 (Pursuant to Bankruptcy Code section 502(e)(1), the court shall disallow a claim for contribution or reimbursement if: 1) the Primary Creditor's claim is disallowed; 2) the claim for reimbursement or contribution is contingent; or 3) the Subrogee asserts a subrogation claim under section 509).

Although the right of subrogation is recognized in the Bankruptcy Code (and is not affected by the 2005 amendments to the Bankruptcy Code), careful analysis is required to consider the applicable exceptions to section 509. Particular caution should be exercised where the Subrogee is the issuer of a letter of credit that is drawn upon to satisfy the claim, or where payment of the debt by the Subrogee could be construed as inequitable. In cases where the Bankruptcy Code's exceptions to subrogation are inapplicable, and in the absence of inequitable conduct on the part of the Subrogee, the Subrogee should be entitled to assert a claim for subrogation against the debtor to the extent the Primary Creditor could have asserted a claim against the debtor in the bankruptcy case had the debt remained unpaid.

In many cases, a creditor in a bankruptcy case (the 'Primary Creditor') has the benefit of a guaranty, an escrow, or a letter of credit provided by a third party (the 'Subrogee') to which it can turn in order to satisfy its claim against the debtor. When the Subrogee pays the debtor's obligation to the Primary Creditor after the debtor has filed a petition in bankruptcy, the Subrogee will in most cases be entitled to assert a subrogation claim against the debtor in the bankruptcy case. Below, we discuss the relevant considerations in determining whether a subrogation claim is valid.

Subrogation

Subrogation is 'the substitution of one party in place of another with reference to a lawful claim or right, so that the one who is substituted succeeds to the position of the other in relation to the other's claim or right.' Robbins International, Inc. v. Robbins MBW Corp. (In the Matter of Robbins International, Inc.), 275 B.R. 456, 470 (S.D.N.Y. 2002) (citing The Aetna Casualty and Surety Co. v. Clerk, U.S. Bankruptcy Court, New York, NY (In re Chateaugay Corp.), 89 F.3d 942, 947 (2d Cir. 1996)). Subrogation is an equitable remedy that is a derivative right, arising from satisfaction of a claim held by a third party against another party. In re Hamada, 291 F.3d 645, 649 (9th Cir. 2002). See also See Aetna Casualty and Surety Co. v. Clerk, U.S. Bankruptcy Court, New York, NY (In re Chateaugay Corp.), 89 F.3d 942, 948 (2d Cir. 1996).

Bankruptcy Code section 509 establishes the requirements for an enforceable subrogation claim in bankruptcy cases. Section 509 applies only when the payment of the Primary Creditor's claim is made after the petition date. In re Four Star Const. Co., 151 B.R. 817, 820 (Bankr. D. Oh. 1993) (citing Collier On Bankruptcy, ' 509.02 at 509-6 (15th ed. 1992)). Where a payment is made prior to bankruptcy, ” 509(a) is inapplicable as the original creditor has been satisfied prepetition through subrogation outside of bankruptcy law.' In re Four Star Const. Co., 151 B.R. at 820 (citing Collier on Bankruptcy, ' 509.02 at 509-7 (15th ed. 1992)). See also In re Tri-Union Development Corp., 314 B.R. 611, 624 (S.D. Tex. 2004) ('Section 509 ' by its terms ' only applies to a co-debtor. If a surety fully funds its suretyship obligation prior to bankruptcy, the subordination provisions of ' 509(c) would not apply.').

Under Code section 509, and subject to certain exceptions, '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' (11 U.S.C. ' 509). Code section 509 requires that the Subrogee's money was used to 'discharge the obligation of another to a third person' and that the Primary Creditor is paid in full by the Subrogee. See Salzman v. Holiday Inns, Inc. , 48 A.D.2d 262, 369 N.Y.S.2d 243 (4th Dep't 1975). The primary inquiry is whether one party's money was used to satisfy the obligation of another party in full. Pandora Industries, Inc. v. Paramount Communications Inc. (In re Wingspread Corporation) (Wingspread II), 145 B.R. 784, 790 (S.D.N.Y. 1992); aff'd without written opinion, 992 F.2d 319 (2d Cir. 1993). Usually the Subrogee satisfies the obligation by virtue of a guaranty (Wingspread II, 145 B.R. at 790). If the Subrogee makes the payment from an escrow or other account to cover the amount due, the right to subrogation still exists. See In re Chateaugay Corp., 89 F.3d at 948; Wingspread II, 145 B.R. at 788; Salzman, 48 A.D.2d at 262, 369 N.Y.S.2d at 243.

The existence of a right of subrogation is less clear when the Primary Creditor draws on a letter of credit posted by a third party in satisfaction of the outstanding debt. Courts are split on whether funds drawn under a letter of credit give the issuer of the letter of credit a subrogation claim. Certain courts have found that the issuer of a letter of credit is in a different position than a guarantor of a debt because an obligation of a debtor to reimburse an issuer of a letter of credit is a direct, primary contractual obligation between the issuer and the debtor. A guarantor's obligation is secondary because the guarantee obligation is an indirect obligation which is not triggered until the debtor defaults in its obligations to the Primary Creditor. In re Hamada, 291 F.3d at 650. Accord Tudor Development Group, Inc. v. United States Fidelity & Guaranty Company , 968 F.2d 357, 364 (3d Cir. 1992) (examining letters of credit in relation to equitable subrogation); In re Agrownautics, Inc., 125 B.R. 350, 352-53 (Bankr. D. Conn. 1991) (same, also citing numerous cases in agreement).

Moreover, the letter of credit agreement is independent from the underlying contract and. therefore, the requirement of being 'liable with' the debtor on the debt is not met (In re Hamada, 291 F.3d at 650). Only a minority of courts have found that a letter of credit is within the same family of co-obligations as guarantees and sureties (See, e.g., Young v. Condor Systems, Inc. (In re Condor Systems Inc.), 296 B.R. 5, 15 (9th Cir. BAP 2003) and permitted subrogation where a letter of credit has been drawn upon. See In re National Service Lines, Inc., 80 B.R. 144, 145 (Bankr. E.D. Mo. 1987) (permitting subrogation by a bank which paid a debtor's obligation pursuant to a letter of credit and finding that a letter of credit functions like a guarantor or surety of an obligation).

An Equitable Remedy

At its heart, the law of subrogation, whether at common law or statutory, is an equitable remedy that ' depends upon the equities and attending facts and circumstances of each case.' In re Wingspread Corp., (Wingspread I), 116 B.R. 915, 930 (Bankr. S.D.N.Y. 1990). In fact, '[s]ubrogation is commonly allowed only to the extent necessary to prevent injustice, based on the circumstances of each case, and will not be permitted where it results in unjust enrichment of the subrogee or other inequities.' Harris v. Supreme Plastics, Inc. (In the Matter of Supreme Plastics, Inc.), 8 B.R. 730, 737 (N.D. Ill. 1980) (citing Travelers Indemnity Co. v. Peacock Construction Co. , 423 F.2d 1153 (5th Cir. 1970)). For these reasons, certain courts occasionally have found it appropriate to limit the recovery of a Subrogee. For instance, where a Subrogee made payments on a lease during bankruptcy in order to protect his own interest in the property, a court found it proper to limit the Subrogee's claim to an amount corresponding to the extent that it conferred a benefit upon the unencumbered assets of the estate (See Id.).

Even though the right of subrogation is based on a pre-petition agreement, as long as the payment is made after the petition date and would constitute an administrative claim if made by the Primary Creditor, the Subrogee's claim will be entitled to administrative status (Section 507(d) provides that a Subrogee is not entitled to a priority claim in certain circumstances. Section 507(d) recognizes that a Subrogee is entitled to assert an administrative expense claim) . When applying subrogation, the Subrogee 'succeeds to the position of the other in relation to the other's claim or right.' In the Matter of Robbins International, Inc., 275 B.R. 456, 470 (S.D.N.Y. 2002). Accordingly, 'a subrogee is entitled to assert any priority or special right of the subrogor.' Wingspread II, 145 B.R. at 791 (citations omitted). As stated in Wingspread I,

'If Congress had intended that priority status not run with these claims, it could have so provided as it did for other sorts of claims. In fact, the legislative history expressly indicates that priority for administrative claims would be transferred to the subrogee.' 124 Cong. Rec. H. 11,095 (Sept. 28, 1978); S. 17,411 (Oct. 6, 1978). Wingspread I, 116 B.R. at 931-32.

Exceptions

Section 509 contains important exceptions that will cause a subrogation claim to be invalidated. A detailed discussion of those exceptions are beyond the scope of this article. Generally, the exceptions invalidate a subrogation claim if: 1) the holder of the subrogation claim already holds an allowed claim on account of the payment of the Primary Creditor's claim; 2) the subrogation claim was already disallowed; or 3) the subrogation claim was subordinated under Code section 510 (Pursuant to Bankruptcy Code section 502(e)(1), the court shall disallow a claim for contribution or reimbursement if: 1) the Primary Creditor's claim is disallowed; 2) the claim for reimbursement or contribution is contingent; or 3) the Subrogee asserts a subrogation claim under section 509).

Although the right of subrogation is recognized in the Bankruptcy Code (and is not affected by the 2005 amendments to the Bankruptcy Code), careful analysis is required to consider the applicable exceptions to section 509. Particular caution should be exercised where the Subrogee is the issuer of a letter of credit that is drawn upon to satisfy the claim, or where payment of the debt by the Subrogee could be construed as inequitable. In cases where the Bankruptcy Code's exceptions to subrogation are inapplicable, and in the absence of inequitable conduct on the part of the Subrogee, the Subrogee should be entitled to assert a claim for subrogation against the debtor to the extent the Primary Creditor could have asserted a claim against the debtor in the bankruptcy case had the debt remained unpaid.