Opinion
CIV. CAUSE NUMBER 3:90-CV-2042-J, BANKRUPTCY CASE NUMBER 3-89-33552-HCA-11, BANKRUPTCY ADVERSARY NUMBER 389-3376.
Filed March 30, 2000.
MEM0RANDUM OPINION AND ORDER
Before the Court is the above-styled bankruptcy appeal. For the following reasons, the ruling of the Court below is AFFIRMED.
Factual Background
The following facts are undisputed. This appeal arises from an Chapter 11 adversary proceeding wherein Appellant Berliner Handels-Und Frankfurter Bank (Bank) sought equitable reclamation of goods pursuant to its honor of a pre-petition letter of credit it issued in favor of a seller of raw steel to be delivered to Appellee Lone Star Steel Company (Lone Star Steel). There are three parties to the $6.5 million irrevocable stand-by letter of credit involved in this case: 1) Appellant Bank, the issuer of the unsecured letter of credit, 2) Appellee Lone Star Steel, the Bank's account customer and the buyer of the steel products involved, and 3) Mannesmann Pipe Steel Co. (Mannesmann), the seller of the steel products and sole beneficiary under the letter of credit.
Under the letter, executed pre-petition, the Bank agreed to pay the seller upon certification that the buyer had failed to timely pay for purchased goods. There were two shipments of slab steel by the seller to the buyer within 18 days after it was placed into involuntary bankruptcy. The value of both post-petition shipments, the only shipments relevant to this appeal, is $1,620,871.00. Delivery of the shipments was at the request of the debtor, who was invoiced by the seller.
The debtor did not pay for the steel. Mannesmann, the seller, then presented its sight draft to the Bank for payment in accordance with the terms of the letter of credit. The Bank paid Mannesmann the amount certified, including the amount due for the two post-petition shipments. At the time of payment, the Bank did not ask for or receive a written assignment of Mannesmann's rights or security interest, if any, in the steel.
Within ten days of delivery of these two shipments, the Bank took all formal steps required to "reclaim" the two shipments from the buyer pursuant to § 2.702(b) the Texas Business and Commerce Code (Texas UCC), including sending the insolvent buyer written notice of demand. Lone Star Steel refused to allow the Bank to reclaim the steel slab, which was used in its business.
Prior to mailing its § 2.702 demand, the Bank filed a proof of claim in bankruptcy and a complaint asserting its right to reclaim the goods. The Bank asserted that it possessed an administrative priority claim, and sought equitable subordination under Texas law and Bankruptcy Code. After consideration of cross motions for summary judgment on stipulated facts, the court ruled that the Bank was not entitled to Mannesmann's subrogation rights. This appeal followed.
The parties entered into an agreed order permitting the use and consumption of the steel products, which were delivered post-petition, in the course of business, in exchange for the grant of an § 503 administrative priority claim against the debtor's estate in like amount should the Bank ultimately prevail on appeal. If the Bank does not prevail upon appeal it has only a general unsecured claim, as do the debtor's other trade creditors.
Legal Standards
This Court has jurisdiction over this appeal pursuant to 28 U.S.C. § 158. Upon appeal, legal questions and conclusions of law are subject to a de novo review. In re Fabricators, Inc., 926 F.2d 1458, 1464 (5th Cir. 1991). Bankruptcy Rule 8013 provides that the Bankruptcy Court's "[f]indings of fact . . . shall not be set aside unless clearly erroneous. . . ."
Accord In re Consolidated Bancshares. Inc. 785 F.2d 1249, 1252 (5th Cir. 1986); Richmond Leasing Co. v. Capital Bank. NA., 762 F.2d 1303, 1307 (5th Cir. 1985); In re Missionary Baptist Foundation of America, 712 F.2d 206, 209 (5th Cir. 1983).
Under the clearly erroneous standard of review if there are two coherent and facially plausible views of testimonial evidence and one is adopted, and it is not contradicted by extrinsic evidence, the finding can virtually never be clearly erroneous.Anderson v. City of Bessemer City, 470 U.S. 564, 575-76, 105 S.Ct. 1504, 1512, 84 L.Ed.2d 518 (1985). "A finding of fact is clearly erroneous `when although there is evidence to support it, the reviewing court on the entire evidence is left with a firm and definite conviction that a mistake has been committed."'Missionary Baptist 712 F.2d at 209 (citing United States v. United States Gypsum Co., 333 U.S. 364, 395, 68 S.Ct. 525, 542, 92 L.Ed. 746 (1948)). However, "[w]hen a finding of fact is premised on an improper legal standard, or a proper one improperly applied, that finding loses the insulation of the clearly erroneous rule," Missionary Baptist. 712 F.2d at 209 (citing Smith v. Hightower, 693 F.2d 359 (5th Cir. 1982)).
Discussion
This appeal raises an issue of first impression within the Fifth Circuit. The Third and the Sixth Circuits, as well as numerous bankruptcy courts, have reached opposite conclusions. Resolution of this issue involves interpretation of the language and policies behind equitable subrogation under the Bankruptcy Code, the Texas Uniform Commercial Code, and the Texas law of equitable remedies.Subrogation under Bankruptcy Code
The court below ruled that the Bank was not entitled to subrogation under the Code because the Bank, as issuer of the letter of credit, was not an "entity that is liable with the debtor [East Texas Steel] . . . on a claim of a creditor against the debtor," as required by 11 U.S.C. § 509 (a). Such joint liability, the court ruled, is missing for three reasons. One, the document from which the debtor's liability arose was not the letter of credit, but the purchase agreement between Mannesmann and the debtor. The Bank was not a party to that agreement.
Second, the "independence principle" of obligations under letters of credit makes the debtor's obligation to pay Mannesmann for the steel completely independent of the Bank's primary and only obligation under the credit, namely, to pay Mannesmann pursuant to the terms of the letter of credit. Third, the Bank was not a guarantor of the debtor's obligation to Mannesmann because, as issuer of the credit, its obligation to pay Mannesmann was primary under letter of credit law. The Bankruptcy Court further ruled that the Bank was not entitled to section 546(c) subrogation because the independence principle again prevented proper application of that section.
The Court below has not been shown to be in error in its findings or conclusions.
The Bank asserts that the court below misinterpreted section 509(c)'s language regarding an "entity that is liable with the debtor" to erroneously require liability created by one document jointly executed by the debtor and the entity. The Bank contends that this single document requirement elevates form over substance. Pointing out that execution of multiple documents is usual in commercial transactions where goods are sold and security interests are created, the Bank contends that the substance of the transaction here is such that only one debt was created — the obligation to pay for the slab steel — and payment of that debt was in reality a joint liability of the debtor and, if the debtor failed to do so, of the Bank. This argument was considered by the court below, and rejected. This Court also rejects this argument because it in essence ignores the reality that the Bank is proceeding under its letter of credit, not the sales draft of Mannesmann.
The Bank further contends that the court below placed undue reliance on the undisputed principle that the issuer's obligation to honor a conforming letter of credit is independent of the buyer's obligation to pay upon invoice for goods ordered and accepted. While conceding that this is a well-settled principle of the law governing letters of credit, the Bank contends that it is irrelevant to the issues in this case.
This Court does not agree. A bank issuing an unsecured standby letter of credit does not automatically obtain, merely upon honor of that letter and after giving the buyer timely notice of its assertion of its right of reclamation, a statutory or equitable right under Texas law or the Bankruptcy Code to be subrogated to the rights of the seller/beneficiary to reclaim goods sold and delivered post-petition (but not paid for) to an insolvent buyer, who is a debtor-in-bankruptcy.
Equitable Subrogation under Code Section 510
Section 510 of the Bankruptcy Code provides that "under principles of equitable subordination, [the bankruptcy court may] subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all of part of an allowed interest to all or part of another allowed interest." 11 U.S.C. § 510 (c)(1). "The legislative history of this provision reflects that Congress" intended that the term "principles of equitable subordination" follow existing case law and leave to the courts development of this principle.'" In re Herby's Foods, Inc., 2 F.3d 128, 131 (5th Cir. 1993).
Citing 124 Cong. Rec. H 11095, H 11113 (Sept. 28, 1978).
"The equitable powers of a bankruptcy court, including the power to subordinate, may be `invoked to the end that . . . that technical considerations will not prevent substantial justice from being done.'" Id. The Court concludes that the court below did not err or otherwise prevent substantial justice from being done.
Citing Peppery. Litton 308 U.S. 295, 305, 60 S.Ct. 238, 244, 84 L.Ed. 281 (1939).
Equitable Subrogation under Other Theories
The court below held that the Bank was not entitled to equitable subrogation under Texas law or the Code because it did not meet parts three and five of the five-part test set forth in In re Kaiser Steel Corp., 55 B.R. 150, 152 (Bankr. D. Cob. 1988). Specifically, the court ruled that the Bank was never jointly liable with the debtor but was primarily liable on the letter of credit, and to grant the Bank an administrative priority claim would cause injustice to other creditors who might truly be entitled to treatment in that class of claims. Those conclusions has not been shown to be erroneous.
The Kaiser Steel test is: (1) the claimant must have made payment to protect his own interests, (2) the claimant must not have been a volunteer, (3) the payment must satisfy a debt for which the claimant was not primarily liable, (4) the entire debt must have been paid, and (5) subrogation must not cause injustice to the rights of others.
Part three of the test is whether the Bank satisfied a debt for which is was not primarily liable. The debt at issue was the bill for the steel. The Bank was not a co-debtor on that bill under the applicable section of the Bankruptcy Code.
The "co-debtor" language of Code § 502(e)(1) is plain language "broad enough to encompass any type of liability shared with the debtor, whatever its basis." In re Baldwin-United Corp., 55 B.R. 885, 890 (Bankr. S.D. Ohio 1985). This shared liability may be based upon claims of suretyship, guarantyship, subordination, reimbursement, contribution, or indemnity. It also arises where the claims are based on a contractual relationship.
The policy behind this section is that the bankrupts estate also should not be burdened by estimated claims of a contingent nature when the underlying claimant has recourse against the entity who is liable on the claim with the debtor. Cf. 3 Collier on Bankruptcy P 502.05[1] (15th ed. 1979) (discussing legislative history, predecessor statutes, and interaction within Bankruptcy Code). in essence, § 502(e)(1)(B) balances the interests of the bankrupt, direct creditors of the bankrupt, and codebtors of the bankrupt. This last group asserts a derivative right against the debtor, based on the debt both parties owe to a third party. The codebtor gains entitlement to assert reimbursement and contribution claims only to the extent the codebtor makes these claims certain, that is, removes the third party from the debt relationship by compensating that party. See id. Otherwise, the bankrupt's estate would be unable to distribute assets to direct creditors because the monies are being held in anticipation of claims which may never materialize. Since the third party would still hold a right against the codebtor, the interests balance against the codebtor and in favor of the other creditors. See Matter of Fox, 64 B.R. 148, 150-51 (Bankr. ND. Ohio 1986).
In re The Charter Co., 81 B.R. 644, 648 (M.D. Fla. 1987), aff'd, 862 F.2d 1500 (11th Cir. 1989).
Although contingent rights to payment are included in the definition of "claim," from the debtor's perspective a co-debtor's contingent claim for reimbursement against the debtor is redundant with the direct claim by the creditor against the debtor. The Bankruptcy Code in § 502(e)(1)(B) therefore treats the claim for reimbursement as premature until the creditors claim against the debtor is allowable and the co-debtor, not the debtor, makes payment to the creditor.
In re Pettibone Corp., 110 B.R. 837, 847 (Bankr. ND. I11. 1990).
In re Pettibone Corp., 110 B.R. 837, 847 (Bankr. ND. I11. 1990). See also In re Charter Co., supra, 81 B.R. at 648; 3 King,Collier on Bankruptcy P 502.05[1] at 502-88 (15th ed. 1989).
For example, courts have disallowed contingent contribution claims based on federal statutes. E.g., In re Provincetown-Boston Airlines, supra, 72 B.R. at 310 (claims for contribution under federal securities law denied). Cf. Perrin v. United States, 444 U.S. 37, 43, 100 S.Ct. 311, 314, 62 L.Ed.2d 199 (1979) (construction of statutory term its ordinary, common meaning includes reference to its use in other federal statutes). As to joint tortfeasors, one court has said
The short answer to [a claimant's] assertion that nothing in the Code or the legislative history reflects an intention that section 502(e)(1)(B) apply to disallow the contingent claim of a joint tortfeasor is that the subsection itself suggests that the joint tortfeasor's claim is within its embrace. Th[is] section disallows a contingent claim for "contribution," a concept clearly associated with the law of torts. And it disallows the claim of "an entity that is liable with the debtor," not merely an entity that is contractually liable with the debtor.
In re Wedtech Corp., 87 B.R. 279, 283 (Bankr. S.D.N Y 1988) (citing In re Baldwin-United Corp., 55 B.R. 885, 890 (Bankr. S.D. Ohio 1985)).
The claims against Appellants in the state court civil suit are largely based on tort claims; the balance are securities fraud claims. Implicit in the Bankruptcy Courts findings and conclusions is the finding that Appellants and FMC were codebtors for the civil suit claims. This conclusion and finding regarding the civil suit has not been appealed.
The Bank was a primary obligor on the unsecured letter of credit it issued. The Bank was not a guarantor, endorser, or surety of the customer's debt to the steel supplier. It was not a co-debtor on the bill for the slab steel.
The result is the same under Texas law. Under the laws of the State of Texas, one who pays a debt for which he is primarily liable is not entitled to be subrogated to the rights and liens of the creditors he paid. The Bank cannot benefit under the Texas doctrine of equitable subordination.
See United States v, Fishing Vessel Mary Ann, 330 F. Supp. 1102, 1105 (D.C. S.D. Tex. 1971), aff'd, 466 F.2d 63 (5th Cir. 1972). cert. denied, 410 U.S. 929, 93 S.Ct. 1365, 35 L.Ed.2d 590 (1973) ("the doctrine of legal subrogation covers only those instances where one party pays a debt for which another is primarily answerable. . . ."); Cheswick v. Weaver, 280 S.W.2d 942, 944 (Tex.Civ.App.-Beaumont 1955, writ ref'd n.r.e.) ("one who assumes a debt and thus becomes primarily liable for its payment is not entitled to subrogation to this debt and the lien securing it."); Rickets v. Alliance Life Ins. Co., 135 S.W.2d 725, 734 (Tex.Civ.App.-Amarillo 1939, writ dism'd) ("the burden is upon the party paying the debt] to both plead and prove her right to subrogation;" "We think the rule is well settled in this State that one is not entitled to subrogation who pays an obligation for which he is primarily liable."); Kerens Nat'l Bank v. Stockton, 94 S.W.2d 161, 165 (Tex. Conan. App. 1936, opinion adopted) ("It is, of course, fundamental that one who pays an indebtedness for which he is primarily liable is not entitled to claim the benefits of equitable subrogation.").
This is in accordance with decisions of other courts. The Third Circuit, citing Pennsylvania law, has held that a bank which issues a letter of credit may not accede to the rights of its customer pursuant to the theory of equitable subrogation. InTudor Development Group, Inc. v. U.S. Fidelity Guar. Co., 968 F.2d 357, 358-59 (3rd Cir. 1992), the Third Circuit stated:
At issue in this case is which party is entitled to a fund of $594,000 paid into the district court. To settle this dispute we must determine whether a bank which has honored a letter of credit may be equitably subrogated to the rights of its customer vis-a-vis funds paid to the customer by a party unrelated to the original letter of credit. We conclude that because the issuing bank was satisfying its own primary liability rather than the liability of another when it made payment under the letter of credit, it may not avail itself of the common-law remedy of equitable subrogation.
The court below found that Appellant Bank was satisfying its own primary liability rather than the liability of another when it made payment under the letter of credit. That finding has not been shown to be clearly erroneous. The Bank may not avail itself of the remedy of equitable subrogation.
Downward Subrogation
The Bank further urges error in the Bankruptcy Court's failure to equitably subrogate its claim upward into a secured claim status. The Bank argues that the ruling of the court below effectively downwardly subrogated its claim. The Court does not agree. The ruling by the court below left the Bank with what it had, an unsecured claim.
The test for a equitable subrogation under the Bankruptcy Code was set forth in In re Mobile Steel Co. Under this test, equitable subordination from an unsecured claim to an secured claim position is justified only if: (1) the debtor engaged in "inequitable conduct"; (2) "the misconduct resulted in injury to the creditors or conferred an unfair advantage on the" debtor; and (3) "equitable subordination of the claim would not be inconsistent with the provisions of" the Code. Id. at 699-700. The debtor here did not engage in conduct that can be considered inequitable. It only did what steel businesses do-buy raw steel for fabrication into finished steel products. The debtor's conduct was reasonable and foreseeable.
Benjamin v. Diamond (In re Mobile Steel Co.). 563 F.2d 692 (5th Cir. 1977).
"Although the exact parameters of inequitable conduct have not been comprehensively or precisely delineated, such conduct does encompass: (1) fraud, illegality, breach of fiduciary duties; (2) undercapitalization; and (3) the claimant's use of the debtor corporation as a mere instrumentality or alter ego."Herby's Foods, 2 F.3d at 131.
In addition to this tripartite test, Mobile Steel held that three additional factors must be considered in determining whether the test has been satisfied.
"First, the inequitable conduct by the claimant may be sufficient to warrant subordination whether or not the misconduct related to the acquisition or assertion of the claim. Second, a claim should be subordinated only to the extent necessary to offset the harm that the bankrupt and its creditors suffered as a result of the inequitable conduct. Third, the claims arising from the dealings between the debtor and its fiduciaries must be subjected to rigorous scrutiny, and, if sufficiently challenged, the burden shifts to the fiduciary to prove both the good faith of the transaction and its inherent fairness."Herby's Foods. Inc., 2 F.3d at 131 (citing Mobile Steel, 563 F.2d at 700-701; Missionary Baptist Foundation, 818 F.2d at 1143-44).
East Texas Steel ordered the balance of its contracted-for steel slab shortly after it had been placed in involuntary bankruptcy (which was later converted to a voluntary bankruptcy) by other creditors. That was not an unreasonable act. It accepted delivery post-petition, yet was unable to pay upon demand. That possibility was foreseeable; that was why the letter of credit was obtained.
The Bank asserts that the ruling of the bankruptcy court effectively allows the debtor a windfall and to be unjustly enriched at the Bank's expense. This is not so. The fact that the debtor was able to use the steel it ordered without promptly paying for it was the natural and foreseeable result of the deal made when the Bank agreed to issue an unsecured but irrevocable standby letter of credit. The fact that the Bank did not adequately structure its business dealings so as to provide itself maximum protection does not entitle it to equitable priority over other creditors after bankruptcy protection was sought.
Conclusions
For the above stated reasons, the ruling of the Court below is AFFIRMED.
It is SO ORDERED.
Signed this the 30th day of March, 2000.