In re AGF Direct Gas Sales CV-01-368-M 04/30/02 UNITED STATES DISTRICT COURT

DISTRICT OF NEW HAMPSHIRE

In r e : AGF Direct Gas Sales & Servicing, Inc., a/k/a AGF Direct Energy, LEG, Debtor

Bank of New Hampshire, Appellant

v. Civil No. 01-368-M Opinion No.

AGF Direct Gas Sales & Servicing, Inc., a/k/a AGF Direct Energy, LEG and Baltimore Gas & Electric Co . , Appellees

O R D E R

Appellee AGF Direct Gas Sales and Servicing, Inc. ("AGF") is

a Chapter 7 debtor. Bank of New Hampshire ("the Bank") appeals a

May 29, 2001, order of the bankruptcy court (Vaughn, C.J.)

granting the Chapter 7 Trustee's motion to approve a stipulation

to settle a claim with Baltimore Gas & Electric Co. ("BG&E), a

creditor of AGF. For the reasons given below, the order of the

bankruptcy court is affirmed. Standard of Review

A bankruptcy court's findings of fact are not set aside

unless clearly erroneous. Palmacci v. Umpierrez,

(1st Cir. 1997) (citing F e d . R. B a n k r . P. 8 013; Commerce Bank &

Trust Co. v. Burgess (In re Burgess) ,

(1st Cir.

1992); F e d . R. C i v . P. 52(c), advisory committee's note to 1991

Amendment). However, a "bankruptcy court's legal conclusions,

drawn from the facts so found, are reviewed de novo." Palmacci,

(citing Martin v. Baiqar (In re Ban gar) ,

(1st Cir. 1997)) .

Absent either a mistake of law or an abuse of discretion, the bankruptcy court ruling must stand. See Siedle v. Putnam Invs., Inc.,

(1st Cir. 1998). A bankruptcy court "may abuse its discretion by ignoring a material factor that deserves significant weight, relying on an improper factor, or, even if it [considered] only the proper mix of factors, by making a serious mistake in judgment."

Picciotto v. Salem Suede, Inc. (In re Salem Suede, Inc.),

(1st Cir. 2001). "On an appeal the district court .

. . may affirm, modify, or reverse a bankruptcy judge's judgment,

order, or decree or remand with instructions for further

proceedings." F e d . R. B a n k r . P. 8013.

2 Factual Background

Before being forced into Chapter 7 bankruptcy, AGF was in

the business of buying and selling natural gas. In the course of

its business, AGF entered into an agreement with BG&E under which

AGF used BG&E's infrastructure to provide gas to its customers

and used BG&E's billing services to collect amounts due from its

customers. To satisfy BG&E's concerns over AGF's ability to meet

its financial obligations, AGF arranged to have the Bank issue a

series of letters of credit. By the time AGF was forced into

bankruptcy, BG&E was the beneficiary of a $100,000 letter of

credit issued by the Bank. That letter of credit was fully

secured by two certificates of deposit owned by AGF. The Bank

also issued several other letters of credit on AGF's behalf, some

of which were not fully secured.

The Chapter 7 petition in this case was filed on September

12, 2000. As of that date, AGF owed BG&E $90,062.93 for use of

its infrastructure and billing services, while BG&E owed AGF

$98,483.66 that BG&E had collected from AGF's customers. Rather

than setting off the amount AGF owed it from the amount it owed

AGF, and then paying the Trustee the difference ($8,420.73),

3 BG&E, pursuant to an agreement with the Trustee, elected to draw

against the letter of credit, and received payment from the Bank

on April 2, 2001. On April 3, 2001, the Bank moved for relief

from the automatic stay in order to take possession of the

certificates of deposit securing the letter of credit, to the

extent the letter was drawn on. That relief was granted by order

of the bankruptcy court dated May 3, 2002. After drawing on the

letter of credit, BG&E paid the Trustee $98,483.66, to be held in

escrow, pending the bankruptcy court's approval of its settlement

with the Trustee. The agreement between BG&E and the Trustee

also called for mutual waiver and release of all claims by both

parties.

In its order of May 29, 2001, the bankruptcy court, over the

Bank's objections, approved BG&E's settlement with the Trustee

and ruled, inter alia, that under the interpretation of

adopted by the majority of the courts that have construed

that statute, the issuer of a letter of credit is not a co-debtor

and, as a consequence, is not subrogated to a creditor's rights

against a debtor. At the same time the bankruptcy court approved

the settlement between BG&E and the Trustee, it approved another

4 compromise under which the Trustee and one of AGF's secured

creditors, Adams Resources Marketing, Limited ("Adams"), agreed

to split AGF's accounts receivable, including the $98,483.66 that

BG&E had collected from AGF's customers but had not yet paid over

to AGF. This appeal followed.

Discussion

In essence, the Bank contends that once BG&E drew on the

letter of credit, the Bank became subrogated to BG&E's right of

set-off, and should have been allowed to collect the $90,062.93

that AGF owed the Bank (by virtue of the Bank's having paid BG&E)

from the $98,483.66 that BG&E owed AGF, rather than having to

draw against the certificates of deposit, owned by AGF, that

secured the letter of credit. The Bank's goal, obviously, is to

keep from depleting the pool of assets potentially available to

back up other undersecured letters of credit issued by the Bank

on AGF's behalf. The Bank argues that the bankruptcy court erred

in approving the stipulated settlement between BG&E and the

Trustee by: (1) failing to recognize and enforce its common-law

right of subrogation; (2) denying its statutory right of

subrogation by misconstruing the "liable with" language of 11

(a); and (3) failing to deem the stipulation between

AGF and BG&E to be ultra vires.

The Trustee counters that: (1) the Bank's appeal is moot,

given its failure to seek a stay pending appeal; (2) the Bank's

exclusive source for subrogation rights is § 509(a), under which,

as the issuer of a letter of credit, it does not qualify as a co­

debtor entitled to subrogation rights; (3) even if the Bank has

subrogation rights in addition to those available under § 509(a),

the doctrine of equitable subrogation does not apply to the facts

of this case; and (4) even if the Bank has common-law subrogation

rights, those rights do not include a right of set-off, because

the Bank has not shown that it qualifies for set-off under the

bankruptcy code.

For its part, BG&E contends that: (1) the Bank's appeal

should be dismissed because the Trustee has offered to preserve

all of the Bank's claims against the money collected by BG&E on

AGF's behalf pending an appropriate adversary proceeding; (2) the

bankruptcy court did not abuse its discretion in approving the

stipulated settlement between BG&E and the Trustee; (3) even if

6 the Bank were subrogated to BG&E's rights, those rights do not

include a right of set-off; (4) even if BG&E did, in the

abstract, have a right of set-off to which the Bank was

subrogated, the debts in this case are not subject to set-off

because they were not mutual; (5) $92,506.71 of the $98,483.66

held by BG&E on AGE's behalf was collected less than 90 days pre­

petition, making that amount ineligible for set-off under

(a)(3); (6) the decision whether to allow set-off is

discretionary, and the bankruptcy court did not abuse its

discretion; (7) the Bank is not entitled to subrogation rights

under § 509(a) because it is not an entity "liable with" the

debtor; (8) the decision whether to grant equitable relief,

including equitable subrogation, is discretionary, and the

bankruptcy court did not abuse its discretion; and (9) the Bank's

claim of ultra vires activity and its assertion of a "marshaling"

theory were not properly before the bankruptcy court.

Without addressing all of the issues raised by the parties,

and without necessarily adopting all of the arguments advanced by

BG&E and the Trustee, the court affirms the order of the

bankruptcy court.

7 The subrogation provision in the bankruptcy code states, in

pertinent part:

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.

(a). In CCF, Inc. v. First Nat'l Bank & Trust Co.

(In re Slamans),

(10th Cir. 1995), a case on which

the bankruptcy court relied, the court of appeals noted that

"[sjection 509(a) of the [bankruptcy] Code governs subrogation in

bankruptcy proceedings," i d . at 473. Based upon a definition of

letters of credit drawn from Oklahoma law, which incorporates the

Uniform Commercial Code, the court of appeals acknowledged that

"the bankruptcy courts disagree whether an issuer of a letter of

credit is eligible for § 509 subrogation," i d . at 475 (footnote

omitted) ; see also 4 L a w r e n c e P. K i n g , C o l l i e r on Bankruptcy §

509.09[3] (15th rev. ed. 2001) ("Since subrogation is an

equitable remedy dependent on the facts of each case, it is not

surprising that courts grappling with subrogation cases may

appear to reach divergent results.") The court then sided with

those courts that have ruled that the issuer of a letter of credit is not eligible for § 509 subrogation because such an

entity is not "liable with" the debtor, but is independently

liable, i d . at 476. In so ruling, the court of appeals explained

that "determination that an issuer of a letter of credit is

liable with the account party [here, AGF] on the beneficiary's

claim against the account party on the underlying transaction

subverts the fundamental essence of letter of credit law." Id.

(citing Centrifugal Casting Mach. Co. v. American Bank & Trust

C o .,

, 1352 (10th Cir. 1992)). That fundamental

essence is "the independence principle, which is the cornerstone

of the commercial vitality of letters of credit." In re Slamans,

(quoting Ward Petroleum Corp. v. Federal Deposit

Ins. Corp..

(10th Cir. 1990)).

The bankruptcy court committed no error of law in relying

upon In re Slamans for the proposition that the issuer of a

letter of credit is not entitled to subrogation rights under §

509.1 Accordingly, to the extent that the bankruptcy court so

1 The court further notes that while the Bank has identified several cases in which the issuer of a letter of credit has been subrogated to the rights of a creditor against a debtor, it has identified no case in which the issuer has been subrogated to a creditor's right of set-off. Rather, issuers have been subrogated to: (1) a creditor's general right to make a claim

9 ruled, the order of that court is affirmed. What remains to be

determined, however, is whether the Bank has a subrogation right

independent of that conferred by § 509.

According to the Bank, the bankruptcy court erroneously

decided, albeit implicitly, that § 509 preempts the field of

subrogation in bankruptcy. (Appellant's B r . at 6.) The Bank

goes on to argue that in addition to whatever rights it may or

may not have under § 509(a), it has a right under the doctrine of

equitable subrogation, and that under the principles of equitable

subrogation, it is entitled to exercise BG&E's right of set-off.

against a bankruptcy estate, see, e.g.. In re Minnesota Kicks, Inc.,

(Bankr. D. Minn. 1985); (2) a creditor's right to a security interest in specific collateral, see, e.g.. In re Valiev Vue Joint Venture,

(Bankr. E.D. V a . 1991); (3) a creditor's right to status as a secured rather than unsecured creditor, see, e.g.. In re Sensor Svs., Inc.,

(Bankr. E.D. Pa. 1987); and (4) a creditor's right to an administrative expense priority claim, see, e.g.. In re Nat'1 Serv. Lines, Inc.,

(Bankr. E.D. Mo. 1987). Here, 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 AGE'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.

10 As a preliminary matter, the court is not at all certain

that the bankruptcy court's order should be read as ruling that §

509(a) preempts the field, nor is it apparent that such a ruling

would constitute legal error. See In re Slamans,

("[sjection 509(a) of the [bankruptcy] Code governs subrogation

in bankruptcy proceedings"). Furthermore, it is not at all clear

that equitable subrogation would provide any greater rights than

those available under § 509(a).

On the one hand, the Bank cites cases that stand for the

proposition that "equitable subrogation is separate and distinct

from the subrogation rights afforded by section 509, and that

section 509 is an additional, but not exclusive remedy in

bankruptcy," In re Spirtos,

(Bankr. C.D. C a l .

1989) . More recently, however, the tenth circuit has explained

that "[t]here is a split of authority whether subrogation in

bankruptcy court is governed exclusively by § 509, or whether the

entity seeking subrogation under § 509 must also satisfy the

five-part equitable subrogation test." In re Slamans,

n.2 (citing Photo Mech. Servs., Inc. v. E.I. Dupont De

Nemours & Co. (In re Photo Mech. Servs., Inc.),

,

11 618-19 (Bankr. D. Minn. 1995)). As for the elements of equitable

subrogation:

Equitable 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.

In re The Medicine Shoppe,

(Bankr. N.D. 111.

1997) (citations omitted). Rather than understanding equitable

subrogation to expand the remedies available to a party in the

Bank's position, contemporary jurisprudence appears to regard

equitable subrogation, when applicable, as a limitation on the

remedies that might otherwise be available under § 509. See,

e.g.. In re The Medicine Shoppe,

("other circuits

have split as to whether a co-debtor seeking subrogation under §

509(a) must also satisfy the more stringent five-part equitable

subrogation test") (emphasis added, citations omitted).

Given the elements of equitable subrogation, the bankruptcy

court had no need to rule that § 509(a) preempts the field in

order to decide that the Bank has no subrogation right. Rather,

12 by adopting the reasoning of In re Slamans, the bankruptcy court

necessarily decided that the Bank was not "liable with" AGF on

BG&E's claim against AGF. Because that decision was based upon

the independence principal. In re Slamans,

6

(citation omitted), the bankruptcy court's ruling on § 509(a)

subrogation must be understood as a decision that the Bank's

payment to BG&E was not payment of a debt owed by AGF for which

the Bank was secondarily liable, but was payment of a debt,

established by the terms of the letter of credit, for which the

Bank was independently and primarily liable. On that basis, the

Bank cannot meet the third prong of the equitable subrogation

test. Furthermore, in light of the half interest in AGF's

receivables that was granted to secured creditor Adams, it seems

unavoidable that subrogation would injure the rights of Adams,

which also prevents the Bank from meeting the fifth prong of the

equitable subrogation test.

In summary, the bankruptcy court committed no legal error by

adopting the reasoning of the tenth circuit, as expressed in In

re Slamans. Under the rule of that case, the Bank is not

entitled to subrogation rights under either § 509(a) or the

13 principles of equitable subrogation. Accordingly, the order of

the bankruptcy court is affirmed.

Having so ruled, the court concludes with the following

observations on the equities of this case. On the facts before

it, the court can discern no overriding equitable principle that

would require - or even support - a contrary result. When it

entered into its agreement with AGF to issue a letter of credit

on AGF's behalf, the Bank was free to negotiate whatever terms it

wished. It chose to protect itself by taking a security interest

in certificates of deposit owned by AGF. It could just as easily

have negotiated for an interest in AGF's accounts receivable, or,

more specifically, an interest in the funds collected for AGF by

BG&E. It did not do so, and the court declines "to rewrite the

contract between the parties to afford [the Bank] greater

protection than that for which it bargained. [The Bank] is in

the business of selling letters of credit; it could factor in the

risk of this situation." Berliner Handels-Und Frankfurter Bank

v. East Texas Steel Facilities, Inc. (In re East Texas Steel

Facilities, Inc.,

(Bankr. N.D. Texas 1990)

14 (declining to allow issuer of letter of credit to be subrogated

to creditor's right to reclamation).

Obviously, the Bank faces a risk created by its failure to

adequately secure one or more other letters of credit issued on

AGF's behalf. But the risk created by the Bank's failure to

protect itself does not transform this situation into one in

which subrogation is necessary "to compel the ultimate discharge

of a debt or obligation by him who in good conscience ought to

pay it." In re Valley Vue Joint Venture,

(quoting Moritz v. Redd,

(Va. 1928). With

respect to the obligations of the parties in this case, the party

who in good conscience ought to discharge the debt to BG&E,

namely AGF, will do so, by virtue of BG&E's claim on the letter

of credit. The Bank is not disadvantaged, because it, in turn,

has full recourse to AGF's certificates of deposit. Thus,

declining to apply the doctrine of equitable subrogation hardly

results in AGF's avoidance of its obligation to the Bank. See in

re Valiev Vue Joint Venture,

) (quoting Federal

Land Bank v. Jovnes,

(Va. 1942) ("The

rationale of subrogation is 'bottomed on sensitivity to the

15 comparative equities involved. Where one is more fundamentally

liable for a debt which another is obligated to pay, such person

shall not enrich himself by escaping his obligation.'").

The 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 BG&E

by making a claim on AGF assets held, or once held, by BG&E, to

which other parties have legitimate claims. In other words,

under the stipulation entered into by the Trustee and BG&E, AGF

will pay its debt to BG&E; equity does not require parties such

as secured creditor Adams to bear any of the burden created by

the Bank's decision to issue undersecured letters of credit on

behalf of AGF.

16 The order of the bankruptcy court is affirmed.

SO ORDERED.

Steven J. McAuliffe United States District Judge

April 30, 2002

cc: Lucy J. Karl, Esq. Carol L. Hoshall, Esq. Frank P. Spinella, Jr., Esq. Deborah A. Notinger, Esq. Geraldine L. Karonis, U.S. Trustee George Vannah, U.S. Bankruptcy Court

17