Ready for Your Close Up: Understanding and Protecting Subrogation Claims in Bankruptcy

The lead actors in any drama of debt gone bad are necessarily the borrower and the lender.  However, there is almost always a supporting cast of other parties in interest.  It is rare that this supporting cast makes an appearance in the first act of the drama - the initial negotiations between borrower and lender.  However, these supporting players in the drama, including guarantors, sureties, endorsers, and pledgors, often enter stage right when the borrower is unable to repay the debt.  These supporting players may have important rights of their own to assert, such as subrogation rights, during their time on stage.  It is important for subrogees to understand the cues and directions for successfully carrying off their part in the drama so they can assert and preserve their subrogation rights in bankruptcy.

I. What is Subrogation?

Subrogation results "when an entity steps into the shoes of a creditor, typically by payment of a debtor's obligation to a creditor." In re Tri-Union Development Corp., 314 B.R. 611, 627 (citing Putnam v. Commissioner, 352 U.S. 82 (1956); Pearlman v. Reliance Ins. Co., 371 U.S. 132 (1962)). The remedy allows "one who has been compelled to pay a debt which ought to have been paid by another...to exercise all the remedies which the creditor possessed against the other." In re Fiesole Trading Corp., 315 B.R. 198, 201-2 (Bankr. D. Mass. 2004) (citing Am. Surety Co. v. Bethlehem Nat'l Bank, 314 U.S. 314, 317 (1941)). Because a subrogee steps into the shoes of the creditor whom it has paid, the subrogee "succeeds to the position of the [creditor] in relation to the [creditor's] claim or right." In re Robbins Int'l, Inc., 275 B.R. 456 470 (S.D.N.Y. 2002).

Therefore, a subrogee is entitled to a secured claim in the amount of the debt paid, if the creditor it paid had a valid secured claim for the amount paid by the subrogee. If the creditor would have been entitled to assert an unsecured claim against the debtor's estate, the subrogee can obtain the right to be an unsecured creditor. Section 507(d) of the Bankruptcy Code restricts the types of priority claims for which a subrogee of those claims can assert the same priority status afforded the original creditor. Guarantors, sureties, endorsers, and pledgors are all examples of constituencies who have potential subrogation claims.

In bankruptcy, subrogation rights have been invoked "under either or both of two theories: Section 509 of the Bankruptcy Code and state law doctrines of equitable subrogation." In re Fiesole Trading, 315 B.R. at 202.

II. What Does the Bankruptcy Code Say About Subrogation?

Section 509(a) provides that an entity is entitled to subrogation if the entity is liable with the debtor on, or has secured, a claim against the debtor, and the entity has paid that claim. A claim of subrogation is not allowed if (1) the claimant has been allowed a claim for reimbursement or contribution under Section 502; (2) the entity's claim has been disallowed other than under Section 502(e); (3) the entity's claim for reimbursement or contribution has been subordinated pursuant to Section 510; or (4) the entity received the consideration for the creditor's claim. Section 509(c) further calls for subrogation claims to be subordinated to the creditor's claim until that claim is paid in full, either through payments under the Bankruptcy Code or otherwise.

Courts have held that Section 509 does not permit subrogation claims for parties "who are primarily liable for the debt...because they received consideration for paying the debt." In re Celotex, 472 F.3d 1318, 1321 (11th Cir. 2006). This statutory language "embodies the general principle that subrogation is not available to a party who satisfied a debt which that party was primarily obligated." Id. at 1322 (citing In re Cornmesser's, Inc., 264 B.R. 159, 163 (Bankr. W.D. Pa. 2001)). Courts have allowed subrogation claims by these parties if a separate agreement transfers the obligation to pay the claims to the debtor. See Feldhahn v. Feldhahn, 929 F.2d 1351, 1353-55 (8th Cir. 1991); In re Cooper, 83 B.R. 544, 547 (Bankr. C.D. III. 1988).

A further limitation on a subrogation claim is that Section 509 applies only when the payment on the debt is made after the petition date. In re Four Star Const. Co., 151 B.R. 817, 820 (Bankr. D. Ohio 1993). If the subrogee pays the debt prior to the bankruptcy filing, the right to subrogation exists independent of Section 509. Id. An entity's claim that is contingent at the time of the petition and becomes fixed during the case; i.e., when the creditor's claim is paid by the entity, "will be treated as if it became fixed before the filing of the case." Norton Bankr. Law & Prac. 3d § 48:38. If a potential subrogation claim cannot be estimated or liquidated prior to confirmation of a plan of reorganization, the plan should propose "specific means of satisfying that claim when its value becomes fixed." Id. (citing In re McCall, 44 B.R. 242 (Bankr. E.D. Pa. 1984)).

III. Are Equity Principles of Subrogation Considered in Bankruptcy?

In addition to any dispute over the requirements set forth specifically in Section 509, parties may also have to analyze whether there are equitable reasons either to permit or deny the subrogation and whether the court can consider those equitable reasons.

The Bankruptcy Code does not define subrogation, and there is some disagreement about whether or to what extent common law on equitable subrogation should be used to interpret and apply Section 509 of the Bankruptcy Code. In re Photo Mech., 179 B.R. at 618. The five-part test for equitable subrogation has the following components: (1) the payment must have been made by the subrogee to protect his own interest; (2) the subrogee must not have acted voluntarily; (3) the debt paid must be one for which the subrogee was not primarily liable; (4) the entire debt must have been paid; and (5) subrogation must not work any injustice to the rights of others. 73 Am. Jur. 2d Subrogation § 5. Although there is not perfect overlap between the first four parts of the equitable subrogation test and Section 509 of the Bankruptcy Code, the overt equitable component found in the five-part common law test is completely absent from the language found in Section 509.

Courts have varied in their determinations about whether the principals of equitable subrogation should play a role in the analysis of Section 509. Some courts have held that the "principles of equitable subrogation provide background for analysis of the Code." See, e.g., In re Chateaugay Corp., 89 F.3d 942, 947 (2nd Cir. 1996). At least one court has even said that the common five-part test for equitable subrogation "has evolved as a requirement to Section 509." In re Photo Mech. Servs., 179 B.R. 604, 618 (Bankr. D. Minn. 1995).

Still other courts have landed somewhere in the middle by, for example, finding equitable requirements in the purpose of the limitations found in Section 509. See In re Valley Vue Joint Venture, 123 B.R. 199, 205 (Bankr. E.D. Va. 1991). It seems that most courts have reasoned that, whether statutory or at common law, the remedy of subrogation is primarily an equitable one that "depends upon the equities and attending facts and circumstances of each case." In re Wingspread Corp., 116 B.R. 915, 930 (Bankr. S.D.N.Y. 1990). But see Creditor's Comm. v. Mass. Dep't of Revenue, 105 B.R. 145, 154 (D. Mass. 1989) (holding that Section 509 only controls in bankruptcy situations); In re Cooper, 83 B.R. at 546 (Bankr. C.D. Ill. 1988) (asserting that the right to subrogate under the Bankruptcy Code is not grounded in state law). Subrogation is often "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." In re Supreme Plastics, Inc., 8 B.R. 730, 737 (N.D. Ill. 1980) (citing Travelers Indemnity Co. v. Peacock Const. Co., 423 F.2d 1153 (5th Cir. 1970)).

Guarantors, sureties, endorsers, and pledgors who give some thought to how their subrogation rights are affected by and can be bolstered in the event of the primary debtor's bankruptcy will be better prepared in the event of an unwelcome casting call from the lender asking them to upgrade from the role of understudy to the lead role and source of repayment.