The Dakin Company

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Case [1:04-bk-15821-MIT Doc 491 Filed 04/03/06 Entered 04/03/06 17:20:06 Desc
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8 UNITED STATES BANKRUPTCY COURT
9 CENTRAL DISTRICT OF CALIFORNIA
10 SAN FERNANDO VALLEY DIVISION
1]
12
Inre
13 | APPLAUSE LLC, Case No. SV 04-15821 MT
\4 Debtor. Chapter 11
IS MEMORANDUM OF DECISION AND
16 ORDER ON DEBTOR’S MOTION FOR
RECONSIDERATION OF THE
7 MEMORANDUM OF DECISION AND
ORDER OVERRULING IN PART AND
18 SUSTAINING IN PART DEBTOR’S
OBJECTION TO CLAIM OF WEST COAST
19 LIQUIDATORS (CLAIM NO. 95)
20 Date: April 3, 2006
Time: 10:00 a.m.
2] Place: Courtroom 302
22
23 Background
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This matter relates to two proofs of claim filed in this case: (1) Claim No. 56, filed
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by AMB Institutional Alliance Fund, iI (AMB) in the amount of $1,317,054.52: and (2)
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Claim No. 95, filed by West Coast Liquidators (WCL) in the amount of $1,084,426.92.

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Both of these proofs of claim were timely filed prior to the January 15, 2005 deadiine.
AMB's claim was exclusively for unpaid future rents arising from breach of the lease.
WCL’s claim was for repayment of its prior payments on a letter of credit it posted in
favor of AMB to cover Debtor's nonpayment, plus miscellaneous contractual damages.

WCL leased a warehouse to Debtor prepetition. Subsequently, WCL sold its
interest in the warehouse to AMB. As part of this transaction, WCL posted a letter of
credit in favor of AMB in the amount of $950,000. Debtor defaulted on rent payments,
and AMB drew against the line of credit. The prepetition draw was $415,738.89, the
postpetition, prerejection draw was $114,950.67, and the postrejection draw was
$304,389.77. The total draw was in the amount of $950,000.

The Debtor objected to both proofs of claim. With respect to the AMB proof of
claim, the Debtor argued that AMB’s claim should be reduced to the extent that it
received a portion of its damages by way of payment from the letter of credit.
Specifically, AMB’s $1.3 million future rents claim would need to be reduced because
AMB received $419,310 in payments on the Debtor's future rents from the WCL letter
of credit. In addition, Debtor contended that AMB either had re-leased the premises or
should have done so under applicable California law. In its response, AMB agreed that
its claim should be reduced by the amount it received from the WCL letter of credit. It
concluded that its proof of claim should be reduced to $941,058.46. Subsequently,
AMB and the Debtor stipulated to a proof of claim in the amount of $800,000,

With respect to the WCL claim, the Debtor argued that the claim must be
disallowed in part and subordinated under 11 U.S.C. § 909(c). First, the claim cannot
exceed $950,000, the amount WCL paid to AMB on the letter of credit. This is because
the claim is based on subordination, not on any contract. There is no contractual

privity. Second, because WCL’s claim is subrogated, it could not receive any

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distribution until AMB is paid in full the amount of its claims against the Debtor's estate.
Third, the priority portion of WCL’s claim would need to be reclassified as a general
unsecured claim. WCL, as a subrogee, stepped into the shoes of AMB and could only
sustain a priority claim that could have been asserted by AMB. However, AMB
expressly waived the right to assert administrative expense or priority gap period priority:
claims on October 8, 2004 in the lease rejection stipulation. Moreover, any
postrejection payments under the lease are not administrative expenses of the estate.

WCL responded to the Debtor’s objection by arguing that sustaining the
objections would result in a windfall to the Debtor. Since AMB was not asserting a
claim on behalf of WCL, if WCL were precluded from doing so on its own by section
509(c), then the Debtor would unfairly benefit. The debt remains due and owing and
cannot be avoided. WCL contended that if AMB waived its right to recover the amount
it received in draws, then the right to seek direct payment should vest with WCL. Thus,
the Court should determine that the $950,000 in draws against the letter of credit are a
valid debt and that, to the extent that AMB does not seek recovery of these draws, WCL
should be entitled to a claim for the full amount of these draws.

Following the filing of the above moving papers, the Debtor and AMB signed a
stipulation that would reduce AMB’s claim to $800,000. In tight of this fact, the Debtor
contended at the January 30, 2005 hearing that WCL could no longer assert a claim
against the state under section 509(c) since AMB has not been paid in full. In addition,
WCL holds only a general unsecured claim due to AMB’s waivers in the lease rejection
Stipulation. At most, WCL could only claim a $800,000 general unsecured claim
against the estate at this point. WCL’s dispute is really with AMB, not the Debtor.

WCL countered that its claim is really one for contribution or reimbursement, or,

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in the alternative, subrogation. AMB has not asserted the claim that WCL is asserting,
and a claim should not simply vanish just because AMB failed to assert it. The claim
has not been disallowed, and someone must have the right to assert it. There is only
one recovery at issue; there is no double-recovery problem. The Debtor clearly
benefitted from the WCL’s payments through the letter of credit. Thus, WCL should be
entitled assert a claim for $950,000. Moreover, since WCL was not a party to the lease
rejection stipulation, this agreement does not bind WCL. As such, WCL should also be
able to assert a priority claim for postpetition rent payments. '

This Court continued this hearing to a February 27, 2006 holding date in case,
after reviewing the pertinent law, the Court needed any additional factual information.
Concluding that no additional facts were necessary, the Court vacated the February 27,
2006 hearing and entered its ruling on February 23, 2006. Relying on the plain
language of in re Chateagay Corp., 94 F.3d 772, 779-80 (2d Cir. 1996), the Court held,
inter alia, that because AMB and the Debtor settled the claim amount, AMB’s claim
constituted “payment in full” under 11 U.S.C. § 509(c).

On March 3, 2006, Debtor filed a Motion Pursuant to Section 502(j) for
Reconsideration of the Court’s order. Having read the motion and opposition thereto
and reviewed all of the relevant facts and law of this case, the Court finds that its prior

order was legally erroneous. Accordingly, the Court’s prior order is hereby VACATED.

1 It should be noted that WCL’s counsel was never served with the
proposed settlement agreement between the Debtor and AMB, notwithstanding
the fact that (1) WCL filed a request for special notice early in this case on
September 23, 2004, (2) the Order Establishing Notice and Service Procedures,
entered on November 25, 2004, required service on WCL's counsel, and (3) this
agreement could potentially have been prejudicial to WCL’s rights.

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Discussion

11 U.S.C. § 509 is not the exclusive source of subrogation rights in a bankruptcy
proceeding. See in re Spiritos, 103 B.R. 240, 244 (Bankr. C.D. Cal, 1989) Instead,
‘[t]here are various types of subrogation, most commonly categorized as ‘conventional’
or ‘contractual’ subrogation, ‘legal’ or ‘equitable’ subrogation, and statutory
subrogation.” {n re Hamada, 291 F.3d 645, 649 (9th Cir. 2002). Here, WCL could have
a claim by way of subrogation either (1) by contract, (2) by way of equitable principles,
or (3) by way of statute, such as 11 U.S.C. § 509. Under any and all of these legal
theories, WCL’'s claim against the Debtor must be subordinated to AMB’s claim.

1. Contractual Subrogation

WCL holds a contractual right to subrogation by virtue of the language of the
First Amendment to Purchase Agreement between it and AMB. See Exh. C to Motion,
p. 207 {"[T]o the extent [AMB] receives any reimbursement pursuant to the Letter of
Credit, [WCL] will be subrogated to any rights that [AMB] may have against the tenant
under the Applause Lease to the extent of any such reimbursement made by [AMB] to
[WCL].”). This First Amendment to Purchase Agreement is “governed by, construed
and enforced in accordance with, the laws of the State of California.” /d.

Under California law it is settled that the “made whole” rule applies to claims that
arise by way of contractual subrogation as well as claims for reimbursement. See
Progressive West Ins. Co. v. Yolo County Superior Court, 135 Cal.App.4th 263, 274
(Cal. App. 2005). “It is a general equitable principle of insurance law that, absent an
agreement to the contrary, an insurance company may not enforce a right to
subrogation until the insured has been fully compensated for [his or] her injuries, that is,

has been made whole.” /d. (citation omitted). A “contractual provision that intends to

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vitiate this rule must ‘clearly and specifically [give] the insurer a priority out of proceeds
from the tortfeasor regardless whether the insured was first made whole.” fd
Progressive considered whether the following policy language vitiated the “made whole
rule”: (1) Progressive "is entitled to all the rights of recovery that the insured person to
whom payment was made has against another"; and (2) "When an insured person has
been paid by us under this policy and also recovers from another person, entity, or
organization, the amount recovered will be held by the insured person in trust for
[Progressive] and reimbursed to [Progressive] to the extent of our payment.” The court
held that because these provisions do not clearly indicate that Progressive’s rights are
first in priority, do not explain that Progressive may seek reimbursement regardless of
whether the insured was made whole by his recovery from a third party, and/or do not
assign or transfer all rights to the insurer to the extent of the insurance company’s
payment, the made-whole rule was not vitiated by this policy language.

The policy language in Progressive is analogous to the subrogation language in
the First Amendment. First, the language does not clearly indicate that WCL’s rights
are first in priority over AMB’s rights. Second, the language does not explain that WCL
may seek reimbursement regardless of whether AMB was made whole. Third and
finally, the language does not specifically assign or transfer any rights. Because, under
the above law, the “made whole’ rule is not vitiated, and because, as | conclude below,
AMB was not made whole, WCL holds at most a $950,000 contingent claim by way of
contractual subrogation. Because WCL’s contractual subrogation claim would not be
enforceable until AMB is paid in full, and because AMB will not be paid in full, WCL’s

claim is in effect subordinated and of no value.

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2. Equitable Subrogation

Under California law, a party will only have the right to equitable subrogation if
five elements are met: “First, the claimant must have paid the debt owed to the
lienholder in order to protect the claimant's own interest. Second, the claimant must not
have acted as a volunteer. Third, the claimant could not have been primarily liable for
the debt he paid. Fourth, the claimant must have paid the entire debt owed to the
lienholder. And, fifth, the subrogation must not work an injustice to the rights of others.”
in re Hamada, 291 F.3d 645, 651 (9th Cir. 2002).

Applying these elements to this case, WCL does not hold a right to equitable
subrogation because, as wiil be demonstrated below, the debt to AMB has not been
paid in full. Thus, any claim for equitable subrogation must be disallowed.

3, Statutory Subrogation under 11 U.S.C. § 509

WCL is subrogated to the rights of AMB to recover unpaid rent from the Debtor
under 11 U.S.C. § 509(a) (“Except as provided in subsection (b) or (c) of this section,
any 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.”). “[T]here is nothing about the basic structure of the
letter of credit transaction that calls for treatment different than other co-obligors in
bankruptcy.” in re Condor Systems, inc., 296 B.R. 5, 16 (9th Cir. B.A.P. 2003). “As

with other forms of guarantee, payment by the issuer gives rise to a right of

2

Although California recognizes that applicants and issuers of letters of
credit are subrogated to the rights of the beneficiary of the letter of credit, see
Cal. Comm. Cade § 5117(a) and (b), this “section does not grant any right of
subrogation. It grants only the right that would exist if the person seeking
subrogation ‘were a secondary obligor.” U.C.C. Comment 1 to Cal. Comm. Code
§ 5117. Thus, the right to subrogation must be derived from another source.

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reimbursement and subrogates the issuer to the rights of the beneficiary.” /d. at 17.

Although WCL asserts that its claim is for contribution or reimbursement, rather
than subrogation, this distinction is immaterial here, since section 509(c) provides that
in either case WCL’s claim would be subordinated until AMB is “paid in full.” 11 U.S.C.
§ 509(c) provides that “[t]he court shall subordinate to the claim of a creditor and for the
benefit of such creditor an allowed claim, by way of subrogation under this section, or
for reimbursement or contribution, of an entity that is liable with the debtor on, or that
has secured, such creditor's claim, until! such creditor's claim is paid in full, either
through payments under this title or otherwise.” Based on this language, the Debtor
contends that WCL is not entitled to any payment because AMB has not been and will
not be paid in full because the estate has insufficient funds to make a large distribution
on unsecured claims. Unsecured creditors are projected to only receive 12-15%.

A. Manifest Error of Law

In this Court’s prior order, | came to the conclusion that Section 509(c) did not
apply to WCL because AMB had been paid in full by virtue of its settlement with the
Debtor. In coming to this conclusion, the Court relied primarily on the language of In re
Chateagay Corp., 94 F.3d 772, 779-80 (2d Cir. 1996) dealing with the question of
whether “payment in full” has been made under Section 509(c) when the primary
creditor settles with the debtor. Specifically, Chateagay stated that “acceptance of the
settlement . . . constitute[s] the requisite ‘full payment’ of the DOL claims within the
meaning of § 509(c).” /d. at 80. Although nothing in the Chateagay opinion itself
causes the Court to change its opinion on this issue, particularly since it never disclosed
the details of the settlement agreement in that case, further research and information

has led me to conclude that AMB has not been and will not be paid in full. Accordingly,

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Section 509(c) applies and WCL’s claim should be subordinated.

Notwithstanding the language of Chateagay, this Court concludes that settlement
between a primary obligor and a debtor in itself does not cause a claim to be paid in full
or deemed as such. If mere settlement caused a claim to be paid in full, then Section
509(c) would not apply if AMB and the Debtor settled their dispute down to $800,000,
but Section 509(c) would apply if AMB voluntarily reduced its claim to $800,000 on its
own accord. This simply does not make sense. Instead, Chateagay must mean that a
claim is paid in full if there is a settlement between a primary obligor and a debtor and
that the amount of the settlement is, in fact, paid. To the extent that Chateagay holds
otherwise, this Court declines to follow it. The fact that AMB has not been and will not
be paid the full $800,000 because the estate has insufficient funds to pay unsecured
creditors in full is the distinguishing factor. Because AMB has not been and will not be
paid in full, Section 509(c) must apply, and WCL’s claim must be subordinated.

B. Policy Justifications

This result is based on sound and weil-established policy principles. The
language in Section 509(c) derives from the common law “made whole” rule, discussed
in more detail above. In Restatement (Third) of Surety and Guaranty, § 27(1), the rule
is described as follows: “Upon total satisfaction of the underlying obligation, the
secondary obligor is suborgated to all rights of the obligee with respect to the underlying
obligation to the extent that performance of the secondary obligation contributed to that
satisfaction." Comment b explains the general policy behind this rule:

The purpose of subrogation is to reallocate the cost of performance from the

secondary obligor to the principal obligor. The mechanism by which this

reallocation is accomplished should not cause any disadvantage to the obligee.

The obligee would be disadvantaged, however, if the secondary obligor were
subrogated to rights of the obligee before complete satisfaction of the underlying

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obligation. In such a case, the rights obtained pursuant to the underlying
obligation, with the result that the remaining rights of the obligee on account of
the underlying obligation could be diminished. Moreover, because both the
secondary obligor and the obligee would be asserting rights arising from the
same undivided claim, conflicting enforcements could easily result. Thus, the
secondary obligor is not entitled to subrogation to the right of the obligee until the
underlying obligation is completely discharged.

In American Surety Co. v. Sampsell, 327 U.S. 269, 273-74 (1946), the Supreme Court
discussed similar policy concerns in the insolvency context:

The bond was intended to protect materialmen and laborers who worked on the

job so that they would not have to bear the risk of Stratton's insolvency. But for

his insolvency and bankruptcy these laborers and materialmen would have been
able to recover from him the money due them, no matter what their rights against
the surety might have been. Consequently the surety should not by claiming
under subrogation or indemnity for money paid to some of the creditors for
whose benefit the bond was intended, be allowed to reduce the share of the
bankrupt’s assets due to other creditors whom the bond also was intended to
protect from insolvency. For this would tend to defeat the very purpose for which
the bond was given and therefore cannot be permitted under the equitable
principles governing distribution of a bankrupt's assets.

By analogy to this case, the Court could find that the letter of credit was intended
to protect AMB, Debtor’s landlord, so that AMB would not have to bear the risk of the
Debtor's bankruptcy. But for Debtor’s insolvency and bankruptcy, AMB would have
been paid for the rents due, no matter what its rights against WCL might have been.
Consequently, WCL should not, by claiming under subrogation or indemnity for rents
paid from the letter of credit, be allowed to reduce the share of the Debtor’s assets due
to AMB, for whom the letter of credit was intended to protect from insolvency. This
would tend to defeat the very purpose for which the letter of credit was given and
therefore cannot be permitted under the equitable or statutory principles governing
distribution of the Debtor’s assets in this case. Put simply, AMB bargained for the letter

of credit to protect itself from the credit risk the Debtor posed. WCL, making a business

decision to close the sale and get the job done, agreed. It makes sense froma policy

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standpoint that now WCL should not be permitted to dilute AMB’s recovery. It
voluntarily assumed the risk that the letter of credit would be drawn upon.
C. Other Considerations
Having said all of this, | have reservations with respect to the result, which derive
from the fact that AMB did not seek to recover any money on behalf of WCL. To the
extent that AMB had the right to assert a full claim (as opposed to its net damages),°
this is unfortunate and leaves matters between AMB and WCL unresolved. As the First
Amendment to Purchase Agreement specifically provides that AMB must reimburse
WCL to the extent it is reimbursed, See Exh. C to Motion, p. 206, there appears to be
no reason why AMB should not have asserted its full claim against Debtor to the extent
it was able to do so. Now, to the extent that WCL has a remedy, it will be against AMB.
D. Amount and Characterization of Claim
In sum, this Court finds that WCL is entitled to a $950,000 subordinated claim.
WCL is specifically not limited to asserting a $800,000 claim. For one, the claim that
AMB is assserting is not identical to and does not overlap with the WCL claim. Thus,
WCL should not be specifically limited to the amount claimed by AMB. Moreover, AMB
did not have the power to modify the characterization or amount of the WCL claim
retroactively. WCL’s rights vested and couid no longer be modified the moment it

acquired them by virtue of payment through the letter of credit. “Although parties may

The Debtor has taken inconsistent positions on this issue. In its objection
to AMB’s claim, it asserted that the claim should be reduced to AMB’s net
damages. Now in the Motion for Reconsideration, it asserts that WCL could
have and should have filed a proof of claim in AMB’s name to recover damages
for AMB and itself under 11 U.S.C. § 501(b). However, Section 501(b)} provides
WCL little solace since that provision specifically applies only if AMB does not
file a proof of claim. In this case, it did.

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by agreement grant greater subrogation rights than would have been ordinarily
recognized in equity, a surety can acquire, by way of equitable subrogation, no greater
rights than were possessed by the creditor at the time of the payment which effected
the subrogation.” C.J.S., Subrogation, § 66 (citing Alexander v. Young, 65 F.2d 752,
757 (10th Cir. 1933 (citing numerous cases))) femphasis added): see also Globe &
Rutgers Fire Ins. Co. v. Hines, 273 F. 774, 777 (2d Cir. 1921) (“The principle is a
general one in the law of subrogation that a surety, paying off a debt, can acquire no
greater rights than the creditor had aft the time of payment, as the surety cannot be
placed in a more favorable condition than the principal.”).

It is unnecessary for me to reach the question of whether any part of WCL’s
claim is a priority claim under 11 U.S.C. § 507(a)(1). Even if a part of it qualified as a
priority claim, it would still be subordinated under Section 509{c).
Conclusion

In conclusion, the Motion for Reconsideration is hereby GRANTED and the
Court's prior order is VACATED. All objections are OVERRULED. The Debtor's
objection to Claim 95 is sustained. Claim 95 is hereby reduced to $950,000 and shall

be subordinated to AMB’s claim until AMB’s claim is paid in full.

IT IS SO ORDERED.

MAUREEN &. TIGHE
United States Bankruptcy Judge

DATED: April , 2006 J

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CERTIFICATE OF SERVICE BY MAIL

to the parties listed below:

AMB Institutional Alliance

c/o Richard S. Wordes; Frank A. Conner
Wordes, Wilshin & Conner LLP

20151 SW Birch Street, Suite 175
Newport Beach, CA 92660

Shiva Delrahim

Peitzman, Weg & Kempinsky LLP
10100 Santa Monica Blvd., Ste. 1450
Los Angeles, CA 90067

Catherine Castaldi

Rus, Miliband & Smith

2600 Michelson Dr., 7" Floor
Irvine, CA 92612

Gary R. Wallace

Haight, Brown & Bonesteel LLP
6080 Center Dr., Ste. 800

Los Angeles, CA 90045

Michael Joncich

Credit Managers Association of S.C.
40 East Verdugo Ave.

Burbank, CA 91502

Office of the U.S. Trustee

128 E. Carillo St.
Santa Barbara, CA 93101

Dated: APR 3 2006

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| certify that a true copy of this ORDER was served on APR 3 2006

Qpunthe A Wibleerne

Y DEPUTY CLERK