The Bottom Line:

On July 25, 2011, the United States Court of Appeals for the Ninth Circuit in In re Flamingo 55, Inc., No. 10-15755, 2011 U.S. App. Lexis 15285 (9th Cir. July 25, 2011), held that a creditor who is a joint borrower rather than a surety, guarantor, or accommodation co-maker, was not entitled to subrogation under 11 U.S.C. § 509(a).  The case involved partners/co-venturers in a development of real property and, because the court held the creditor was a co-borrower with its own direct (and joint) liability, subrogation under section 509 was not available when the underlying claim was paid to the third party creditor. However, although it did not affect the result (since the subrogation claim was denied), the Ninth Circuit also held that the type of “payment” required for a subrogation claim could be more than simply cash consideration.  The loss of property (in this case, through foreclosure) suffices.

What Happened:

In In re Flamingo 55, Inc., Gregory Grantham and John Saba, were members of a limited liability company, Broadway-Acacia, LLC (“BA”), which acquired in real property in California.  The other members of BA formed an entity named Flamingo 55, Inc. (“Flamingo”) to acquire real property in Nevada.  To finance the acquisition of the property in Nevada, Flamingo and BA borrowed $675,000 from Datacom and executed a note representing the loan.  The note was secured by the property to be acquired in Nevada and BA’s property in California.  In addition, pursuant to a cross-collateralization agreement, Datacom could foreclose on the property in Nevada or California if BA and Flamingo defaulted on the note. 

During Flamingo’s involuntary bankruptcy proceeding, Datacom filed a claim against Flamingo and sought relief from the stay to foreclose on the property in Nevada.  The Bankruptcy Court, however, directed Datacom to exercise its rights against the property in California first.  Accordingly, Datacom foreclosed on the property in California and returned proceeds in excess of its claim to Grantham and Saba, successors in interest to BA.  On account of value of the property lost to Datacom in the foreclosure, Grantham and Saba filed a claim against Flamingo, asserting subrogation rights under section 509(a) of the Bankruptcy Code. 

The trustee of Flamingo objected.  The bankruptcy court sustained the trustee’s objections and disallowed BA’s subrogation claim because BA did not meet the basic requirements of section 509(a).  Section 509(a) provides that “an entity that is liable with the debtor on . . . 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(a).  The bankruptcy court found that the plain language of section 509 clearly shows that “section 509 effects subrogation only when nonbankruptcy law distinguishes between primary and secondary liability.  Thus, Section 509 does not apply when the liability of the person seeking subrogation is direct and of equal status with the debtor’s.”  In Flamingo, BA’s and Flamingo’s liability to Datacom was joint and several.  Thus, BA was not just liable with but rather is directly liable on the debt to Datacom.  Because BA’s obligation was of equal status with the debtor, Flamingo, BA was not entitled to subrogation.  Of relevance to the Ninth Circuit’s decision, the bankruptcy court also held that BA failed to satisfy the second element of section 509(a), as it did not make a “payment” to Datacom to extinguish its debt.  The bankruptcy court held that the foreclosure of the underlying property in satisfaction of Datacom’s claim did not constitute “payment” of the debt.

The Ninth Circuit’s decision is a short one, incorporating much of the lower court’s decision.  However, in two areas the Ninth Circuit differed.  First, it “clarified” that the creditor’s position as a partner or coventurer clearly indicated that it was a “joint borrower” and therefore, not entitled to subrogation under section 509(a).  The decision was limited to those facts and circumstances and “should not be read as reaching further than the situation presented by the relationship between the borrowers in this case.”  2011 U.S. App. LEXIS 15285 at *2.  More importantly, the Ninth Circuit rejected the bankruptcy court’s finding that foreclosure of property owned by the creditor asserting the subrogation claim could not constitute “payment.”  Payment of cash is not a prerequisite for asserting subrogation rights and foreclosure of valuable property suffices. 

Why the Case is Interesting:

The decision is a reminder that the structure of a transaction can affect the participants’ claims against each other.  Because the transaction was structured with both parties acting as direct and joint borrowers, the recovery by the third party creditor (e.g., Datacom) was not deemed a recovery on account of a claim against the debtor (e.g., Flamingo).  In addition, the Ninth Circuit afforded a broader interpretation of “payment” by holding that the payment of cash is not a prerequisite for creditors asserting subrogation rights.