Court Opinion

ID: 9001742
Source: CourtListenerOpinion
Date Created: 2022-11-27 13:09:40.162775+00
Date Added: 2024-06-11T17:11:11.524534
License: Public Domain

BECKER, Circuit Judge,
dissenting.
This appeal presents a close, difficult, and important question that has divided both courts and scholars. The majority concludes that, under Article 5 of the Uniform Commercial Code and the common law, a bank that has issued a standby letter of credit may never qualify for equitable subrogation to the rights of its defaulting customer in the underlying commercial transaction. The majority opinion is a fine piece of advocacy for a respectable position, one that has been adopted by a majority of the courts to face the issue (although rejected by the only federal appellate court that has reached the question). Nevertheless, I believe that the majority has backed the wrong horse. I would hold that an issuer of a standby letter of credit may, in proper circumstances, obtain equitable sub-rogation to the rights of its customer.
The majority also concludes that, even assuming that equitable subrogation is available in some cases, the equities in this case do not warrant it. Because I believe that genuine issues of material fact remain on this issue, I would not decide it on summary judgment. I would instead remand the case to the district court for *365further proceedings to determine whether the facts and equities here weigh in favor of or against Dauphin Deposit’s claim. I therefore respectfully dissent.
I. THE GENERAL AVAILABILITY OF SUBROGATION TO AN ISSUER OF A LETTER OF CREDIT
Investors offers three reasons why issuers of standby letters of credit should not be entitled to subrogation. First, Investors argues that an issuer does not qualify for subrogation as a matter of common law because the issuer is primarily liable on its obligation to the beneficiary, not secondarily liable for the debt of another, as the common law requires. Second, Investors contends that the principles un-dergirding Article 5 of the U.C.C. bar sub-rogation by issuers of letters of credit. Finally, Investors suggests that an issuer can (and Dauphin Deposit did) protect itself adequately by insisting on security before agreeing to issue a letter of credit. In Investors’ view, subrogation should be denied because it would only protect the imprudent issuer. Because each issue is close, difficult, and important, and because Article 5 of the U.C.C. is under study for possible major revision, I will discuss all three.
A. Common Law Bar: Primariness of the Issuer’s Obligation
The centerpiece of the majority’s position is that Dauphin Deposit was primarily liable on its own obligation to the township under the letter of credit. In its view, Dauphin Deposit, as a primary obligor paying its own debt rather than the debt of another, cannot seek subrogation. In my view, the majority takes undue advantage of the ambiguity of the terms “primary” and “secondary” liability.
Certainly, Dauphin Deposit was “primarily” liable in one temporal sense, in that, pursuant to the letter of credit arrangement, it had to pay the township immediately on the township’s proper demand, with (unlike a guarantor or surety) no right to assert any defenses that Associates may have had. On the other hand, even the majority concedes that Dauphin Deposit was temporally “secondarily” liable in the sense that its obligation arose only after Associates failed to satisfy its obligation. [Majority op. at 362.] I agree with the majority that Dauphin Deposit was “primarily” liable in the sense that (like a surety) it was directly liable, under its own contractual agreement, to make a payment to the township. But that is not the relevant meaning of “primary” liability in the subrogation context, for if it were, then no guarantor or surety would ever qualify for equitable subrogation.1
In my view, the relevant question is whether Dauphin Deposit was “secondarily” liable in the sense that it paid the debt of another, Associates. Investors, and the majority, have
failed to distinguish the primary liability of a debtor to its creditor to repay a loan and the primary obligation of the issuer to its beneficiary to honor a letter of credit. When a standby credit supporting a loan is honored, the issuer admittedly is satisfying its obligation as a primary obligor to honor the standby credit, but at the same time it is in fact satisfying a debt for which a person other than the issuer is primarily liable....
[T]he notion that an issuer’s obligation to honor the letter of credit is a “primary obligation” should be interpreted to mean that, under the independence principle, the issuer may not avoid its obligation to honor the credit by identifying deficiencies in underlying contracts or by otherwise asserting defenses that are typically available to parties who are generally considered to be “secondarily liable” such as guarantors and sureties. Thus ... the “primary obligation” language in the letter of credit context concerns itself with the issuer’s ability to avoid honoring its letter of credit, whereas the “primary liability” language in the *366subrogation context concerns itself with whether the entity, after reducing a claim of a creditor, received the consideration from the creditor.
In re Valley Vue Joint Venture, 123 B.R. 199, 204, 206 (Bankr.E.D.Va.1991).
In this case, Dauphin Deposit paid the debt of another when it satisfied Associates’ obligation. Associates was liable to the township to make site improvements. Dauphin Deposit’s letter of credit served as the township’s backup in case Associates defaulted. Associates did default, and Dauphin Deposit, pursuant to its obligation under the letter of credit, satisfied Associates’ obligation to the township.
As the issuer of a letter of credit, Dauphin Deposit had fewer defenses than would the issuer of a guaranty or performance bond, but the substance of Dauphin Deposit’s obligation was nevertheless essentially similar to that of a guarantor or surety. There can be no doubt that all three parties considered Dauphin Deposit as a de facto surety and the letter of credit as a substitute for a performance bond. Paragraph 5 of the subdivision agreement provides:
As a further condition to approval of said Plan, Subdivider shall furnish a bond * in the amount of One Million Eighty-eight Thousand Six Hundred Forty Six ($1,088,646.00) Dollars to guarantee the proper completion of the improvements required by the Ordinance. * Irrevocable Straight Letter of Credit No: S-10181 from Dauphin Deposit Bank and Trust Company
The parties struck out the word “bond” and replaced it with a reference to the letter of credit. Quite clearly, the parties intended the letter to serve the same economic role as a performance bond would have: “to guarantee the proper completion of the improvements required by the Ordinance” (emphasis added).
Guarantors and sureties pay their own legal obligations, yet they are still entitled to seek equitable subrogation as well as contractual subrogation. That is because in meeting their own “primary” obligations, guarantors and sureties are also “secondarily” liable to pay others’ debts. So far as the common law is concerned, the same logic should apply to issuers of letters of credit such as Dauphin Deposit.
Thus I conclude that the common law by itself poses no bar to the assertion of sub-rogation rights by issuers of letters of credit. I next turn to whether the U.C.C.’s statutory provisions on letters of credit require a different result.
B. The U.C.C. Statutory Bar
1. Prohibition by the Text of Article 5
As just mentioned, Dauphin Deposit’s basic theory is that its role was as a quasi-guarantor, and thus, like a guarantor, it is entitled to equitable subrogation. As the majority notes, however, the text of and official commentary to Article 5 of the U.C.C. make clear that a letter of credit is not equivalent to a guaranty.
The “independence principle” is the cornerstone of Article 5 and the law of letters of credit. Under the independence principle, the issuer of a letter of credit (unlike a guarantor) generally may not look to the underlying transaction and assert the defenses of the party whose obligation is guaranteed. Instead, the issuer must look only at the documents presented by the beneficiary and determine if they, on their face, meet the conditions that invoke the issuer’s obligation to pay on the letter of credit. See 13 Pa.Cons.Stat.Ann. § 5114(a) (Purdon 1984) (equivalent to U.C.C. § 5-114(1)) and comment 1 thereto. In short, the issuer must pay first and worry about its reimbursement and the merits of the dispute involving its customer later. Id.
Accordingly, the issuer’s duty to its customer does not ordinarily include liability for performance of the underlying contract. See 13 Pa.Cons.Stat.Ann. § 5109(a) (Purdon 1984) (equivalent to U.C.C. § 5-109(1)). The commentary explicitly notes that “the issuer receives compensation for a payment service rather than for a guaranty of performance.” Id. comment 1. Correlatively, the customer must, upon request, immediately reimburse the issuer if the issuer honored the letter according to its terms, again without regard to the mer*367its of any dispute over the underlying transaction. See 13 Pa.Cons.Stat.Ann. § 5114(c) (Purdon 1984) (equivalent to U.C.C. § 5-114(3)). Moreover, the commentary to Article 5 suggests that the law of letters of credit has been marred by “occasional unfortunate excursions into the law of guaranty.” 13 Pa.Cons.Stat.Ann. § 5101 comment (Purdon 1984) (official comment to U.C.C. § 5-101). The U.C.C. undeniably declares its intention “to set an independent theoretical framework for the further development of letters of credit.” Id.
From these snippets, Investors argues and the majority apparently concludes that subrogation would be contrary to the spirit, if not the letter, of the Code. I am not persuaded. The drafters’ concern about importing the law of guaranty was not about subrogation, but about eroding the independence principle (which, as I shall explain in the next section, is not compromised by allowing subrogation). The drafters of Article 5 took great pains to establish the independence principle in order to promote smooth commercial relations, but it does not follow that they intended to do away with subrogation simply because guarantors are eligible for subrogation. As one court has observed,
[wjhile a letter of credit may require conformity with certain obligations and formalities which are not required of a guarantee, where there is no contrary policy reason for treating them dissimi-larly for other purposes, precluding the assertion of subrogation rights to issuers of standby letters of credit while allowing guarantors to assert them would be no more than an exercise in honoring form over substance.
In re Minnesota Kicks, Inc., 48 B.R. 93, 104-05 (Bankr.D.Minn.1985) (citation omitted).
Indeed, the U.C.C. commentary explicitly anticipates that issuers will have recourse against beneficiaries by way of subrogation to the rights of their customers, at least in appropriate cases:
The customer will normally have direct recourse against the beneficiary if performance fails, whereas the issuer will have such recourse only by assignment of or in a proper case subrogation to the rights of the customer.
13 Pa.Cons.Stat.Ann. § 5109 comment 1 (official comment to U.C.C. § 5-109).
This official commentary disproves any suggestion that the drafters of Article 5 considered subrogation antithetical to the law of letters of credit. On the other hand, this comment does not prove that subrogation should apply in this case as a matter of course. First, the comment speaks of sub-rogation to the customer's right against the beneficiary, and Dauphin Deposit seeks subrogation to Associates’ rights against USF & G, not the township. More basically, the question remains what classes of cases are “proper” cases. On that score, there is little legislative history behind Article 5 to turn to, for the case law on subrogation in letter of credit contexts was extremely sparse before the adoption of the Code. See Michael Evan Avidon, Subrogation in the Letter of Credit Context, 56 Brook.L.Rev. 129, 133-34 (1990); Peter R. Jarvis, Standby Letters of Credit-Issuers’ Subrogation and Assignment Rights-Part I, 9 U.C.C. L.J. 356, 375-77 (1976).
In sum, the text and commentary of the U.C.C. itself do not rule in or rule out subrogation in the letter of credit context. I therefore look to policy reasons (including policies embedded in the Code, such as the independence principle) to determine what is a “proper” case for subrogation.
2. Interference with the Independence Principle
The recent American Bar Association/U.S. Council on International Banking Task Force on the Study of U.C.C. Article 5 reached no definitive conclusion on when and whether subrogation is available in the letter of credit context, although it agreed that statutory resolution of the question would be useful. See its report, An Examination of U.C.C. Article 5 (Letters of Credit) 21 (Sept. 29, 1989), reprinted in 45 Bus.Law. 1527 (1990). The task force did agree, however, that “the question of the *368availability of subrogation is one which must be regarded as being essentially outside of credit law and the letter of credit transaction,” and that “the primary factor in determining [subrogation’s] availability should be whether it would affect the integrity of principles vital to letter of credit law.” Id.
As noted above, the cornerstone of the law of letters of credit is the independence principle, and thus if granting subrogation to issuers of letters of credit would undermine the independence principle, then such subrogation must not be permitted. In my view, allowing the issuer of a letter of credit to subrogate to the rights of its customer would not undermine the independence principle.
The independence principle ensures the beneficiary of prompt payment and basically determines that the beneficiary will have the dollars in its pocket if there is a dispute between it and the customer over the underlying transaction. See, for example, Itek Corp. v. First National Bank of Boston, 730 F.2d 19, 24 (1st Cir.1984). As discussed above, this distinguishes a letter of credit from an ordinary guaranty: a guaranty is not independent in this sense, and guarantors may generally assert defenses available to the party whose obligation is guaranteed.
Investors suggests that the independence principle must be viewed as a wall between the letter of credit side and the underlying transaction side. Some courts have similarly argued that allowing subro-gation would permit an issuer to interfere with the underlying contract. See, for example, In re Economic Enterprises, 44 B.R. 230, 232 (Bankr.D.Conn.1984). But the point of the independence principle is not to set up a wall for the sake of a wall, but to serve certain purposes. The independence principle undoubtedly requires the issuer to pay first, without looking through to the underlying transaction. Subrogation should therefore be unavailable before the issuer has paid the beneficiary. Once the issuer has done so, however, as Dauphin Deposit has here, the purpose of the independence principle has been served: the beneficiary has the money-
Insistence on perpetual separation is thus pointless formalism.2 On a more pragmatic level, I would agree that if the possibility of subsequent subrogation would discourage issuers from honoring already-issued letters of credit,3 then subro-gation should not be permitted, because that would undercut the purposes of Article 5. But I cannot see why that would be so. If anything, the ^availability of subsequent subrogation might discourage issuers from honoring the letters because they would have one less means of obtaining reimbursement.
In sum, the policies underlying Article 5 of the U.C.C. do not require courts to deny subrogation to all issuers of standby letters of credit. The remaining question is whether other policy considerations commend the per se rule argued by Investors and adopted by the majority.
C. Other Policy Considerations
1. The Issuer’s Ability to Protect Itself Contractually
In my view, Investors’ (and the majority’s) best argument is that the issuer of a letter of credit is perfectly able to protect itself contractually. That is, the issuer receives a payment for its services and may also demand assignment rights to collateral in the event that it is forced to pay on the letter. Investors argues that Dauphin Deposit made a deal with Associates and received certain collateral rights, including assignment rights to the other bonds involved in the Green Hill Project (the “Wau-sau bonds”). It is certainly fair to ask why Dauphin Deposit should receive the additional right of subrogation, simply because it made a bad gamble or wasn’t wary *369enough when negotiating its reimbursement agreement with Associates. Many courts have voiced similar concerns. See, for example, In re Agrownautics, Inc., 125 B.R. 350, 353 (Bankr.D.Conn.1991); In re Carley Capital Group, 119 B.R. 646, 650 (W.D.Wis.1990).
Nevertheless, this argument, although powerful, proves too much. Generally applied, the same argument would virtually eliminate equitable subrogation altogether, for it would apply to every guaranty or suretyship contract. Moreover, in many cases this may lead to the customer receiving an undeserved windfall. A customer may default on both its obligation on the underlying transaction and its obligation to reimburse the issuer of the letter of credit, yet retain any income deriving from the original transaction. In short, the issuer’s ability to protect itself may be a strong equity against it, as is the fact that it receives a fee for its services, but countervailing equities may outweigh these considerations in certain cases. See In re Glade Springs, Inc., 826 F.2d 440, 442 (6th Cir.1987) (reinstating the subrogation remedy that had been ordered by the bankruptcy court, 47 B.R. 780 (Bankr.E.D.Tenn.1985)).4
2. Efficiency
At bottom, what concerns me most is how the rule that courts adopt will affect incentives to issue letters of credit-in the first place. It is possible that if no equitable subrogation were permitted, fewer banks would issue such letters, which would be commercially undesirable. Given the vagaries of commerce, it may be difficult for the issuer to forecast precisely which security will have value years down the road. If courts allow traditional equitable subrogation, the transaction costs in negotiating letters of credit may.be lower than under a rule where the parties must specify subrogation rights contractually.
On the other hand, with the law as unsettled as it now is, prudent would-be issuers may already have reacted by demanding greater fees or security, and the system appears to be functioning well. Parties may even be willing to incorporate the entire body of equity jurisprudence by contractual reference. Perhaps in the long run, the. rule that the majority adopts will not make much of a difference, as good lawyers and prudent issuers will react accordingly. I concede too that a bright-line no-subrogation rule would promote legal certainty and thereby reduce litigation costs.
The issue is very close, but on balance I think that the better rule is to retain subro-gation on a case-by-case basis and apply it sparingly. When the unexpected happens, as it so often does, it is desirable to leave courts with equitable powers to avoid windfalls and to achieve a result fair to all parties. Certainly that was the solution of the common- law, and I have found nothing in the U.C.C. as adopted in Pennsylvania that justifies my predicting that the Pennsylvania Supreme Court would vote to oust the common law in this field. See also 13 Pa.Cons.Stat.Ann. § 1103 (equivalent to U.C.C. § 1-103) (supplemental common law principles continue to apply unless explicitly displaced by the U.C.C.).
As noted above, Article 5 of the U.C.C. has been under study by a task force. That study recommended that the question of subrogation rights be resolved statutorily. I agree that that is the best solution. Perhaps further policy study will show that the equitable subrogation game isn’t worth the candle, and the U.C.C. will be amended so to provide. Under the law as it stands, however, I cannot agree with the majority that'equitable subrogation should be corn-*370pletely unavailable in the letter of credit context.
II. SUBROGATION IN THIS CASE
A. Adequacy of a Remedy at Law
After Dauphin Deposit paid on the township’s draft upon the letter of credit, it was statutorily and contractually entitled to immediate reimbursement from Associates. See 13 Pa.Cons.Stat.Ann. § 5114(c) (equivalent to U.C.C. § 5-114(c)). Dauphin Deposit was also, however, contractually entitled not only to a substantial annual fee for its services, which included taking some risk of nonreimbursement, but also to an assignment of a security interest in the Wau-sau bonds. Dauphin Deposit also received a collateral note from Tudor, Associates’ general partner. The only apparent reason for this suit is that those legal remedies may not suffice to make Dauphin Deposit whole.5
The majority suggests that Dauphin Deposit’s legal remedies against possibly as-setless Tudor and Associates are “adequate,” precluding equitable relief. It cites Willing v. Mazzocone, 482 Pa. 377, 393 A.2d 1155, 1158 (1978), and Chartiers Valley School District v. Virginia Mansions Apartments, 340 Pa.Super. 285, 489 A.2d 1381, 1386-87 (1985), which hold in non-subrogation contexts that the adequacy of a legal remedy is measured by its availability, not its likelihood of success, and, concomitantly, that a defendant’s insolvency does not justify equitable intervention.6
I find those cases distinguishable. Notably, Investors and the majority cite no case nor have I found any case from Pennsylvania or any other state that denies equitable subrogation (as opposed to injunctive or other equitable relief) on the ground of adequate remedies at law.7 The majority’s conclusion also produces an anomaly. It denies equitable subrogation when the owing party is judgment-proof, yet that is precisely when subrogation is most likely to be necessary. Consider, too, a contract between a principal and its surety. If the principal has assets, its creditor is unlikely to have to call upon the surety for payment. Moreover, under Pennsylvania law a surety always has a contract action (express or implied) against its principal for indemnity, yet it is ordinarily entitled to subrogation as well. See generally 35 Pennsylvania Law Encyclopedia, Suretyship §§ 131-134 (West, 1961 & 1991 Supp.).
Thus, the nominal availability of legal action against Tudor and Associates should not bar Dauphin Deposit from seeking sub-rogation to the rights of Associates. At most, the availability of superior remedies should be a subject for the district court on remand as part of the equitable balance.8
*371B. The Balance of Equities
The relevant equities are those between Dauphin Deposit and the remaining claimant to the USF & G bonds, Investors. I have already discussed the mixed equities in favor of Dauphin Deposit. The parties also dispute the equities as to Investors. Investors claims that it is an innocent as-signee with no reason to expect that its assignment rights would be subject to the subrogation claim of Dauphin Deposit. Dauphin Deposit counters that Investors was not a good faith assignee for value, but the successor and affiliate of a foreclosing creditor, Summit. According to Dauphin Deposit, Investors knew of Dauphin Deposit’s role from its participation at meetings with the township and is benefiting from the windfall of improvements financed by the draft on Dauphin Deposit’s letter of credit.
I have no idea which version is the more accurate or whose story is more compelling. Because this balancing of the equities is quintessentially a matter for a trial court, and the district court has not undertaken this task, I would remand the issue.
C. Scope of the USF & G Bonds
Finally, the parties dispute whether the USF & G Bonds even covered the work that led to the default that required Dauphin Deposit to pay on the letter of credit. Investors argues that the USF & G bonds covered construction of buildings, not the site improvements that were the subject of Dauphin Deposit’s letter of credit. Dauphin Deposit contends that the USF & G bonds covered the entire project, both buildings and site improvements. The district court and the majority never reached this issue, although Judge Garth, in concurring footnote 4 to the majority opinion, agrees with Investors.
This question involves contractual construction that is not simple: the Susquehanna Construction agreement is complex and probably ambiguous, and hearing parol evidence and evidence of the parties’ course of conduct may prove necessary. Simply because the Wausau bonds covered only site improvements, it does not necessarily follow that the USF & G bonds were entirely complementary and covered only buildings. Moreover, Dauphin Deposit argues that Associates is estopped to deny that the USF & G bonds covered the site improvements. Because the district court did not reach these issues, I would remand them, too.
III. CONCLUSION
For the foregoing reasons, I would reverse the judgment of the district court and remand for further proceedings.

. On the confusion engendered by the unhelpful “primary”-"secondary” dichotomy, see also Boris Kozolchyk, The Emerging Law of Standby Letter of Credit and Bank Guarantees, 24 Ariz.L.Rev. 319, 321 n. 9 (1982).

. The majority appears to recognize this, for it concedes that "the vitality of the independence principle is unlikely to be substantially diminished were we to allow subrogation in this situation.” Majority op. at 363.

. I discuss below incentives regarding the issuance of letters of credit in the first place.

. Furthermore, if offered to support a per se rule against equitable (as opposed to contractual) subrogation, the argument is somewhat circular. As I am about to discuss, an issuer of a letter of credit might have elected not to contract for specific protection in the belief (ill-advised, in light of the majority’s holding) that general principles of subrogation will provide broader protection than any particular security could providé. I must concede, however, that this- argument is unavailable on the facts of this case because Dauphin Deposit did contract for specific security.

. Associates and Tudor may be judgment-proof. Dauphin Deposit apparently has an action pending in Pennsylvania court against Associates, but it is unresolved. It is less clear why Dauphin Deposit's interest in the Wausau bonds is insufficient. Dauphin Deposit apparently , did not perfect its security interest in the Wausau bonds, but at all events Jacobs v. Northeastern Corp., 416 Pa. 417, 206 A.2d 49, 54-55 (1965), holds that a failure to file financing statements on bonds does not bar subrogation.

. The Pennsylvania rule appears to be the minority rule, widely criticized by commentators. But, of course, however questionable that rule may be in general, it is not questionable by this court applying Pennsylvania law in a diversity case.

. In Willing, lawyers sought an injunction against a former client to prevent her from picketing their office with an allegedly defamatory sign. The Pennsylvania Supreme Court primarily ruled that the injunction ordered by the lower courts was an impermissible prior restraint on speech. In so doing, however, it also rejected the Superior Court’s conclusion that an injunction was necessary because an action for damages would be pointless because the defendant was indigent.
In Chartiers Valley School District, the plaintiffs, a school district and a township, sought to impose a constructive trust on property, to rescind conveyances of that property, and to enjoin further transfers of it. The court noted that the underlying action was in fact legal, for the suit was an effort to ensure collection of taxes by preserving the taxpayer’s assets.
Neither case has anything to do with subrogation, -nor do the hoary cases that they cite.

. If the argument is instead that equitable remedies should not supplement presumptively exclusive statutory remedies, then the argument fails because the issuer’s remedy under 13 Pa.Cons.Stat.Ann. § 5114(c) was not intended to rule out subrogation in a "proper” case. See 13 Pa.Cons.Stat.Ann. § 5109 comment 1.