In re James S. HAMADA, Debtor. James S. Samada, Appellant, v. Far East National Bank, a California Corporation, Appellee, 291 F.3d 645

THOMAS, Circuit Judge. In this appeal, we consider, inter alia, the rights of statutory and equitable sub-rogation held by the issuer of a standby letter of credit. Under the circumstances presented by this case, we conclude that no right of subrogation existed. Therefore, we reverse the judgment of the district court. I James S. Hamada was the defendant in a breach of fiduciary duty and fraud action filed by his former partner in medicine. The judgment provided for damages of $500,000, punitive damages of $1.25 million, and prejudgment interest.

Hamada appealed, and sought a supersedeas bond to stay execution of the judgment while his appeal was pending. He applied for a bond with Fidelity and Deposit Company of Maryland (“Fidelity”), and Fidelity agreed to provide the supersedeas bond if Hamada paid certain fees, indemnified Fidelity if the bond were to be called, and posted a standby letter of credit for the full amount. Hamada secured the letters of credit from Imperial and Far East banks, which agreed to provide the letters in exchange for Hamada’s indemnification and provision of real and personal property as collateral.

The letters were issued, and Fidelity issued the supersedeas bond. The California Court of Appeal modified, vacated and affirmed parts of the 1990 judgment and remanded the case to the trial court for further proceedings. Hama-da filed for bankruptcy in October 1995. In January 1996, Michelson filed an adversary proceeding in the bankruptcy court seeking a determination that his claims under the court judgment were non-dis-chargeable.

After an order from the bankruptcy court granting Hamada’s motion for relief from the automatic stay, the California trial court entered another judgment in the fraud action in May 1996. Nearly a year later, in July 1997, Michelson obtained a final judgment from the bankruptcy court holding that the damages, punitive damages and prejudgment interest awarded in the state case were non-disehargeable pursuant to 11 U.S.C. §§ 523(a)(2)(A), 523(a)(4) and 523(a)(6).

In November 1997, the California Court of Appeal again reversed the trial court’s judgment, and offered Michelson a remitti-tur reducing the punitive damages award to $500,000, which Michelson accepted. Michelson then made a demand on Fidelity’s supersedeas bond for payment of the judgment. Fidelity sought payment from Hamada, who told the surety that he could not pay the judgment or satisfy his obligation to indemnify Fidelity. Fidelity then presented the letters of credit to Imperial and Far East, and each bank honored its letter and paid Fidelity in excess of $1.2 million.

Fidelity then executed assignment agreements in favor of Far East and Imperial, assigning any rights it had to subrogation based upon its partial satisfaction of the Michelson judgment. Far East and Imperial filed an adversary action against Hamada one year later seeking non-dischargeability of the debts owed to them. The parties stipulated to the material facts, and filed cross-motions for

summary judgment. The Bankruptcy Court conducted a hearing on the matter in March 1999, and in March 2000 issued an order granting Hamada’s motion and denying the motion filed by Imperial and Far East. The court held that the banks’ claims were purely contractual and that they were not entitled to subrogation to the non-dischargeability of the Michelson judgment.

The court found that the banks’ direct claims arising from the letters of credit were dischargeable and that their failure to file timely non-discharge-ability complaints precluded them from seeking non-dischargeability “at this late date.” The court also rejected the banks’ claim that they were entitled to equitable subro-gation, and rejected their contention that the assignment agreements had assigned any subrogation rights held by Fidelity to Far East and Imperial.

The Bankruptcy Court determined that the agreements were unenforceable for lack of consideration and noted that the agreements “appear to be merely a litigation ploy by the Banks in an attempt to bootstrap themselves into a more favorable position than they bargained for in their agreements” with Hamada and Fidelity. Far East appealed to the District Court, which reversed the bankruptcy court’s ruling, essentially because the Michelson judgment was based on Hamada’s fraudulent conduct.

The District Court issued a judgment reversing the Bankruptcy Court and finding Far East entitled to subrogation of the non-dischargeable Michelson claims. Hamada timely appeals. II We review a district court’s decision on appeal from a bankruptcy court de novo. Gruntz v. County of Los Angeles (In re Gruntz), 202 F.3d 1074, 1084 n. 9 (9th Cir.2000) (en banc). “We independently review the bankruptcy court’s decision and do not give deference to the district court’s determinations.” Preblich v. Battley, 181 F.3d 1048, 1051 (9th Cir. 1999) (citation omitted).

We review the bankruptcy court’s findings of fact for clear error; we review conclusions of law and mixed questions of law and fact de novo. Beaupied v. Chang (In re Chang), 163 F.3d 1138, 1140 (9th Cir.1998). The question of whether a claim is non-dis-chargeable presents mixed issues of law and fact, which we review de novo. Murray v. Bammer (In re Bammer), 131 F.3d 788, 792 (9th Cir.1997) (en banc). III Far East failed to file an adversary proceeding objecting to discharge of its debt within the statute of limitations. See Fed. R. Bankr.P. 4007; State Bank & Trust, N.A. v.

Dunlap (In re Dunlap), 217 F.3d 311, 315 (5th Cir.2000) (“The strict time limitation placed upon creditors who wish to object to a debt’s dischargeability reflects the Bankruptcy Code’s goal of providing debtors with a fresh start.”). Thus, unless Far East is legally subro-gated to the Michelson non-dischargeability judgment by virtue of its payment to Fidelity, Far East’s claims were subject to discharge in the Hamada bankruptcy. A In general terms, subrogation is the substitution of one party in place of another with reference to a lawful claim, demand or right.

It is a derivative right, acquired by satisfaction of the loss or claim that a third party has against another. Subrogation places the party paying the loss or claim (the “subrogee”) in the shoes of the person who suffered the loss (“the subrogor”). Thus, when the doctrine of subrogation applies, the subrogee succeeds to the legal rights and claims of the subro-gor with respect to the loss or claim. See, e.g., Amer. Surety Co. of New York v. Bethlehem Nat. Bank, 314 U.S. 314, 317, 62 S.Ct. 226, 86 L.Ed. 241 (1941) (discussing equitable doctrine of subrogation in surety context); Han v.

United States, 944 F.2d 526, 529 (9th Cir.1991) (discussing equitable subrogation generally). There are various types of subrogation, most commonly categorized as “conventional” or “contractual” subrogation, “legal” or “equitable” subrogation, and statutory subrogation. “Conventional” or “contractual” subrogation rights arise from an express or implied agreement between the subrogor and subrogee. Mutual Serv. Cas. Ins. Co. v.

Elizabeth State Bank, 265 F.3d 601, 626 (7th Cir. 2001). “Equitable subrogation is a legal fiction, which permits a party who satisfies another’s obligation to recover from the party ‘primarily liable’ for the extinguished obligation.” In re Air Crash Disaster, 86 F.3d 498, 549 (6th Cir.1996). The right of “legal” or “equitable” subrogation arose as a “creature of equity” and “is enforced solely for the purpose of accomplishing the ends of substantial justice.” Memphis & L.R.R. Co. v. Dow, 120 U.S. 287, 302, 7 S.Ct. 482, 30 L.Ed. 595 (1887).

Statutory subrogation, as one might expect, occurs by virtue of a right created by statute. See, e.g., Carter v. Derwinski, 987 F.2d 611, 614 (9th Cir.1993) (en banc). Far East alleges that it is subrogated to the Michelson non-dischargeability judgment by virtue of a right of statutory subrogation under the Bankruptcy Code and a right of equitable subrogation. B Far East claims a right of statutory subrogation under the Bankruptcy Code pursuant to 11 U.S.C. § 509(a), which provides: 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. The legislative history to § 509 indicates that it was designed to describe rights available to a limited class of creditors, namely, true co-debtors who have actually paid a debtor’s obligation to the third party in question: This

section is based on the notion that the only rights available to a surety, guarantor, or comaker are contribution, reimbursement, and subrogation. The right that applies in a particular situation will depend on the agreement be-' tween the debtor and the codebtor, and on whether and how the payment was made by the codebtor to the creditor. H.R.Rep. No. 95-595, 95th Congr., 1st Sess. (1977) p. 358, U.S. Code Cong. & Admin. News at 5963, 6314. For our purposes, the critical question under § 509(

a) is whether Far East was “liable with the debtor on, or has secured, a claim of a creditor against a debtor.” Fidelity, as a surety or guarantor of Hamada’s obligation, satisfies this requirement. However, Far East, as the issuer of a letter of credit rather than a guarantor of Hamada’s debt, is in a different position with respect to the Michelson debt. A letter of credit “is an undertaking by the issuing bank ... that it will pay a draft drawn on it ... upon presentation of specified documents.” H. Ray Baker, Inc. v.

Associated Banking Corp., 592 F.2d 550, 552 (9th Cir.1979). “[T]he key distinction between letters of credit and guarantees is that the issuer’s obligation under a letter of credit is primary whereas a guarantor’s obligation is secondary — the guarantor is only obligated to pay if the principal defaults on the debt the principal owes.” Tudor Dev. Group, Inc. v. United States Fidelity & Guaranty Co., 968 F.2d 357, 362 (3d Cir. 1992).

A bank issuing a letter of credit, unlike a guarantor, is not obligated “until after its customer fails to satisfy some obligation, [and] it is satisfying its own absolute and primary obligation to make payment rather than satisfying an obligation of its customer.” Id. Thus, as opposed to the guaranty given by a surety, in a letter of credit transaction the bank’s obligation under the letter of credit is independent of the underlying contract. Id. See also San Diego Gas & Elec. Co. v. Bank Leumi, 42 Cal.App.4th 928, 50 Cal.

Rptr.2d 20, 24 (1996) (discussing the “independence principle” as the primary characteristic of letters of credit). In short, issuers of letters of credit are not “liable with” the debtor on the obligation owed to the creditor; therefore, letter of credit issuers are not eligible under § 509 for statutory subrogation in this context. Slamans v. First Nat’l Bank & Trust Co. (In re Slamans), 69 F.3d 468, 475-76 (10th Cir.1995) (letter of credit issuer does not satisfy the plain language requirements of § 509); Kaiser Steel Corp. v. Bank of Am.

Nat’l Trust & Savings Assoc. (In re Kaiser Steel Corp.), 89 B.R. 150, 153 (Bankr.D.Colo.1988) (same); but see In re Valley Vue Joint Venture, 123 B.R. 199, 204 (Bankr.E.D.Va.1991) (rejecting Kaiser’s analysis and holding that issuer of letter of credit is “an entity that is liable with the debtor” under 11 U.S.C. § 509(a)). Thus, Far East’s claim for statutory subrogation under the Bankruptcy Code fails. C Far East also claims a right to assert the Michelson non-dischargeability judgment by virtue of equitable subrogation. Equitable subrogation is a doctrine governed by state law. Mori v.

United States, 86 F.3d 890, 893 (9th Cir.1996). Thus, we must turn to the law of California, which provides for equitable subrogation if the party seeking subrogation meets five specific criteria: 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. Fidelity Nat.

Title Ins. Co. v. U.S. Dept. of the Treasury, I.R.S., 907 F.2d 868, 870 (9th Cir.1990) (citations omitted). See also Simon v. United States, 756 F.2d 696, 698-99 (9th Cir.1985) (applying five equitable principles of subrogation in context of land purchase at a county tax sale). The first requirement “extends to those who pay in performance of a legal duty in order to protect their own rights or interests.” Union Pac. Corp. v. Wengert, 79 Cal.App.4th 1444, 95 Cal.Rptr.2d 68, 71 (2000). Because Far East had a legal duty to pay Fidelity, it “acted for its own interest” when it honored the letter of credit.

Thus, Far East satisfies the first factor. The second requirement is that the subrogee claimant may not have acted as a volunteer. In this case, the Bankruptcy Court determined that Far East qualified as a volunteer because it entered into its agreement with Hamada for profit and with full knowledge of the non-dis-chargeable nature of the claim.

However, under California law, a party is considered a volunteer under the doctrine if, “in making a payment, they have no interest of their own to protect, they act without any obligation, legal or moral, and they act without being requested to do so by the person hable on the original obligation.” Mort, 86 F.3d at 894. Here, Far East did not act “without any obligation” — in fact it acted because o/its obligation. Therefore, Far East does not qualify as a volunteer, and has satisfied the second requirement. The third requirement is that Far East not be primarily liable for the debt it paid.

Because it was primarily liable on the letter of credit, Far East does not satisfy this element. As the Bankruptcy Court correctly observed, Far East paid Fidelity because of its contractual obligation under the letter of credit agreement, which was independent of the obligation Fidelity owed Michelson under the surety agreement. The California Supreme Court explained the concept this way: the rules applicable to surety relationships do not govern the relationships between the parties to a letter of credit transaction....

Nor does the beneficiary of a credit owe any obligations to the issuer; literal compliance with the letter of credit’s terms for payment is all that is required. Western Sec. Bank v. Superior Court, 15 Cal.4th 232, 62 Cal.Rptr.2d 243, 253, 933 P.2d 507 (1997) (citations omitted). The independence of the obligations of a letter of credit issuer in this context was underscored by the California Court of Appeal in San Diego Gas & Elec. Co., 50 Cal.Rptr.2d at 23: Three contractual relationships exist in a letter of credit transaction.

Underlying the letter of credit transaction is the contract between the bank’s customer and the beneficiary of the letter of credit, which consists of the business agreement between these parties. Then there is the contractual arrangement between the bank and its customer whereby the. bank agrees to issue the letter of credit, and the customer agrees to repay the bank for the amounts paid under the letter of credit.... Finally, there is the contractual relationship between the bank and the beneficiary of the letter of credit created by the letter of credit itself.

The bank agrees to honor the beneficiary’s drafts or demands for payment which conform to the terms of the letter of credit. Id. (citations omitted). For these reasons, Far East must be considered primarily liable on the debt upon which its claim is founded: its debt to Fidelity under the letter of credit agreement. Thus, Far East cannot satisfy the third element. The fourth requirement for the application of equitable subrogation under California law is the claimant must have paid the entire debt owed by the debtor.

Although there is some dispute about the precise amount of the payment, Hamada does not seriously contest that the debt was extinguished by virtue of the payment. Therefore, for the purposes of this analysis, we will presume that Far East met this requirement. The final element for a finding of equitable subrogation under California law is that the subrogation must not work an injustice to the rights of others. Far East argues that because the Michelson non-dischargeability judgment was based on Hamada’s fraud, the equities tip in its favor. The district court apparently found this argument decisive.

Hamada contends that he has suffered enough due to the underlying litigation and the bankruptcy- Neither argument addresses the salient inquiry. In this context, the rights that must be balanced are the rights of other creditors in the Hamada bankruptcy. By declaring the Far East debt to be non-dischargeable, the court would be placing Far East in a much better position than other similarly-situated creditors. As to Michelson, this result was not only eminently fair, but dictated by the Bankruptcy Code due to the finding of the Bankruptcy Court that Hamada had committed a breach of fiduciary duty and fraud.

However, Far East is not in the same position as Michelson. Hamada committed no fraud on Far East. Rather, Far East consciously undertook to grant a letter of credit to Fidelity with full knowledge of Michelson’s allegations against Hamada, including the alleged fraud. It did so as a commercial transaction in which Hamada pledged certain real estate assets as collateral. Far East, in accepting that collateral, assumed the risk that the collateral might be insufficient to satisfy Michelson’s claim. Moreover, it failed to take appropriate action in the bankruptcy court to protect its interest.

Thus, given these circumstances, the equities that Michelson might assert vis-a-vis other creditors do not accrue equally to Far East. Having entered into the commercial transaction with full knowledge of Hamada’s alleged wrongdoing, Far East cannot, like Casablanca’s Captain Renault, express shock at having now “discovered” it. Rather, Far East is in the same position as every other disappointed commercial creditor to whom Hamada owed a debt. Nor has Hamada unjustly been removed from his responsibility to pay the Michelson judgment.

To the contrary, Hamada made financial arrangements that resulted in satisfaction of the judgment. The defrauded creditor in whose favor the bankruptcy court entered a non-dischargeability judgment has received full payment, and there is no claim that Hamada committed fraud against Far East that would entitle it to preferential treatment over other creditors to whom Hamada owes money. Hamada has also not been relieved of his responsibility to Far East; however, that responsibility will be discharged through operation of the pro rata distribution of his assets to all creditors.

For these reasons, the fifth element of equitable subrogation also is unsatisfied. Far East argues that application of California’s equitable subrogation doctrine does not depend upon “slavish” adherence to the five criteria enunciated by the California Supreme Court. It is true that California courts have, on occasion, liberally construed the doctrine. See, e.g., Johnson v. Kristovich (In re Johnson’s Estate), 240 Cal.App.2d 742, 50 Cal.Rptr. 147, 149 (1966). Indeed, the California Supreme Court has held explicitly that equitable subrogation is not limited to circumstances where the five factors are met.

Caito v. United Calif. Bank, 20 Cal.3d 694, 144 Cal.Rptr. 751, 756-57, 576 P.2d 466 (1978). However, California courts have yet to extend the doctrine to cases in which the purported subrogee is primarily liable on the debt and, in this case, the equities do not fall in Far East’s favor when the rights of the other creditors are considered. D Far East also claims a right to claim an exception to discharge based on the assignment of Fidelity’s subrogation rights. However, we have previously held that sureties do not have a right of subrogation under such circumstances. See Nat’l Collection Agency v.

Trahan, 624 F.2d 906, 908 (9th Cir.1980). Thus, Far East did not acquire any rights to the Michelson non dischargeability judgment by assignment of the surety’s rights. IV Because Far East is neither entitled to statutory nor equitable subrogation, its claim for declaratory relief necessarily fails. The bankruptcy court was entirely correct in so holding. Thus, we must reverse the judgment of the district court which reversed the judgment of the bankruptcy court. REVERSED. .

Under California law, which applies to the substance of the underlying transaction, a letter of credit is "an engagement by a bank or other person made at the request of a customer ... that the issuer will honor drafts or other demands for payment upon compliance with the conditions specified in the credit.” Cal. Com.Code § 5103(a). . The district court's order and judgment does not reflect its reasoning.

However, at the time set for the hearing on the motion, the court observed, among other extraneous matters, that: “I think the intent of the law should be and the better policy argument is there is no policy that I am aware of to let people get a better deal or get out of any part of their debt and simply by reason of the fact that it was a fraud and that otherwise they'd get a fresh start.... The volunteer here, in my judgment, was the debtor, who had the assets. He agreed; he didn't have to, but he did agree. Put up the assets, they went down in value.

Had he not done it, the other person wouldn’t have volunteered, so he actually induced the alleged volunteer.” . In Trahan, a surety contracted with a debtor to post bond to insure the debtor's payment of state sales taxes. Trahan failed to pay the taxes, and an assignee of the surety satisfied the obligation. When Trahan filed bankruptcy, the assignee sought to except the debt from discharge on the theory that it was sub-rogated to the state's non-dischargeable tax claim. Citing "the overriding policy favoring dischargeability,” we rejected this argument and declined to find a right of subrogation. .

Given this holding, we need not reach the question of whether a judgment of non-dis-chargeability is assignable under the Bankruptcy Code.