Equitable Results Still the Backbone of Section 509

By: Patrick James Kondas
St. John's Law Student
American Bankruptcy Institute Law Review Staff

Recently, in Innovative Communication Corp. v. Prosser (In re Innovative Communication Corp.),[1] a Pennsylvania bankruptcy court held that under section 509, a claim was extinguished when a co-lessee purchased it from a creditor.[2] The co-lessee claimant co-leased a motor vehicle lease with a chapter 11 debtor corporation, which he owned and controlled at the time the lease was executed.[3] Later, the claimant purchased all rights to the claim and attempted to assert the claim against the corporation’s bankruptcy estate.[4] The court found the claim was extinguished by the claimant’s purchase of it.[5]

In holding that the purchase by the co-lessee extinguished the claim, the court considered the issue of one co-obligor seeking to be subrogated to the rights and claims of the original creditor.[6] Section 509(a) states that “an entity that is liable with a debtor on a claim of a creditor against the debtor, and that pays such claim, is subrogated to the rights of such creditor . . . . ”[7] The application of section 509(a) is limited by 509(b), which, among other things, bars subrogation where the purchasing co-obligor received consideration for the claim.[8] The Innovative Communication Corp. court noted that the operative question under 509(b)(2) is whether the entity asserting subrogation was primarily or secondarily liable for the debt.[9] As such, it based its decision on the premise that subrogation is disallowed where the entity is primarily liable, as primary liability indicates receipt of consideration for the creditor’s claim.[10]

The relationship between consideration and primary liability has been framed by several courts. A New York district court in Pandora Indus. Inc. v. Paramount Communication Inc. (In re Wingspread Corp.) explained that the inquiry is “whether [the entity’s] payment was used to satisfy another’s obligation,” and that this question is resolved by identifying which of the liable parties received consideration.[11] Similarly, in Fibreboard Corp. v. Celotex Corp. (In re Celotex Corp.),[12] the Eleventh Circuit held that subrogation was unavailable where a co-defendant who was jointly and severally liable paid the full amount of a claim, since the paying co-defendant received consideration in the form of release from further obligation.[13] The fundamental issue, as these opinions show, is the relationship between the co-obligor and debtor. As such, the Innovative Communication court noted that section 509(b)(2) bars subrogation where the relationship between the co-obligor and debtor is such that the co-obligor is effectively paying its own debt.[14]

In re Innovative Communication Corp. applies the well-settled principles of section 509 to instances where a Chapter 7 debtor purchases the claim for which he is primarily liable as co-obligor with an entity he owned and operated at the creation of the obligation.[15] In doing so, the court adhered to the equitable common law principles of equitable subrogation, now codified in section 509,[16] to find that the purchase of a claim by a co-lessee extinguishes that claim. Though the doctrine’s codification differs in some respects from its common law origins, it clearly remains fundamental that a co-obligor cannot in fairness pay his own debt and then collect that payment from another.[17]