Friendly and Hays, Circuit Judges, and Clarie, District Judge.*fn*
This appeal from an order of Judge Tyler in the Chapter X proceedings of Yale Express System, Inc., in the Southern District of New York, raises interesting questions of the rights of a surety in bankruptcy, some of which are only dimly illumined by the case law.
The debtor Yale Express, a motor carrier certificated under the Interstate Commerce Act, was insured by Boston Insurance Company against liability for loss or damage to cargo under policies requiring Yale to pay the first $5000 of each claim. The basic policy contained an endorsement, obtained by Yale in order to effect compliance with ICC regulations under § 215 of the Act, 49 C.F.R. § 1741 (b), whereby Boston undertook to pay any shipper or consignee for all loss or damage to property coming into Yale's possession for which the carrier might be held legally liable, up to a maximum of $2000 in respect of loss or damage occurring at any one time and place and of $1000 in respect of loss or damage to property carried on any one motor vehicle. The endorsement was to apply "irrespective of the financial responsibility or lack thereof or insolvency or bankruptcy of the insured," but Yale agreed to reimburse Boston "for any payment that the Company would not have been obligated to make under the provisions of the policy, except for the agreement contained in this endorsement."
At the filing of the Chapter X petition Yale had some 22,000 pending claims for cargo loss and damage, many of which were asserted by shippers owing freight charges. The trustee promptly notified all claimants that because of the Chapter X proceedings Yale could make no payments on pre-petition claims save as part of a plan of reorganization but that Boston was obligated to pay them directly at least up to $1000. When claims began to be filed against Boston, it sent the shippers letters indicating willingness to honor their claims after processing by the debtor but asserting its right to deduct any outstanding freight. At the same time employees of Yale were informing claimants that all freight charges had to be paid to it within the credit period. Fearing this conflicting advice would impair his efforts to retain or win back the custom of the claimants, the then trustee negotiated an arrangement with Boston and petitioned the district court ex parte for its approval. The arrangement, which applied only to claims payable by Boston under the endorsement, provided that Boston would stop sending letters to the claimants asserting the right to set off unpaid freight; that in paying for cargo loss or damage Boston would deduct outstanding freight charges, informing the shipper that the debtor had set off the receivable against the cargo claim; and that the debtor would pay to Boston any freight collected from the shipper after the date of the arrangement and before the cargo claim was processed. The judge denied the trustee's application but, on the petition of Boston, reheard the matter on notice to all parties; at that hearing the trustee reversed his previous position. The judge concluded that Boston was not entitled to reduce liability to claimants under the endorsement by setoff of freight owing to the debtor and that in any event it would be improvident to allow such extensive depletion of the debtor's cash resources.
In order to succeed on appeal Boston must establish:
(1) That it stood as a surety for Yale with respect to the claims here in question;
(2) That as a surety it was equitably entitled to require deduction of freight owing to Yale;
(3) That this equitable right should be recognized in bankruptcy; and
(4) That enforcement of the right would not unduly interfere with the rehabilitative objective of the Chapter X proceeding.
We hold that Boston has established the first three propositions, and that a further hearing is required because the judge acted on a mistaken assumption in considering the fourth.
We conclude swiftly but surely that Boston was a surety to Yale for the claims payable solely under the endorsement. "Suretyship is the relation which exists where one person has undertaken an obligation and another person is also under an obligation or other duty to the obligee, who is entitled to but one performance, and as between the two who are bound, one rather than the other should perform." ALI, Restatement, Security § 82. Both Yale and Boston are obligated to the shipper, and Yale's promise to reimburse Boston for any payments made solely by virtue of the endorsement shows that it rather than Boston is the principal who "should perform." Id. at 230.*fn1 It is of no moment that a claimant can proceed directly against Boston; suretyship relations are not confined to cases where "the creditor's assertion of his right against the surety must be postponed until some action is taken against the principal. So far as the creditor is concerned, the surety may be the primary obligor." Id. at 230. The fact that the premiums covered payment for Boston's undertaking under the endorsement does not mean that Boston was not a surety; it means only that it was a compensated one. These controlling rules are so elementary and their fit to the facts so perfect that further citation or development of this point would be supererogation.
It is equally well settled that "where the duty of the principal to the creditor is fully satisfied, the surety to the extent that he has contributed to this satisfaction is subrogated * * * to the interests which the creditor has in security for the principal's performance and in which the creditor has no continuing interest." Restatement, Security § 141. The claimants' power to satisfy their damage claims in whole or in part by deducting their liability for unpaid freight*fn2 was security of the most perfect kind. To be sure, it is generally held that so long as the principal is solvent and thus able to respond to a claim for exoneration, "a surety cannot compel him to assert a counterclaim in the surety's exoneration, nor can the surety use it himself, when sued." United States ex rel. Johnson v. Morley Const. Co., 98 F.2d 781, 789 (2 Cir. 1938), see Meeker v. Halsey, 87 F.2d 299, 301 (2 Cir. 1937); 4 Williston, Contracts § 1251 (Rev. ed. 1936). But when the principal is insolvent, the surety may set off the principal's claim, Clark Car Co. v. Clark, 48 F.2d 169 (3 Cir. 1931); Restatement, Security § 133(2) (c), or obtain a decree requiring the creditor and the principal to adjust their controversies, remaining liable to the creditor only for the amount not covered by the principal's claim against him. Scholze v. Steiner, 100 Ala. 148, 14 So. 552 (1893); Armstrong v. Warner, 49 Ohio St. 376, 31 N.E. 877, 17 L.R.A. 466 (1892); St. Croix Timber Co. v. Joseph, 142 Wis. 55, 124 N.W. 1049 (1910). Judge L. Hand explained the rationale in the Morley case:
"If the creditor then recovers from the surety, the surety has no recourse over against the principal, but must bear the loss except for such dividends as he may get in the insolvency proceedings. Yet having recovered from the surety and realized upon his claim, the creditor is without set-off when sued on the counterclaim by the principal's trustee or receiver, and the recovery goes to swell the estate. Had the creditor not sued the surety, he could, and of course would, have used the claim as a set-off against the counterclaim. Thus, the upshot of denying the surety a right to assert the counterclaim is to enhance the principal's estate at the expense of the surety, which is contrary to the fundamental relation between the two. The truth is that after insolvency the counterclaim becomes the creditor's security for his own claim, a means by which it can be paid dollar for dollar through his right of set-off. However, it is only after the surety pays the creditor that he is subrogated to all the creditor's securities, and that would be a condition here, except that the surety cannot pay the debt without losing the security, for ...