The opinion of the court was delivered by: PALMIERI
This is an appeal by Seaboard Surety Company from a decision of the Bankruptcy Court.
The facts of the case can be stated briefly. Eastern Freight Ways, Inc. ("Eastern") and Associated Transport, Inc. ("Associated") were licensed common carriers of freight under the regulatory authority of the Interstate Commerce Commission. In accordance with the Commission's regulations, Eastern and Associated were authorized to act as self-insurers against cargo losses sustained by their shipping customers. Eastern gained control of Associated in 1974 and, upon authorization of the ICC, was operating and managing its affairs.
Prior to 1974, Associated had caused Seaboard to issue bonds in connection with its liability as self-insurer to third parties relating to its shipping business. After Eastern gained control of Associated, both companies began to do business with Seaboard. In September 1974, a number of agreements were executed among these companies, the precise legal effect of which remains to be ascertained. These included: 1) a "Collateral Agreement", under which Eastern and Associated agreed to provide collateral for Seaboard's exposure under any bonds issued or to be issued on behalf of Eastern or Associated; 2) a "General Agreement of Indemnity", under which Eastern and Associated agreed to indemnify and hold Seaboard harmless against liabilities incurred by Seaboard under such bonds; and 3) a letter of credit which Eastern procured from the Chase Manhattan Bank, N.A. ("Chase") from which Seaboard was authorized to draw up to $2,000,000 by sight draft and upon written certification that it had "not been released from liability under the surety (bonds) or (undertakings)... executed on behalf of Eastern...." During this same period Seaboard issued bonds on behalf of Eastern in connection with its liability as self-insurer to third parties for bodily injury, property damage, workmen's compensation, and the like.
Subsequent to the above arrangements, Eastern entered into various security agreements with Manufacturers Hanover Trust ("Manufacturers"), International Harvester Credit Corporation ("International Harvester"), and Fruehauf Corporation ("Fruehauf"), conveying to these companies security interests in Eastern's accounts receivable.
Eastern and Associated filed petitions for arrangement under Chapter XI of the Bankruptcy Act on April 22, 1976 and both were adjudged bankrupt on April 28, 1976. (Eastern briefly re-entered Chapter XI in June of 1976, but was again adjudged bankrupt on August 25, 1976.) Sidney B. Gluck, plaintiff below, was appointed trustee in bankruptcy of Eastern ("Eastern trustee"), and Thomas J. Cahill was appointed trustee in bankruptcy of Associated ("Associated trustee").
When Eastern filed its Chapter XI petition, approximately 20,000 unpaid cargo claims had been presented to Seaboard, many of which were asserted by claimants who also owed freight charges to Eastern. On April 28, 1976, when Eastern and Associated were originally adjudged bankrupt, Seaboard delivered its certification to Chase, took down the proceeds of the letter of credit, and began to use such proceeds to satisfy claims on the bonds which it had written for both Eastern and Associated. Seaboard also began sending letters to the shipping customers of Eastern and Associated, advising them that they could set off sums they owed for freight charges against cargo claims they asserted against those companies and that Seaboard would not be responsible for more than the difference between the two.
The present adversary proceeding was commenced on November 3, 1976, by the filing of the Eastern Trustee's complaint which pleaded three causes of action. The first sought, inter alia, a determination that, because of the prior assignments of the accounts receivable, Seaboard could not invite setoffs from Eastern's customers. The second, which was dismissed by the Bankruptcy Judge and is not the subject of any appeal or cross-appeal, sought damages for Seaboard's alleged conversion of Eastern's accounts receivable. The third cause of action set forth two requests for relief: first, a declaration that the proceeds of the letter of credit are to be used by Seaboard to satisfy only claims under bonds written for Eastern, and second, a judgment that Seaboard must first exhaust the proceeds of the letter of credit before being able to take advantage of any alleged right to invite setoffs.
All of the defendants except Seaboard answered, most of them asserting cross-claims against Seaboard. Seaboard moved to dismiss the first and second causes of action of the complaint and related cross-claims for failure to state claims upon which relief could be granted; it also moved to dismiss the third cause of action and related cross-claims on the ground that the Bankruptcy Court lacked jurisdiction to grant the relief requested.
A hearing was held on Decm
A hearing was held on December 13, 1976 and Judge Babbitt of the Bankruptcy Court rendered an opinion on April 7, 1977, which in essence denied Seaboard's various motions to dismiss (except as to the second cause of action), awarded declaratory relief to the Eastern trustee to the effect that no setoff can be claimed by Seaboard until the proceeds of the letter of credit are exhausted, made permanent a temporary injunction restraining Seaboard from sending letters to Eastern's customers, and set down an evidentiary hearing on the proper allocation of the proceeds of the letter of credit. The latter hearing was stayed pending the resolution of this appeal.The Bankruptcy Judge did not reach the allegations of the first cause of action and related cross-claims, finding that his resolution of the third cause of action disposed of the case. Seaboard was granted "leave to return... at such time when it appears that it is a norecourse position." An order was entered on May 27, 1977, in accordance with this opinion. Seaboard's appeal from the May 27, 1977 order followed.
Seaboard's alleged equitable right to invite setoffs
The sole issue of substance resolved by the Bankruptcy Court and presently before this court for review concerns the effect of the proceeds of the letter of credit upon the claimed right of the surety, Seaboard, to invite setoffs by Eastern's shipping customers. All of the parties are in agreement that the analysis must commence with the landmark case of In re Yale Express System, Inc., 362 F.2d 111 (2d Cir. 1966) ("Yale Express"), and that the essential question posed here is whether that authority is controlling on these facts.
In Yale Express, a Chapter X case, the United States Court of Appeals for the Second Circuit held that "the surety of an insolvent debtor is entitled to have a creditor apply a debt owing to the debtor to satisfaction of his claim", supra at 116. This holding represents an exception to the general rule that a surety cannot compel a solvent principal to assert a counterclaim against third party creditors nor use the principal's counterclaim when sued by such creditors. Meeker v. Halsey, 87 F.2d 299, 301 (2d Cir. 1937), cited in United States ex rel. ...