State Law Preference Actions: A Thing of the Past?
Nathan, Bruce S., Cargill, Scott, Business Credit
Sherwood Partners v. Lycos, Inc.
Credit grantors usually think of a preference claim as part and parcel of a debtors bankruptcy case. However, numerous states have insolvency proceedings that also permit the recovery of preferences. Wow, another source of preference headaches!
An assignment for benefit of creditors ("ABC") is one such state law liquidation proceeding that resembles a liquidation case under Chapter 7 of the Bankruptcy Code. California has a modern and widely used ABC statute, including a preference statute that is similar to Section 547 of the Bankruptcy Code (the "Bankruptcy Preference Statute"). California's preference statute enables an "Assignee" for the benefit of creditors, who is akin to a Chapter 7 bankruptcy trustee, to recover preferential transfers.
However, the United States Court of Appeals for the Ninth Circuit in Sherwood Partners v. Lycos, Inc., recently ruled that the California preference statute is preempted by the United States Bankruptcy Code and directed dismissal of the Assignee's pending preference action. If that ruling stands, and it is subject to a request for rehearing and reconsideration, state law preference actions in California and possibly other states might become a thing of the past.
An Overview Of ABCs
An ABC is an alternative means of liquidating a financially troubled debtor, in lieu of a liquidation under Chapter 7 of the Bankruptcy Code. An ABC is governed by state law, either by common law or by statute. ABC's are not uniform nationwide, unlike the uniform liquidation regimen of Chapter 7 of the Bankruptcy Code. Each state has different ABC procedures. Some states, like California, have a modern ABC statute that has led to the widespread use of ABCs, while other states, like New York, have more antiquated, less used ABC statutes.
As a general proposition, an ABC is a contract under which a debtor transfers all of its right, title, interest in and custody and control of its property to a third party, an Assignee, in trust. An ABC is designed to be a more expeditious, less expensive liquidation than a federal bankruptcy case. In an ABC, the debtor, who could be an individual, partnership, corporation, or limited liability company, selects the Assignee. A bankruptcy trustee is either selected by the United States Trustee, an arm of the United States Department of Justice, or--in rare cases--elected by creditors. The Assignee is charged with liquidating the debtor's property and distributing the proceeds to the debtor's creditors according to priorities established under state law. Creditors usually must file a proof of claim to participate in an ABC and the Assignee is responsible for reconciling and, if necessary, objecting to claims.
The Califormia Assignment Of Benefit For Creditors Statute
Section 1800 of the California Code of Civil Procedure and other provisions of the California Code of Civil Procedure, California Civil Code and California Commercial Code govern ABC proceedings in California and the rights and duties of the Assignee of benefit for creditors. Among other things, they: (i) require that the Assignee send notice of the assignment to creditors and set a deadline for the submission of claims against the debtor; (ii) give certain priorities for payment of claims for wages, salaries, commissions, employee benefit contributions and consumer deposits; (iii) grant the Assignee the right to occupy and utilize the debtor's business premises during the liquidation process; (iv) grant the Assignee the status of a "lien creditor" with priority over unperfected security interests; and (v) grant the Assignee the power to recover preferential transfers.
An Assignee's statutory right to avoid preferences under California Code of Civil Procedure [section] 1800 (the "California Preference Statute") was the only part of California's ABC statute that was considered by the Sherwood decision. The California Preference Statute gives an Assignee the exclusive right to pursue preference claims against the debtor's creditors. The California Preference Statute mirrors the Bankruptcy Preference Statute. The California Preference Statute requires that the Assignee prove all of the following to avoid a preference: (i) a payment or other transfer of property of the debtor; (ii) to or for the benefit of a creditor; (iii) made on account of an antecedent debt owed by the debtor to the creditor before the transfer; (iv) made when the debtor was insolvent (a balance sheet test; liabilities exceed assets); (v) made within the 90 days before the assignment; and (vi) that enables the creditor to receive more than another creditor of the same class. Also, a defendant in a California state law preference action can assert the same statutory affirmative defenses (e.g., ordinary course of business, contemporaneous exchange, new value) that exist in the Bankruptcy Preference Statute to reduce or eliminate preference liability. California preference actions are initiated by complaint that the Assignee files in a California state or federal court of competent jurisdiction.
Sherwood Partners v. Lycos, Inc.
International Thinklink Corporation, a unified messaging service provider, entered into an agreement with Lycos, which operated a network of websites. Lycos agreed to exclusively promote Thinklink's messaging service on Lycos' websites for two years. Thinklink eventually encountered financial difficulties and made a general assignment for the benefit of creditors to Sherwood Partners in California. Sherwood shut down Thinklink's business and sued Lycos in California state court to recover Thinklink's $1 million payment to Lycos, made within two months of the assignment, as a preference under the California Preference Statute.
Lycos removed the action to federal court, and then moved for dismissal arguing that the Bankruptcy Code preempts the California Preference Statute. The United States District Court denied Lycos' motion to dismiss and eventually granted summary judgment to Sherwood. Lycos appealed this decision to the Ninth Circuit Court of Appeals.
Federal Doctrine Of Preemption Bars Preference Actions Under The California Preference Statute
Under the United States Constitution's Supremacy Clause, federal law trumps and "preempts" conflicting state laws where the federal interest dominates a particular area. By way of example, federal law exclusively governs patents, copyrights, currency, national defense and immigration. There are no state laws governing these subjects because they require uniform regulation by the federal government.
However, just because state and federal law regulate the same activity does not necessarily mean the state law is invalid. Often state law can coexist with, and even supplement or extend, federal statutes without conflict. Indeed, the Bankruptcy Code includes numerous provisions where a creditor's state law rights are preserved under the federal bankruptcy law (for example, state property exemptions from the bankruptcy estate, state fraudulent conveyance law and state reclamation rights). But when state law becomes an obstacle to carrying out the purposes and objectives that Congress intended in enacting certain federal statutes, the state law must yield to the federal statute.
The Ninth Circuit in the Sherwood case had to consider whether the California Preference Statute is preempted by the Bankruptcy Code. The Bankruptcy Code's liquidation device, Chapter 7, was enacted to: (1) grant an individual debtor a discharge of most indebtedness to provide a fresh start for the debtor, and (2) equitably distribute a debtor's assets among competing creditors. The United States Supreme Court held that states could not grant debtors a discharge or release from their debts because a discharge is a principal feature of bankruptcy law and reserved for Congress. State laws that discharge indebtedness interfere with the Bankruptcy Code and the power granted to Congress in the United States Constitution to enact uniform laws on bankruptcy matters.
The issue before the Sherwood court was whether the other principal purpose of the federal bankruptcy law, the equitable distribution of a debtors assets among its creditors, could coexist with the California Preference Statute, or if the two laws conflicted in such a way as to preempt the California Preference Statute. The Ninth Circuit concluded that the Bankruptcy Code preempts state statutes that implicate the Bankruptcy Code's goal of equitable distribution of assets among creditors. The Bankruptcy Code seeks to achieve such equitable distribution through a special form of collective proceeding. It creates a bankruptcy estate and triggers an automatic stay when the debtor flies bankruptcy. The automatic stay prevents creditors from enforcing their claims, and dismembering a debtor, thus preserving the debtor's assets for distribution by the bankruptcy trustee.
The Sherwood court ruled that preferences should be subject to the federal bankruptcy Jaw's tougher standards and procedural protections, and not the more lax procedures and standards of California's ABC statute. One of the major powers that the Bankruptcy Code confers on a bankruptcy trustee is the power to avoid and recover preferences for distribution to creditors. The trustee is under the supervision of the United States Trustee and United States Bankruptcy Court, in contrast to the lack of supervision over the Assignee's activities in a California ABC. In addition, the bankruptcy trustee is not handpicked by the debtor, as was Sherwood, or any other assignee in a California ABC. Instead, the trustee is appointed and supervised by the United States Trustee, or elected by creditors, to ensure impartiality.
Bankruptcy law protects creditors, like Lycos, from the trustee's possible conflicts of interest and other powers of self-dealing. When a trustee is appointed in a federal bankruptcy case there are substantial disclosure requirements and conflict of interest rules that must be complied with in order for the appointment to be approved.
The Ninth Circuit's Rejection Of Sherwood's Arguments
The Ninth Circuit rejected Sherwood's argument that a preference defendant, who did not believe it was being treated fairly by a debtor's Assignee, could simply file an involuntary federal bankruptcy petition against the debtor and obtain the safeguards that are afforded in a federal bankruptcy case. The Sherwood court noted that in most cases, at least three unsecured creditors must join in an involuntary bankruptcy petition. If a preference defendant believes it is being mistreated, it may not be able to obtain two other creditors to participate in an involuntary bankruptcy filing.
The Ninth Circuit also rejected Sherwood's argument that Bankruptcy Code Section 544(b) incorporates the California Preference Statute into the Bankruptcy Code. Section 544(b) allows a bankruptcy trustee to avoid transfers that are otherwise voidable by unsecured creditors under applicable law, including state law. A bankruptcy trustee's Section 544(b) powers are limited to those of unsecured creditors, such as the right of an unsecured creditor to set aside and recover a fraudulent transfer under state law. Only those states' preference laws that give Assignees or other fiduciaries the power to avoid preferences already held by the debtor's unsecured creditors would pass muster with the Ninth Circuit and not be barred by the preemption doctrine. In contrast, an Assignee's power to set aside preferences under the California Preference Statute is barred under the Ninth Circuit's Sherwood decision because such power arises solely by virtue of his or her standing as an Assignee, not the ability to step into the shoes of other unsecured creditors, who cannot assert such a claim.
Bottom Line Of Ninth Circuit's Decision
The Bankruptcy Code preempts Sherwood's exercise of preference avoidance powers under the California Preference Statute as inconsistent with the federal bankruptcy system. As a result, Sherwood's pending state law preference action against Lycos should have been dismissed. Congress enacted the Bankruptcy Code to conduct collective insolvency proceedings. To that end, Congress established both substantive standards and procedural protections to ensure fair treatment of both debtors and creditors. The Ninth Circuit found that the California preference statute improperly circumvents this federally designed, court-supervised, process by allowing a debtor to turn over preference claims to an unsupervised Assignee of the debtor's own choosing.
The Aftermath Of The Ninth Circuit's Decision
The Ninth Circuit's decision in Sherwood, which bars a claim under the California Preference Statute, could have far reaching adverse consequences for the ability of Assignees in California, and possibly other states, to bring preference actions. The decision could be applauded as restricting preference claims in assignment proceedings. On the other hand, it could be condemned to the extent it has an adverse impact on ABCs.
And folks, the Ninth Circuit's opinion will likely not be the end of the matter. Only two of the three judges on the Ninth Circuit panel that heard the case found the California Preference Statute was in conflict with federal bankruptcy law. The dissenting judge would have upheld the California Preference Statute because it is not materially different from other state ABC statutes, long upheld by courts as valid, which give an Assignee more power than creditors may exercise.
This story is continuing to unfold as this article goes to press. Sherwood has petitioned for a rehearing of the case before the same panel of judges of the Ninth Circuit that ruled on the case, as well as for a rehearing "en bend" before all of the judges on the Ninth Circuit. Sherwood argues in part, that the Ninth Circuit decision overlooked and conflicts with decisions of the United states Supreme Court and the Seventh Circuit Court of Appeals that upheld state law preference statutes where Assignees were granted avoidance powers beyond those that could be exercised by individual creditors. Credit Managers Association of California, San Diego Wholesale Credit Association and Insolvency Services Group, Inc., who frequently serve as Assignees in ABCs, have also filed a petition with the Ninth Circuit seeking permission to file a "friend of the court" brief in support of Sherwood's position.
With such a developed ABC law in California, and its multiple advantages over federal bankruptcy proceedings, expect much more litigation on the issue.
Bruce S. Nathan, Esq. is a Partner in the law firm of Lowenstein Sandler PC in New York, NY. He is also a member of NACM and the American Bankruptcy Institute. He can be reached via e-mail at firstname.lastname@example.org.
Scott Cargill is a counsel in Lowenstein Sandler's Roseland, New Jersey office.…
Questia, a part of Gale, Cengage Learning. www.questia.com
Publication information: Article title: State Law Preference Actions: A Thing of the Past?. Contributors: Nathan, Bruce S. - Author, Cargill, Scott - Author. Magazine title: Business Credit. Volume: 107. Issue: 3 Publication date: March 2005. Page number: 66+. © 1999 National Association of Credit Management. COPYRIGHT 2005 Gale Group.
This material is protected by copyright and, with the exception of fair use, may not be further copied, distributed or transmitted in any form or by any means.