Trade creditors think of preference claims as part and parcel of a debtor's bankruptcy case. However, preference claims can also be asserted outside of bankruptcy. Numerous state statutes permit the recovery of preferences as part of state law insolvency proceedings, and it is not infrequent for a creditor to have to defend a state law preference claim.

An assignment for the benefit of creditors (ABC) is one such state law insolvency proceeding. An ABC resembles a liquidation case under chapter 7 of the Bankruptcy Code. California has an ABC statute that includes a preference statute similar to §547 of the Code. California's preference statute enables an "assignee" for the benefit of creditors, the fiduciary responsible for collecting assets and adjudicating claims, to recover preferences.

Recently, the Ninth Circuit Court of Appeals in Sherwood Partners Inc. v. Lycos Inc., 394 F.3d 1198 (9th Cir. 2005), ruled that the Code preempts California's preference statute and directed dismissal of the assignee's pending preference action. The Ninth Circuit refused to grant rehearing, and the assignee has stated its intention to file a petition for certiorari with the U.S. Supreme Court to seek reversal of the decision. Unless overruled, the Ninth Circuit's Sherwood holding threatens the viability of state law preference claims in California, other states in the Ninth Circuit and possibly other states in other circuits.

An Overview of ABCs

ABCs are governed by either common law or statute. Each state has different ABC procedures. Some states, like California, have modern, widely used ABC statutes, while others, like New York, have more antiquated, less-used statutes.

An ABC typically arises by contract where a debtor (the assignor), transfers all of its property to an assignee to be held in trust. An ABC is designed to be a more expeditious, less-expensive type of liquidation proceeding than a chapter 7 bankruptcy case. The debtor/assignor could be an individual, partnership, corporation or limited liability company. The debtor selects the assignee, in contrast to a chapter 7 case, where the U.S. Trustee selects, or in rare cases creditors elect, the bankruptcy trustee. An assignee, like a bankruptcy trustee, is responsible for liquidating the debtor's property and distributing the proceeds to the debtor's creditors according to state law priorities. Creditors participate in any distribution by filing a proof of claim, and the assignee reconciles and, if necessary, objects to claims.

The California ABC Statute

Section 1800 and other provisions of the California Code of Civil Procedure (CCCP), the California Civil Code and the California Commercial Code govern ABCs in California. As part of most ABCs, (1) the assignee must send notice of the assignment to creditors; (2) a deadline is set for creditors to submit claims against the debtor; (3) certain categories of claims, such as wages, salaries, commissions, employee benefit contributions and consumer deposit claims, have a right to payment ahead of the claims of general unsecured creditors; (4) the assignee can occupy the debtor's business premises; and (5) the assignee is considered a "lien creditor" with the power to avoid unperfected security interests, as well as avoid and recover preferential transfers.

California's preference statute is contained in CCCP §1800, which grants an assignee the exclusive right to recover preference claims. CCCP §1800, like §547(b) of the Code, requires that the assignee prove all of the following to recover a transfer as a preference: (1) a transfer of property of the debtor (2) to or for the benefit of a creditor (3) made on account of an antecedent debt owed by the debtor to the creditor before the transfer (4) made when the debtor was insolvent, which is based on a balance-sheet test (liabilities exceed assets) and affords the assignee a rebuttable presumption of insolvency within the 90-day preference period, like §547(f); (5) made within the 90 days of the ABC (and between 90 days and one year of the ABC if the transferee was an insider and had reasonable cause to believe the debtor was insolvent at the time of the transfer); and (6) that enabled the creditor to receive more than another creditor of the same class. CCCP §1800, like §547(b), allows a preference defendant to assert ordinary-course-of-business, contemporaneous exchange, new value and other preference defenses to reduce or eliminate preference liability. California assignors commence preference actions by filing a complaint in a California state or federal court of competent jurisdiction.

Sherwood Partners v. Lycos Inc. Background

The plaintiff, International Thinklink Corp., was a unified messaging service provider, while the defendant, Lycos, operated a network of web sites. Lycos agreed to exclusively promote Thinklink's messaging service on Lycos's web sites for two years. Thinklink's financial problems eventually forced it to make an assignment for the benefit of creditors to Sherwood Partners in California. Two months earlier, Thinklink had paid $1 million to Lycos. Sherwood sued Lycos in a California state court, relying on CCCP §1800 to recover Thinklink's $1 million payment to Lycos as a preference.

Lycos removed the lawsuit to federal court, then moved for dismissal because the Code preempts California's preference statute. The U.S. District Court denied Lycos's motion to dismiss and granted summary judgment to Sherwood. Lycos appealed this decision to the Ninth Circuit Court of Appeals.

The Bankruptcy Code Preempts Preference Actions under the California Preference Statute

The Ninth Circuit reversed and held that the Code preempts California's preference statute. Federal law "preempts" conflicting state laws over matters that require uniform regulation by the federal government. When state law thwarts the implementation of federal statutes enacted by Congress, the state law must yield to the federal statute.

The Ninth Circuit observed that Congress had enacted chapter 7 of the Code to (1) grant an individual debtor a fresh start by discharging most indebtedness and (2) equitably distribute a debtor's assets among competing creditors. The U.S. Supreme Court held that the discharge provisions of the Code preempt state laws that granted debtors a discharge from their debts because a discharge is a principal feature of bankruptcy law that is reserved solely for Congress. State laws that discharge indebtedness interfere with the Code and the power granted to Congress in the U.S. Constitution to enact uniform laws on bankruptcy matters. See Pobreslo v. Joseph M. Boyd Co., 287 U.S. 518 (1933); Int'l. Shoe Co. v. Pinkus, 278 U.S. 261 (1929); Stellwagen v. Clum, 245 U.S. 605 (1918).

The Ninth Circuit also held that the Code preempts state statutes that have any bearing on the Code's other goal of equitably distributing a debtor's assets. The Code achieves this goal by creating a federally controlled system for distributing a debtor's assets to creditors and reconciling claims. A debtor's chapter 7 bankruptcy filing triggers the creation of a bankruptcy estate into which all of the debtor's non-exempt assets are transferred. It also triggers the selection of a bankruptcy trustee to collect assets, adjudicate claims and otherwise administer the debtor's bankruptcy estate. An automatic stay bars creditors from collecting their claims from the debtor's assets in order to preserve them for distribution to creditors.

The court noted that preferences should be subject to the federal bankruptcy law's more rigorous standards and procedural protections, including those dealing with the appointment of a bankruptcy trustee, and not the more lax state procedures and standards of California's ABC statute. The power to avoid and recover preferences for distribution to creditors should be exercised only by a trustee, appointed and supervised by the U.S. Trustee, or elected by creditors. The trustee should also be under the supervision of the federal courts and subject to the standards and elaborate procedural safeguards designed to ensure a fair result to debtors and creditors. Creditors, like Lycos, are protected in bankruptcy from a trustee's potential conflicts of interest and other powers of self-dealing because a trustee must comply with substantial disclosure requirements and conflict-of-interest rules. Creditors would not be similarly protected from a California assignee's conflict of interest or potential self-dealing, where the assignee is hand-picked by the debtor and is not subject to either the disclosure obligations and conflict-of-interest rules or court supervision that are present in bankruptcy cases.

The Ninth Circuit rejected Sherwood's argument that §544(b) incorporates CCCP §1800 into the Code. Section 544(b) allows a bankruptcy trustee to avoid transfers that are otherwise voidable by unsecured creditors under state law, such as the right of an unsecured creditor to set aside and recover a fraudulent conveyance. The Ninth Circuit noted that the U.S. Supreme Court, in Stellwagen v. Clum, 245 U.S. 605 (1918), had upheld Ohio's preference statute, which granted a state trustee only those avoidance powers held by creditors. This is in contrast to California's ABC law, where an assignee has the sole power to set aside preferences and unsecured creditors have no independent right to avoid and recover preferences. State statutes, such as CCCP §1800, that confer avoidance powers upon state assignees or other fiduciaries beyond those held by individual creditors, encroach upon the exercise of federal bankruptcy power.

The court also noted that a trustee's powers under §544(b) extend only to the avoidance claims of creditors. Section 101(10)(A) defines a "creditor" as an "entity that has a claim against the debtor that arose at the time of or before an order for relief concerning the debtor." That definition does not include an assignee in an ABC, which is included in the definition of a "custodian" in §101(11)(B).

The Ninth Circuit also rejected Sherwood's argument that a creditor aggrieved by an ABC preference claim and seeking the safeguards afforded by the federal bankruptcy system could always opt out of the ABC by filing an involuntary bankruptcy petition against the debtor. The Ninth Circuit did not regard this as a feasible option because, in most cases, at least three unsecured creditors must join in an involuntary bankruptcy petition, and there is no assurance that an ABC preference defendant could solicit the other two creditors.

The Dissenting Opinion

There was a vigorous dissenting opinion that rejected the majority's preemption analysis. Sherwood Partners Inc., 394 F.3d at 1206. The dissent noted that the courts have upheld other state ABC statutes, not materially different from California's ABC statute, that granted an assignee more power than an individual creditor could otherwise exercise. The U.S. Supreme Court in Pobreslo v. Joseph M. Boyd Co. upheld Wisconsin's ABC statute. 287 U.S. 518 (1933). While the Supreme Court focused on the preemptive effect of the discharge provisions of federal bankruptcy law and noted that Wisconsin's ABC statute did not provide for a discharge of debts, the court never suggested that federal bankruptcy law preempted state ABC statutes that regulated the distribution of a debtor's assets.

The dissent also noted that California's preference statute does not interfere with bankruptcy's goal of equitable distribution, since it contains virtually identical grounds for recovering preferences to those contained in §547(b) of the Code. Both §547 and California's preference statute preserve assets and ensure an equitable distribution of assets among creditors, and should therefore be allowed to coexist.

The dissent also noted that the majority opinion would push insolvent entities into more expensive bankruptcy cases, rather than the less costly or stigmatic ABCs. ABCs have coexisted with the bankruptcy system as a means of distributing a debtor's assets without interfering with bankruptcy's goal of equitable distribution. The Code even recognizes ABCs, whereas §543(d)(2) excuses assignees appointed more than 120 days before the filing of a bankruptcy petition from turning over a debtor's property to a trustee, and §101(11)(B) defines a "custodian" to include an assignee under an ABC.

The Ninth Circuit's Denial of Sherwood's Motion for Rehearing

The Ninth Circuit recently denied Sherwood's motion for rehearing and rehearing en banc. The Ninth Circuit rejected the argument raised in favor of Sherwood's position that the U.S. Supreme Court and Seventh Circuit Court of Appeals had upheld state preference statutes, much like California's preference statute, that granted assignees avoidance powers beyond those that could have been asserted by individual creditors. See Pobreslo v. Joseph M. Boyd Co., 287 U.S. 515 (1933); Johnson v. Star, 287 U.S. 527 (1933); In re Wisconsin Builders Supply Co., 239 F.2d 649 (7th Cir. 1956), cited in support of Sherwood's position. Sherwood's counsel has stated that Sherwood intends to file a petition for certiorari with the U.S. Supreme Court for reversal of the Ninth Circuit's Sherwood decision.

The Ninth Circuit's decision in Sherwood Partners, if upheld, will virtually eliminate the ability of an assignee in an ABC (or similar fiduciary) in states within the Ninth Circuit (Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon and Washington) to recover preferences under applicable state law similar to California's preference statute. However, the Ninth Circuit's opinion is not binding on courts in the other circuits. Time will tell whether these courts will follow the lead of the Ninth Circuit.