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C R E D I T
C O L U M N
State Law Preference Actions:
A Thing Of The Past?
BRUCE S. NATHAN, ESQ. & SCOTT CARGILL
Sherwood Partners v. Lycos, Inc.
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I
ntroduction
Credit grantors usually think of a preference claim as part and parcel of a debtor’s
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.
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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.
An Overview Of ABCs
The Califormia Assignment Of
Benefit For Creditors Statute
An ABC is an alternative means of liquidating a
financially troubled debtor, in lieu of a liquidation
Section 1800 of the California Code of Civil
Procedure and other provisions of the California
C R E D I T
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 § 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.
Background
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.
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 debtor’s 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 files 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 law’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 super-
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BUSINESS CREDIT MARCH 2005
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.
C O L U M N
C R E D I T
C O L U M N
vised 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 selfdealing. 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.
BUSINESS CREDIT MARCH 2005
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
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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 banc” 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 [email protected].
Scott Cargill is a counsel in Lowenstein
Sandler’s Roseland, New Jersey office.