Ninth Circuit Ruling on Preference Avoidance Power

The Dissent

Judge Nelson dissented, stating that “the Supreme Court … has never suggested that state laws that regulate the distribution of assets in a voluntary assignment might meet the same fate [as unconstitutional discharge provisions].” Sherwood, 394 F.3d at 1207. Judge Nelson further stated the practical effect of the majority's ruling is to “push corporations threatened with insolvency from the less stigmatic, and less costly, voluntary assignment scheme into the world of federal bankruptcy,” and that “[t]his should not be the case … both voluntary assignments and the bankruptcy system can 'peaceably coexist' as twin mechanisms aimed at distributing the resources of the debtor.” Sherwood, 394 F.3d at 1208.

In its Petition for a Writ of Certiorari, Sherwood asserts, among other things, that review of the Ninth Circuit majority's ruling is of vital importance because assignment laws are in effect in almost half of the states, a majority of which authorize an assignee to void preferences. As recognized by Judge Nelson's dissent, the opinion reached by the majority “would preempt any number of state laws governing voluntary assignments for the benefit of creditors … ” Sherwood, 394 F.3d at 1206. In addition to striking down the California anti-preference statute, the majority's decision has effectively called into question the voluntary assignment laws of at least 15 other states that authorize an assignee to recover preferential transfers.

Sherwood asserts that Federal bankruptcy and state assignment statutes have been structured by Congress and state legislatures to coexist and are in no sense inconsistent. Congress has included certain provisions in the Bankruptcy Code that are designed to preserve assignment proceedings, rather than to preempt these proceedings. See, eg, 11 U.S.C. '' 305 (' 305), 543(d)(1) (' 543(d)(1)) and (2) (' 543(d)(2). Congress expressly provided that assignment proceedings may, and in some circumstances must continue, even after a bankruptcy filing. See 11 U.S.C. '' 101(11), 543(d)(1), 543(d)(2), 303(h)(2). Congress has also recognized that it may be appropriate for a bankruptcy court to abstain from asserting jurisdiction in favor of a state assignment proceeding if it would better serve the interests of creditors and the debtor. See 11 U.S.C. ' 305 (' 305); see also In re M. Egan Co., 24 B.R. 189, 191-92 (Bankr. W.D.N.Y. 1982) (In re M Egan Co.) (motion to abstain granted where, among other things, preference recovery could be pursued in the context of an existing state-law assignment proceeding).

California's anti-preference provision was intended to align state law and federal bankruptcy law and “is, by design, virtually identical to the Bankruptcy Code's preferential transfer statute.” Sherwood, 394 F.3d at 1207; see also Angeles Electric Co. v. Superior Court, 27 Cal. App. 4th 426, 430-31, 32 Cal. Rptr. 2d 660 (1994); Angeles Electric Co. v. Superior Court ' 27 Cal. App. 4th 426 (1995) (discussing intentional conformance of 1800 with federal bankruptcy law).

As such, Cal. Civ. Proc. Code ' 1800 is interpreted in light of case law addressing Bankruptcy Code ' 547. See Blonder v. Cumberland Eng'g, 71 Cal. App. 4th 1057, 1061, 84 Cal. Rptr. 2d 216 (1999). The dissent points out that Cal. Civ. Proc. Code ' 1800 and Bankruptcy Code ' 547 both serve and are consistent with the goal of equitable distribution. “That California's voluntary assignment system has such a provision [Cal. Civ. Proc. Code ' 1800 makes it more capable of affecting the equality of distribution that is the aim of bankruptcy law; it does not necessarily interfere with bankruptcy's goal of achieving equal distribution." Sherwood, 394 F.3d at 1207-08. Judge Nelson's dissent further states, "[T]he nature of the regulated activity — distribution of the debtor's assets [and furthering the goal of equitable distribution]” — is not one rendering it impossible to conclude that the state and federal systems can peaceably coexist.” Sherwood, 394 F.3d at 1208.

The Majority

The Ninth Circuit majority observes that one of the primary goals of the Bankruptcy Code is to ensure equality of distribution of an insolvent debtor's assets among all creditors. See Sherwood, 394 F.3d at 1203. However, the majority's ruling in this case could promote the opposite result. The Ninth Circuit majority's reading of Stellwagen v. Clum, 245 U.S. 605 (1918) as approving state anti-preference statutes so long as the recovery power “could have been exercised by any creditor” is an invitation to state legislatures to provide for exactly that. See Sherwood, 394 F.3d at 1205, citing Stellwagen, 245 U.S. 605, 611, n.1. However, the effect of such state statutes could be to promote inequality in payments to creditors by an insolvent debtor's assignment estate. If an individual creditor could file an action against another creditor who received a preferential transfer and recover that payment for itself, whichever creditor first succeeded in obtaining a judgment against another would potentially satisfy its claim in a greater percentage than other creditors. Such an inequitable result would force creditors to elect bankruptcy as their only option.

Sherwood asserts that the Ninth Circuit majority's assumption that California's voluntary assignment proceedings involving Cal. Civ. Proc. Code ' 1800 by granting an assignee an avoidance power not held by individual creditors, was somehow unique and distinguishable from the assignment procedures previously upheld by the Supreme Court is demonstrably false. The Wisconsin statute at issue in the Supreme Court's decision in Pobreslo, 287 U.S. 518, and the Texas statute at issue in Star, 287 U.S. 527, like that of California and many other jurisdictions today, incorporated a preference avoidance power to be exercised solely by assignees and were upheld by the Supreme Court against preemption attack. Pobreslo and Star's Johnson each involved, like Cal. Civ. Proc. Code ' 1800, state anti-preference statutes that: 1) are only triggered upon the commencement of a voluntary assignment; 2) only authorize an assignee (and not an individual creditor) to commence an action; 3) authorize an individual creditor to commence an action only if the assignee fails to commence an action within a specified time period and, then, only in the name and for the benefit of the assignee; and 4) if any action is brought by a creditor after the assignee declines or fails to timely do so, then any recovery must be delivered to the assignee for equitable distribution to creditors.

The underlying basis for the Ninth Circuit majority's ruling appears to be the majority's clear preference for invoking the machinery of the federal bankruptcy system over the less cumbersome state law remedy of a voluntary assignment. Sherwood has asserted that the Ninth Circuit majority's bias favoring the federal bankruptcy system over that of state voluntary assignments is unprecedented. In her dissent, Judge Nelson states that “the Supreme Court … has never suggested that state laws that regulate the distribution of assets in a voluntary assignment might meet the same fate [as unconstitutional discharge provisions].” Sherwood, 394 F.3d at 1207.

Conclusion

The Ninth Circuit majority acknowledges that voluntary assignments are a “venerable” and valid state law alternative to formal federal bankruptcy proceedings, were upheld by the Supreme Court in Pobreslo, and were expressly contemplated in the Bankruptcy Code to coexist with federal bankruptcy proceedings. See Sherwood, 394 F.3d at 1201, 1206. Nevertheless, the Ninth Circuit majority strikes down California's anti-preference law because it furthers the same goal of bankruptcy law to promote equality of distribution. The dissent found this approach to be illogical. See Sherwood, 394 F.3d at 1207. Further, in Pobreslo, the Supreme Court held that Wisconsin's assignment statute was ” … in harmony with the purposes of the federal [bankruptcy] act … served to protect creditors against each other and goes to assure equality of distribution.” Pobreslo, 287 U.S. at 525. The dissent points out that, although the Ninth Circuit majority acknowledges that the Supreme Court has repeatedly upheld voluntary assignments as a valid state law alternative to federal bankruptcy proceedings, “[t]he majority's concerns about section 1800 are not distinguishable from concerns about voluntary assignment provisions generally.” Sherwood, 394 F.3d at 1206.

David S. Kupetz, a partner in SulmeyerKupetz, located in Los Angeles and Menlo Park, CA, specializes in business reorganization, bankruptcy and other insolvency matters. SulmeyerKupetz is counsel to Sherwood Partners, Inc., as assignee for the benefit of creditors of International ThinkLink Corporation, in the case discussed in this article. Kupetz can be reached at [email protected].

Last month, we discussed Sherwood Partners, Inc., Assignee for the Benefit of Creditors of International Thinklink Corporation v. Lycos, Inc., 394 Fed11198 (9th Cir. 2005). In that case, the Ninth Circuit Court of Appeals, by a divided court, held that a state statute authorizing an assignee for the benefit of creditors to void a preferential transfer is preempted by the federal Bankruptcy Code. This month, we discuss the ruling in depth.

The Ninth Circuit's Decision

The Ninth Circuit majority based its ruling that Cal. Civ. Proc. Code ' 1800 (C.C.P. ' 1800) is preempted by federal bankruptcy law on the holding that “statutes that give state assignees or trustees avoidance powers beyond those that may be exercised by individual creditors trench too close upon the exercise of the federal bankruptcy power.” Sherwood, 394 F.3d at 1205. The Ninth Circuit majority's opinion is also based on its holding that, like state discharge laws that intrude upon federal bankruptcy law, “state statutes that implicate the federal bankruptcy law's other major goal, namely equitable distribution,” are preempted. See Sherwood, 394 F.3d at 1203. The Ninth Circuit majority's theory is that any state law that advances a goal of the federal bankruptcy law is necessarily preempted. The majority reasoned that because the federal bankruptcy law preempts state statutes that discharge the debtor from debt in furtherance of the bankruptcy fresh start goal, a state statute for voiding preferential transfers must also be preempted by the federal law because both further the goal of equitable distribution to creditors. See Sherwood, 394 F.3d at 1203-05.

The Dissent

Judge Nelson dissented, stating that “the Supreme Court … has never suggested that state laws that regulate the distribution of assets in a voluntary assignment might meet the same fate [as unconstitutional discharge provisions].” Sherwood, 394 F.3d at 1207. Judge Nelson further stated the practical effect of the majority's ruling is to “push corporations threatened with insolvency from the less stigmatic, and less costly, voluntary assignment scheme into the world of federal bankruptcy,” and that “[t]his should not be the case … both voluntary assignments and the bankruptcy system can 'peaceably coexist' as twin mechanisms aimed at distributing the resources of the debtor.” Sherwood, 394 F.3d at 1208.

In its Petition for a Writ of Certiorari, Sherwood asserts, among other things, that review of the Ninth Circuit majority's ruling is of vital importance because assignment laws are in effect in almost half of the states, a majority of which authorize an assignee to void preferences. As recognized by Judge Nelson's dissent, the opinion reached by the majority “would preempt any number of state laws governing voluntary assignments for the benefit of creditors … ” Sherwood, 394 F.3d at 1206. In addition to striking down the California anti-preference statute, the majority's decision has effectively called into question the voluntary assignment laws of at least 15 other states that authorize an assignee to recover preferential transfers.

Sherwood asserts that Federal bankruptcy and state assignment statutes have been structured by Congress and state legislatures to coexist and are in no sense inconsistent. Congress has included certain provisions in the Bankruptcy Code that are designed to preserve assignment proceedings, rather than to preempt these proceedings. See, eg, 11 U.S.C. '' 305 (' 305), 543(d)(1) (' 543(d)(1)) and (2) (' 543(d)(2). Congress expressly provided that assignment proceedings may, and in some circumstances must continue, even after a bankruptcy filing. See 11 U.S.C. '' 101(11), 543(d)(1), 543(d)(2), 303(h)(2). Congress has also recognized that it may be appropriate for a bankruptcy court to abstain from asserting jurisdiction in favor of a state assignment proceeding if it would better serve the interests of creditors and the debtor. See 11 U.S.C. ' 305 (' 305); see also In re M. Egan Co., 24 B.R. 189, 191-92 (Bankr. W.D.N.Y. 1982) (In re M Egan Co.) (motion to abstain granted where, among other things, preference recovery could be pursued in the context of an existing state-law assignment proceeding).

California's anti-preference provision was intended to align state law and federal bankruptcy law and “is, by design, virtually identical to the Bankruptcy Code's preferential transfer statute.” Sherwood , 394 F.3d at 1207; see also Angeles Electric Co. v. Superior Court , 27 Cal. App. 4th 426, 430-31, 32 Cal. Rptr. 2d 660 (1994); Angeles Electric Co. v. Superior Court ' 27 Cal. App. 4th 426 (1995) (discussing intentional conformance of 1800 with federal bankruptcy law).

As such, Cal. Civ. Proc. Code ' 1800 is interpreted in light of case law addressing Bankruptcy Code ' 547. See Blonder v. Cumberland Eng'g , 71 Cal. App. 4th 1057, 1061, 84 Cal. Rptr. 2d 216 (1999). The dissent points out that Cal. Civ. Proc. Code ' 1800 and Bankruptcy Code ' 547 both serve and are consistent with the goal of equitable distribution. “That California's voluntary assignment system has such a provision [Cal. Civ. Proc. Code ' 1800 makes it more capable of affecting the equality of distribution that is the aim of bankruptcy law; it does not necessarily interfere with bankruptcy's goal of achieving equal distribution." Sherwood, 394 F.3d at 1207-08. Judge Nelson's dissent further states, "[T]he nature of the regulated activity — distribution of the debtor's assets [and furthering the goal of equitable distribution]” — is not one rendering it impossible to conclude that the state and federal systems can peaceably coexist.” Sherwood, 394 F.3d at 1208.

The Majority

The Ninth Circuit majority observes that one of the primary goals of the Bankruptcy Code is to ensure equality of distribution of an insolvent debtor's assets among all creditors. See Sherwood, 394 F.3d at 1203. However, the majority's ruling in this case could promote the opposite result. The Ninth Circuit majority's reading of Stellwagen v. Clum , 245 U.S. 605 (1918) as approving state anti-preference statutes so long as the recovery power “could have been exercised by any creditor” is an invitation to state legislatures to provide for exactly that. See Sherwood, 394 F.3d at 1205, citing Stellwagen, 245 U.S. 605, 611, n.1. However, the effect of such state statutes could be to promote inequality in payments to creditors by an insolvent debtor's assignment estate. If an individual creditor could file an action against another creditor who received a preferential transfer and recover that payment for itself, whichever creditor first succeeded in obtaining a judgment against another would potentially satisfy its claim in a greater percentage than other creditors. Such an inequitable result would force creditors to elect bankruptcy as their only option.

Sherwood asserts that the Ninth Circuit majority's assumption that California's voluntary assignment proceedings involving Cal. Civ. Proc. Code ' 1800 by granting an assignee an avoidance power not held by individual creditors, was somehow unique and distinguishable from the assignment procedures previously upheld by the Supreme Court is demonstrably false. The Wisconsin statute at issue in the Supreme Court's decision in Pobreslo, 287 U.S. 518, and the Texas statute at issue in Star, 287 U.S. 527, like that of California and many other jurisdictions today, incorporated a preference avoidance power to be exercised solely by assignees and were upheld by the Supreme Court against preemption attack. Pobreslo and Star's Johnson each involved, like Cal. Civ. Proc. Code ' 1800, state anti-preference statutes that: 1) are only triggered upon the commencement of a voluntary assignment; 2) only authorize an assignee (and not an individual creditor) to commence an action; 3) authorize an individual creditor to commence an action only if the assignee fails to commence an action within a specified time period and, then, only in the name and for the benefit of the assignee; and 4) if any action is brought by a creditor after the assignee declines or fails to timely do so, then any recovery must be delivered to the assignee for equitable distribution to creditors.

The underlying basis for the Ninth Circuit majority's ruling appears to be the majority's clear preference for invoking the machinery of the federal bankruptcy system over the less cumbersome state law remedy of a voluntary assignment. Sherwood has asserted that the Ninth Circuit majority's bias favoring the federal bankruptcy system over that of state voluntary assignments is unprecedented. In her dissent, Judge Nelson states that “the Supreme Court … has never suggested that state laws that regulate the distribution of assets in a voluntary assignment might meet the same fate [as unconstitutional discharge provisions].” Sherwood, 394 F.3d at 1207.

Conclusion

The Ninth Circuit majority acknowledges that voluntary assignments are a “venerable” and valid state law alternative to formal federal bankruptcy proceedings, were upheld by the Supreme Court in Pobreslo, and were expressly contemplated in the Bankruptcy Code to coexist with federal bankruptcy proceedings. See Sherwood, 394 F.3d at 1201, 1206. Nevertheless, the Ninth Circuit majority strikes down California's anti-preference law because it furthers the same goal of bankruptcy law to promote equality of distribution. The dissent found this approach to be illogical. See Sherwood, 394 F.3d at 1207. Further, in Pobreslo, the Supreme Court held that Wisconsin's assignment statute was ” … in harmony with the purposes of the federal [bankruptcy] act … served to protect creditors against each other and goes to assure equality of distribution.” Pobreslo, 287 U.S. at 525. The dissent points out that, although the Ninth Circuit majority acknowledges that the Supreme Court has repeatedly upheld voluntary assignments as a valid state law alternative to federal bankruptcy proceedings, “[t]he majority's concerns about section 1800 are not distinguishable from concerns about voluntary assignment provisions generally.” Sherwood, 394 F.3d at 1206.

David S. Kupetz, a partner in SulmeyerKupetz, located in Los Angeles and Menlo Park, CA, specializes in business reorganization, bankruptcy and other insolvency matters. SulmeyerKupetz is counsel to Sherwood Partners, Inc., as assignee for the benefit of creditors of International ThinkLink Corporation, in the case discussed in this article. Kupetz can be reached at [email protected].