Alliotts Bankruptcy Article Sherwood Case

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BANKRUPTCY LAW 9th Cir. ‘Sherwood’ Case By Craig Rankin and Christopher Alliotts

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n oct. 3, the U.S. Supreme Court declined to hear an appeal from the 9th U.S. Circuit Court of Appeals’ decision earlier this year in Sherwood Partners v. Lycos Inc., 394 F.3d 1198 (9th Cir. 2005). In that case, a divided panel of the 9th Circuit held that a state statute authorizing an assignee under an assignment for the benefit of creditors to avoid and recover a preferential transfer is pre-empted by § 547 of the federal Bankruptcy Code. The majority’s decision has been widely criticized for calling into question the validity of not only state law preference actions but also assignments for the benefit of creditors generally. This article discusses this decision and its impact on insolvency practice going forward.

ABCs allow debtors to avoid bankruptcy court As a general matter, an assignment for the benefit of creditors (ABC) is a voluntary transfer by a debtor of substantially all of its assets to a designated person, the assignee, in trust for the purpose of having the assignee liquidate the assets and distribute the proceeds to creditors according to applicable law. ABCs have long been recognized by state and federal courts as legitimate tools for liquidating insolvent estates for the benefit of creditors without having to institute Craig Rankin is a partner at Los Angeles-based bankruptcy boutique Levene, Neale, Bender, Rankin & Brill. Christopher Alliotts is of counsel to the Menlo Park, Calif., office of Los Angeles-based SulmeyerKupetz.

federal bankruptcy proceedings, which can be more costly and time-consuming. Management and boards of directors of insolvent technology companies have increasingly resorted to ABCs as the fastest and most unobtrusive method of exiting a failed enterprise. A principal goal of any insolvency proceeding is to provide fair and equitable treatment of creditors in accordance with applicable law. The ability to avoid and recover preferential payments made to creditors by the debtor is a vital instrument in the pursuit of that goal. Under the Bankruptcy Code, the ability to bring preference actions is squarely vested in the bankruptcy trustee (or debtor in possession in Chapter 11). In the ABC context, an assignee stands in the place of the assignor and cannot avoid and recover preferential payments made by the debtor-assignor, unless there is a statute expressly authorizing him to do so. State statutes typically mirror the requirements of § 547 of the Bankruptcy Code that the payment or other transfer be made during a prescribed period of time before the start of the ABC, that the payment or transfer be made by the debtor to one of its creditors on account of a pre-existing debt, and that the payment or transfer provide the creditor

more than the creditor would have otherwise received in the proceeding. In Sherwood Partners, the debtor had made a payment of $1 million to the defendant within the 90-day statutorily prescribed period. The debtor subsequently made its general assignment for the benefit of its creditors to the plaintiff, as assignee, in accordance with California law. The plaintiff then filed a lawsuit against the defendant in state court seeking to avoid and recover the $1 million payment for the benefit of the debtor’s creditors pursuant to the state statute. The defendant removed the action to federal court based upon diversity jurisdiction. Following motions to dismiss by the defendant and for summary judgment by the plaintiff, the district court held that the state preference statute was not pre-empted by the Bankruptcy Code, and the defendant appealed. Despite the fact that no such state statute had ever been held to be in conflict with federal bankruptcy law, the 9th Circuit reversed the district court and ruled in the defendant’s favor. The 9th Circuit majority held that the state statute at issue, § 1800 of the California Civil Code, is pre-empted by federal bankruptcy law based on its reasoning that statutes giving assignees avoidance powers beyond those that may be exercised by individual creditors trench too close upon the exercise of the federal bankruptcy power. The majority also opined that, like state discharge laws that intrude upon federal bankruptcy law, state statutes that implicate a major goal of federal bankruptcy law, such as the equitable treatment of creditors, are

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pre-empted. In other words, the majority reasoned, because the federal bankruptcy law pre-empts state statutes that discharge a debtor from debt in furtherance of the bankruptcy goal of a fresh start, a state statute authorizing the avoidance and recovery of preferential transfers is similarly pre-empted by the federal law. The dissenting opinion in the case found a fallacy in the majority’s reasoning. The dissent pointed out that the U.S. Supreme Court has never suggested that state laws regulating the distribution of assets in an ABC might meet the same fate as unconstitutional discharge provisions. The dissent argued that the majority’s position essentially ignores the long history of peaceful coexistence between state law ABCs and federal bankruptcy cases. The dissent’s position on peaceful coexistence has support in the Bankruptcy Code itself. For instance, certain provisions in the Bankruptcy Code are designed to preserve ABC proceedings, rather than to pre-empt them. See, e.g., 11 U.S.C. 305, 543(d)(1) and (2). In addition, Congress expressly 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 an ABC if it would better serve the interests of creditors and the debtor. See 11 U.S.C. 305; see also In re M. Egan Co., 24 B.R. 189, 191-92 (Bankr. W.D.N.Y. 1982) (motion to abstain granted when, among other things, preference recovery could be pursued in the context of an existing state law assignment proceeding). Even the majority acknowledged that ABCs are a “venerable” and valid state law alternative to formal federal bankruptcy proceedings previously upheld by the Supreme Court. Yet the underlying basis for the majority’s ruling appears to be its clear preference for invoking the machinery of the federal bankruptcy system over the less cumbersome state law remedy of a voluntary assignment. As the dissent suggested, the practical effect of the majority’s ruling will be to preclude insolvent debtors from

MONDAY, OCTOBER 24, 2005

liquidating their assets under the streamlined system of ABCs and forcing them into more costly, more visible and arguably less efficient bankruptcy proceedings. The ramifications of the majority’s decision are potentially far-reaching. Almost half of the states have enacted laws authorizing ABCs as an alternative to federal bankruptcy. A majority of these state statutes authorizes an assignee to avoid and recover preferences. While the majority opinion was limited to striking down a specific state anti-preference statute, the majority’s reasoning could theoretically be extended to pre-empt the entire state system of ABCs and, in effect, render ABCs extinct.

A state statute allowing an assignee for the benefit of creditors to recover a preferential transfer was held to be pre-empted. The recent decision by the Supreme Court to deny certiorari did little to dispel this notion in the minds of some. As always, however, the import of the Supreme Court’s denial of certiorari should not be overstated. No other circuit court has addressed the issue in a published opinion, so there is no conflict among circuits to resolve. The matter may well have to wait for another appellate panel to issue an inconsistent opinion on the subject before the high court will revisit its prior precedents upholding ABCs. For now, it seems clear that an assignee cannot bring a preference action under state law, at least in the 9th Circuit. If a debtor needs to commence a liquidation proceeding and the case does not involve any significant preference issues, the debtor may still avail itself of the state law ABC. However, if it will be in the best interests of all creditors to avoid and recover preferences in the liquida-

tion proceeding, management may be forced to file a bankruptcy case or potentially face liability for breach of fiduciary duty. Even if the debtor decides to commence an ABC, creditors may have to file an involuntary petition against the debtor in order to preserve preference claims under the Bankruptcy Code.

Creditors may be hurt by debtors’ forced filings The irony of forcing debtors to file bankruptcy cases instead of ABCs is that this result may turn out to be detrimental to creditors. After the Bankruptcy Code was essentially re-written in 1978, state legislatures enacted preference statutes that mirrored § 547 as originally enacted. Since that time, Congress has revised § 547 on several occasions, but states have been less vigilant in revising their preference statutes. As a result, subtle distinctions have developed over the years between the federal and state anti-preference statutes. The most recent example of such distinctions is the recent amendment to § 547 enacted by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). Among other things, BAPCPA strengthened the ordinary course of business defense that a creditor has to a trustee’s preference claim. Thus, a trustee in bankruptcy may have a harder time avoiding and recovering a preferential transfer than an assignee would have under the applicable state statute. It may very well be undesirable to have dual insolvency regimes in which the federal substantive law on preferences differs from that employed by individual states. This lack of uniformity exists today and has the potential for forum shopping and other abuses. However, the solution to this problem, to the extent it exists, is legislation, not judicial fiat. NLJ

This article is reprinted with permission from the October 24, 2005 edition of THE NATIONAL LAW JOURNAL. © 2005 ALM Properties, Inc. All rights reserved. Further duplication without permission is prohibited. For information, contact ALM, Reprint Department at 800-888-8300 x6111 or www.almreprints.com. #005-05-06-0021