By: Donald L Swanson

The interface between federal bankruptcy law and similar state laws has a long history, going back to at least 1819, when the U.S. Supreme Court rules that a state insolvency law:

• may discharge a person from debtor’s prison; but
• may not discharge that person’s debt.[Fn. 1]

A more current interface is between, (i) the U.S. Bankruptcy Code, and (ii) a state assignment for benefit of creditors law (an “ABC Law”).  In Sherwood Partners, Inc. v. Lycos, Inc., 394 F.3d 1198 (9th Cir. 2005)(cert. denied):

• The majority says an assignee may not pursue 90-day preference claims under a state’s ABC Law, because of preemption by the bankruptcy Code.
• The dissent disagrees.

What follows is, (i) a summary of the Sherwood facts and preference statute, (ii) a summary and comparison of the two opinions, and (iii) an explanation of why the dissent is wrong.

Sherwood Facts

Lycos agrees to promote Thinklink’s services for two years.

Thinklink defaults, and the agreement is renegotiated: Thinklink’s remaining payments are reduced from $17 million to $1 million plus stock. Thinklink delivers the $1 million but not the stock.

Sixty days later, Thinklink makes a voluntary assignment for benefit of creditors to Sherwood Partners under California’s ABC Law.

Then, Sherwood shuts Thinklink’s business down and sues Lycos to recover the $1 million payment as a preferential transfer.

Lycos argues that the ABC Law’s preference provision is preempted by the Bankruptcy Code, and the issue reaches the Ninth Circuit Court of Appeals.

Sherwood Preference Statute

The ABC Law’s 90-day preference provision is just like the Bankruptcy Code’s, with one exception: the 90-day reach-back begins at bankruptcy filing in one and at assignment in the other. 

Here’s an important similarity:

• only the designated fiduciary (trustee or assignee) can exercise the preference power under either law—and only after bankruptcy is filed or assignment is made; and
• no single creditor can exercise such a power for its own benefit under either state or federal law—ever.

MAJORITY OPINION

Preemption Primer

Congress has broad authority to preempt state laws: it’s a matter of congressional intent.  Preemption can occur by an express statutory statement. 

Preemption can also be inferred from:

• a scheme of federal regulation “so pervasive” that “Congress left no room for the States to supplement it”; and
• a less-pervasive scheme in which state laws would be an “obstacle” to effectuating the full purposes and objectives of Congress.”

Preemption Applied

The majority says, there “can be no doubt” that the Bankruptcy Code is “pervasive”:

• the federal interest is dominant, arising from the U.S. Constitution; and
• the Code occupies a full title of the United States Code, providing a comprehensive system of rights administered by federal bankruptcy courts and U.S. trustees.

The Bankruptcy Code also coexists peaceably with, and often incorporates, state laws on debtor and creditor rights. 

So, the question is whether the state ABC preference Law is preempted by inference:

• is it tolerated by the Bankruptcy Code; or
• is it within the heartland of bankruptcy administration?

Sec. 544(b)—The Fulcrum of Disagreement

The fulcrum of disagreement between the majority and dissent centers on § 544(b).

One argument says the ABC Law’s preference provision is specifically incorporated into the Bankruptcy Code by § 544(b), which grants state law avoiding powers to the bankruptcy estate.

–Majority

Majority rejects this § 544(b) argument because the term “creditor” in § 544(b) does not include an ABC Law assignee. The Bankruptcy Code:

• defines “creditor” as an entity with “a claim against the debtor”;
• says “custodian” includes assignees under an ABC Law;
• views custodians as in a fiduciaries—not as creditors;
• does not mention custodians alongside creditors in § 544(b); and
• so, an ABC assignee does not qualify as a “creditor” § 544(b).

Accordingly, the ABC Law’ 90-day preference power is preempted by the Bankruptcy Code because:

• such power cannot be exercised by a single creditor—ever; and
• such power is just like the Bankruptcy Code’s 90-day preference avoiding power and within the heartland of bankruptcy administration.

–Dissent

Dissent rejects the can-only-be-exercised-by-assignee distinction.  That’s because ABC Law assignees exercise lots of powers that are unavailable to general creditors.  For example:

• the assignee “distributes a debtor’s assets among creditors”;
• exercises other powers on behalf of all creditors; and
• thus, exercising powers greater than any one creditor could exercise.

Accordingly, the majority’s basis for preemption is faulty.

WHY DISSENT IS WRONG

The essential difference between majority and dissent is this:

• Majority focuses on a single power that no one person can perform under state law, other than an ABC Law’s assignee; but
• Dissent paints with a broad brush, saying ABC Law assignees can do lots of things “on behalf of all creditors” that no one creditor can do independently.

Dissent is saying:

• Assignees take possession of and liquidate debtor’s assets—on behalf of all creditors;
• Assignees then distribute the liquidated proceeds—to all creditors; and
• No one creditor can do any such collective thing.

The reality, however, is that every unsecured creditor CAN do those things—all of them—but only for itself in the courthouse race.  For example, under state law, every unsecured creditor can, through legal processes:

• take possession of and liquidate Debtor’s assets—to collect its own claim;
• pursue fraudulent transfers under the Uniform Fraudulent Transfer Act and similar laws—to collect its own claim; and
• distribute the liquidated proceeds—to pay its own claim.

So, the difference between the two opinions is this:

• Majority focuses on a specific power to adjust creditors’ rights that is, (i) exclusive to assignees; and (ii) similar in every respect to bankruptcy preference law, including the reach-back dating from a filing/assigning event.
• Dissent looks at broad powers of an assignee to do collective things for unsecured creditors—all of which can be performed by any unsecured creditor for itself in the courthouse race.

There is a material difference between those two things, and the preference power in question is within the heartland of bankruptcy administration. The dissent fails to recognize this and is, therefore, wrong.

Conclusion

The interface between the U.S. Bankruptcy Code and state ABC Laws can be unclear and confusing: do they peaceably coexist, or does federal law preempt, or is it a combination of the two?

Time will tell.  But the Sherwood majority and dissenting opinions are a good start to grappling with the subject.

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Footnote 1:  The opinion is Sturges v. Crowninshield, 17 U.S. 122 (1819). 

Footnote 2:  The opinion is Stellwagen v. Clum, 245 U.S. 605 (1918).

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