Bankruptcy Code v. ABC Laws: Why Sherwood Partners v. Lycos’s Dissent is Wrong

The interface between federal bankruptcy law and similar state laws has a long history, dating back at least to 1819, when the United States Supreme Court ruled that a state insolvency law:

  • can discharge a person from debtors’ prison; but
  • cannot pay that person’s debt.[Fn. 1]

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

  • The majority says an assignee cannot pursue 90-day preferential claims under a state’s ABC law, due to the preemption of the Bankruptcy Code.
  • The dissent does not agree.

The following is, (i) a summary of sherwood the facts and the law of preference, (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 deal is renegotiated: Thinklink’s remaining payments are reduced from $17 million to $1 million plus shares. Thinklink delivers the million dollars but not the stock.

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

Then Sherwood closes the Thinklink business and sues Lycos to recover the $1 million payment as a preferential transfer.

Lycos argues that the ABC law preference provision is preempted by the Bankruptcy Code and the matter is before the Ninth Circuit Court of Appeals.

sherwood Preference status

The 90-day preference provision of ABC law is identical to that of the Bankruptcy Code, with one exception: the 90-day period begins on filing for bankruptcy in one and on assignment in the other.

Here is an important similarity:

  • only the appointed trustee (trustee or assignee) can exercise the power of preference under either statute – and only after the filing of bankruptcy or assignment; and
  • no creditor may exercise such power for its own benefit under state or federal law – ever.

Primer of preemption

Congress has broad authority to anticipate state laws: it is a matter of Congressional intent. Pre-emption can take place through an express statutory declaration.

Pre-emption can also be deducted from:

  • a federal regulatory system “so pervasive” that “Congress left no room for the states to complete it”; and
  • a less common pattern in which state laws would be an “impediment” to achieving the full goals and objectives of Congress.

Preemption applied

The majority say that there is “no doubt” that the Bankruptcy Code is “pervasive”:

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

The Bankruptcy Code also peacefully coexists with and often incorporates state debtor and creditor rights laws.

Thus, the question is whether the state’s ABC law of preference is preempted by inference:

  • is it tolerated by the Bankruptcy Code; Where
  • is this at the heart of bankruptcy administration?

Second. 544(b)—The pivot of disagreement

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

One argument indicates that the ABC law preference provision is specifically incorporated into the Bankruptcy Code by section 544(b), which grants state law powers of avoidance to the assets of the bankruptcy.

-Majority

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

  • defines “creditor” as an entity having “a claim on the debtor”;
  • said “custodian” includes assignees under ABC law;
  • treats custodians as trustees, not creditors;
  • does not mention depositaries alongside creditors in § 544(b); and
  • thus, an ABC assignee is not considered a § 544(b) “creditor”.

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

  • such power cannot be exercised by a single creditor—never; and
  • such power is like the 90-day preference of the Bankruptcy Code avoiding power and at the heart of bankruptcy administration.

-CONTESTATION

The dissent rejects the distinction which can only be exercised by the assignee. This is because ABC Law assignees exercise many powers that are not available to general creditors. For instance:

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

Therefore, the basis for majority preemption is flawed.

The essential difference between majority and dissent is as follows:

  • The majority focuses on a single power that no one can exercise under state law except the assignee of an ABC statute; but
  • The dissent paints with a broad brush, saying ABC Law assignees can do many things “on behalf of all creditors” that no creditor can do independently.

Dissent says:

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

The reality, however, is that every unsecured creditor BOX do these things – all of them – but only for himself in the race for the courthouse. For example, under state law, each unsecured creditor may, through court proceedings:

  • take possession and liquidate the debtor’s assets—to recover its own claim;
  • prosecute fraudulent transfers under the Uniform Fraudulent Transfers Act and similar laws – to recover its own claim; and
  • distribute the proceeds of liquidation – to pay its own claim.

So the difference between the two opinions is this:

  • The majority focus on a specific power to adjust the rights of creditors that is (i) exclusive to assignees; and (ii) similar in all respects to bankruptcy preference law, including reversion to the date of a filing/assignment event.
  • The dissent examines the sweeping powers of an assignee to do collective things for unsecured creditors – all of which can be performed by any unsecured creditor for themselves in the rush to the courthouse.

There is an important difference between these two things, and the power of preference in question lies at the heart of bankruptcy administration. The dissent does not recognize this and is therefore wrong.

Conclusion

The interface between the US Bankruptcy Code and state ABC laws can be fuzzy and confusing: do they co-exist peacefully, or does federal law prevent, or is it a combination of the two?

Time will tell us. But the sherwood majority and dissenting opinions are a good start to broach the subject.