The Bankruptcy Code Preempts California Law: Preferences May Now Be Set Aside Only In Federal Bankruptcy Court
A California assignee for benefit of creditors may no longer use California Code of Civil Procedure § 1800 ("Section 1800") to recover preferential payments to creditors made before the assignment, according to the Ninth Circuit. Instead, preferential transfers can only be set aside in a federal bankruptcy case. Section 1800, applicable in California when a debtor made a general assignment for the benefit of its creditors, purported to allow an assignee to set aside certain payments made to "preferred" creditors over other creditors. Under Section 1800, the assignee could sue the creditor who received preferential payment and use the recovery to pay all creditors under statutory priorities.
In Sherwood Partners, Inc. v. Lycos, Inc., United States Court of Appeals for the Ninth Circuit, No. 03-55247 (January 12, 2005), Judge Kozinski, writing for the panel’s two-member majority, held that the Bankruptcy Code preempted Section 1800. The debtor in Sherwood Partners, Thinklink Corp., had made a general assignment to Sherwood Partners, Inc. as assignee for benefit of its creditors. After the assignment, Sherwood Partners sued one of Thinklink's creditors, Lycos, Inc., in California state court for the benefit of Thinklink's other creditors to recover a $1 million transfer that fell within the statutory 90-day preference period.
Lycos removed the case to federal court and moved to dismiss based on federal preemption. The district denied Lycos's motion, but the Ninth Circuit reversed, dismissing Sherwood Partners' complaint.
Judge Kozinski reasoned that, because the bankruptcy clause in section 1 of the U.S. Constitution gives the federal government the power to make "uniform" bankruptcy laws, federal preemption is particularly strong in the area of bankruptcy, where the Congress has passed comprehensive legislation in the form of the Bankruptcy Code.
Since Section 1800 gave powers to a California assignee for benefit of creditors similar to a key power of a bankruptcy trustee but different from those held by an ordinary creditor under state law, the Ninth Circuit held that Section 1800 was preempted by federal law. Notably, according to the Ninth Circuit, Section 1800 conflicted with the Bankruptcy Code's goals of equitable distribution, because it deprived a bankruptcy trustee of the opportunity to recover the transfer and distribute it equally to the debtor's creditors under federal priorities. It also set up a state alternative that competed with the federal bankruptcy system.
This decision – if not reversed – has several important consequences. First, any creditor sued under Section 1800 for receiving a preference should remove the case from state court to federal District Court (where the Ninth Circuit Sherwood Partners decision is controlling law).
Second, creditors concerned that an assignor for benefit of creditors has made preferential payments to others (particularly to insiders) should consider filing an involuntary bankruptcy against the debtor, because those preferences are now only recoverable in bankruptcy.
Finally, those winding up a company who wish to do so without the overhang of preference litigation against former suppliers or employees who got back salary may choose a state law assignment for benefit of creditors instead, specifically because there is no right to sue to set aside those preferences.
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