In a recent 3-2 decision, the Ninth Circuit Court of Appeals held that California's statute governing preference recoveries by a voluntary assignee for the benefit of creditors was preempted by federal bankruptcy law. The decision has raised doubts in the Ninth Circuit about whether state laws such as assignments for the benefit of creditors and receivership actions can co-exist with the Bankruptcy Code. This issue is particularly important in view of the passage of the Bankruptcy Reform Act and the anticipated search for alternative debtor/creditor remedies.

What Is Preemption?

Preemption occurs when Congress enacts a federal law or statutory scheme that is intended to preclude enforcement of state laws on the same subject. Congressional "intent is most easily detected where the statute expressly pre-empts other laws, but preemption may also be inferred where it is clear from the statute and surrounding circumstances that Congress intended to occupy the field, leaving no room for state regulation."¹

In describing preemption, the Supreme Court has stated that:

[a]bsent explicit pre-emptive language, Congress's intent to supersede state law altogether may be found from a "'scheme of federal regulation...so pervasive as to make reasonable the inference that Congress left no room for the states to supplement it,' because 'the Act of Congress may touch a field in which the federal interest is so dominant that the federal system will be assumed to preclude enforcement of state laws on the same subject,' or because 'the object sought to be obtained by the federal law and the character of obligations imposed by it may reveal the same purpose.'"²

Bankruptcy law is clearly a pervasive statutory scheme. However, there are dozens of statutes in every state that regulate the rights and duties of debtors and creditors. In addition, there are dozens of decisions from both federal and state courts that examine whether these state statutes are preempted by bankruptcy law.³ Based on a review of these cases, it appears that the primary questions to examine in determining whether a state statute is preempted by bankruptcy law is "whether a state insolvency law is a 'bankruptcy' law and thus generally preempted by Congress's exercise of its power under the Bankruptcy clause...[or] whether a particular state statute conflicts with some specific aspect of the federal bankruptcy law."⁴

---

It is expected that the Bankruptcy Reform Act will send debtors and creditors searching for alternative state statutes to seek redress of their rights.

---

The Decision

Sherwood Partners Inc. became the assignee for the benefit of creditors of Thinklink Corp. In this capacity, Sherwood commenced a lawsuit against Lycos Inc. for recovery of a $1 million preferential transfer pursuant to Cal. Civ. Proc. Code §1800(b). This statute provides that:

[t]he assignee of any general assignment for the benefit of creditors...may recover any transfer of property of the assignor:

1. to or for the benefit of a creditor;
2. for or on account of an antecedent debt owed by the assignor before the transfer was made;
3. made while the assignor was insolvent;
4. made on or within 90 days before the date of the making of the assignment...and
5. that enables the creditor to receive more than another creditor of the same class.⁵

Lycos removed the lawsuit to federal court on diversity grounds, where the district court granted summary judgment to Sherwood Partners. Lycos appealed.

The Ninth Circuit began its analysis by recognizing the basic premise that federal preemption occurs where the federal statutory scheme is so pervasive as to occupy the field and displace any and all state regulation in a specific area. However, the Ninth Circuit further noted that "state law is [also] preempted...where [it] stands as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress."⁶

Based on this observation, the court undertook an analysis of the goals of the Bankruptcy Code and specifically liquidation proceedings to determine whether the California assignment statute could peaceably co-exist with the Code. The court noted that bankruptcy liquidation proceedings embody two functions: "(1) giving the individual debtor a fresh start by giving him a discharge of most of his debts, and (2) equitably distributing a debtor's assets among competing creditors."⁷ It has long been held that state statutes that give a debtor a discharge are preempted.⁸ However, if a state statute also invades the province of the federal bankruptcy scheme by precluding an equitable distribution to creditors, then such a scheme, the Ninth Circuit noted, is also preempted.⁹

In examining the California statute, the court found that §1800 was problematic because it was not merely another creditor provision of the kind tolerated by the Bankruptcy Code. Rather, the California statute gave the state assignees special avoidance powers by virtue of their position.¹⁰ As a result, such actions invaded the province of bankruptcy trustees who operate under a system in which they are charged with the orderly collection, liquidation and distribution of the debtor's assets, including the right to commence preference actions.¹¹ The court concluded 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."¹² In other words, a state law cannot go beyond contract or trust law to give entirely new rights to third parties that would not otherwise be held by debtors or creditors.¹³ The consequence of giving such power to third parties jeopardized the federal goal of equitable distribution and was thus preempted.¹⁴

Reconciling Sherwood Partners

Throughout its analysis, the Ninth Circuit attempted to reconcile its decision with holdings from other jurisdictions in which state preference and bankruptcy type provisions were not preempted by the Code. The Ninth Circuit appeared to draw three distinctions between the California statute and other state statutes that have not been preempted. First, the court noted that statutes cannot give new rights to third parties that do not already belong to debtors and creditors, and those that have been upheld do not grant new or greater rights.¹⁵

Second, the court found it significant that a state statute must not affect the incentives of various parties to avail themselves of the bankruptcy laws.¹⁶ Because an action by the state assignee under §1800 might diminish the likelihood that creditors would join the affected creditor in an involuntary bankruptcy filing, such a state scheme must be preempted.¹⁷

Finally, the court was concerned by the fact that a state assignee could recover preferential transfers and preclude a federal trustee from recovering the same sum. In other words, "distribution of the recovered sum would have been made by a state assignee subject to state procedures and substantive standards, rather than by the federal trustee subject to bankruptcy law's substantive standards and procedural protections."¹⁸

Application to Other States' Laws

Does the holding in Sherwood Partners mean that preference laws may not be utilized in other nonbankruptcy liquidation proceedings? It is certainly too early to tell. However, Sherwood Partners casts a large shadow over other alternative state provisions such as receivership statutes and statutes governing assignments for the benefit of creditors. Are these kinds of statutes preempted in their entirety? What about receivership statutes such as the Washington state receivership statute that was amended in 2004 to mimic many of the sections of the Code? It would appear that based on the holding in Sherwood Partners, any statute that vests in third parties' power that is reserved for debtors or trustees in bankruptcy invades the province of the Code and would be preempted. For example, under the Washington statute, receivers can now assume or reject leases. Clearly, this is not a right that belongs to debtors or creditors under state contract law and can only be found in the Code. As a result, it would appear under the holding in Sherwood Partners that such a provision is preempted. What about the stay provisions that arise automatically under the Washington state receivership statute upon the filing of a receivership? Can such a provision be likened to a TRO, or is the provision too invasive of the province of the Code?

It is expected that the Bankruptcy Reform Act will send debtors and creditors searching for alternative state statutes to seek redress of their rights. As a result, there will likely be a surge in challenges across the country to such statututory schemes that mimic or invade the province of the Code.

---

Footnotes

¹ Sherwood Partners Inc. v. Lycos Inc., 394 F.3d 1198, 1200 (9th Cir. 2005). Return to article

² Pacific Gas & Electric Co. v. State Energy Resources Conservation & Development Commission, 461 U.S. 190 (1983) (quoting Fid. Fed. Sav. & Loan Ass'n. v. De la Cuesta, 458 U.S. 153 (1982) (quoting Rice v. Santa Fe Elevator Corp., 331 U.S. 218, 230 (1947))). Return to article

³ See, e.g., Pobreslo v. Boyd, 287 U.S. 518 (1933) (upholding a Wisconsin statute governing assignments for the benefit of creditors containing a preference avoidance provision, but not a discharge provision); International Shoe v. Pinkus, 278 U.S. 261 (1929) (striking down Arkansas receivership statute that granted a discharge to a debtor otherwise ineligible for a bankruptcy discharge); Stellwagen v. Clum, 245 U.S. 605 (1918) (state statutes intended to avoid conveyances actually or constructively fraudulent are not preempted by national bankruptcy law); Moskowitz v. Prentice (In re Wisconsin Builders Supply Co.), 239 F.2d 649 (7th Cir. 1956) (involuntary receivership provisions superseded by Bankruptcy Act); In re Newport Offshore Ltd., 219 B.R. 341 (Bankr. D. R.I. 1998) (Rhode Island involuntary receivership statute not preempted); Goldstein v. Columbia Diamond Ring Co. Inc., 366 Mass 835 323 N.E. 2d 344 (1975) (state insolvency law, which was a full and complete bankruptcy law with discharge provisions, was preempted by federal bankruptcy law). Return to article

⁴ Tabb, Charles Jordan, The Law of Bankruptcy 27 (Foundation Press 1997) at 48. Return to article

⁵ Cal. Civ. Proc. Code §1800(b). Return to article

⁶ Sherwood Partners, 394 F.3d at 1201 (quoting Pacific Gas & Electric Co., supra at 204). Return to article

⁷ Sherwood Partners at 1203. Return to article

⁸ See Int'l. Shoe Co., supra. Return to article

⁹ Sherwood Partners at 1203. Return to article

¹⁰ Sherwood Partners at 1205. Return to article

¹¹ Id. at 1204. Return to article

¹² Id. Return to article

¹³ Id. at 1206 at n. 8. Return to article

¹⁴ Id. Return to article

¹⁵ Id. at 1205, n. 7, n. 8. Return to article

¹⁶ Id. at 1205. Return to article

¹⁷ Id. at 1204-05. Return to article

¹⁸ Id. at 1204. Return to article