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The United States Supreme Courts seems to appreciate that preference actions are the bane of the vendor, given the Supreme Court’s recent decision to refuse to consider the appeal form. It seems that with any customer filing bankruptcy (no matter the bankruptcy chapter), vendors are targeted for payments received (or even goods that were returned by the customer) during the 90 days prior to the bankruptcy filing. A vendor may be surprised to find that a preference action is not limited to the federal bankruptcy system. Rather, over 20 states have also enacted state preference statutes. The effect of the state preference law is that if a customer does not liquidate its assets through a bankruptcy filing, but, rather, an out-of-court liquidation, such as an assignment for benefit of creditors (“ABC”), the vendor may still be sued for a preference pursuant to the state’s preference law.
However, a state preference suit may now be barred under the doctrine of preemption and the federal bankruptcy preference. The US Supreme Court refused to consider the Ninth Circuit Court of Appeals decision, in Sherwood Partners, Inc. v. Lycos, Inc.,1 that an assignee under an assignment for benefit of creditors (“ABC”) statute does not have authority to pursue preference actions under California law. In that Ninth Circuit decision, the court ruled that the assignee had no such authority and ordered the preference action be dismissed. The court’s ruling and its meaning to vendors is considered.
A. Assignment for Benefit of Creditors
The ABC is a formal out-of-court liquidation where a fiduciary takes title to all of the debtor’s assets and liquidates them for the benefit of the creditors. The ABC is pursuant to state law, and is an alternative to the federal Bankruptcy Code’s Chapter 7 liquidation. Creditors are paid the proceeds in a manner similar to that established in the Bankruptcy Code.
The procedure for the ABC varies from state to state, with some states maintaining tight control over the process and others providing little regulation. Generally, the assignee is selected by the debtor. The ABC is comparable to an out-of-court Chapter 7 liquidation. However, an ABC does not require much financial disclosure, unlike a Chapter 7 filing, which requires schedules and statement of financial affairs to be filed. California’s ABC law permits an assignee to sue vendors to recovery preference payments made within 90 days of the ABC.
1. States That Have Adopted the ABC
The following states that have adopted ABC’s are Arizona, Arkansas, California, Colorado, Delaware, District of Columbia, Florida, Georgia, Indiana, Iowa, Kentucky, Rhode Island, Massachusetts, Michigan, Minnesota, Mississippi, Missouri, New Jersey, New Mexico, New York, North Carolina, South Carolina, South Dakota, North Dakota, Ohio, Oklahoma, Pennsylvania, Tennessee, Utah, Vermont, Virginia, Washington, West Virginia and Wisconsin.
B. Background of Preference Laws
Fundamental to insolvency law since its creation in the sixteenth century is paying creditors of the same class an equal percentage on their claims. This principle disfavors payments to one creditor at the expense of other creditors of the same class. Preference laws are central to this, and are the method to attempt to achieve the equality of distribution to creditors. The focus of preference laws has shifted from the culpability of the debtor, to the culpability of creditors, to the present day standard of strict liability; e.g. the vendor received payment within the preference period.
Preference laws seek to deter individual creditor action by threatening recapture of transfers made during the debtor’s backslide into insolvency. In addition, it is believed that preference actions adhere to the policy of maximizing the insolvent estate.
1. The Bankruptcy Preference
The Bankruptcy Code vests the debtor (or trustee, or trust, if one is appointed) withfar-reaching powers to recapture payments to creditors within the 90 days of the bankruptcy filing. The purpose of the preference provision is two-fold. First, unsecured creditors are discouraged from racing to the courthouse to dismember a debtor, thereby hastening its slide into bankruptcy. Second, debtors are deterred from preferring certain unsecured creditors by the requirement that any unsecured creditor that receives a greater payment than similarly situated unsecured creditors disgorge the payment so that like creditors receive an equal distribution of the debtor's assets.
The elements of a preference that a debtor must establish are:
Not all transfers made within the preference period are avoidable. To protect those transactions that replace value to the bankruptcy estate previously transferred, the Bankruptcy Code carves out seven exceptions or defenses to the trustee's recovery powers.
2. The State Preference Law
The states’ preference statutory scheme generally operate the same as the bankruptcy preference statute. For example, in California, where the Sherwood Partners case state preference statute was examined, the preference statute is comparable to the bankruptcy preference statute. Vendors may assert defenses commonly raised in a bankruptcy preference, such as contemporaneous exchange, ordinary course of business and new value.
Besides California, the following have also adopted state preference laws: Colorado, Delaware, Georgia, Indiana, Iowa, Kentucky, Maryland, Missouri, Montana, New Hampshire, New Jersey, New York, North Carolina, Ohio, Oklahoma, Pennsylvania, South Carolina, South Dakota, Tennessee, Washington and Wisconsin.
C. Sherwood Partners v. Lycos:
The Out-of-Court Liquidation and State Preference Suit in Action The state preference suit in Sherwood Partners arose from an agreement between the debtor, Thinklink Corporation, and the vendor, Lycos, Inc. The debtor defaulted on the agreement and, through negotiations; the debtor paid the vendor $1 million.
1. The Assignee Sues the Vendor for a Preference under State Law
Approximately two months after the debtor paid the vendor $1 million, the debtor made a general assignment for the benefit of creditors to Sherwood Partners, a consulting firm, the assignee. The assignee shut down the debtor’s business and liquidated its assets, and sued the vendor in state court to recover the $1 million payment as a preferential transfer.
a. Removal of Preference Action to the Federal District Court
The vendor removed the preference suit from state court to federal court on diversity grounds and moved to dismiss the preference suit. The vendor argued that the state preference statute was preempted by the federal Bankruptcy Code’s preference statute, and, therefore, the preference suit should be dismissed.
2. The District Court Denies Vendor’s Motion to Dismiss and Grants Preference Judgment
The vendor filed a motion with the district court to have the preference compliant dismissed. The district court denied the vendor’s motion to dismiss, and eventually granted judgment in favor of the assignee for $1 million. The vendor appealed the decision to the Ninth Circuit Court of Appeals.
3. The Ninth Circuit Court of Appeals Reverses the District Court and Remands the Case for Dismissal
In a split decision, the Ninth Circuit compared the preference avoidance powers granted to an assignee under the state’s preference statute with the avoidance powers of a trustee under the Bankruptcy Code. The Ninth Circuit determined that the assignee appointed pursuant to the state preference statute is given new avoidance powers by virtue of his position and the federal Bankruptcy Code preempts the state preference statute.
a. The Bankruptcy Code Preempts the State Avoidance Statute
Key to the Ninth Circuit’s ruling that an assignee may not prosecute preference actions under California’s state preference statute is whether the federal bankruptcy preference statute preempts the state preference statute. The court ruled:
“Congress’ 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 Sates to supplement it . . . There can be no doubt that federal bankruptcy law is ‘pervasive’ and involves a federal interest ‘so dominant’ as to ‘preclude enforcement of state laws on the same subject . . .” 2
The court found that the state statute granted the assignee new avoidance powers as a result of the assignee’s position.
The court further noted that:
“One of the major powers the [Bankruptcy] Code gives the trustee is the power to avoid preferential transfers. . . [and] may be exercised only under the supervision of the federal courts. Federal law protects creditors—particularly out-of-state creditors like Lycos— from the trustee’s possible conflicts of interest and other possible sources of self-dealing. [citation omitted].”
The court held that the assignee’s prosecution of preference actions under state law was inconsistent with the federal bankruptcy code and was therefore preempted.
b. Assignee Appointed by Debtor a Problem
An ABC permits the debtor’s officers to select the assignee, unlike a bankruptcy trustee in a Chapter 7 liquidation, where a trustee is selected from a panel of trustees by the Office of the United States Trustee, which is an adjunct of the Justice Department. In Sherwood Partners, the Ninth Circuit court was concerned that an assignee was not subject to U.S. Trustee or court oversight. The Ninth Circuit found that absent this oversight, creditors were not assured that an assignee may act in the best interests of creditors.
c. No Double Recovery Under Sate Preference Law and Federal Law
The Ninth Circuit also was concerned that an assignee could recover preferences under state law, distribute the proceeds, yet still face a bankruptcy proceeding. In this setting, a bankruptcy trustee could not also pursue preference claims against the same creditors.
4. The US Supreme Court Refuses to Consider Assignee’s Appeal From Ninth Circuit
The US Supreme Court refused to grant certiorari to consider the Ninth Circuit’s ruling. The consequence of the Supreme Court’s ruling is that a vendor may now contend that the Ninth Circuit’s decision is now binding on federal courts within the Ninth Circuit. The vendor may also contend that federal courts outside of Ninth Circuit should be persuaded by the court’s decision.
D. Goodbye to State Preference Actions?
1. Constitutionality of State Preference Actions
The Ninth Circuit found that an assignee may not pursue a preference action in a state court liquidation as the federal bankruptcy code preempted the state court preference statute.
a. Removal to Federal District Court?
As preference actions in ABC’s are generally commenced in state courts, a vendor seeking to invoke the Sherwood decision may need to consider removing the preference action to the federal district court. A vendor may have a case removed to federal court on the grounds of federalquestion jurisdiction. On the other hand, a state court may adjudicate issues of federal preemption. Accordingly, either way, a defense under Sherwood Partners may be raised.
2. Good News for Vendors (Facing Potential Preference Claims), But What of Preference Claims Against Insiders?
Vendors that have received meaningful payments during the preference period should be pleased with the Sherwood Partners decision. But what of the insiders that may have received preference payments? If insiders received meaningful payments from the debtor during the preference period, is the assignee under a duty to disclose to creditors such payments?
a. Vendors may be Better Served in ABC than Chapter 7
Depending on the vendor’s view, whether they received meaningful payments during the preference period, may shape their decision to support the assignment, as opposed to move for an involuntary bankruptcy petition.
b. Does Assignee Have a Fiduciary Duty to Investigate Preferential Transfers and Disclose the Preference Analysis to Vendors?
Under an ABC, an assignee is handpicked by the debtor’s officers. An assignee holds the preference powers and the financial information as to which parties received payments during the preference period. Does an assignee, who has a fiduciary duty to creditors, have a responsibility to conduct a preference analysis? If the assignee prepares a preference analysis and determines there are significant preferences, both to vendors and insiders, does the assignee file bankruptcy, thereby losing his assignment?
3. Prejudgment Remedies may Have a Greater Appeal for the Vendor
States generally have prejudgment remedies available for creditors where a debtor fails to pay. Those prejudgment remedies may include attaching a debtor’s assets. Should the creditor’s attachment occur 90 days prior to the debtor’s bankruptcy, the creditor would like face a preference suit. If the debtor files an ABC instead of a bankruptcy, the attachment may not be challenged as a preference. Given this distinction between out-of-court and bankruptcy liquidations as a result of the Sherwood Partners decision, a vendor may be inclined to pursue a prejudgment remedy if it anticipates that the debtor may assign its assets.
4. More Involuntary Petitions May be Filed by Vendors so Insider Preference Claims May be Pursued
If the debtor assigns its assets under an ABC, vendors may respond by filing an involuntary bankruptcy petition to preserve possible bankruptcy preference claims against insiders. An eligibility requirement to file an involuntary petition is that thepetitioner be a creditor holding an unsecured claim aggregating $12,300. If a debtor has greater than 12 creditors, then three petitioning creditors’ claims must aggregate $12,300. The petitioner’s claim must not be subject to a bona fide dispute, and the debtor must generally not be paying its debts when due.
a. The Abstention Doctrine may be Undermined
Even if the involuntary petition is found to be properly filed, the bankruptcy court nevertheless may exercise its discretion to abstain from entering an order for relief and dismiss the petition. The grounds for dismissal are that it would be in the best interests of the creditors and debtor, or that creditors have adequate remedies under state law, including where state court remedies would promote a more efficient means of administering the debtor’s assets. Given the Sherwood Partners decision, petitioning creditors facing an assignee’s abstention motion may have a compelling argument for a bankruptcy jurisdiction: the assignee cannot pursue preference claims, especially if such claims exist against insiders, the parties that selected the assignee.
5. State Must Amend Preference Statute
The state legislature will need to amend the preference statute to address the court’s concerns.
The Lesson for the Credit Professional
Debtors, trustees, litigation trustees, and creditors’ committees among others seem more intent than ever to pursue preference actions in federal bankruptcy cases. Given this bent to pursue bankruptcy preferences, a vendor may be pleased with the Sherwood Partners decision, especially if they have received meaningful payments from a customer during the preference period that elects to liquidate their assets under state law. Vendors facing preference demands and suits under state law may consider using the Sherwood Partners as an absolute defense to the state court preference claims, and the US Supreme Court seems to agree.