Vivian Luo, a Preference for States? the Woes of Preempting State Preference Statutes

• Publication year: 2011

A PREFERENCE FOR STATES? THE WOES OF PREEMPTING STATE PREFERENCE STATUTES

INTRODUCTION

Financially distressed businesses, especially in California, are increasingly using assignments for the benefit of creditors ("ABCs") to liquidate their assets as an alternative to filing a chapter 7 bankruptcy.¹An ABC is a state collective action mechanism, akin to a chapter 7 liquidation, that permits a debtor to transfer its assets to its chosen fiduciary "for administration, liquidation, and equitable distribution among his creditors."²For example, between the years

2000 and 2005, many California businesses initiated ABCs due to the collapse of the dot-com industry. Additionally, more business entities have been inclined to accept and promote general assignments as an alternative to bankruptcy in the past two decades.³This is because state assignments, as compared with bankruptcy, have been viewed as a superior exit strategy for businesses.⁴ABCs are more efficient,⁵less costly, and minimize negative publicity for management.⁶

Despite their popularity, ABCs have weaknesses. One defect with common law ABCs is that assignees do not have the power to recover preferential transfers.⁷A preference is a transfer of property or an equitable interest in property by the debtor, typically to a favored or powerful creditor, for payment of prior debt.⁸"Usually, a preferential transfer is inequitable because that transfer takes away funds that would otherwise be shared by similarly situated creditors."⁹Recognizing this defect, practitioners have long advocated legislation directed at protecting general creditors against preferences.¹⁰As a result, twenty-two states¹¹have adopted statutes that permit the assignee to recover preferences.¹²California, a leader in the promotion of ABCs, has codified the preference recovery power in Section 1800 of the California Code of Civil Procedure.¹³However, California's preference recovery statute has recently faced a constitutional preemption challenge. While all but one court that ruled on the issue upheld the state preference law, the potential invalidation of state preference recovery laws means that any business seeking to utilize an ABC must forgo any preference claims.

Recently, several courts considered whether the California preference statute, which gives a state assignee, but not creditors generally, the power to recover preferences, is preempted by the Bankruptcy Code. The Ninth Circuit

Court of Appeals concluded that the statute had been preempted,¹⁴because the power to avoid preferences lies "within the heartland of bankruptcy administration."¹⁵However, two divisions of the California Court of Appeals and a Wisconsin District Court took a non-preemptionist view of the issue.¹⁶

The California Court of Appeals reasoned that the statute does not run afoul of "the essential goals and purposes" of the Bankruptcy Code because Congress recognizes the validity of state ABC laws.¹⁷Therefore, the California statute does not contravene any Congressional purpose, and upholding the statute would not interfere with the operation of federal law.¹⁸This Comment addresses whether the Bankruptcy Code, in granting a federal trustee the power to recover preferential transfers, preempts a state statute which grants a state assignee, but not an unsecured creditor, a similar power to avoid preferences.¹⁹

The decision to file for bankruptcy or to initiate ABC proceedings is predominantly a creditor concern. The decisions of the California Court of Appeals and the Ninth Circuit have substantial impact on creditors because a preemptionist resolution to the debate at hand would result in a tradeoff between recovering preferences in bankruptcy and lower expenses in ABCs. The preemptionist view also operates against the collective interests of creditors. By precluding any preference recovery actions by a state assignee, the Ninth Circuit effectively allowed creditors to keep their preferential payments. Even if the debtor later files for bankruptcy, there is a strong likelihood²⁰that the preferential payment would fall outside the ninety-day preference recovery window granted by federal law.²¹Thus, in either bankruptcy or state law insolvency proceedings, the otherwise avoidable preference most likely remains with the preferred creditor, diminishing the amount available for distribution to the remaining creditors.

Some, including the Ninth Circuit, have suggested that this preemption challenge is primarily a debtor concern. Jurists and practitioners have recognized that, currently, if a debtor in California pursues the state law remedy, it risks invalidation of any preference recovery actions instituted by its assignee.²²Alternatively, if the debtor files for bankruptcy, Sec. 547 of the

Bankruptcy Code ensures the trustee a preference avoidance power upon the filing of a bankruptcy petition.²³The downside to bankruptcy is that filing and operating under federal law is more costly,²⁴more drawn out, and enshrouds the individual with a stigma than most are unwilling to tolerate.²⁵To managers and directors of corporations hoping to maintain friendly relations with its creditors or who live in the public eye, state law may seem to offer less cumbersome proceedings. Even given these concerns, however, the effect on debtors is negligible.

The corporate debtor itself has little concern about the results of their insolvency proceedings when the end game is liquidation.²⁶Corporate debtors receive no exemptions nor are they discharged from debt.²⁷Oftentimes, once the company goes out of business, it goes out of existence. The managers of the company may have some opinion in the means of liquidation insofar as they have a vested interest. For example, principles may be concerned where they have personally guaranteed loans or have a desire to maintain good creditor relations in the hopes of building a new business. They may also opt for the least expensive process in the hopes of obtaining a share of any leftover proceeds after creditors have been paid.²⁸

Any final resolution of the conflict between the Ninth Circuit and the California Court of Appeals will substantially affect creditors and will, at most, nominally impact debtors. If the Ninth Circuit's preemption view controls, creditors who receive a preferential transfer likely keep their preferential payments, and thus benefit at the expense of the other creditors. If the California Court of Appeals' anti-preemptionist view prevails, then the door remains open for states to grant an assignee more powers than are available to any general creditor. As the Ninth Circuit states, this may seem contrary to

Congress's intent²⁹in enacting a national bankruptcy law because the danger of inequitable distribution of the debtor's assets in state proceedings may dissuade certain parties from undergoing bankruptcy.³⁰However, the Ninth

Circuit's argument is logically unsound, its conclusion stands contrary to the weight of authority, and creates undesirable public policy.

This Comment supports the decision of the California Court of Appeals to uphold California's ABC law granting a state assignee the ability to recover preferential transfers for four reasons: (1) there can be no conflict when no bankruptcy petition has been filed; (2) the weight of authority, including Supreme Court precedent and subsequent state and federal decisions, favors upholding the state law; (3) California's ABC provision does not interfere with the operation of the federal Bankruptcy Code but furthers the goals of insolvency legislation; and (4) statutes, such as section 1800, make good policy. Furthermore, this Comment addresses the possibility that both the Ninth Circuit and the California courts failed to address the core issue raised in Sherwood and Haberbush, the principal preemption and non-preemption cases. The question that should have been considered by the court is whether

Congress has preempted the ability of the states to create fiduciary³¹duties to creditors.

Part I discusses relevant Bankruptcy Code provisions and bankruptcy alternatives in state law. It examines the development of federal preemption law and describes the operation and benefits of state ABC provisions. This section also provides a brief summary of the federal preemption doctrine and its scope in the bankruptcy context. Additionally, it summarizes and explains the operation of the California statute at issue-section 1800 of the California Code of Civil Procedure.

Part II presents a summary of the Sherwood Partners and Haberbush cases. This section steps through the Ninth Circuit's rationale, which lead to the conclusion that section 1800 is preempted, and the California Court of Appeals' reasoning for reaching the opposite conclusion.

Part III provides an analysis of the Sherwood Partners and Haberbush cases, considers their effect on bankruptcy, and weighs the merits of each court's ruling. This part looks at state preference laws and discusses similar state assignment provisions that passed constitutional muster. The analysis also offers additional interpretations of the Ninth Circuit's rationale for invalidating California's ABC provision. In doing so, this Comment raises additional issues the courts may have overlooked and concludes that the arguments of the Sherwood court seem shortsighted at best. Finally, this section reviews the policy and purpose of bankruptcy and insolvency legislation and discusses the repercussions of permitting and denying states the ability to enact preference avoidance statutes.

I. BACKGROUND BANKRUPTCIES-THE OLD AND THE NEW

The problem of preferential transfers has pervaded the bankruptcy jurisprudence of both English and American law.³²A trustee's power to avoid preferences was, and remains, rooted in the notion of equity.³³Today, preferences and fraudulent transfers are distinguished as separate ideas,³⁴however "the emergence of preference law was closely tied to the concept of fraud."³⁵The...