A three-judge panel for the U.S. Court of Appeals for the Ninth Circuit has ruled 2-1 that federal bankruptcy law preempts a provision of California state law covering assignments for benefit of creditors (ABC). The dissent warned that other ABC provisions could be preempted under the same rationale.

In Sherwood Partners, Inc. v. Lycos, Inc., No. 03-55247 (Jan. 12, 2005), the Ninth Circuit panel held that a California provision that gives an assignee selected by the debtor the power to void preferential transfers, which cannot be voided by an unsecured debtor, is preempted.

The Sherwood case stemmed from an agreement between Thinklink Corp., a unified messaging service provider, and Lycos, which agreed to promote Thinklink’s service on its Web sites. When Thinklink defaulted on one of its payments, the companies renegotiated, shortening the term of exclusivity and reducing Thinklink’s liability in exchange for prompt payment. Thinklink then paid Lycos $1 million.

Shortly after making its payment to Lycos, Thinklink made a voluntary general assignment for the benefit of creditors to Sherwood Partners. Sherwood shut down Thinklink’s business and sued Lycos in state court under Cal. Civ. Proc. Code section 1800 to recover the $1 million payment as a preferential transfer.

Lycos removed the case to federal district court, and argued that section 1800 was preempted by the Bankruptcy Code. The district court denied Lycos’ motion and granted summary judgment to Sherwood. Lycos appealed.

In addressing the preemption issue, the Ninth Circuit noted section 544(b) of the federal Bankruptcy Code limits a trustee’s powers to those of unsecured creditors, such as the right of an individual unsecured creditor to set aside fraudulent conveyances under state law.

“By contrast, the power to set aside preferential transfers under California’s section 1800 can be exercised only by general assignees, not by individual unsecured creditors,” the Ninth Circuit stated. “In other words, the assignee appointed pursuant to section 1800 is given new avoidance powers by virtue of his position.”

These “special avoidance powers” cannot “peacefully coexist” with the federal bankruptcy scheme, the court determined, because the power of a state assignee under section 1800 to recover a preferential transfer and distribute its proceeds to creditors may affect whether some parties would be willing to seek remedy under federal bankruptcy law.

“The creditor whose ox is being gored by the state assignee may have a new incentive to begin an involuntary federal proceeding; other creditors…may have diminished incentives,” the court stated. Such alteration of incentives would interfere with the Bankruptcy Code’s goals of equitable distribution of a debtor’s assets, concluded the court.

The dissent warned that the panel’s rationale threatens the entire statutory scheme surrounding ABCs.

“The majority’s concerns about section 1800 are not distinguishable from concerns about voluntary assignment provisions generally,” stated Circuit Judge D.W. Nelson. “When the majority’s reasoning is carried to its logical extension, it has the effect of pushing corporations threatened with insolvency from the less stigmatic, and less costly, voluntary assignment scheme to the world of federal bankruptcy.

“I believe that both voluntary assignments and the bankruptcy system can ‘peaceably coexist’ as twin mechanisms aimed at distributing the resources of an insolvent debtor.”

Sherwood reportedly is likely to appeal the decision. Until then, the ruling in Sherwood may be used to argue that ABCs are preempted altogether. The Ninth Circuit’s analysis also may be used to argue that California’s uniform fraudulent transfer statute is preempted by section 548 of the Bankruptcy Code. Hence, a creditor sued for recovery of an alleged fraudulent transfer may consider asserting an affirmative defense based on Sherwood.