Business Law

The Northern District of California Concludes the Ninth Circuit’s Sherwood Partners Decision Remains Binding

SUMMARY

In Windmill Health Products, LLC v. Sensa Products (Assignment for the Benefit of Creditors), LLC, 2015 U.S. Dist. LEXIS 145685 (N.D. Cal., Oct. 27, 2015), the U.S. District Court for the Northern District of California held that the Ninth Circuit’s prior ruling that bankruptcy law pre-empted California’s statute permitting an assignee for the benefit of creditors to avoid a preference governed, even though subsequent state court decisions rejected that view. To read the full unpublished decision, click here.

FACTS

Windmill Health Products, LLC (“Windmill”) sued Sensa Products, LLC (“Sensa”) in California state court. The parties’ ensuing settlement obligated Sensa to make a series of $200,000 payments to Windmill. After making two of the payments, Sensa made a general assignment for the benefit of creditors (an “ABC”) under California law. The assignee then demanded that Windmill return the $400,000 as avoidable preferences under California Code of Civil Procedure section 1800(b). Windmill filed for declaratory relief in the district court, asking for a declaration that federal bankruptcy law and its preference provisions in Bankruptcy Code section 547 pre-empted section 1800(b) per Sherwood Partners, Inc. v. Lycos, Inc., 394 F.3d 1198, cert. denied, 546 U.S. 917 (2005) and that it therefore was not liable to the assignee for the return of the $400,000. The parties made cross summary judgment motions. The district court granted Windmill’s motion and denied Sensa’s motion.

REASONING

The district court held that it was bound by the Ninth Circuit’s decision in Sherwood. As the district court explained, Sherwood concluded that the Bankruptcy Code pre-empted section 1800(b) because it alters the incentives for commencing a bankruptcy proceeding and the scheme for equitable distribution to creditors it entails. Why file a bankruptcy with its attendant complexities just to recover preferences when they can be recovered via an ABC? Moreover, creditors in a subsequent bankruptcy proceeding would be denied the benefits of recovery of preferences under section 547 if an assignee for the benefit of creditors had already avoided those transactions.

The district court rejected Sensa’s argument that two post-Sherwood California Courts of Appeal cases rejecting Sherwood were binding on the district court. While federal courts should look to state courts for the rule of decision on state law issues, federal law governs the question of whether federal law pre-empts state law, which was the issue before the district court in Windmill. Therefore, the district court concluded that the Ninth Circuit’s decision in Sherwood was binding, and federal law pre-empts section 1800(b).

AUTHOR’S COMMENTARY

The author believes that the decision in Windmill is correct given the controlling authority of Sherwood. But the logic of that decision remains debatable. Why does Sherwood conclude that Bankruptcy Code section 547 pre-empts state preference law, but Bankruptcy Code section 548 does not pre-empt state fraudulent conveyance law? It can be argued that Congress indicated an intent not to pre-empt unsecured creditors’ rights by, for example, effectively incorporating state fraudulent conveyance law via Bankruptcy Code section 544(b).

However, one could also contend that state fraudulent conveyance law interferes with the incentives to employ the remedial scheme of the Bankruptcy Code every bit as much as section 1800(b). Moreover, the Bankruptcy Code enables recovery of fraudulent conveyances for the benefit of all creditors, not just a particular creditor as is the case under state law. Further, there no clear reason why Congress’ attitude toward state preference law as interfering with bankruptcy should be any different than its attitude towards state fraudulent conveyance law. Indeed, cases that have criticized Sherwood argue that, taken to its logical conclusion, the reasoning of Sherwood could be used to attack state ABC law altogether, since ABCs are themselves a form of relief designed to deliver equitable distribution to creditors of distressed companies, just as is the Bankruptcy Code.

These materials were written by Adam Lewis of Morrison & Foerster LLP in San Francisco, California (alewis@mofo.com). Editorial contributions were provided by Leib M. Lerner of Alston & Bird, LLP in Los Angeles, California.

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee

Co-Chair
Leib Lerner 
Alston & Bird LLP
Leib.Lerner@alston.com

Co-Chair
Corey Weber 
Ezra Brutzkus Gubner LLP
cweber@ebg-law.com

Co-Vice Chair
Asa S. Hami 
SulmeyerKupetz, A Professional Corporation
ahami@sulmeyerlaw.com

Co-Vice Chair
Reno Fernandez 
Macdonald Fernandez LLP
Reno@MacFern.com

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