On May 31, 2006, the California Court of Appeal for the Second Appellate District, in Haberbush v. Charles and Dorothy Cummins Family Ltd. Partnership, Case No. B175947, disagreed with the Ninth Circuit’s majority opinion in Sherwood Partners v. Lycos, 394 F.3d 1198 (9th Cir. 2005) and held that California Code of Civil Procedure section 1800 is not preempted by the federal Bankruptcy Code.

Sherwood had previously held that Section 1800, which allows an assignee for the benefit of creditors to recover certain transfers of a debtor’s property in order to ensure equitable distribution of a debtor’s assets, is preempted by the Bankruptcy Code, which similarly permits a debtor in possession or trustee to avoid preferential transfers.  Under this reasoning, an assignee proceeding under California law would not be able to avail itself of state preference laws, thereby significantly reducing the utility of assignments as an alternative to federal bankruptcy proceedings.  The Sherwood Partners majority had concluded that an assignee’s powers to avoid and recover preferential transfers cannot peaceably coexist with the federal bankruptcy scheme because, among other things, where a preferential transfer is recovered and distributed by an assignee, and a bankruptcy proceeding is later commenced, the trustee will now be precluded from recovering the same sum.  The Sherwood majority also expressed concern that the availability of the state preference laws may create a disincentive for parties to elect to commence a potentially more expensive and time-consuming federal bankruptcy case.  The state law, it concluded, must therefore yield to the regulation of Congress.  The California Court of Appeal, however, expressly disagreed with this analysis, finding it impossible to conclude that Section 1800 is inconsistent with the essential goals and purposes of federal bankruptcy law.

The California Court of Appeal, however, declined to follow the Ninth Circuit’s decision, noting that the decisions of lower federal courts on federal questions, while they may be persuasive, do not bind state courts.  The Court began its analysis anew with a review of the principles governing preemption.  Preemption is a question of Congressional intent, which may be indicated expressly or by inference where it is clear that Congress intended to occupy the field and the state law in question stands as an obstacle to Congressional purposes and objectives.  In rejecting the reasoning of the Sherwood majority and concluding that Section 1800 had not been preempted, the California Court of Appeal—essentially adopting the reasoning of Judge Nelson’s dissent in Sherwood—noted that it is beyond dispute that Congress intended to permit the coexistence of state laws governing voluntary assignments for the benefit of creditors.  (In fact, Bankruptcy Code section 544(b) makes state law on voidable transfers available to the bankruptcy trustee.)  The Court therefore concluded that it reaches too far to suggest that any state statute "implicating" the Bankruptcy Code’s equitable distribution scheme is preempted.  The Court further noted that, as for the possible alteration of incentives to commence a federal bankruptcy case–particularly in favor of an alternative that may be "less expensive and time-consuming"—the only pertinent question is whether the state statute’s effect on those incentives somehow interferes with or is an obstacle to the Bankruptcy Code’s objective of equitable distribution.  In the Court’s view, the Sherwood Partners majority provided no cogent explanation of how the assignee’s avoidance powers conflict with that objective.  Instead, the Court adopted the reasoning of the Sherwood dissent, observing that because the common law right to make an assignment of property for the benefit of creditors is well-established, it is “illogical that state laws that provide a forum for the equitable distribution of that property should be preempted by federal bankruptcy law.”  Moreover, California’s preference recovery provision is, by design, virtually identical to the Bankruptcy Code’s preference statute. If the same transfer can be avoided in both the state and federal systems, the Court concluded that the state system cannot reasonably be said to interfere with the Bankruptcy Code’s goal of equitable distribution.

The Court of Appeals therefore stated that "we can discern no persuasive reason to conclude that California’s ‘less stigmatic, and less costly, voluntary assignment scheme’ –which, like the federal bankruptcy system, serves to ensure equality of distribution of a debtor’s assets – ‘stands as an obstacle to the accomplishment . . . of the full purposes and objectives” of the federal bankruptcy system.’"  Accordingly, the Court held that Section 1800 is not preempted by the Bankruptcy Code.

A copy of the Haberbush opinion can be found here.

Authored by:

Mette H. Kurth

(213) 617-5501