The U.S. District Court for the Northern District of California recently upheld the Ninth Circuit’s ruling in Sherwood Partners, Inc. v. Lycos, Inc. regarding the preemption of California’s preference statute by federal bankruptcy law. This decision, in Windmill Health Products, LLC v. Sensa Products (Assignment for the Benefit of Creditors), LLC, clarifies the interplay between state and federal law in assignments for the benefit of creditors (ABCs).
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Ninth Circuit’s Sherwood Partners Ruling Holds Precedence
The core issue in Windmill revolved around a $400,000 payment made by Sensa Products, LLC to Windmill Health Products, LLC before Sensa made a general assignment for the benefit of creditors. The assignee, invoking California Code of Civil Procedure section 1800(b), sought to recover the payment as a preference. Windmill, however, argued that federal bankruptcy law, specifically Bankruptcy Code section 547, preempted the state statute based on the Sherwood Partners precedent.
The District Court, bound by the Ninth Circuit’s decision in Sherwood Partners, granted summary judgment in favor of Windmill. The Sherwood Partners ruling established that California’s preference statute alters the incentives for filing bankruptcy and disrupts the equitable distribution scheme envisioned by federal law. Allowing recovery of preferences through state ABC proceedings could discourage debtors from pursuing bankruptcy, thereby depriving creditors of the comprehensive protections afforded by the Bankruptcy Code.
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State Court Decisions Don’t Overturn Federal Preemption
The defendant, Sensa, argued that subsequent California state court decisions rejecting the Sherwood Partners holding should control. However, the District Court emphasized that federal courts have the final say on matters of federal preemption. While state courts interpret state law, the question of whether federal law supersedes state law is a matter of federal jurisdiction. Therefore, the Ninth Circuit’s interpretation in Sherwood Partners, establishing federal preemption of section 1800(b), remained binding.
The Ongoing Debate Surrounding Sherwood Partners
While the Windmill decision reinforces the Ninth Circuit’s position, the underlying logic of Sherwood Partners continues to be debated. Critics question why Section 547 of the Bankruptcy Code preempts state preference laws while Section 548, concerning fraudulent conveyances, does not. Some argue that Congress, by incorporating state fraudulent transfer law into the Bankruptcy Code through Section 544(b), signaled an intent not to preempt state laws protecting unsecured creditors’ rights.
Conversely, one could argue that state fraudulent conveyance laws could potentially interfere with the Bankruptcy Code’s remedial framework as much as state preference laws. State laws allow recovery for individual creditors, while the Bankruptcy Code aims for equitable distribution among all creditors. The lack of clear Congressional guidance on this issue leaves room for continued discussion and potential challenges to the scope of Sherwood Partners. The decision in Windmill underscores the importance of understanding the complex relationship between state and federal law in insolvency proceedings, particularly when dealing with assignments for the benefit of creditors.
