Supreme Court Throws a Curve at the Assignment
for Benefit of Creditors Process *
By Richard Macias

Two rituals of American life resume every October: baseball playoffs and the traditional opening for the new term of the U.S. Supreme Court. Lawyers and creditors in California have waited throughout the summer to see how the Justices would rule on an important commercial law case involving the Ninth Circuit Court of Appeal's decision in Sherwood Partners v. Lycos, Inc., which overturned a significant element of California's Assignment For the Benefit of Creditors (AFBC) procedure. On October 3 (the opening day for the new “Roberts Court”) the Supreme Court issued an order refusing to hear the Sherwood appeal.

The procedures for an AFBC are commonly found as part of the commercial debtor/creditor laws of most states. The AFBC has a long history, some of which predates the modern federal bankruptcy process. The AFBC is often analogized to a "common law” bankruptcy run under state law. California has been one of the most active AFBC states and has a well developed body of law on the AFBC practice. The AFBC became a popular alternative to Chapter 7, especially where the business debtor had an assortment of potentially valuable assets to liquidate. In an AFBC, the insolvent debtor assigns its remaining assets to a third party, the Assignee. The debtor then ceases to operate. The Assignee gathers the cash, sells the assets, collects all the claims of creditors and eventually makes a pro rata distribution to the creditors from the pool of assets it has managed to accumulate and sell.

Debtor attorneys often favored this process as more streamlined, economical and expedited in comparison to the sometimes unwieldy Chapter 7 process. One element that had been a mainstay of AFBC practice, especially in California, was the recovery of preferences by the Assignee. Essentially, the rules for identifying preferences under a California AFBC mirrored the Bankruptcy Code rules. For the most part, however, the preference cases under the AFBC process were usually resolved faster than the two to three year process often encountered in a Chapter 7.

In the Sherwood case the Ninth Circuit, based in San Francisco, ruled the preference recovery element of the California's AFBC procedure was pre-empted by the preference recovery provisions of the federal Bankruptcy Code. In that case, Sherwood Partners, acting as the Assignee for the Benefit of the Creditors of Thinklink Corporation, obtained a seven figure preference judgment in state court against Lyco Inc., a creditor of Thinklink. Lycos appealed and the ruling of the Ninth Circuit overturned that judgment. In summary, the Ninth Circuit held that Congress intended for the more rigorous requirements of federal bankruptcy law and procedure to govern the process of preference avoidance involving debtor estates and that state law in this area was preempted by federal law. The decision of the Supreme Court not to hear Sherwood’s appeal means the ruling of the Ninth Circuit stands.

While the Sherwood decision did not completely eliminate the AFBC process, for debtors and their creditors the outcome of the Sherwood case means one of the key methods of funding the AFBC "estate", preference recovery actions by the Assignee, no longer is available. This will make the viability of the assignment mechanism questionable because one of the foremost elements of funding the work of the Assignee was through preference recovery actions. The impact of the Sherwood decision is clear. In the future, a financially challenged company that elects to wind down and close its doors with large potential preference payments outstanding must file a Chapter 7 in order to recover those preferences. One would have to conclude that a key element of the AFBC practice has struck out.

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Richard Macias is a partner of the Los Angeles creditors' rights law firm of Creim Macias Koenig & Frey LLP. He may be reached by telephone at 213-614-1944 and by email at rmacias@cmkllp.com

*This article appeared in Credit Today magazine, October, 2005.