A Comparison of Avoiding Powers Under California Business Liquidation Strategies

by René Lastreto II1 and Michael J. Gomez2

Those that deal with a troubled business on the verge of liquidation must be aware of the risks. Most are aware that payment of “old” invoices or accounts just prior to filing a bankruptcy may result in preference liability for the business that has collected on the “old” account. But there are other options available to a liquidating business under California law. Two of those non-bankruptcy options are Assignments for Benefit of Creditors and Receiverships. Does a business dealing with a troubled company have to be concerned about their own liability even if a bankruptcy is not filed? This article explores those concerns.

A. Preference Claims

Bankruptcy trustees and assignees for the benefit of creditors are statutorily authorized to pursue preferences. 11 U.S.C. § 547; Cal. Code of Civ. P. §§ 1800 – 1802. The Ninth Circuit Court of Appeals has declared that the power of assignees to unwind preferences under state law is preempted by the federal preference law contained in the Bankruptcy Code. Sherwood Partners v. Lycos, Inc., 394 F.3d 1198 (9th Cir. 2005), cert. denied, 126 S.Ct. 397 (2005). Despite Sherwood, two California appellate courts have upheld the California preference scheme. Haberbush v. Charles and Dorothy Cummins Family Ltd. P’ship, 139 Cal.App.4th 1630 (Cal. Ct. App. 2006); Credit Managers Ass’n of Cal. v. Countrywide Home Loans, Inc., 144 Cal.App.4th 590 (Cal. Ct. App. 2006); see also Ready Fixtures Co. v. Stevens Cabinets, 488 F.Supp.2d 787 (W.D. Wis. 2007) (noting the “problems with the Sherwood decision are manifold . . . ”). Thus, while an assignee’s right to recover a preference may be barred in certain federal courts, the remedy remains available before California state courts and possibly federal courts outside of the Ninth Circuit. Viz Media LLC v. Steven M Spector PC, 2007 U.S. Dist. LEXIS 29442 (N.D. Cal. April 10, 2007) (declaratory relief claim based on federal preemption argument set up defensively to bar assignee’s preference action in state court does not establish federal question subject matter jurisdiction); Spector v. Melee Entertainment LLC, 2008 Del. Super. LEXIS 48 (Del. February 6, 2008) (involving the same assignment for the benefit of creditors as Viz Media and following Haberbush and Countrywide over Sherwood Partners).

Overall, the ability of assignees to recover preferences is broader than that of trustees. First, the definition of “new value” for the new value preference defense does not include the proceeds of money, money’s worth in goods, services, or new credit, or the release of property previously transferred to the transferee. Compare Cal. Code of Civ. P. § 1800(a)(5) with 11 U.S.C. § 547(a)(2). Second, the ordinary course of business defense still requires that the transaction was in the ordinary course of the dealings between the parties and made on customary industry terms whereas after BAPCPA, the defense for bankruptcy purposes only requires one of the two to be proven. Compare Cal. Code of Civ. P. § 1800(c)(2) with 11 U.S.C. § 547(c)(2). Third, the preference defense for purchase money security interests applies to security interests perfected within twenty (20) days after the security interest attaches, not thirty (30) days under federal law; and transfers involving security interests are deemed made when perfected using shorter safe harbor periods. Compare Cal. Code of Civ. P. §§ 1800(c)(3)(B) and 1800(e)(2) with 11 U.S.C. §§ 547(c)(3)(B) and 547(e)(2). Fourth, there are no specific defenses for Deprizio style transfers. See 11 U.S.C. §§ 547(I) and 550©).3 Fifth, unlike trustees, preference recoveries for assignees are less restricted by reclamation rights. 11 U.S.C. § 546©), (d). Sixth, there is no express prohibition on assignees recovering preferences that involve a margin or settlement payment, a repurchase agreement, a swap agreement, or a master netting agreement. 11 U.S.C. § 546(e), (f), (g), and (j). Seventh, the types of domestic support obligations that may be recovered includes voluntary assignments of domestic support obligations made for purposes of collection. Compare Cal. Code of Civ. P. § 1800(c)(8)(A) with 11 U.S.C. § 101(14A)(D). Finally, there are no threshold, minimum transaction limits for preference actions as there are under federal law. See 11 U.S.C. § 547(c)(8), (9).

In certain respects, however, the ability of assignees to recover preferences is narrower than that of trustees. For instance, transfers to or for the benefit of insiders may only be recovered if it can be proven that the insider had reasonable cause to believe that the debtor was insolvent at the time of the transfer. Compare Cal. Code of Civ. P. § 1800(b)(4) with 11 U.S.C. § 547(b)(4). Second, assignees are expressly prohibited from recovering preferences that extinguished potential mechanic and materialmen’s liens. See Cal. Code of Civ. P. § 1800(c)(7). Third, preferences cannot be recovered from subsequent transferees and assignees may only recover the property transferred, not the value of the property. See 11 U.S.C. § 550(a). Fourth, there is no right that allows assignees to preserve avoided liens for the benefit of creditors. Compare 11 U.S.C. § 551 and Cal. Code of Civ. P. § 493.060(b) with Cal. Code of Civ. P. § 493.060(a). Hence, it may be fruitless to avoid a senior lien if junior liens are unavoidable. Lastly, the statute of limitations for assignees to pursue preference claims, which is one year, may be shorter than trustees in most instances. Compare Cal. Code of Civ. P. § 1800(g) with 11 U.S.C. § 546(a).

Additionally, there are other differences which may ultimately be more or less beneficial for assignees. First, for preference actions initiated by assignees, there is no definition of when a tax debt is incurred. See 11 U.S.C. § 547(a)(4). Second, there are slight variations in the definitions of “affiliate” and “transfer.” Compare Cal. Code of Civ. P. § 1800(a)(3), (10) with 11 U.S.C. §§ 101(2) and 101(54). Arguably, the definition of “transfer” for purposes of bankruptcy, which was broad to begin with, was broadened by BAPCPA’s changes. Similarly, the defense for creditors that hold security interests in inventory and receivables dealing with the improvement of their position is formulated slightly differently under bankruptcy law by referencing the new value defense. Compare Cal. Code of Civ. P. § 1800(c)(5)(A) with 11 U.S.C. § 547(c)(5)(A). For preferences pursued by assignees, there is also no express provision that allocates the burdens of proof as there is under bankruptcy law. See 11 U.S.C. § 547(g). In situations where the assignor is an individual, the assignor may elect to use an exemption scheme unique to preferences sought to be recovered by assignees. See Cal. Code of Civ. P. § 1801. This unique exemption scheme may impact the statutory insolvency determination. Compare Cal. Code of Civ. P. § 1800(a)(1)(A)(ii) with 11 U.S.C. § 101(32)(A)(ii).

Separate from being subject to challenge as preferences, liens created by attachments or temporary protective orders that have not seasoned for ninety (90) days before a bankruptcy filing or an assignment for the benefit of creditors are expressly terminated under California law as to trustees and assignees. Cal. Code. Civ. P. § 493.030(a), (b). These liens may be reinstated if the bankruptcy case is dismissed, the trustee abandons the property subject to the liens, or the assignment is set aside for reasons other than the filing of bankruptcy. Cal. Code. Civ. P. § 493.050(a). There are no similar preference rights for receivers.4

B. Fraudulent Transfers

Statutorily, bankruptcy trustees and assignees may seek to unwind fraudulent transfers. 11 U.S.C. §§ 544(b), 548; Cal. Civ. Code § 3439.01©) (defining assignees as creditors). Likewise, equity receivers may also seek to recover fraudulent transfers. Cal. Civ. Code § 3440(b);Southmark Corp. v. Cagan, 999 F.2d 216 (7th Cir. 1993); Scholes v. Lehmann, 56 F.3d 750 (7th Cir. 1995); Donnell v. Kowell, 533 F.3d 762 (9th Cir. 2008); contra Global Grounds Greenery, LLC, 405 B.R. 659 (Bankr. D. Ariz. 2009). Trustees may unwind transfers that took place up to two years before the bankruptcy filing. 11 U.S.C. § 548(a)(1). Trustees may also avoid transfers that took place as far back as allowed by applicable state law, but only if they can identify a creditor that existed at the time of the transfer that holds a claim. 11 U.S.C. § 544(b); In re Acequia, Inc., 34 F.3d 800 (9th Cir. 1994). Assignees are subject to the same restriction and may only seek relief for the benefit of creditors that are the beneficiaries of the assignment. Cal. Civ. Code § 3439.07(d).

Aside from differences arising from standing and statute of limitation periods, recoveries and the types of transfers that can be avoided may vary depending on whether a bankruptcy trustee, a receiver, or an assignee is involved. For example, fraudulent transfer recoveries by receivers and assignees are limited to the lesser of the value of the property transferred or the amount necessary to satisfy the claims of creditors. Recoveries of fraudulent transfers by trustees, on the other hand, may either result in the return of the asset transferred or the value of the asset, subject to the court’s discretion. Compare Cal. Civ. Code § 3439.08(b), ©) with 11 U.S.C. § 550(a)(1). Bankruptcy trustees may therefore be entitled to capture any appreciation in a transferred asset. Moreover, trustees may preserve avoided liens for the benefit of creditors while assignees and receivers may or may not have a similar right in the fraudulent transfer context. Compare 11 U.S.C. § 551 and Cal. Code of Civ. P. § 493.060(b) with Cal. Civ. Code § 3439.07(a)(3)©) and Cal. Code of Civ. P. § 493.060(a). Trustees may not recover certain fraudulent transfers that involve a margin or settlement payment, a repurchase agreement, a swap agreement, or a master netting agreement. 11 U.S.C. § 546(e), (f), (g), and (j). There is no similar prohibition on assignees and receivers.

C. Avoidance of Unperfected Security Interests

The Bankruptcy Code expressly authorizes bankruptcy trustees to avoid unperfected security interests in three circumstances, including one dealing with real property. 11 U.S.C. § 544(a); see also Global Grounds Greenery, LLC, 405 B.R. 659 (Bankr. D. Ariz. 2009) (noting the limited authorities that have on occasion allowed receivers to avoid unperfected interests in real property). Additionally, bankruptcy trustees, assignees, and equity receivers may also trump the rights of creditors that hold unperfected security interests in personal property as well as creditors that make further advances after the appointment of a bankruptcy trustee, assignee, or equity receiver. Cal. Comm. Code § 9102(a)(52)(A)(ii) – (iv) (defining assignees, bankruptcy trustees, and equity receivers as “lien creditors”); Cal. Comm. Code § 9317(a)(2) (subordinating unperfected security interests and agricultural liens to lien creditors); Cal. Comm. Code § 9323(b) (subordinating certain future advances made by creditors holding a perfected security interest to the rights of lien creditors).

An Assignee or a Receiver may not have the “buyer in ordinary course” protection if the Assignee or Receiver disposes of an asset. In California, there is some judicial acceptance that a purchaser on a bulk sale or distressed basis may be found not to have taken the asset free of a security interest because of the context of the purchase. While not involving an Assignment or a Receivership, the Court of Appeals in American National Bank v. Cloud, 201 Cal. App. 3d 766, 776 (1988) held that a sale that is not “ordinary” may require more vigilance on the part of the buyer and the buyer may not be protected by the “ordinary course” argument.

D. Alter Ego/Unlawful Dividend Claims

Bankruptcy trustees may not pursue alter ego claims against the principals of bankrupt entities as those rights solely belong to individual creditors. Ahcom, Ltd. v. Smeding, 63 F.3d 1248 (9th Cir. 2010); Shaoxing County Huayue Import & Export v. Bhaumik, 191 Cal.App.4th 1189 (Cal. Ct. App. 2011). By extension, neither assignees nor receivers may assert those rights because they are particular to creditors under California law, they are not a claim of the assignor/debtor or creditors in general.

Claims for relief involving illegal dividends, however, belong to the assignor/debtor as a general harm to all stakeholders and therefore belong to bankruptcy trustees, general equity receivers, and assignees. Cal. Corp. Code § 506(a), (b) (“Suit may be brought in the name of the corporation to enforce the liability (1) to creditors . . . or (2) to shareholders . . .”); but see Rockwood v. Foshay, 66 F.2d 625 (8th Cir. 1933) (“Holding as we do, that the right conferred by the Delaware statute [to recover unlawful dividends] belongs exclusively to the creditors and not to the corporation after insolvency, and that this right may not be enforced by appellant, an ordinary chancery receiver, it follows that the decree dismissing the bill of complaint should be and is affirmed.”).

1. Mr. Lastreto is an owner/shareholder at Lang Richert & Patch, in Fresno, California. With over 30 years of experience in all aspects of creditor’s rights litigation and insolvency law, Mr. Lastreto focuses his practice on assisting creditors with various issues that arise in both State and Federal Courts, including Bankruptcy Court.

2. Mr. Gomez is an associate in the Financial Services Litigation group at Lang, Richert & Patch, in Fresno, California. Mr. Gomez has been involved in insolvency and restructuring law with an emphasis on creditor’s rights in his six years of practice. Prior to private practice, Mr. Gomez was a law clerk for the Hon. Meredith Jury, U.S. Bankruptcy Judge for the Central District of California.

3. It appears that assignees do not have the option of recovering preferential transfers from transferees or from the creditor for whose benefit the transfer was made though the creditor did not receive the property. Compare Cal. Code of Civ. P. § 1800(b) with 11 U.S.C. § 550(a)(1) and Cal. Civ. Code § 3439.08(b)(1). Assignees may therefore be limited to recovering preferential transfers from the recipient of the transfer.

4. A concealed preference may be invalidated as an actual intent fraudulent transfer. Menton v. Adams, 49 Cal. 620 (1875); M. Radin, Fraudulent Conveyances in California and the Uniform Fraudulent Conveyance Act, 27 Cal. L. Rev. 1, 8 n.12 (1938); but see In re Cushman Bakery, 526 F.2d 23, 32-34 (1st Cir. 1975), cert denied, 96 S.Ct. 1670 (1976). A preference to an insider may also be recovered under an unjust enrichment theory notwithstanding Cal. Civ. Code § 3432. Commons v. Schine, 35 Cal.App.3d 141 (Cal. Ct. App. 1973).