American Bankruptcy Institute Update

February 3, 2005

In This Issue

Highlights

Legislation Update

Grassley Re-introduces Bankruptcy Measure

Senate Finance Chairman Grassley late on Tuesday introduced the “Bankruptcy Abuse Prevention and Consumer Protection Act of 2005”(S. 256). The bill is the same as the measure considered in the 108th Congress, save for exclusion of the Schumer amendment on debts arising from abortion clinic protests.

Sen. Rick Santorum (R-Pa.), a member of the Senate leadership, said he is confident the chamber will bring a bill to the floor this month, Bloomberg News reported. He said a planned effort to add the Schumer amendment is the only challenge to a compromise this year with the House. Schumer said yesterday that he intends to offer the abortion amendment again. This year, Republicans may be able to defeat the amendment because of the expanded majority they gained in the November elections. Republicans gained four Senate seats, giving them 55 of 100 votes in the chamber. Supporters will need 60 votes to defeat all procedural tactics by opponents of the broader bill. Santorum predicted it would pass the Senate with 70 or 80 votes. House Judiciary Committee Chairman James Sensenbrenner (R-Wis.) has said he intends to move legislation to the floor of that chamber this year.

Class-Action Measure Passes Panel Without Amendments

Judiciary Chairman Arlen Specter (R-Pa.) today said he plans to support a contentious amendment by Sen. Jeff Bingaman (D-N.M.) during next week's floor deliberations, after his panel approved the class-action bill on a 13-5 vote with no amendments, CongressDaily reported. Stanton Anderson, executive vice president of the U.S. Chamber of Commerce and chairman of the Class Action Fairness Coalition, said the Bingaman amendment would gut the bill. But he said the amendment is likely to fail despite Specter's support. "I think we still have the votes on the floor to pass a clean bill," Anderson said.

The class-action bill would move many multistate class-action lawsuits from state courts to federal courts, where more stringent rules would govern the cases. The Bingaman amendment would give federal judges guidance for certifying class-action cases based on state consumer laws. Before approving the bill, the committee rejected, 13-5, an amendment by Senate Judiciary ranking member Patrick Leahy (D-Vt.) to increase federal judges' salaries.

Asbestos Legislation Could Be Marked Up Next Week

Asbestos legislation could be marked up next week and be on the Senate floor before the Easter recess, Senate Judiciary Chairman Arlen Specter said today, CongressDaily reported. Specter said he has talked to Majority Leader Bill Frist (R-Tenn.) about a floor vote either immediately before or after the break. Specter said he has satisfactorily answered questions about how a proposed asbestos trust fund would treat victims exposed to both asbestos and silica -- the subject of a Judiciary Committee hearing yesterday. He plans by next Thursday to complete legislative language in a bill that has been circulated as a draft with key details left blank.

Joint Tax Committee Staff Report Recommends Changes to Tax Exempt Status of Some Credit Counseling Firms

The staff of the Congressional Joint Committee on Taxation has prepared a report and recommendations on changes to the tax exemption status of credit counseling agencies, particularly those that charge fees for services or promote debt management plans. To maintain tax exempt status under IRC Section 501(c)(3) and (c)(4), counseling and education activities would have to become the primary activity of the firms, while credit repair activities and lending would be prohibited, among other provisions aimed at refocusing the mission of credit counseling on providing free or low cost services to the poor. The proposal responds to abuses arising out of the growing commercialization of an industry that has largely operated in nonprofit form. Read the full text of the proposal.

Gonzales Appointed by Senate Today

Alberto Gonzales was confirmed by the Senate today as Attorney General. The vote was 60-36, with all of the “no” votes coming from Democrats. Gonzales, a former Justice on the Texas Supreme Court, most recently served as White House Counsel.

Bankruptcy Code Preempts State Assignment Law, Says Ninth Circuit

Sherwood Partners Inc. V. Lycos, Inc, 2005 Wl 74090 (9th Cir., Jan. 12, 2005)

By Jeff Morris, Robert M. Zinman ABI Resident Scholar

The Supremacy Clause of the Constitution provides that federal law supercedes conflicting state laws, and the Supreme Court has employed that power to strike down state laws that conflict with bankruptcy laws. For example, in 1929, the Court struck down a state statute that purported to discharge debts. International Shoe Co. v. Pinkus, 278 U.S. 261, 265-66 (1929). There is a long history of bankruptcy laws preempting state laws that would operate to provide a discharge for debtors. See, e.g., Mayer v. Hellman, 91 U.S. 496 (1875)(Ohio statute not preempted because it does not discharge the debtor from arrest or imprisonment and leaves after-acquired property available to creditor claims); Stellwagen v. Clum, 245 U.S. 605 (1918)(the decisions of the Court place great stress on the feature of the discharge in determining whether a particular state law is preempted by federal bankruptcy law); Straton v. New, 283 U.S. 318 (1931)(state law that does not purport to provide the debtor a discharge is not preempted by federal bankruptcy law). This principle has been recognized even recently when parties challenged certain state statutes as in violation of the supremacy clause. For example, in In re Newport Offshore, Ltd., 219 B.R. 341 (Bankr. D. R.I. 1998), the court considered whether the Bankruptcy Code preempted the Rhode Island corporate receivership provisions. The court conducted an extensive review of the Supreme Court’s decisions in this area and concluded by stating that:

State laws that operate to effect, or to coerce from creditors, the insolvent debtor’s discharge or release from indebtedness are preempted. Those that operate to distribute an insolvent’s estate, without effecting a discharge, are not.

219 B.R. at 353. The court held that the Bankruptcy Code did not generally preempt the Rhode Island statutes governing corporate receiverships since they did not operate to provide a discharge to the debtor.

The Ninth Circuit recently had an opportunity to address a similar issue. In Sherwood Partners, Inc. v. Lycos, Inc.,2005 WL 74090 (9th Cir., Jan. 12, 2005), Sherwood Partners was the assignee for the benefit of the creditors of Thinklink Inc., a messaging service that Lycos agreed to promote on its web sites. Thinklink agreed to pay Lycos $1 million cash along with stock in the company in satisfaction of an outstanding indebtedness. Thinklink paid the money, but did not deliver the stock. Shortly thereafter, Thinklink initiated the assignment for the benefit of creditors naming Sherwood Partners as the assignee.

Sherwood Partners, as assignee, thereafter brought an action under a California statute against Lycos for its preferential receipt of the $1 million. The California statute essentially mirrors §547 (b) of the Code. The action was brought in state court, but Lycos removed the case to the federal district court on the grounds of diversity of citizenship. Lycos then defended on the basis that the Bankruptcy Code preempts the California statute under which Sherwood Partners had sought the recovery. The district court granted summary judgment in favor of the assignee, and Lycos appealed to the Ninth Circuit. In an opinion by Judge Kozinski, the Ninth Circuit reversed and held that the Bankruptcy Code preempts the California provision. The court, citing a number of Supreme Court precedents, noted that the Bankruptcy Code has two primary goals: providing a fresh start for the debtor and equitably distributing the debtor’s assets to creditors according to the Code’s distribution system. Judge Kozinski then noted that the Supreme Court has repeatedly held that state laws that discharge debts are preempted. He then took the next step by concluding that state statutes that would adjust the distributional provisions of the Bankruptcy Code are likewise preempted. (When I say “step,” of course, I mean “gigantic leap!!!") He continued by noting that the bankruptcy system seeks to avoid the piecemeal dismantling of debtors by staying collection efforts, and substituting the bankruptcy distribution scheme for the collective benefit of creditors. Consequently, any state law providing otherwise would be inconsistent with the bankruptcy laws.

Judge Kozinski held that the collective nature of assignments for the benefit of creditors is essentially the same as a bankruptcy proceeding, but is inconsistent with the Bankruptcy Code. The statutes grant powers to the collective representative, the assignee, different from the Bankruptcy Code provisions that give the trustee the rights and powers of unsecured creditors. Those are individual rights, so that they do not conflict with the collective goals of a bankruptcy case. Notwithstanding these differences, however, it is difficult to see how the Ninth Circuit’s decision squares with so many Supreme Court decisions that have upheld similar collective collection laws. Moreover, Judge Kozinski seems to reach the conclusion that the law is preempted because it is inconsistent with the distributional goals of the bankruptcy laws, and that goal is impacted both by individual and collective actions under state law.

Judge Kozinski also anticipated the argument that creditors who do not like the assignment for the benefit of creditors can simply commence an involuntary bankruptcy case. He argued that a disgruntled creditor may not be in a position to take such action. He noted that under the procedures governing these actions, the debtor selects the assignee, and there is no bankruptcy court or United States Trustee to oversee the appointment and guarantee the propriety of the assignee’s actions. So, the assignee could take action to recover a preference from one creditor and could let other creditors off the hook. In that event, the disgruntled creditor could commence an involuntary case against the debtor only if it could convince two other creditors to join in the action (assuming the debtor has more than 12 creditors). Since the other creditors would be disadvantaged by a bankruptcy filing, they would not join in the petition, and no bankruptcy would ensue. Thus, the debtor and its other creditors could effectively conspire to recover the “state” preference from one creditor and redistribute that amount to the other creditors, and by controlling the assignee, they would essentially be immune from an action to recover the preferences that they had received.

The hypothetical situation that Judge Kozinski posits, like all hypothetical situations, could occur. The likelihood of it happening, however, seems quite remote. In fact, if the court’s decision in Sherwood Partners was limited to that situation, the case would not be so troubling. Instead, notwithstanding Judge Kozinski’s emphasis on collective nature of assignments for the benefit of creditors, the decision arguably applies to any action to recover from a debtor when the method of distribution of the assets is inconsistent with the Bankruptcy Code. If that is the case, then even collection by writ of execution or garnishment (and all other state court recovery methods) would appear to be preempted by the Bankruptcy Code. Under Judge Kozinski’s analysis, any state law that caused a debtor’s assets to be distributed in a manner inconsistent with the distributional system established by the Bankruptcy Code is preempted. For example, it is not unusual for commercial enterprises that are experiencing financial problems to be just a bit behind on their payroll withholding or sales taxes. In a bankruptcy case, the taxing authority would have, at the very least, a priority claim. The creditor pursuing the garnishment under the applicable state provision would not be setting aside any of the garnisheed funds for the benefit of the taxing authorities. The funds would be paid to the creditor that initiated the garnishment action. If the assets were recovered and distributed in a bankruptcy case, the taxing authority would be paid in full before the unsecured creditor. Even if one considers the unsecured creditor as having crossed over to secured status by virtue of a garnishment lien, that lien would be vulnerable to a preference attack under § 547 of the Bankruptcy Code and the taxing authority would still be paid in full prior to any distribution being made to the creditor who had obtained a lien. Since this is inconsistent with the bankruptcy distributional system, it would seem to violate Judge Kozinski’s rule as set out in Sherwood Partners.

Surely both the generally applicable judicial collection processes and the provisions governing assignments for the benefit of creditors are not unconstitutional. Surely it is not a coincidence that the Supreme Court has held on several occasions that state laws that include a discharge for debtors are unconstitutional, but the Court has never held that state laws that effect the distribution of a debtor’s assets (in the absence of a pending bankruptcy case) are unconstitutional. As Judge Nelson noted in the dissent, the Supreme Court actually has held that state assignment for the benefit of creditors laws are constitutional. In Pobreslo v. Joseph M. Boyd Co., 287 U.S. 518, 53 S.Ct. 262, (1933), the Court upheld the Wisconsin assignment for the benefit of creditors provisions noting that they did not include any provision for the discharge of debts. Instead, the provisions were simply “regulatory of such voluntary assignments [and] serve to protect creditors against each other, and go to assure equality of distribution unaffected by any requirement or condition in respect of discharge.” 287 U.S. at 526, 53 S.Ct. at 264. Thus, the Supreme Court distinguished its earlier decision in International Shoe v. Pinkus (which invalidated a law that included a discharge provision), which certainly would seem to have put to rest the notion that federal bankruptcy law preempts state assignment for the benefit of creditors provisions.

There is another interesting aspect to Sherwood Partners that is not immediately apparent from the decision. Under 28 U.S.C. §2403(b), the courts are directed to notify the state attorney general if a party has drawn into question the constitutionality of a state law. This statute and Rule 24(c) of the Federal Rules of Civil Procedure, are intended to ensure that the chief legal officer of the sovereignty whose law is being challenged has an opportunity to appear and be heard on the issue. While it does not appear that the appellee failed to raise any of the arguments that the California Attorney General might have raised, the presence of the state before the court certainly could have had some impact on the decision. Perhaps there will be an effort to seek a rehearing en banc in the Court of Appeals, and California could have an opportunity to participate at that time.

In the meantime, it would be prudent for creditors who are displeased with the course of an assignment for the benefit of creditors to review the decision in Sherwood Partners and challenge the constitutionality of those provisions. Of course, if you do, keep in mind that the state attorney general has a right to be at the hearing!

Directory CD-Rom Now Arriving in Members’ Mailboxes

If you haven’t received your copy of the new ABI Membership Directory on CD-rom, you should receive it any day now. This year’s directory, free to all members, contains the same robust search functionality as the online directory featured on the ABI World web site. Also included is the capacity to sort your search results by name, company and city/state, as well as the ability to e-mail members directly from their listing. This format makes for a perfect traveling companion, allowing you to locate other professionals when you are away from the office.

Register to Attend ABI’s Bankruptcy Fundamentals Program

Join ABI for its popular "Bankruptcy Fundamentals — Nuts & Bolts for New and Young Practitioners" on Thursday, March 3, 2005, at the Westin Century Plaza Hotel in Los Angeles.

At this special one-day program, an outstanding faculty of judges and practitioners will explain the fundamentals of bankruptcy. Topics covered include structure of the Code, commencing the case, concepts such as discharge, property of the estate, claims, priority, ethics, adequate protection and the automatic stay, executory contracts and leases, chapter 11 from beginning to end and chapter 7 from both the debtor and creditor perspectives. The fee for the program is $295 for ABI members and $465 for non-members. (Attendees can register at a reduced rate if they also attend ABI's Bankruptcy Battleground West on March 4.)

All attendees receive a copy of Bankruptcy in Practice. Register by Feb. 11 and receive a complimentary Mini-Code and Rules! For more information click here, or contact Caroline Milani at cmilani@abiworld.org or by calling (703) 739-0800.

ABI Bankruptcy Taxation Committee e-Newsletter Available Online

The February issue of ABI’s Bankruptcy Taxation Committee e-Newsletter is available online. Read articles on sovereign immunity in post-sale proceedings and a new model order designed to both p rotect trading markets and preserve NOLs in chapter 11. Learn about the presentation the committee’s two new co-chairs are preparing for the Annual Spring Meeting.

Latest Job Postings at ABI Career Center

Check out the ABI Career Center. The Center is a one-stop site for job seekers and employers in the insolvency community. Career Center resources are available free to both employers and job seekers. New positions are featured daily. The latest listings include: