By: Donald L Swanson

Here are three propositions of law, based on the U.S. Supreme Court’s Clark v. White, 13 U.S. 178 (1838), opinion:

1. absent evidence of wrongful knowledge or intent, a creditor’s efforts at racing-to-the-courthouse to collect a debt are among the basic rights of contract that cannot be abridged by the states;
2. state laws for avoiding creditor preferences, without an element of wrongful knowledge or intent, are unconstitutional (let’s call such laws a “No-Fault Preference”); but
3. state laws for avoiding fraudulent transfers (which require evidence of wrongful knowledge or intent) are fine.

I’ll try to explain.

Limitations on State Contract Laws in U.S. Constitution

The U.S. Constitution imposes two limitations on state laws that involve contract rights:

1. “The Congress shall have Power . . . to establish . . . uniform Laws on the subject of Bankruptcies throughout the United States” (Art. 1, Sec. 8); and
2. “No state shall enter into any . . . Law impairing the Obligation of Contracts” (Art. 1, Sec. 10)

So . . . what is it, exactly, that these two limitations prevent state laws from doing?

Such a question is difficult to answer, because the outer limits of “the subject of Bankruptcies” and of laws “impairing the Obligation of Contracts” have rarely been explored by the U.S. Supreme Court.

Clark v. White, 13 U.S. 178 (1838)

But the U.S. Supreme Court did delve into those subjects in its Clark v. White, 13 U.S. 178 (1838), opinion.

Clark v. White deals with a debtor’s “composition” with creditors:

• back in 1838, a “composition” refers to creditors voluntarily discharging their claims against debtor, under state law, in exchange for a partial payment of what is owed; and
• in Clark v. White, creditors claim to have been deceived and defrauded by debtor.  

Freedom of Contract

The U.S. Supreme Court, in Clark v. White, declares that a debtor and its creditor are free to make contracts and then to modify those contracts. 

A debtor and creditor can agree, for example, that debtor will pay a lesser sum than is due and then receive, in exchange, a discharge of the remaining contract obligation. 

Fraud Changes the Rule

But when fraud is involved, the rule changes.  The fraud-involved rule is this:

• in both law and equity, a court can intervene when the actions of contracting parties are accompanied by (i) fraudulent intent, and (ii) a resulting injury; and
• underhand agreements cannot be sustained, because they are subversive of sound morals and public policy.

Creditors Racing to the Courthouse

Clark v. White involves what we now call a race to the courthouse among creditors of a debtor.

Clark v. White stands for the proposition that a creditor’s right to race to the courthouse to collect on a debt is a basic right of contract that cannot be impaired by state law. 

In such a race, these are the governing rules when a wrongful knowledge or intent is not involved: 

• each creditor can act for itself and in opposition to every other creditor; and
• each creditor can rely upon its own vigilance to gain a priority payment over every other creditor.

Moreover, if any creditor obtains, without wrongful knowledge or intent, a priority payment over other similarly-situated creditors, that successful creditor is entitled to keep the priority payment, the validity of which cannot be questioned by other creditors under state laws.

Further, a debtor, acting without wrongful knowledge or intent, may prefer a particular creditor, pay that creditor fully, and exhaust debtor’s whole property, leaving nothing for other claims that are equally meritorious.  In such a circumstance:

• should a third person try to interfere, debtor and creditor could well say to that creditor, “You are a stranger”; and
• the interfering creditor must stand aside.

In the Clark v. White circumstances, the debtor paid some debts fully, others partially and some not at all. And the U.S. Supreme Court’s attitude was this:

• there is no evidence of wrongful knowledge or intent; and
• so, there is nothing wrong with that.

Application to 90-Days and 1-Year Preference Avoidance Laws

The Bankruptcy Code provides in § 547 for avoidance of a No-Fault Preference: i.e., without regard to the knowledge or intent of anyone involved in the transaction.  Such avoidance powers apply to transfers:

• made within 90-days before the bankruptcy filing to non-insiders; and
• made within 1-year before the bankruptcy filing to insiders.

Under the U.S. Constitution’s bankruptcy clause, that § 547 No-Fault Preference statute is just fine: Congress is authorized by the Constitution’s bankruptcy clause to impair contract rights in such a manner.

But, based on Clark v. White, states may not similarly impair contract rights by a No-Fault Preference, without evidence of a wrongful knowledge or intent.

A prime example of a No-Fault Preference under state law is this California statute:

• California Code of Civil Procedure §1800 provides for avoidance of transfers made within 90-days prior to an assignment for benefit of creditors, without regard to anyone’s knowledge or intent—just like the Bankruptcy Code’s § 547.

Application to Fraudulent Transfer Laws

All state laws for avoiding fraudulent transfers, by contrast, involve an element of wrongful knowledge or intent, such as:

• an actual intent to hinder, delay or defraud creditors; or
• a constructive intent consisting of a combination of such elements as (i) less than a fair consideration received, and (ii) a related insolvency.

Further, even the elements of an insider-preference claim, under the Uniform Fraudulent Transfer Act and its successor, have a knowledge-related requirement.  The elements for such a claim include:

• a transfer of debtor’s assets;
• to an insider;
• for an antecedent debt;
• debtor was insolvent at that time; and
• the insider had reasonable cause to believe that the debtor was insolvent (emphasis added).

 Conclusion

Based on the U.S. Supreme Court’s Clark v. White opinion, a state’s No-Fault Preference statute is unconstitutional under the bankruptcies and contracts clauses of the U.S. Constitution.

Post Script

A Drafting Committee of the Uniform Law Commission is preparing a uniform law on assignments for benefit of creditors. 

My view is that such a law should not contain a No-Fault Preference avoidance provision similar to § 547 of the Bankruptcy Code.  That’s because, based on Clark v. White, such a state statute would be unconstitutional under the bankruptcies and contracts clauses of the United States Constitution.

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