Crown Financial LLC v.

• Court: Court of Appeals for the Third Circuit
• Decided: September 1, 2021
• Docket: 20-3333
• Status: Unpublished

Opinion

NOT PRECEDENTIAL

UNITED STATES COURT OF APPEALS FOR THE THIRD CIRCUIT ____________

No. 20-3333 ______

In re Abeinsa Holding Inc., et al., Reorganized and Liquidating Debtors,

Crown Financial, LLC, Appellant ____________

On Appeal from the United States District Court for the District of Delaware (D.C. Civ. No. 1-19-cv-00643) District Judge: Colm F. Connolly ____________

Submitted under Third Circuit LAR 34.1(a) June 1, 2021

Before: HARDIMAN, PHIPPS, and COWEN, Circuit Judges.

(Filed: September 1, 2021) ____________

OPINION* ____________

* This disposition is not an opinion of the full Court and pursuant to I.O.P. 5.7 does not constitute binding precedent. PHIPPS, Circuit Judge.

California law, which governs this dispute, imposes harsh, if not draconian,

consequences upon unlicensed contractors who perform construction work in the state: in

general, they may not recover any compensation for their services. See Cal. Bus. & Prof.

Code § 7031(a). That principle permeates this controversy, which involves an unlicensed

subcontractor that performed millions-of-dollars’ worth of construction work in

California for a general contractor, which, for financial reasons, slow-paid the

subcontractor’s invoices. Because the unlicensed subcontractor needed those funds to

pay its own workers and suppliers, it sold its invoices to a financial firm in return for

prompt, but twenty-percent discounted, payments. When the financially distressed

general contractor eventually filed for bankruptcy, the financial firm submitted a proof of

claim for the outstanding balance of the invoices. The Bankruptcy Court rejected its

claim, as did the District Court on appeal. In reviewing the legal conclusions of the

courts below de novo, see In re Nortel Networks, Inc., 669 F.3d 128, 136–37 (3d Cir.

2011), we will affirm: due to California’s strict rule disallowing compensation for

unlicensed construction work, the financial firm’s claim is invalid.

I. FACTUAL BACKGROUND

At the heart of this case are contracts to supply and install insulation on piping and

equipment as part of the construction of a concentrated solar power plant in the Mojave

Desert in California. The general contractor, Abener Teyma Mojave General Partnership

(‘ATM’), subcontracted with Synflex Insulation, LLC, to perform that service in

exchange for approximately $10.2 million. Although it was based in Texas, Synflex

2 represented that it held a California contractor’s license, as required by California law for

construction work in the state. See Contractors State License Law, Cal. Bus. & Prof.

Code §§ 7000–7191; see also White v. Cridlebaugh, 100 Cal. Rptr. 3d 434, 441–42 (Cal.

Ct. App. 2009).

A few months into performance, the relationship began to sour. Despite Synflex’s

completion of various milestones under the construction contracts, ATM was slow to

remit payments. That posed a problem for Synflex, which needed funds to pay its own

workers and suppliers. To alleviate that cash-flow issue, Synflex endeavored to sell its

accounts receivable through a financial arrangement known as ‘factoring.’ See 4 James J.

White et al., Uniform Commercial Code § 30:20 (6th ed. July 2021 update) (describing

factoring as a form of financing in which a factor purchases accounts receivable at a

discount in exchange for assignment of the right to collect the full amount owed on the

accounts). Only one financial firm, Crown Financial, LLC, a Texas factoring company,

was receptive to such an arrangement with Synflex.

In April 2014, Crown, Synflex, and ATM formalized that factoring arrangement.

First, Synflex and Crown executed an account purchase agreement. Under that contract,

Synflex agreed to submit its accounts receivable, in the form of invoices, to Crown for

review. Crown then had the option to factor those invoices by purchasing them at eighty-

percent face value. In exchange, Synflex would assign Crown the exclusive right to

collect the full amount due on the invoices, subject to potential rebates to Synflex.

Second, the three parties signed a letter agreement. Through that agreement, Crown

formally notified ATM that Synflex had “assigned all rights, title, and interest in its

3 accounts receivable” to Crown. Letter Agreement (Apr. 3, 2014) (JA 22). The

agreement further instructed ATM to remit all future invoice payments to Synflex to

Crown’s bank account. Finally, through ATM’s signature on the letter agreement, it

confirmed that the invoices listed in an attachment were “in line for payment” and that

“the payment obligation of [ATM] is not subject to any offsets, back charges, or disputes

of any kind or nature.” Id.

After finalization of the letter agreement, Crown began purchasing certain

invoices and wiring the discounted funds to Synflex. That process continued for six-and-

a-half months and included forty-two invoices. In total, Crown remitted approximately

$4.3 million to Synflex in exchange for the right to collect about $5.4 million from ATM.

But just as it had done before, ATM slow-paid its obligations. And in October

2014, despite still owing Crown about $2 million, ATM ceased making payments

altogether. Around that time, it came to light that Synflex did not hold – and never had

held – a valid California contractor’s license.

II. PROCEDURAL HISTORY

In early 2016, ATM, along with several related entities, filed voluntary petitions

for relief under Chapter 11 of the Bankruptcy Code. As part of those bankruptcy

proceedings, Synflex and Crown each filed a proof of claim against ATM. See 11 U.S.C.

§ 501. Crown, in particular, claimed a right to $2,022,527 – the amount outstanding on

Synflex’s factored invoices. But the litigation trustee, Drivetrain, LLC, objected to both

Synflex and Crown’s claims, asserting that they should be disallowed as “unenforceable

4 against the debtor,” id. § 502(b)(1), due to Synflex’s status as an unlicensed

subcontractor, see Cal. Bus. & Prof. Code § 7031(a).

Exercising jurisdiction pursuant to 28 U.S.C. §§ 1334(b), 157(a), and

157(b)(2)(B), the Bankruptcy Court sustained the objections. As to Synflex’s claim, the

Bankruptcy Court held that Synflex was not entitled to any compensation for its “illegal

unlicensed contract work” under California law. Bankr. Ct. Op. 10 (citing Cal. Bus. &

Prof. Code § 7031) (JA 432). And treating Crown as an assignee of Synflex, the

Bankruptcy Court held that Crown likewise lacked an enforceable claim.

Crown appealed, seeking review in the District Court of the Bankruptcy Court’s

final order. See 28 U.S.C. § 158(a)(1). The District Court affirmed the disallowance of

Crown’s claim, reasoning that, as Synflex’s assignee, “Crown has exactly what Synflex

has: no right to payment.” District Ct. Op. 9 (JA 9).

Crown again appealed, invoking the appellate jurisdiction of this Court. See

28 U.S.C. §§ 158(d)(1), 1291. It now contends that it has a valid claim against ATM –

not as Synflex’s assignee under the construction contracts, but rather directly under the

April 2014 letter agreement.

III. DISCUSSION

A. California Law Governs Crown’s Claim

5 The Bankruptcy Code disallows claims that are “unenforceable against the debtor

. . . under any . . . applicable law.” 11 U.S.C. § 502(b)(1). To evaluate the enforceability

of a claim, federal courts must apply the substantive law that created the debtor’s

obligation. See Travelers Cas. & Sur. Co. of Am. v. Pac. Gas & Elec. Co., 549 U.S. 443,

450 (2007). This case implicates two potential sources of ATM’s putative obligations to

Crown: first, the construction contracts, and second, the letter agreement. The question

thus becomes which state’s law governs those documents. There is no dispute that

California law applies to the construction contracts.1 But throughout this litigation, the

parties have disagreed about which law applies to the letter agreement, with Crown

arguing that Texas law applies and the litigation trustee (on behalf of ATM) arguing that

California law applies. Given the possibility of a true conflict between those potentially

applicable laws,2 a choice-of-law analysis is required. See Williams v. Stone, 109 F.3d

890, 893 (3d Cir. 1997).

This Court has not yet precedentially resolved the choice-of-law rules applicable

in bankruptcy proceedings – an issue that has long divided the circuit courts. See

generally 19 Charles Alan Wright & Arthur R. Miller, Federal Practice and Procedure

§ 4518 (3d ed. April 2021 update); 17A Moore’s Federal Practice – Civil § 124.30[1]

1 In addition to consensus among the parties, choice-of-law provisions in those contracts designate the applicability of California substantive law. 2 As explained below, California imposes strict consequences on unlicensed construction work as a matter of public policy – including the voiding of certain contracts. Texas contract law, however, might not carry the same implications based on an out-of-state public policy.

6 (2021). At least one circuit has directed bankruptcy courts to apply the choice-of-law

rules of the forum state, as do district courts sitting in diversity. See, e.g., In re Payless

Cashways, 203 F.3d 1081, 1084 (8th Cir. 2000); cf. Klaxon Co. v. Stentor Elec. Mfg. Co.,

313 U.S. 487, 496 (1941). Another has instructed bankruptcy courts to apply federal

choice-of-law principles. See, e.g., In re Lindsay, 59 F.3d 942, 948 (9th Cir. 1995). And

finally, as a sort of compromise between the two, some circuits – including a panel in this

Circuit in a nonprecedential decision – have held that bankruptcy courts should apply

forum-state choice-of-law rules unless there is an overriding or conflicting federal

interest. See, e.g., In re PHP Healthcare Corp., 128 F. App’x 839, 843 (3d Cir. 2005)

(per curiam); In re Gaston & Snow, 243 F.3d 599, 606–07 (2d Cir. 2001); In re Merritt

Dredging Co., 839 F.2d 203, 206 (4th Cir. 1988).

This case, however, does not require resolution of that issue. The state choice-of-

law rules of Delaware (the forum state) and the federal choice-of-law rules of this Circuit

follow the same approach. They both apply the substantive law of the state with the most

significant relationship to the parties and the underlying transaction. See, e.g., Cong.

Talcott Corp. v. Gruber, 993 F.2d 315, 319 n.4 (3d Cir. 1993) (applying the ‘most

significant relationship’ test of the Second Restatement of Conflicts in a federal-question

case); Certain Underwriters at Lloyds v. Chemtura Corp., 160 A.3d 457, 464 (Del. 2017)

(following the Second Restatement of Conflicts and its ‘most significant relationship’

analysis); see also Restatement (Second) of Conflicts § 188 (Am. L. Inst. 1988).

Under that ‘most significant relationship’ test, California law governs the letter

agreement. The agreement flows directly from the California construction contracts: it

7 gives notice of the assignment of rights that arose under those contracts, and it provides

instructions for the payment of invoices reflecting unlicensed construction work

performed in California pursuant to those contracts. And beyond the terms of the

agreement, California has a significant public policy interest in restricting the recovery of

compensation for such work performed in the state. That strong interest coupled with the

interrelated nature of the letter agreement and the underlying construction contracts

strongly favor the application of California law to the letter agreement. The few Texas

contacts – including that Synflex and Crown (but not ATM) are Texas companies – do

not overcome that conclusion.

B. California Law Imposes Strict Consequences for Unlicensed Construction Work

Several principles of California law are relevant here. First, under California law,

contractors must be licensed to perform construction work in the state. See Cal. Bus. &

Prof. Code § 7026 (defining “contractor”); id. § 7028 (declaring the performance of

unlicensed contract work to be “a misdemeanor” and setting forth criminal penalties). A

failure to be duly licensed at all times during performance comes with a severe

consequence: the loss of a legally enforceable right to compensation for the services

provided. See id. § 7031(a). That “stiff all-or-nothing penalty,” MW Erectors, Inc. v.

Niederhauser Ornamental & Metal Works Co., 115 P.3d 41, 49 (Cal. 2005), applies

“[r]egardless of the equities,” Hydrotech Sys., Ltd. v. Oasis Waterpark, 803 P.2d 370, 376

(Cal. 1991), and is subject to only a narrow exception for good-faith lapses, see Cal. Bus.

& Prof. Code § 7031(e). The California Supreme Court has explained the harshness of

8 this consequence as a means of deterring unlicensed contract work, thereby “protect[ing]

the public from incompetence and dishonesty.” Hydrotech, 803 P.2d at 374; see also

Lewis & Queen v. N. M. Ball Sons, 308 P.2d 713, 719 (Cal. 1957) (explaining that

§ 7031(a) “represents a legislative determination that the importance of deterring

unlicensed persons from engaging in the contracting business outweighs any harshness

between the parties”).

California law also provides that a contract with an unlawful object is void. See

Cal. Civ. Code § 1598; see also id. § 1667 (defining “unlawful” as “[c]ontrary to an

express provision of law” or “to the policy of express law, though not expressly

prohibited”). Consistent with that principle, California courts will not enforce illegal and

void contracts. See Lewis & Queen, 308 P.2d at 719–20 (noting “the general rule that

illegal contracts are unenforceable”); Gatti v. Highland Park Builders, Inc., 166 P.2d 265,

266 (Cal. 1946) (“[A] contract made contrary to the terms of a law designed for the

protection of the public and prescribing a penalty for the violation thereof is illegal and

void, and no action may be brought to enforce such contract.”).

C. The Letter Agreement Is Unenforceable

Putting the pieces together, in California, a contract performed by an unlicensed

contractor is generally illegal and void, and, thus, unenforceable. See Lewis & Queen,

308 P.2d at 721 (holding that a subcontractor’s “failure to obtain a license [before

performance] made the transaction illegal”); Loving & Evans v. Blick, 204 P.2d 23, 29

9 (Cal. 1949) (“[T]he contract . . . was illegal and void because of [the contractors’] failure

to comply with the licensing requirements.”); Wilson v. Steele, 259 Cal. Rptr. 851, 852

(Cal. Ct. App. 1989) (“A contract by an unlicensed contractor is void and illegal.”);

cf. MW Erectors, 115 P.3d at 61 (holding that “application of the void contract principle

is inappropriate” where a contractor, “though unlicensed when a contract for services was

entered, was fully licensed at all times during performance”). It follows that a contract to

pay a third party for work performed by a contractor who was unlicensed during

performance – an object that is “[c]ontrary to the policy of express law, though not

expressly prohibited,” Cal. Civ. Code § 1667 – would also be void, id. § 1598, and

unenforceable.

Applying that principle here, the letter agreement – the only basis upon which

Crown now seeks recovery3 – is void and unenforceable. To the extent that the letter

agreement otherwise satisfies the elements of a contract, it loses its enforceability

because its object is to pay Crown for unlicensed construction work that Synflex

performed. And enforcing an agreement with that object would “circumvent

[California’s] clear statutory policy of deterring unlicensed contract work.” Hydrotech,

803 P.2d at 372. Put differently, if Crown could enforce the letter agreement, then any

3 See Crown Br. 11 (“Synflex did not hold a California contractor’s license and Section 7031 makes unenforceable any claim by an unlicensed contractor for compensation. Understanding that an assignee suing on an assigned claim has no greater rights tha[n] the assignee, Crown did not bring that claim [under the construction contracts]. . . . Crown asserted only a claim based on the direct promise [in the letter agreement].”).

10 unlicensed contractor could evade California’s strict prohibition simply by filtering

compensation for its illegal construction work through a financial intermediary. Nothing

in California law suggests a willingness to allow the state’s harsh consequence for

unlicensed construction work to be so easily overcome. See Walker v. Nitzberg, 91 Cal.

Rptr. 526, 531–32 (Cal. Ct. App. 1970) (holding that an unlicensed contractor’s assignee

had no right to recover because otherwise “the contractor’s license law could be easily

evaded . . . by the mere making of an assignment of the contract upon which [the

unlicensed contractor] himself could not recover”). Accordingly, the letter agreement is

not enforceable, and Crown’s claim against ATM is invalid.

* * *

In sum, the letter agreement does not provide Crown with a right to payment from

ATM. The Bankruptcy Court and the District Court therefore properly disallowed its

claim. See 11 U.S.C. § 502(b)(1). We will affirm.