United States: Court Remains Uncertain On How To Apply The New Due Diligence Requirement For Preference Claims

The Bankruptcy Code and its predecessor statutes have long permitted bankruptcy trustees (or their equivalents) to claw back preferences, which involve transfers made on preexisting debts within 90 days (or 1 year, if made to an insider) before a debtor files for bankruptcy. The trustee's power to avoid preferences is codified in Section 547(b) of the Bankruptcy Code.¹ Significantly, the Bankruptcy Code recognizes that many payments within the preference period do not involve improper partiality for one creditor over others; in fact, making such payments might be necessary for a debtor to stay in business and avoid bankruptcy altogether. As a result, Section 547(c) of the Bankruptcy Code codifies affirmative defenses, including, for example, where a debtor received "new value" in exchange for a transfer or where the transfer was made in the ordinary course of business or was made according to ordinary business terms.² As one court recently explained, these affirmative defenses are important to protect "most transfers attacked under § 547," which are made pursuant to "'legitimate . . . established commercial practices.'"³

In 2019, Congress passed the Small Business Reorganization Act of 2019, which amended the Bankruptcy Code.⁴ Among other provisions, Congress added the following italicized language to Section 547(b): "the trustee may, based on reasonable due diligence in the circumstances of the case and taking into account a party's known or reasonably knowable affirmative defenses under subsection (c), avoid any transfer of an interest of the debtor in property."⁵ Courts have since been grappling with the practical significance of this added language. In particular, they are divided on whether the 2019 amendment adds an affirmative pleading requirement and, if so, how that pleading requirement can be met. The resolution of this debate could have a tangible impact on the viability of many preference claims.

Background

One reason that courts have been inconsistent in applying the 2019 amendment to Section 547(b) is that there "is no explanation, in the Code or in the legislative history to the amendment, of what is required to meet the new requirement."⁶

While there is no express legislative history illuminating the requirement, it is not hard to trace the impetus for the amendment back to the 2012-2014 Final Report and Recommendation of the American Bankruptcy Institute's Commission to Study the Reform of Chapter 11 (the "Commission").⁷ Among many other recommendations, the Commission proposed modifying Section 547(b) in a manner that was similar—but not identical—to the actual amendment made by Congress in 2019.

In considering aspects of then-existing preference law that "appear[ed] unfair," the Commission noted testimony from public hearings showing that "trustees may pursue preference claims in situations in which a cost-benefit analysis indicates little value for the estate, but significant cost and burden for the targeted creditors."⁸ Rather, the testimony suggested, trustees bring such claims merely "to extract a settlement payment."⁹

Balancing these concerns against the reality that a trustee may face challenges at the outset of a bankruptcy proceeding in obtaining the information necessary to state a preference claim, the Commission concluded that a Chapter 11 trustee:

should be precluded from issuing a demand letter to, or filing a complaint against, any party for an alleged claim under section 547 unless, based on reasonable due diligence, the trustee believes in good faith that a plausible claim for relief exists against such party under section 547, taking into account the party's known or reasonably knowable affirmative defenses under section 547(c).¹⁰

In an effort to reach a "reasonable compromise" of the different interests involved, the Commission recommended that Congress revise Section 547 to "codify[] a standard that required the trustee to perform reasonable due diligence and to make good faith efforts to evaluate the merits of the preference claim," as well as to plead "with particularity" the facts supporting each element of the preference claim.¹¹

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Footnotes

1 11 U.S.C. § 547(b).

2 Id. § 547(c).

3 See In re Servicom LLC, No. 18-31722 (AMN), 2023 WL 2755572, at *8 (Bankr. D. Conn. March 31, 2023) ("Defenses to preferential transfers are designed to rescue from attack in bankruptcy those kinds of transactions, otherwise fitting the definition of a preference, that are essential to commercial reality and do not offend the purposes of preference law, or that benefit the ongoing business by helping to keep the potential bankrupt afloat." (internal quotation marks omitted)).

4 Pub. L. No. 116-54.

5 Id. § 3(a) (emphasis added).

6 In re Ctr. City Healthcare, LLC, 641 B.R. 793, 801 (Bankr. D. Del. 2022); see also In re Arete Healthcare LLC, No. 19-52578-CAG, 2022 WL 362924, at *11 (Bankr. W.D. Tex. Feb. 7, 2022) ("The House Report offers no explanation for the amendment.").

7 American Bankruptcy Institute, Final Report and Recommendations of the Commission to Study the Reform of Chapter 11 (2014); see also H.R. Rep. No. 116-171, at 4 (2019) (noting that the Small Business Reorganization Act of 2019 is "largely derived from the[] recommendations" of the American Bankruptcy Institute and similar organizations).

8 American Bankruptcy Institute, Final Report and Recommendations of the Commission to Study the Reform of Chapter 11, at 149-50 (2014).

9 Id. at 150.

10 Id. at 148.

11 Id. at 150-51.

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