One common interaction businesses have with the United States bankruptcy system is the unfortunate experience of being a defendant in a preference action. Generally, the business receives a demand letter from a bankruptcy trustee or is served with a complaint seeking to recover payments made by the debtor to the business in the 90 days leading up to the filing of the bankruptcy case. Preference claims add insult to injury as, more often than not, the debtor still owes the business for goods or services provided and the case is often brought in a jurisdiction hundreds or even thousands of miles away from the business’ location, making defending the action both inconvenient and often expensive.
Preference law is thought to assure equality of distribution in a bankruptcy proceeding by: (1) discouraging a race to collect receivables when a business is failing; (2) limiting the ability of a debtor to favor one creditor over another; and (3) encouraging trade creditors to continue supplying goods and services to the debtor as it attempts to avoid a bankruptcy filing.
While these goals may be laudable, there is also a sense that the power to bring the claims can be abused. Some trustees, with the two year statute of limitations under 11 U.S.C. §546 approaching, make demand or commence an adversary proceeding without assessing the merits of the case even though they possess some ability to assess the defenses most commonly raised—payments made in the ordinary course of business, contemporaneous exchange, and subsequent new value. To some defendants, even those with meritorious defenses, the demand seems like a shakedown and many decide that paying some portion of the amount demanded is more cost effective than engaging counsel to defend the case.
In an attempt to somewhat level the playing field and help to assure claims that are brought have merit, Congress adopted two provisions as part of the Small Business Reorganization Act (“SBRA”) that became effective on February 19, 2020.
Section 547(b) was amended to require a plaintiff in a preference case to conduct reasonable due diligence regarding the defendant’s known or reasonably knowable affirmative defenses before filing a preference action. The introductory sentence to Section 547(b) now reads (emphasis added), “Except as provided in subsections (c), (i) and (j) of this section, 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…”
The full impact of the amendment is not yet known and it raises many questions. Is conducting some modicum of due diligence a condition precedent to bringing a preference action, failing which the action is subject to dismissal regardless of the merits of the case? What facts, if any, must the Trustee plead to overcome dismissal? What constitutes “reasonable” due diligence? Answers to these questions and others will be debated as case law develops.
At least one court, noting the provision was adopted “to curb what [Congress] perceived as an improper use of preference actions in some instances,” interpreted the new requirements (reasonable due diligence and consideration of known or reasonably knowable affirmative defenses) as statutory prerequisites to a trustee bringing a preference claim that must be pled. See In re ECS Refining, Inc., 625 B.R. 425, 454 (Bankr. E.D. Cal. Dec. 15, 2020) (finding that the general nature of the allegations in the trustee’s complaint suggested a lack of pre-filing due diligence it dismissed the preference action). While the court granted the trustee leave to amend the complaint, presumably the trustee would need to allege the requisite due diligence to defeat a further motion.
Another court considering a motion to dismiss on the grounds that the trustee failed to plead facts necessary to satisfy the due diligence requirement declined to reach the question. Pointing to allegations in the complaint that noted the trustee had reviewed bank and wire records and invoices relating to the preference defendant transactions with the debtor, the court found that enough had been done to reach the prerequisite if one exists. See In re Trailhead Eng’g LLC, No. 18-32414, 2020 WL 7501938 (Bankr. S.D. Tex. Dec. 21, 2020).
Together, these opinions suggest that if a complaint is filed with no demand letter having been sent and it is lacking allegations that establish the trustee has assessed defenses, raising the issue will be a valuable tool to reach a better resolution for the defendant.
Recognizing the burden on defendants to defend away from their home jurisdiction, the SBRA also amended Section 1409(b) of Title 28, a venue provision, increasing the monetary threshold from $13,650 to $25,000. Actions to recover a non-consumer debt against a non-insider defendant below that amount must be brought where the defendant resides, not where the bankruptcy case is pending. It is unclear if the provision applies to preference actions and while the weight of authority suggests no, some courts have indicated it does. Compare In re Munson, Inc. 627 B.R. 507 (Bankr. C.D. Ill. 2021), with Dynamerica Mfg. LLC v. Johnson Oil Co., LLC, No. 08-11515 (KG), 2010 WL 1930269 (Bankr. D. Del. May 10, 2010). Raising venue in a smaller dollar case may also help achieve a favorable result.
Finally, newly enacted Section 547(j) provides a safe harbor for commercial landlords and sellers of goods and services who choose to work with businesses impacted by the pandemic. A debtor or trustee may not avoid payments (other than fees, penalties, or interest the debtor would have owed without the deferral) made by a debtor during the preference period for rent or supplier arrearages provided that the debtor and creditor amended the lease or contract after March 13, 2020, and the amendment deferred or postponed payments that were otherwise due under the lease or contract. The provision sunsets on December 27, 2022 but still applies to cases filed before that date.