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

• Published date: 19 February 2024
• Subject Matter: Insolvency/Bankruptcy/Re-structuring, Insolvency/Bankruptcy
• Law Firm: Cohen & Gresser
• Author: Mr Daniel Tabak, Randall Bryer and Christine Jordan

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...