Delaware Bankruptcy Court Rules That Due Diligence Is Element Of Preference Claim Rather Than Basis For Affirmative Defense

• Published date: 27 July 2023
• Subject Matter: Insolvency/Bankruptcy/Re-structuring, Insolvency/Bankruptcy
• Law Firm: Jones Day
• Author: Mr Mark Douglas and Daniel Merrett

A bankruptcy trustee's ability to avoid and recover pre-bankruptcy preferential transfers is essential to preserving or augmenting the estate for the benefit of all stakeholders. In 2019, however, the Bankruptcy Code was amended to add a due diligence requirement to the Bankruptcy Code's preference avoidance provision, apparently as a way to minimize the volume of speculative and coercive preference litigation. Neither the amendment nor its legislative history, however, clearly specifies the pleading rules or the allocation of the evidentiary burdens associated with the due diligence requirement, which has led to confusion among the courts.

The U.S. Bankruptcy Court for the District of Delaware recently addressed this issue in In re Pinktoe Tarantula Ltd., 2023 WL 2960894 (Bankr. D. Del. Apr. 14, 2023). In dismissing a preference avoidance complaint without prejudice, the court concluded that the due diligence requirement in section 547(b) of the Bankruptcy Code is an element of a preference claim that must be proved by the preference plaintiff rather than the basis for an affirmative defense that must be proved by the defendant.

Avoidance of Preferential Transfers

Under section 547(b) of the Bankruptcy Code, a bankruptcy trustee (or a chapter 11 debtor in possession ("DIP") by operation of section 1107(a)) 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 [section 547(c)]," avoid any transfer made by an insolvent debtor within 90 days of a bankruptcy petition filing (or up to one year, if the transferee is an insider) to or for the benefit of a creditor if such creditor, by reason of the transfer, receives more than it would have received in chapter 7 liquidation, if the transfer had not been made. 11 U.S.C. ' 547(b) (emphasis added).

Section 547(c) contains nine defenses or exceptions to avoidance. These include, among other things, contemporaneous exchanges for new value, ordinary course business transfers, transfers involving purchase-money security interests, and transfers after which the transferor subsequently provides new value to the debtor.

Section 547(g) provides that the trustee or DIP "has the burden of proving the avoidability of a transfer" under section 547(b) and that "the creditor or party in interest against whom recovery or avoidance is sought has the burden" of establishing the existence of an affirmative defense under section 547(c).

The "reasonable due diligence" requirement was added to section 547(b) as part of the Small Business Reorganization Act of 2019 (the "SBRA"), which created a new subchapter V of chapter 11 of the Bankruptcy Code to provide a more expeditious path for small businesses to restructure successfully. See In re Blue, 630 B.R. 179, 186 (Bankr. M.D.N.C. 2021) (citing cases and H.R. Rep. No. 116-171, 1 (2019) (stating that subchapter V is meant to be a streamlined "process by which small business debtors reorganize and rehabilitate their financial affairs")).

The reasons for the addition of the due diligence requirement to section 547(b) are unclear. For example, the House Report accompanying the SBRA (cited above) gives no explanation for the change. As noted by a leading commentator:

The most plausible explanation is that it seems to have been the practice for chapter 11 liquidating trusts to employ what are called, in the vernacular, "preference mills." The same practice may also be prevalent in larger chapter 7 cases. These entities pursue preference actions for the trustee and take a percentage of the recovery. Their business model is simple: they take the list from the debtor's statement of affairs of all payments the debtor made in the 90 days before bankruptcy and file...