The New Due Diligence Requirements
The principal purpose of the Small Business Reorganization Act (SBRA), effective February 19, 2020, was, as its name suggests, to create a quicker, cheaper, and simpler process for eligible small businesses to reorganize their financial affairs under chapter 11 of the Bankruptcy Code. But the SBRA also amended section 547(b) of the Code, which sets forth the elements of a preference (i.e., a pre-bankruptcy transfer by a debtor that a trustee can “avoid” for the benefit of the bankruptcy estate). Specifically, the SBRA inserted a due diligence requirement into the introductory provision of section 547(b):
Except as provided in subsections (c) and (i) 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 ….
Congress provided no legislative history as to the purpose or application of this new element of preference law. Nonetheless, the authors of Collier on Bankruptcy surmise that it is meant to curtail the abusive practice of chapter 7 trustees and chapter 11 liquidating trusts bringing preference actions against all recipients of transfers from a debtor made within 90 days of a bankruptcy filing without regard to whether such recipients have meritorious defenses to avoidance of the transfers under section 547(c) of the Bankruptcy Code.
The new provision, particularly without legislative history, raises a host of questions, obviously including what is sufficient due diligence, how must a trustee go about taking into account affirmative defenses, and what are the consequences of a trustee’s failure to satisfy the new requirement. More subtly, the SBRA’s insertion of the due diligence requirement into the introductory provisions of section 547(b) gives rise to the question of whether due diligence is now an element or condition precedent of a preference claim or if it merely creates an affirmative defense. If the due diligence requirement is now an element of a preference claim, a trustee’s due diligence efforts should be pleaded in the complaint to state a prima facie claim that will survive a motion to dismiss. On the other hand, if the due diligence requirement is in the nature of an affirmative defense, it would be up to a preference defendant to assert the issue in its answer.
Current Case Law
Three recent decisions have addressed motions to dismiss preference complaints for alleged failure to satisfy the new due diligence requirement. In Husted v. Taggart (In re ECS Ref., Inc.), 625 B.R. 425 (Bankr. E.D. Ca., Dec. 15, 2020), the bankruptcy court concluded that the new language inserted into section 547(b) did indeed create a condition precedent to a preference claim, requiring that the trustee’s due diligence efforts be set forth in the complaint to state a prima facie claim. The court found that the amended complaint did not expressly recite the trustee’s efforts to evaluate the merits of a prima facie case or defendant’s reasonably knowable affirmative defenses. Accordingly, the court granted the motion to dismiss but gave the trustee leave to file an amended complaint.
In Sommers v. Anixter, Inc. (In re Trailhead Eng’g LLC), 2020 Bankr. LEXIS 3547 (Bankr. S.D. Tex. Dec. 21, 2020), the bankruptcy court found it was not required to decide if reasonable due diligence was now an element of a preference claim, but noted that the new “the circumstances of the case” language meant that it had discretion in applying the requirement. The complaint reflected that the trustee had reviewed certain debtor financial records, invoices relating to the subject transfer, and the alleged structure of the parties’ relationships. The court concluded that these allegations, “in the circumstances of this case, and taking into account [defendant’s] known or reasonably knowable affirmative defenses” provided sufficient information regarding the trustee’s due diligence to prevent dismissal of the complaint.
Finally, in Faulkner v. Lone Star Brokering, LLC (In re Reagor-Dykes Motors, LP), 2021 Bankr. LEXIS 1643 (Bankr. N.D. Tex. June 18, 2021), the court stated that whether the new due diligence language created an additional pleading requirement was unclear, but noted that in bringing a preference action, a trustee must exercise due diligence and consider a party’s known or reasonably knowable affirmative defenses. The court noted that the complaint asserted “minimal factual allegations” about the relationship between the debtors and the defendant and the circumstances of the relevant transfers. Nonetheless, the court declined to dismiss the preference claim, instead concluding that “[a]t this stage, allegations—or lack thereof—do not reflect an abusive filing. [Defendant] has not answered the suit; its affirmative defenses are unknown.”
It is an understatement to say that there is uncertainty regarding precisely what the new due diligence provisions of section 547(b) require. Nonetheless, the limited case law to date demonstrates that a trustee or other preference claimant should not only exercise reasonable due diligence (whatever that means in the circumstances of a particular case) before filing suit, but include in the complaint specific allegations as to the nature and extent of that due diligence. Likewise, preference claim defendants should evaluate whether a complaint contains sufficient allegations regarding the trustee’s due diligence and evaluation of affirmative defenses, and consider a motion to dismiss if the required allegations are absent or potentially insufficient. Stay tuned for further developments – they are certain to come.
Luis F. Ruiz