Major Change for Bankruptcy Preference Defendants Tucked into New Small Business Chapter 11 Law


On August 23, 2019, the President signed the “Small Business Reorganization Act,” which changed the Bankruptcy Code and goes into effect on February 19, 2020.

While the SBRA is intended to make the Chapter 11 reorganization process less costly and more efficient, Congress included in the SBRA legislation a change to another section in the Bankruptcy Code that could (and should) have a significant impact on various unsecured creditors. Tucked into the middle of the law—separate and distinct from the new language regarding small business bankruptcy cases—is a short paragraph amending Section 547 of the Bankruptcy Code: the dreaded “preference” statute.

Many companies that sell products and provide services—which then become unsecured creditors in the bankruptcy cases of their customers—are all too familiar with this statute. Section 547 of the Bankruptcy Code allows unsecured creditors to be sued by bankruptcy trustees to force the return by the creditors of payments, called “preferences,” which were legitimately owed and paid by debtors to the creditors within the 90-day period prior to the bankruptcy filing. The Bankruptcy Code presumes that all payments made in the preference period were “preferential” (intended by the debtor to prefer one unsecured creditor over another, which violates the public policy underlying the Bankruptcy Code of similarly-situated creditors being treated the same), and therefore subject to disgorgement. There are three major defenses available to unsecured creditors in these actions, and this is where the change included in the SBRA comes into play.

Until now, the basic course of action for many bankruptcy trustees has been to send demand letters to all unsecured creditors who received payments by the debtor within the 90-day preference period, usually without performing any substantive due diligence and, consequently, without consideration of any defenses that may be available to the targeted creditors. As a result, creditors with valid defenses would nevertheless be forced to hire counsel to respond to demand letters and, in most instances, spend significant legal fees defending lawsuits filed against the creditors by the trustees.

The tucked-in language in the SBRA legislation added the highlighted language below to Section 547(b) of the Bankruptcy Code:

“[T]he 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 … ”

No longer may a bankruptcy trustee’s only effort be to look at a debtor’s payment ledgers to establish a broad pool of targets to receive disgorgement demands. They now must do some actual and substantive due diligence before seeking to avoid payments made during the preference period.

The author believes that reasonable due diligence by trustees would be able to uncover evidence of the all three of the major defenses available to unsecured creditors. For example, a review by the trustee of a debtor’s records would indicate: (i) whether the creditor gave value to the debtor at the time the payment was made (the “contemporaneous exchange of new value” defense under Section 547(c)(1)); (ii) whether the debt was incurred, and the payments made, by the debtor in the ordinary course of business of the debtor and creditor (the “ordinary course of business” defense under Section 547(c )(2)); and/or (iii) whether the creditor made subsequent advances to the debtor after the payments were made (the “subsequent new value” defense under Section 547(c)(4)).

If followed by bankruptcy trustees, this new statutory language can and should greatly reduce the volume of disgorgement demands made by them.

A few of the key issues that will arise from this new law are:

  1. If the bankruptcy case is administratively insolvent when the trustee is appointed, or if the debtor’s record-keeping was shoddy, do these “circumstances of the case” obviate the necessity of the trustee performing due diligence before avoiding potential preferential transfers?
  2. What constitutes “reasonable” due diligence by the trustee?
  3. Can a trustee shift the due diligence burden by demanding that a preference target establish their defenses?
  4. Must the due diligence be performed by the trustee before making any disgorgement demand, or simply before actually filing suit to avoid and recover the alleged preferential transfer?
  5. What remedies are available to unsecured creditors if the trustee fails to perform due diligence, and how and when should a trustee’s alleged lack of due diligence be raised to the bankruptcy court?

Bankruptcy, district and circuit courts of appeals across the country are certain to weigh in on these issues in the coming years. Regardless, the addition of this simple language should prove going forward to be a boon to unsecured creditors who would otherwise have been sure-fire targets of bankruptcy trustees.

If you receive a preference demand letter or adversary complaint summons from a bankruptcy trustee, you should immediately seek out competent bankruptcy counsel.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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