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“Reasonably Knowable Affirmative Defenses”: a Small Change to the Bankruptcy Code Could Have a Big Impact on Preference Litigation

On August 23, 2019, President Trump signed H.R. 3311 into law.  The goal of the Small Business Reorganization Act is to facilitate reorganization among small businesses.  One of my fellow bloggers has provided a summary that you can read here.  But in addition to helping small businesses, the SBRA also offered some relief to vendors and other suppliers of goods from the bane of preference lawsuits—not just in small business cases, but in all cases under the Bankruptcy Code.

Section 547(b) of the Bankruptcy Code authorizes a trustee (or a debtor in possession, a liquidating trustee, a post-confirmation trust, etc.) to “avoid” certain kinds of payments made by a debtor within 90 days before the filing of a bankruptcy case.  In theory, this curtails the perceived unfairness of a debtor paying some creditors in full prior to bankruptcy and then leaving others to squabble over the pennies that remain.  In practice, however, preference lawsuits – particularly in complex commercial Chapter 11 cases – are a boon to lawyers, a burden to the Courts, and a cost of doing business for vendors and suppliers of goods that often yield little meaningful recovery to creditors.

Preference defendants – especially vendors whose continued extension of credit in the days and weeks prior to a bankruptcy filing is essential to a successful transition into Chapter 11 – have always had strong defenses to a claim under Section 547(b). Vendors who are paid in the “ordinary course of business” (Section 547(c)(2)) or who extend “new value” (Section 547(c)(4)) after receipt of an otherwise preferential payment can be fully or partially shielded from liability, even if the Trustee can prove each element of a preference set forth in Section 547(b).  But, in many cases, plaintiffs commence preference lawsuits regardless of a defendant’s ability to assert one or more meritorious affirmative defenses.  Oftentimes, the list of preference defendants includes virtually every single party that received a payment from the debtor in the 90 days prior to bankruptcy.  This puts some defendants in the unenviable position of having to choose between expending legal fees to prevail on summary judgment or at trial, or pay some percentage of the amount demanded by the plaintiff in ransom. 

Prior to the enactment of the SBRA, this practice was permissible.  Courts refused to adopt a per se rule requiring preference plaintiffs to conduct pre-filing diligence of defendants’ affirmative defenses.  “Under Rule 9011 an attorney is required to make a ‘reasonable inquiry’ before filing a document. The determination of the reasonableness of an attorney's inquiry necessarily depends upon the circumstances of the particular case. Thus how much investigation is reasonable in a given case is a question of line-drawing. Ordinarily, it will be reasonable for a plaintiff's counsel not to make a pre-filing investigation regarding affirmative defenses.”[1] And, at least one court expressed concern about the practical application of such a rule:

It seems eminently fair to distinguish between claims and defenses in applying Bankruptcy Rule 9011. Generally, the facts supporting a claim are within the knowledge of or readily accessible to the party filing the claim. This is not generally true with respect to a defense. In addition, if a plaintiff were required to fully investigate the basis for a defense before filing a complaint, the defendant would be given an unfair advantage. By informally asserting myriad defenses, a defendant could impose a substantial pre-filing burden on a plaintiff with no risk to himself under Bankruptcy Rule 9011. Moreover, the investigation of those defenses would have to be conducted without the tools and safeguards available under the Federal Rules of Civil Procedure. If the action were ultimately filed, this discovery might have to be repeated to produce evidence useable at trial. Without a clear indication that such an application is intended, this Court will not interpret Bankruptcy Rule 9011 to require such a result.[2]

Despite these concerns, the SBRA amended Section 547(b) to subject the authority of a trustee or debtor-in-possession to commence a preference lawsuit to “reasonable due diligence in the circumstances of the case and taking into account a party’s known or reasonably knowable affirmative defenses.”  This new language certainly raises a number of questions for Bankruptcy Courts to grapple with in future cases:  how much due diligence is “reasonable”?  What is a “reasonably knowable affirmative defense”?  Is it enough for the trustee to review only the books and records of the debtor?  Or does she have to ask the putative defendant for a summary of its affirmative defenses?  Does the availability of Bankruptcy Rule 2004 mean that the trustee is required to undertake pre-filing discovery in order to ascertain the existence and strength of the defendant’s affirmative defenses?   

However, a few things are clear.  First, case law excusing a trustee from conducting any pre-filing diligence regarding affirmative defenses is almost certainly no longer good law.  Second, trustees – who often fear the wrath of other creditors if they do not file a preference lawsuit, even one of dubious merit – have newfound discretion to elect not to commence certain actions under Section 547.  And, above all, even with the uncertainty surrounding precisely how courts will interpret the amended provision, Congress has established a clear and meaningful hurdle to mass preference litigation. The days of suing every single party that appears on a debtor’s check register for the 90 days prior to bankruptcy appear to be over.

 

[1] In re Excello Press, Inc., 967 F.2d 1109, 1112-13 (7th Cir. 1992)(emphasis added). 

[2] In re W. Die Casting Co., 106 B.R. 645, 649 (Bankr. N.D. Cal. 1989)