Bankruptcy Preference Claims are Coming to a Mailbox Near You: Understanding Recent Changes to Preference Law

As the world was learning about COVID-19 and grappling with stay-at-home orders, the Small Business Reorganization Act (https://www.congress.gov/116/plaws/publ54/PLAW-116publ54.pdf) (the "SBRA") came into effect on February 19, 2020. Although I blogged about it and updated the most recent version of our California Construction Law treatise at the time, it was understandably easy to have missed two important changes to the bankruptcy preference statutes that will impact businesses across the country. As more and more bankruptcies are filed on the heels of the pandemic, it is essential that all financial executives and credit professionals understand these changes.

Quickly stated, the SBRA is good news for most businesses that are dealing or soon will deal with preference claims seeking to recover payments made by a now-bankrupt customer. This is because: (1) the bankruptcy trustee (or a debtor in possession, committee, or other person exercising the rights of a trustee) must now analyze preference defenses before filing a preference lawsuit (preventing the “shotgun” approach used in the past to sue everyone that has received money in the 90 day preference window); and (2) preference lawsuits under $25,000 must be filed in a venue where the creditor is located rather than where the bankruptcy was commenced (often, Delaware).

For those businesses that are unfamiliar with bankruptcy preference law, you are one of the lucky ones. In essence, bankruptcy preference laws seek to even the playing field for creditors of a bankrupt entity. Federal law thus generally allows a trustee to recover all payments made to creditors of a now bankrupt entity within the 90-day period prior to the bankruptcy filing. The typical course of action for a bankruptcy trustee is to review the debtor’s bank records to determine the identity of any creditor that received one or more payments from the debtor within the 90-day preference period. If the trustee determines such a payment was made by the debtor to an unsecured creditor during the time frame, the trustee generally sends a demand letter to the creditor, often times offering to accept a slightly discounted lump sum payment from the creditor (e.g., 90%) in exchange for satisfaction of any future preference liability. The trustee usually sends these letters without performing any substantive analysis or consideration of any defenses that may be available to the targeted creditors. As a result, creditors with valid defenses would nevertheless be forced to incur legal fees to analyze the creditor’s potential preference defenses before or after the trustee filed a preference lawsuit.

The SBRA now requires a trustee to consider a creditor’s statutory defenses “based on reasonable due diligence in the circumstances of the case and taking into account a party’s known or reasonably knowable affirmative defenses” prior to commencing an action to recover an alleged preference payment. Arguably, this language introduces two new elements that must be established by a trustee in order to prevail on a preference claim (i.e., due diligence and consideration of potential affirmative defenses). While it is unclear what diligence the trustee must conduct before filing a complaint, it is clearer that the trustee must conduct at least some analysis of a creditor’s “contemporaneous exchange,” “ordinary course,” “new value, and other potential defenses. Therefore, this amendment to the law requires a debtor or trustee to undertake due diligence and analysis prior to commencing a legal action under section 547 and may provide an additional defense to a creditor sued under section 547 if the trustee cannot both plead and prove that it performed reasonable due diligence and/or an analysis of the creditor’s potential defenses before the filing of the suit.

In addition, the SBRA impacts where a preference defendant can be sued. Prior to February 19, 2020, preference claims under $13,650 were required to be filed in the district where the defendant resides or is domiciled (as opposed to the district where the bankruptcy case is pending). The SBRA increases the $13,650 threshold to $25,000 (and subject to additional increases based on the Consumer Price Index). This change requires trustees to weigh the costs of filing an out-of-state action for any preference claim under$25,000 and will necessarily lead to less litigation for claims under this threshold.

---CN

The content contained herein is published online by Gibbs Giden Locher Turner Senet & Wittbrodt LLP for informational purposes only, may not reflect the most current legal developments, verdicts or settlements, and does not constitute legal advice. Do not act on the information contained herein without seeking the advice of licensed counsel.

Copyright 2021 Gibbs Giden Locher Turner Senet & Wittbrodt LLP?

Attorney Newsletter Advertisement