When Does The SBRA’s “Due Diligence” Preference Duty Apply?

Must prepare to perform (photo by Marilyn Swanson)

(b) . . . 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—

–This quotation is from 11 U.S.C. § 547(b), with highlighting of language added by Sec. 3 of the Small Business Reorganization Act of 2019 (“SBRA”).

Conventional wisdom on highlighted language in the quotation is this: it is a limitation on the trustee’s right to file a preference lawsuit, with the new due diligence duty ending at the complaint’s filing.

While the new law undoubtedly requires due diligence efforts before filing a preference complaint, the new language contains no pre-filing limitation.

So . . . here’s suggesting that the trustee’s due diligence duty, under § 547(b), continues throughout the prosecution of the preference lawsuit. The trustee must, therefore, prepare to perform, both before and after the filing of the preference complaint.

How the issue first hits

Here’s a fact pattern on how the issue first hits:

In September of 2019, a Chapter 7 Trustee makes demand to ABC Co. for return of a preference;
ABC Co. responds with evidence of subsequent advances beyond the amount of the demand;
In October of 2019, Trustee files a preference complaint against ABC Co., without investigating the subsequent advance information; and
On February 20, 2020, (the day after the effective date of SBRA) ABC Co. sends a written demand to the trustee to, (i) conduct a due diligence investigation of ABC Co.’s subsequent advance defense, and (ii) then, dismiss the pending complaint with prejudice.

What then follows is an argument between the Chapter 7 Trustee and ABC Co. on whether the SBRA due diligence requirement applies to this case. Not wanting to be a guinea pig on the issue, the Trustee looks into the subsequent advance defense and resolves the preference claim by agreeing to a small settlement payment.

How the issue hits next

Here’s a fact pattern on how the issue hits next:

In March of 2020, a Chapter 7 Trustee identifies transfers recoverable as preferences;
Debtor’s records are in terrible shape, such that Trustee cannot do a meaningful evaluation of potential defenses under § 547(c);
So, Trustee makes a preference demand on XYZ Co., which contains a request for information on any potential defenses, but XYZ Co. fails to respond;
Then, the Chapter 7 Trustee files a preference complaint containing the allegations that Trustee, (i) did a “reasonable due diligence in the circumstances of the case,” (ii) asked XYZ Co. for information on any defenses and received no response, and (iii) did not find any evidence of a “known or reasonably knowable affirmative defense under subsection (c)”; and
Shortly after service of process, XYZ Co., (i) files an answer identifying subsequent advances beyond the amount of the preference claim, (ii) provides documentation supporting the subsequent advances defense, and (iii) makes demand upon the Trustee to dismiss the complaint with prejudice.

XYZ Co. threatens the Chapter 7 Trustee with a claim for damages (e.g., payment of attorney fees XYZ Co. incurred) and other unspecified remedies for violating post-filing due diligence duties under § 547(b).

Trustee responds that the § 547(b) due diligence duty was satisfied before filing and no longer applies. Arguments between the parties ensue.

So, not wanting to be a guinea pig for the issue, the Chapter 7 Trustee investigates XYZ Co.’s subsequent advance claim and settles for a small payment.

Result

The result of the foregoing is this: we still don’t have a judicial opinion (as far as I can tell) on the new due diligence duty for plaintiffs in preference lawsuits.

A Question

An unresolved question is this: Is the § 547(b) due diligence duty satisfied by pre-filing efforts, or does the due diligence duty extend to post-filing prosecution of the preference claim?

A Prediction

My best prediction, as indicated above, is that courts will find an ongoing duty of due diligence under § 547(b). Here’s why:

The new preference provision in § 547(b) makes no mention of a pre-filing limitation on the due diligence duty;
Instead, the new due diligence language is sandwiched between the words, “the trustee may” and “avoid any transfer”;
This suggests that the “due diligence” duty applies both, (i) prior to filing the preference complaint, and (ii) during the prosecution of the preference lawsuit—and continues on until avoidance actually occurs; and
Due process concerns ought not arise, since no plaintiff should be pursuing a meritless claim anyway.

Conclusion

It will be interesting to see what the bankruptcy courts do with this preference/due diligence issue. When will the trustee’s duty to prepare to perform end?

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