On August 23, 2019, three bankruptcy bills were enacted into law: the Family Farmer Relief Act of 2019 (H.R. 2336), the Honoring American Veterans in Extreme Need Act of 2019 (H.R. 2938) and the Small Business Reorganization Act of 2019 (H.R. 3311, the “SBRA”). These bills bring several welcome reforms to the Bankruptcy Code, such as increasing the amount of debt that may be addressed by farmers in a chapter 12 bankruptcy case, protecting disability benefits for veterans in a chapter 7 bankruptcy case, and facilitating the chapter 11 bankruptcy process for small businesses. In addition to these reforms, the SBRA includes amendments to lower the burden on non-debtors in defending against any preference claims brought by trustees or debtors in bankruptcy. As such claims are at issue in almost every bankruptcy case, all creditors should be aware of these developments.
The Bankruptcy Code aims to maximize (or at least preserve) the value of a troubled entity for the benefit of creditors and to provide equal treatment among creditors. However, distressed companies often attempt to deal with liquidity constraints by selectively paying creditors, which can result in creditors with similar legal rights receiving different recoveries on their claims if the recovery efforts are not successful and a bankruptcy case is commenced. To remedy this, the Bankruptcy Code provides for the avoidance and recovery of such transfers (commonly referred to as “preferential transfers” or simply as “preferences”). In particular, subject to certain exceptions, the Bankruptcy Code empowers the trustee or debtor in possession to avoid and recover any transfer of money or other property made to or for the benefit of a creditor by a debtor in the 90 days before bankruptcy (one year for transfers to insiders) on account of an existing debt that enables such creditor to receive more than it would in a liquidation under chapter 7 of the Bankruptcy Code.
While this power to avoid and recover prebankruptcy payments promotes the goal of creditor equality generally, it is often highly disruptive to the recipient and the process is heavily weighted in favor of the plaintiff in many key respects. Because the elements of a preference are so broad, a claim can be asserted with minimal effort and cost, and it is not unusual for trustees in bankruptcy or debtors in possession to file preference actions against every entity that received any payment from the debtor during the applicable period before bankruptcy (other than for entities who are critical vendors or counterparties to assumed contracts, as the claims of such entities would be otherwise satisfied). Frequently, less-diligent debtors and trustees file complaints that do little more than parrot the statutory elements in reference to an attached list of payments, are mass filed on or just prior to the expiry of the statute of limitations for such claims, and seek to disallow any pending claims for other amounts filed by the recipient. While the Bankruptcy Code provides for various defenses against preference claims, including with respect to transfers from a debtor made in a contemporaneous exchange of new value, in the ordinary course of business, or for which the creditor subsequently provided new value, these defenses are often highly fact intensive and can be difficult or costly to assert. Accordingly, while these defenses impact the value of the asserted claim and any potential settlement, creditors generally cannot rely on these defenses to dispose of the preference action prior to discovery and summary judgment.
The discrepancy in costs and burdens for plaintiffs and defendants in a preference action is further exacerbated by the applicable venue provisions, which usually provide for venue of such cases in the bankruptcy court where the debtor’s case is pending. This is often inconvenient for the creditor in terms of distance and cost and provides a “home field” advantage for the debtor. In addition, it has become increasingly common for plaintiffs to seek and obtain, sometimes before commencing the subject adversary proceedings or otherwise on little notice to defendants, mandatory case procedures governing all preference claims (and other avoidance actions) that have further advantages for the plaintiff over the defendant, such as requiring the defendant to participate in mandatory mediation proceedings in the plaintiff’s chosen venue and extending the plaintiff’s time to respond to any dispositive motion from the defendant until after conclusion of the mediation.
Overall, the extensive procedural advantages held by the plaintiff in a preference action will often compel the defendant to settle a preference claim on less favorable terms than otherwise warranted by the merits of the underlying claim. The SBRA amendments to preference claims will lessen the procedural burdens on defendants in such actions and may significantly impact preference litigation and valuation in practice.
The SBRA impacts potential preference actions by requiring, effective as of February 19, 2020, that the plaintiff account for the recipient’s defenses before asserting the preference claim and by requiring that certain bankruptcy actions with less than $25,000 at issue be commenced in the district where the defendant resides.
First, the SBRA amends section 547(b) of the Bankruptcy Code to explicitly condition the assertion of a preference claim by the plaintiff “on reasonable due diligence in the circumstances of the case and taking into account a party’s known or reasonably knowable affirmative defenses” under section 547(c) of the Bankruptcy Code. As an initial matter, this new requirement is likely to result in fewer preference claims being brought overall, and may even curb the practice of filing preference actions against every entity receiving any prebankruptcy transfer. More importantly, with reasonable due diligence and accounting for defenses as a statutory prerequisite for the assertion of a preference claim, we expect that plaintiffs will need to include detailed statements regarding the due diligence undertaken and defenses accounted for. This should assist creditors in defending such claims (and facilitate discovery) but should also require bankruptcy courts to consider the applicability of the preference defenses under section 547(c) of the Bankruptcy Code on motions by defendants for dismissal under Rule 12(b)(6) or for judgment on the pleadings under Rule 12(c). Accordingly, while each preference claim and defense will remain highly fact intensive, this amendment should be significantly favorable for preference defendants.
Second, the SBRA amends section 1409(b) of Title 28 to require that any proceeding arising in or related to a bankruptcy case against a non-insider to recover a non-consumer debt of less than $25,000 (an increase from $13,650 currently) be commenced in the district where the defendant resides. While there is some dispute among bankruptcy courts (and no binding authority in any jurisdiction) whether section 1409(b) applies to preference actions, the SBRA legislative history is clear that the section 1409(b) amendment was specifically intended to apply to preference actions. If so applied, this would shift the venue and cost advantages from the plaintiff to the defendant for the subject preference actions, and would also procedurally benefit defendants by preventing such actions from being subject to any mandatory case management procedures imposed by the debtor’s bankruptcy court.
The SBRA amendments are likely to significantly reduce some key procedural disadvantages for defendants to preference claims and are likely to substantially impact the early stages of preference litigation. All creditors should consider the impact of these amendments when evaluating preference exposure and potential litigation.