It is bad enough when a customer or borrower files for bankruptcy and you have to write off the debt, but things can get worse when you are then faced with a lawsuit to recover payments made within the 90 days prior to the bankruptcy filing, known as preference payments or preferential transfers. However, there is good news for creditors who have to defend themselves in that situation. A bankruptcy trustee or debtor-in-possession must now conduct “reasonable due diligence” before a preference suit is commenced.

The Small Business Reorganization Act (“SBRA”) was signed into law on August 23, 2019 and amends § 547(b) of the Bankruptcy Code to include a due diligence requirement. Prior to the signing of this act, trustees were authorized by §547(b) to “avoid” certain kinds of payments made by debtor prior to filing. This revised section (new language in italics) states that the trustee or debtor-in-possession “may, based on reasonable due diligence in the circumstances of the case and taking into account a party’s known or reasonably knowable affirmative defense under subsection c, avoid any transfer of an interest of the debtor in property” if it otherwise satisfies the elements of a preferential transfer. Given that there are numerous statutory defenses to preference claims set forth in §547(c), trustees must now undertake an analysis of each such defense on a potential preference claim. It is important to note that the substantive elements of a preference claim have not changed and Congress did not provide any obvious mechanism for a preference defendant to enforce the pre-filing obligation. It may be that a bankruptcy trustee or debtor-in-possession sends a demand letter requesting information on a potential defendant’s affirmative defenses, which is often the case before SBRA was enacted. However, determining how a plaintiff will be required to demonstrate due diligence is left to the courts to decide on a case-by-case basis.

There are three major takeaways from the enactment of the SBRA: First, any case law excusing a trustee from conducting any pre-filing due diligence regarding affirmative defenses is no longer applicable; second, it no longer allows for a trustee to sue every party that appears on a debtor’s check register within the 90-day period (or 1 year for “insiders”) prior to a bankruptcy filing; and, finally, it will likely reduce the amount of non-meritorious preference actions commenced. For creditors, it is good news indeed.

This alert does not purport to be a substitute for advice of counsel on specific matters.

Harris Beach has offices throughout New York State, including Albany, Buffalo, Ithaca, Melville, New York City, Rochester, Saratoga Springs, Syracuse, Uniondale and White Plains, as well as New Haven, Connecticut and Newark, New Jersey.