To a layperson, the idea that a debtor can assert a cause of action against a company who supplied goods or services to a debtor before the bankruptcy case, whom the debtor then paid, seems preposterous. Yet the Bankruptcy Code gives trustees and debtors in possession that right in 11 U.S.C. Section 547—the right to seek to recover a payment to a third party in the 90-day period prior to the commencement of a bankruptcy case as a "preference."

Justifiable frustration at this provision, and mass preference litigation, has encouraged Congress to act. On Aug. 23, 2019, the Small Business Reorganization Act of 2019 (SBRA) became law, effective Feb. 22, 2020. One of the provisions of the SBRA amends the language of Section 547, to add a due diligence requirement. Though the intent behind the added language seems clear, it may not have its intended effect.

There are two conflicting dynamics in preference litigation, each of which is correct some of the time, and if correct, cancels the other out. The first is that goods suppliers and service suppliers do business with companies all the time, and in every transaction, there is the assumption of risk by the supplier that they will receive payment. Suppliers cannot always know when—or if—their customers are in financial distress. Thus, should one those customers commence a bankruptcy case, that is the cost of doing business. The supplier may have to wait years in order to obtain payment, if at all, on recently shipped goods.

Yet it should not be the cost of doing business to allow a debtor to then request the return of payments made to the supplier in the 90-day period prior to the bankruptcy case, as Section 547 permits. The supplier did nothing wrong. Not only was it not aware that bankruptcy was imminent, it had no control over whether the debtor paid it or not.

Hello, angel.

The second dynamic is the opposite: the suppliers likely became aware of imminent bankruptcy, and the debtor certainly was. At a certain point, a bankruptcy filing becomes a certainty. Yet the debtor does not file a case immediately. Instead, as part of its pre-bankruptcy planning, it slow-pays its creditors to conserve cash. It may do this for months. It tells no vendors that bankruptcy is imminent. As its payables mount and creditors begin calling, the debtor makes a choice as to who it needs to pay, to survive a little longer, all with the goal of pushing out a bankruptcy filing as long as possible. Eventually word gets out that the debtor is in dire financial trouble. Observant creditors may seek collection remedies, such as shortening net payment invoice terms, or recording liens. By the time the debtor commences the bankruptcy case, its relationships with its suppliers are in shambles.

Hello, the other one.

Popular frustration with preference litigation arose, and exists, due to the first category of cases. Thousands of suppliers might receive payments in the 90-day period prior to the commencement of a case. The debtor's bankruptcy might have been triggered by an unpredictable calamity, such as the loss of a business license, or major customer or some other event that takes even the debtor by surprise. The debtor may not have time to prefer to pay certain creditors, even if it wanted to.

In that situation, Section 547 seems unnecessary and cruel. Payments automatically meet the requirements for avoidance if certain elements are met, and those requirements are not particularly difficult. Was there a payment made by the debtor? To a creditor? Within 90 days before bankruptcy? Because the creditor delivered goods or services? Most of the factors are satisfied right there. All that remains is that the trustee assert that the creditor would have received less than 100% of the amount of that transfer had the debtor simply liquidated instead—something easy to prove if the debtor is having difficulty meeting its debts. Insolvency, another element, is presumed.

Prior to Feb. 22, if all of those things were met, the trustee "may avoid any transfer of an interest…" But the SBRA adds a phrase between the words "may," and "avoid." The phrase is this: "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),"

This additional language requires us to skip ahead to the five defenses that defendants in preference actions can assert, set forth in Section 547(c). Two of them apply to transfers that create perfected security interests, and are not discussed further here. Two relate to whether the defendant provided value for the transfer. The most litigated one relates to whether the payment was made in the ordinary course of business.

Of these defenses, the ones relating to value are straightforward:  did the defendant, around the time it received the transfer or afterward, deliver any goods or services to the debtor? If so, the value of those goods and services is a dollar for dollar offset on any preference liability. It is either a "contemporaneous exchange" under Section 547(c)(1) or its is "new value" under Section 547(c)(4). The vendor may still be left holding the bag on supplies it made to the debtor that were never paid for, but its consolation prize is that it is immunized, at least partially, from preference liability.

The ordinary course of business defense is more complicated, as it was designed to protect angels. It is less precise and as such, not easily subject to resolution by way of motion for summary judgment. The defense is this: if the debtor did business with the supplier like any other company in the debtor's industry would have done, that's a complete defense. Alternatively, if the debtor did business with the supplier like it had done in the past, that is a complete defense.  In the absence of better metrics, parties often look to the number of days between invoice and payment to discern if there is a change in the pattern of payment. In the case of angels, the number of days between invoice and payment may be relatively unchanged.  In the other category, there may be significant delays, or payments made too soon, suggesting that a creditor demanded payment upon learning of a debtor's financial difficulty, before such payment was due.

An analysis of these types of defenses is beyond the scope of this article. But because of the SBRA, it is now wholly within the scope of commencing a preference action. Regardless of how the new SBRA language is interpreted, Congress' intent could not be more clear. Every complaint seeking to recover a preference payment must now contain, at a minimum, a paragraph stating that the trustee has performed due diligence and considered the defendant's defenses. At the first status hearing in each adversary proceeding, a trustee will need to be prepared to discuss this "diligence" in greater detail.

On the one hand, this may not be so difficult for a Trustee to accomplish. The trustee may be able to determine if the bankruptcy case falls into the angel category of cases, or the other category, by reviewing records, questioning the debtor at a meeting of creditors, or reviewing the debtor's communications with creditors before the bankruptcy case.

Was the debtor making regular payments to all creditors steadily up to the date of filing? Was the debtor making all payments to all creditors within 30 to 45 days of invoice? Do the debtor's professionals and employees indicate that they were unaware of the imminence of the bankruptcy filing? If yes, further investigation may be necessary before complaints are filed.  Any other answer suggests that anomalies could have occurred in the payment of creditors—and provides the trustee with plenty of facts that can be asserted in any complaint that demonstrate evidence of "diligence."

Regarding a defendant's "contemporaneous exchange" or "new value" defenses, those defenses are easy to apply if the information exists. Do the debtor's business records identify deliveries of goods or services by creditor, during the 90-day period? If so, those deliveries will provide a dollar for dollar offset for transfers made on or before that date. Are business records lacking? If so, discovery may be necessary to obtain those records before complaints are filed.

But mass preference litigation is rarely easy, and the amendments to Section 547 are written in such a way that a defendant could feel incentivized to move to dismiss a complaint or move for summary judgment on a complaint that contains perceived inadequacies. The result of these amendments could be increased litigation costs for the bankruptcy estate, reducing ultimate creditor payouts in the case, without any appreciable benefit to an individual defendant. The most significant impact of the SBRA may be to discourage preference litigation against out-of-district defendants, as the SBRA also increases to $25,000 the amount that must be pleaded to litigation against an out-of-district defendant in the district in which the bankruptcy case sits, as set forth in 28 U.S.C. Section 1409(b).

The SBRA amendments relating to preference litigation thus may affect very little, except require trustees and debtors-in-possession to obtain documents ahead of time sufficient to tell at least two stories. The first story is the story of how the debtor became a bankrupt, and the business of the debtor during the 90-day period leading up to that date. The second story is the story of each individual defendant, who may be reduced at that point to nothing more than the dollar amount of transfers they received, and the dollar amount of goods they provided to the debtor, during that same period.

But even that story is more than defendants often received in the past, and thus, from the angel's perspective, is better than nothing. Angels will have additional leverage over trustees to request evidence showing haphazard payments, cash hoarding, supplier preference or anything else that suggests that a debtor chose its payees deliberately. Angels may not like the result, of course, should the trustee obtain that information. But trustees have leverage too, even over angels. A trustee's request for defense information can no longer be ignored until a complaint is filed—at least, without risking waiver of the added obligation the SBRA seeks to impose on that trustee.

It is unlikely, of course, that the SBRA amendments will quell vendors' distaste for preference litigation. But rigor in due diligence hurts no one. In a way, the pedestrian language added to Section 547 exalts the trustee. Congress has directed, and trustees may as well accept, their new role as the separator of the angels from everyone else.

Steve Werth is an attorney in the Los Angeles office of SulmeyerKupetz, a premier business, financial restructuring and litigation law firm. Contact him at 213-617-5210 or [email protected].