A bankruptcy court in Delaware recently addressed important statutory changes affecting Chapter 11 disputes about “preferential payments.” In a Chapter 11 bankruptcy proceeding, a reorganizing debtor can claw back certain payments made within 90 days of the bankruptcy filing. Those returned funds are then distributed to the bankrupt company’s creditors as part of the bankruptcy estate’s regular administration. In concept, this rule is designed to ensure that an insolvent company does not treat one creditor more favorably than others.
Congress amended the statute governing preferential payment claw backs in The Small Business Reorganization Act of 2019, where it added due diligence language for debtors seeking such claw backs. The new language states that a bankruptcy court can reverse a debtor’s transfer made within 90 days of a bankruptcy filing only if the debtor’s demands were “based on reasonable due diligence in the circumstances of the case and taking into account a party’s known or reasonably known affirmative defenses.” This due diligence language has been treated in different ways by courts, rendering parties unsure of their responsibilities to meet the new requirements.
Bankruptcy Judge Mary F. Walrath helped to clarify what this due diligence requirement means in practice in a decision released on June 13, 2022. In that case, the Chapter 11 debtor had made payments within 90 days of bankruptcy. Upon identifying payments that were potentially covered by the preferential payment rule, the debtor sent demand letters to each creditor asking for return of the paid funds. Those creditors moved to dismiss the debtor’s eventual court claim for a preferential payment claw back, asserting that the debtor had not sufficiently met Congress’s new due diligence language. Judge Walrath disagreed, finding that the debtor had indeed properly alleged its due diligence. Although the debtor did not describe its consideration of any specific potential affirmative defenses to a claw back, Judge Walrath found that at the motion to dismiss stage, the debtor had sufficiently alleged its due diligence in two ways: first, the debtor specifically asserted that it had analyzed the subject transactions for potential defenses. Second, the debtor specifically pled that it had sent demand letters to the creditors. In doing so, it alleged conduct consistent with investigating whether the creditors had any affirmative defenses.
This decision provides a greater level of transparency for bankruptcy litigants disputing preferential payments. Judge Walrath held that Congress’s new due diligence language does not require a debtor to specifically negate any of the creditor’s particular affirmative defenses at the pleading stage. Despite Judge Walrath’s helpful decision, cases discussing this new due diligence language remain an incomplete patchwork. Some courts have ruled that the amendment adds an entirely new element to a claim for preferential payment claw backs, while others have stated that the new requirement is more akin to a condition precedent that must be pled and proven at trial. Judge Walrath’s decision helped to provide additional clarity for disputes at the motion to dismiss stage. However, the level of proof of due diligence that a debtor will eventually be required to provide at a full hearing or trial on the merits of a preferential payment claim remains unclear. In any event, to avoid the possibility of losing a preferential payment claw back claim or suffering the risk of court sanction for insufficient due diligence, debtors and trustees would be well served by making discrete attempts to discover their creditors’ potential affirmative defenses. Moreover, best practices indicate that a plaintiff should specifically allege its due diligence attempts – and the consideration of potential defenses – to survive a motion to dismiss a preferential payment claw back claim.