Recent Interpretations of “Reasonable Due Diligence” Under Section 547(b)

In May 2021, the ABI Journal examined the recently-added “reasonable due diligence” requirement of 11 U.S.C. § 547(b), [1] with an in-depth analysis of how such a requirement may shift the burdens of proof assigned in 11 U.S.C. § 547(g). [2] Since the revision’s enactment, several courts have examined the new language, shedding light on what is required under this new standard in the real world.

Section 547(b) provides that, “[e]xcept as provided in subsections (c), (i), and (j) of this section, 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 …” [3] Yet, in § 547(g), Congress assigns the trustee “the burden of proving the avoidability of a transfer under subsection (b) [of § 547], and the creditor or party in interest against whom recovery or avoidance is sought has the burden of proving the nonavoidability of a transfer under subsection (c) [of § 547]”, which sets forth available affirmative defenses. [4] In addition to this potential shift of burden, whether or not the new language creates heightened federal pleading requirements has been a hot topic in its examination.

In re ECS Refining, Inc. [5] kicked off the bankruptcy courts’ analysis of the new standard by evaluating, first and foremost, whether “reasonable due diligence” is a condition precedent to litigation under § 547(b) and a prima facie element of a preference cause of action. [6] The Bankruptcy Court for the Eastern District of California looked to the Prison Reform Act and related opinions [7] for guidance on whether the due diligence language in § 547 creates an additional pleading requirement, holding that, in § 547(g), “Congress has expressly allocated the burden of proof on the issue of due diligence under § 547(b) to the trustee”, and that “treatment of due diligence as an element of the prima facie case under § 547(b) is consistent, rather than at odds, with Congressional intent.” [8] The court found that the trustee in ECS Refining failed to adequately plead facts detailing its pre-filing investigation of the preference causes of action and granted the defendant’s motion to dismiss the complaint under Fed. R. Civ. P. 12(b)(6) on this and other grounds. [9]

In In re Trailhead Engineering LLC, [10] also in the context of a motion to dismiss under Rule 12(b)(6), the Bankruptcy Court for the Southern District of Texas declined to comment on whether “reasonable due diligence” is an element of a preference claim but recognized that the reference to “in the circumstances of the case” in the statutory language means “a level of discretion is involved.” [11] The court found that the “reasonable due diligence” requirement was satisfied where the complaint demonstrated that the trustee reviewed bank and wire records, invoices related to the defendant, correspondence between the parties, and the contract between the parties and mapped out the structure of the parties’ relationships in the complaint. [12]

In re Reagor-Dykes Motors, LP [13] followed with a two-for-one analysis in its June 2021 opinion. Examining complaints filed in separate adversary proceedings against the three named defendants, the Bankruptcy Court for the Northern District of Texas found that, while one complaint, describing the relationship between the debtors and defendant and the transactions at issue with specificity, met the new due diligence standard, the other two complaints, containing only information available from the debtor’s bank statements and identifying transferees as “vendors,” with no substantive information regarding their relationships with the debtors, did not meet the “reasonable due diligence” standard under § 547(b). [14]

Finally, the Bankruptcy Court for the District of Delaware in In re Insys Therapeutics, Inc. [15] distinguished ECS Refining, declining to rule on “due diligence” as an element of the claim and stating that “there is no requirement that a plaintiff plead around potential affirmative defenses.” [16] The court found due diligence where the trustee (1) sent a letter to defendant demanding return of the transferred property and requesting defendant advise the trustee of its defenses, and (2) took such defenses into account in conjunction with its review of the debtor’s books and records. [17]

As case law continues to develop, trustees and counsel should look these post-SBRA cases for best practices to minimize opportunities for claim dismissal, including updating preference-related forms and pleadings, reviewing and/or requesting information on potential affirmative defenses from transferees, and reciting due diligence efforts as a component of a § 547(b) claim. Likewise, counsel for preference defendants should pay special attention to whether the new “reasonable due diligence” standard has been met when evaluating complaints and potential defenses to preference litigation.