The Small Business Reorganization Act of 2019 (SBRA), Pub. L. No. 116-54 § 3(a), is probably the largest wholesale change to the Bankruptcy Code since BAPCA in 2005. Enacted in February 2020, the SBRA essentially created subchapter V of chapter 11 and made it easier for small business owners to keep their equity without having to liquidate and sell the remainder of their assets. However, in addition to creating subchapter V and making it easier for small businesses to reorganize, the SBRA also revised § 547(b) of the Bankruptcy Code with little fanfare associated with the change. Essentially, the amendment to § 547(b) requires a preference plaintiff to take into account a defendant’s affirmative defenses prior to filing an adversary proceeding, noting that “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.” [1]
Some commentators predicted that the amendment would make it easier for defendants to bring claims against preference plaintiffs based on the failure to investigate. Certainly, the amendment may be abused in the future against a plaintiff that brought an action in good faith, but no courts have taken up the issue to date.
Instead, many courts have recently taken up the issue of whether a plaintiff must plead that it investigated the defendant’s potential affirmative defenses. In other words, based on the SBRA amendment to § 547(b) of the Bankruptcy Code, is the investigation of affirmative defenses itself an element of a preference action? Only one court, after noting that the revised language of § 547(b) was a clear “condition precedent,” affirmatively indicated that the investigation itself is an element of the cause of action. [2] Most courts taking up the issue have concluded that the determination of the issue was irrelevant, as the investigation was properly pled in the complaint for purposes of a motion to dismiss, or the issue could not be decided at the motion-to-dismiss stage. [3]
One recent case examined this issue in detail. In Center City, [4] Judge Walrath of the U.S. Bankruptcy Court for the District of Delaware ruled on a motion to dismiss a preference action based on, among other things, the plaintiff’s failure to properly plead the nature and extent of its investigation into the defendant’s affirmative defenses. In that case, the complaint contained assertions regarding the plaintiff’s investigation of potential defenses, noting that the plaintiff “conducted an analysis of the Transfers made to the Defendants during the Avoidance Period and whether they were protected from avoidance by any applicable defense.” [5] The complaint also referenced demand letters sent to the defendants “inviting an exchange of information regarding any potential defenses.” [6] The bankruptcy court concluded that “there is no requirement that the Debtors plead how the affirmative defenses are not available; the Debtors must simply plead that they considered them.” [7] The bankruptcy court therefore denied the motion to dismiss and held that the plaintiff’s investigation of potential affirmative defenses was adequately pled.
While no court has determined that an investigation of affirmative defenses is an element of a preference action under § 547(b), practitioners may wish to allege sufficient facts to defeat a motion to dismiss in any event. It is clear that a blanket statement that an investigation was performed may not suffice under Rule 8 pleading standards. [8] However, it is also clear that alleging sufficient facts regarding the plaintiff’s investigation may be enough to survive a motion to dismiss. For example, in Ctr. City, the plaintiff alleged that it considered affirmative defenses, sent a demand letter, and invited the defendant to exchange information regarding potential defenses to defeat a motion to dismiss. [9] In some cases, courts examined the complaint and looked for clear evidence that the plaintiff engaged in sufficient diligence prior to filing the complaint. Courts have found that plaintiffs have exercised reasonable diligence by, among other things, reviewing bank records and correspondence, attaching relevant payment documents, and describing and reviewing any operative agreements between the debtor and defendant. [10]
It remains to be seen whether a reasonable investigation of affirmative defenses is an element of the cause of action, as even Colliers has expressed hesitation to take a position. [11] However, preference action plaintiffs would be wise to consider including as much detail into their investigation of the transfers generally and the defendant’s “known or reasonably knowable affirmative defenses.” Failure to do so may result in dismissal or require an amended complaint, resulting in wasted time and resources.
[1] 11 U.S.C. § 547(b).
[2] Husted v. Taggart (In re ECS Ref. Inc.), 625 B.R. 425, 454 (Bankr. E.D. Cal. 2020) (“This court believes that this condition precedent, i.e., due diligence and consideration of affirmative defenses, is an element of the trustee’s prima facie case.”).
[3] See, e.g., Harker v. Webb (In re GYPC Inc.), No. 19-3046, 2020 WL 13421284, at *9 (Bankr. S.D. Ohio Aug. 4, 2020) (refusing to dismiss complaint on grounds of lack of investigation, as bankruptcy court could not “determine from the pleadings this issue as a matter of law”); Henrich v. Quinn Emanuel Urquhart & Sullivan LLP (In re Insys Therapeutics Inc.), No. 21-50359 (JTD), 2021 WL 5016127, at *3 (Bankr. D. Del. Oct. 28, 2021) (“There is no requirement that a plaintiff plead around potential affirmative defenses.”); Weinman v. Garton (In re Matt Garton & Assocs. LLC), No. AP 21-1215 TBM, 2022 WL 711518 (Bankr. D. Colo. Feb. 14, 2022) (“The Court rejects [the defendant]’s other argument about reasonable due diligence since [the defendant] seems to be contesting the [plaintiff]’s factual allegations of due diligence on the merits.”); In re Reagor-Dykes Motors LP, No. 18-50214-RLJ-11, 2021 WL 2546664, at *3 (Bankr. N.D. Tex. June 21, 2021) (“At this stage, allegations — or lack thereof — do not reflect an abusive filing. [The defendant] has not answered the suit; its affirmative defenses are unknown.”).
[4] Ctr. City Healthcare LLC v. McKesson (In re Ctr. City Healthcare LLC), No. 21-50796 (MFW), 2022 WL 2133974 (Bankr. D. Del. June 13, 2022).
[5] Id. at *6.
[6] Id.
[7] Id.
[8] Arete Creditors Litigation Trust v. Tricounty Family Medical Care Group LLC (In re Arete Healthcare LLC), No. 21-05079-CAG, 2022 WL 362924, at *11 (Bankr. W.D. Tex. Feb. 7, 2022) (dismissing complaint on other grounds and noting that “[i]f due diligence is an element, merely paraphrasing the element will not satisfy Rule 8”).
[9] Ctr. City, 2022 WL 2133974, at *6.
[10] See, e.g., Robichaux v. The Moses H. Cone Memorial Hospital Operating Corporation (In re Randolph Hosp. Inc.), No. 20-10247, 2022 WL 3146789, at *7 (Bankr. M.D.N.C. Aug. 5, 2022) (“The Plaintiff also demonstrates sufficient due diligence under the circumstances of this case by, among other things, attaching wire and check records of the alleged transfers made to the Defendants, attaching the [relevant contract] between [relevant parties], and describing the contractual relationship between [debtors] and the [d]efendants.”); Sommers v. Anixter Inc. (In re Trailhead Eng'g LLC), No. 20-3094, 2020 WL 7501938, at *7 (Bankr. S.D. Tex. Dec. 21, 2020) (“[T]he [c]omplaint demonstrates that [the t]rustee reviewed [the debtor’s] bank and wire records, invoices relating to the [transfers], correspondence, and the contract between [the relevant parties]. Additionally, [the plaintiff] mapped out the alleged structure of the parties’ relationships in the [c]omplaint”).
[11] 5 Collier on Bankruptcy ¶ 547.02A (16th ed. 2020) (“[I]t is unclear whether the ‘reasonable due diligence’ requirement is an element of the preference claim.”)