Delaware Bankruptcy Court Rules that Due Diligence Is Element of Preference Claim Rather Than Basis for Affirmative Defense

A bankruptcy trustee's ability to avoid and recover pre-bankruptcy preferential transfers is essential to preserving or augmenting the estate for the benefit of all stakeholders. In 2019, however, the Bankruptcy Code was amended to add a due diligence requirement to the Bankruptcy Code's preference avoidance provision, apparently as a way to minimize the volume of speculative and coercive preference litigation. Neither the amendment nor its legislative history, however, clearly specifies the pleading rules or the allocation of the evidentiary burdens associated with the due diligence requirement, which has led to confusion among the courts.

The U.S. Bankruptcy Court for the District of Delaware recently addressed this issue in In re Pinktoe Tarantula Ltd., 2023 WL 2960894 (Bankr. D. Del. Apr. 14, 2023). In dismissing a preference avoidance complaint without prejudice, the court concluded that the due diligence requirement in section 547(b) of the Bankruptcy Code is an element of a preference claim that must be proved by the preference plaintiff rather than the basis for an affirmative defense that must be proved by the defendant. 

Avoidance of Preferential Transfers

Under section 547(b) of the Bankruptcy Code, a bankruptcy trustee (or a chapter 11 debtor in possession ("DIP") by operation of section 1107(a)) 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 [section 547(c)]," avoid any transfer made by an insolvent debtor within 90 days of a bankruptcy petition filing (or up to one year, if the transferee is an insider) to or for the benefit of a creditor if such creditor, by reason of the transfer, receives more than it would have received in chapter 7 liquidation, if the transfer had not been made. 11 U.S.C. § 547(b) (emphasis added).

Section 547(c) contains nine defenses or exceptions to avoidance. These include, among other things, contemporaneous exchanges for new value, ordinary course business transfers, transfers involving purchase-money security interests, and transfers after which the transferor subsequently provides new value to the debtor.

Section 547(g) provides that the trustee or DIP "has the burden of proving the avoidability of a transfer" under section 547(b) and that "the creditor or party in interest against whom recovery or avoidance is sought has the burden" of establishing the existence of an affirmative defense under section 547(c).

The "reasonable due diligence" requirement was added to section 547(b) as part of the Small Business Reorganization Act of 2019 (the "SBRA"), which created a new subchapter V of chapter 11 of the Bankruptcy Code to provide a more expeditious path for small businesses to restructure successfully. See In re Blue, 630 B.R. 179, 186 (Bankr. M.D.N.C. 2021) (citing cases and H.R. Rep. No. 116-171, 1 (2019) (stating that subchapter V is meant to be a streamlined "process by which small business debtors reorganize and rehabilitate their financial affairs")).

The reasons for the addition of the due diligence requirement to section 547(b) are unclear. For example, the House Report accompanying the SBRA (cited above) gives no explanation for the change. As noted by a leading commentator:

The most plausible explanation is that it seems to have been the practice for chapter 11 liquidating trusts to employ what are called, in the vernacular, "preference mills." The same practice may also be prevalent in larger chapter 7 cases. These entities pursue preference actions for the trustee and take a percentage of the recovery. Their business model is simple: they take the list from the debtor's statement of affairs of all payments the debtor made in the 90 days before bankruptcy and file preference actions against all the recipients without undertaking any investigation of the merits of the causes of action, such as whether the transfer was ordinary course, whether it was COD or otherwise a contemporaneous exchange, or any other defense. They file adversary proceedings in the home court (except for those under $13,650—the then preference venue cut-off—which probably aren't worth pursuing in any event). The defendants have to hire distant (often New York or Delaware) counsel to defend. It thus becomes very expensive to defend the action. It makes economic sense for defendants to settle for nuisance value or the cost of defense …. [T]he new language … seems to have been designed (1) to make it more expensive for the preference mills to pursue the adversary proceedings, and (2) to eliminate some of the suits when it is clear upon examination that the payments were ordinary course or substantially contemporaneous. 

Collier on Bankruptcy ("Collier") ¶  547.02A (16th ed. 2023); see also In re Art Inst. of Philadelphia LLC, 2022 WL 18401591, *20 (Bankr. D. Del. Jan. 12, 2022) ("The 2019 amendment to section 547 appears to be a response to [the preference mills], imposing an obligation on trustees (not typically borne by plaintiffs) to assess the availability of an affirmative defense before filing suit."); In re Reagor-Dykes Motors, LP, 2021 WL 2546664, *2 (Bankr. N.D. Tex. June 21, 2021) ("The language added to § 547(b) under the Small Business Reorganization Act of 2019 is meant to deter the filing of abusive preferential transfer suits."); see generally David S. Forsh et al., New Bankruptcy Amendments Lower the Burdens of Preference Actions on Defendants, 16 Pratt's Journal of Bankruptcy Law 1, 3 (2021) (explaining that this new requirement is likely to discourage the practice of filing preference actions against every entity that received a prebankruptcy transfer); Brook E. Gotberg, Poking at Preference Actions: SBRA Amendments Signal the Need for Change, 28 Am. Bankr. Inst. L. Rev. 285, 295 (2020) (describing how the reasonable due diligence requirement should operate to prevent trustees from filing preference actions with only nuisance value).

In addition, neither section 547(b) nor its legislative history specifies how proof of compliance with the due diligence requirement is to be established, or what even constitutes "reasonable due diligence. 

In the absence of statutory or Congressional guidance, court rulings addressing the due diligence requirement—including whether it is an element of a preference claim that must be pleaded by the DIP or trustee, as distinguished from an affirmative defense, proof of which must be established by a preference defendant—have been inconsistent and confusing. See generally Collier at ¶ 547.02A (discussing cases). 

Most courts have avoided deciding this question. See, e.g., In re Ctr. City Healthcare, LLC, 641 B.R. 793, 802 (Bankr. D. Del. 2022) (finding it unnecessary to resolve the issue because the plaintiff alleged that the debtors conducted an analysis of transfers made in the avoidance period, including defenses, sent demand letters to defendants inviting an exchange of information regarding defenses, and received no responses); Art Inst. of Phila. LLC, 2022 WL 18401591, at * 20 (finding it unnecessary to resolve the issue because the court was dismissing the complaint on other grounds); In re Randolph Hosp., Inc., 644 B.R. 446, 462 (Bankr. M.D.N.C. 2022) (concluding that due diligence was adequately pled when the plaintiff alleged that he reviewed books and records, evaluated reasonably knowable defenses, attached to the complaint documentary evidence of the transfers, and described the contractual relationship between the debtor and defendant); In re Insys Therapeutics, Inc., 2021 WL 5016127, *3 (Bankr. D. Del. Oct 28, 2021) (declining to decide the issue because the preference complaint generally met the pleading standard of Fed. R. Civ. P. 8, the liquidating trustee alleged he sent a letter to the defendant demanding return of the transfers and inviting the defendant to advise of any defenses, which were reviewed if presented, and the trustee alleged he reviewed the debtors' books and records); Reagor-Dykes Motors, 2021 WL 2546664, at *5 (finding it unnecessary to resolve the issue, but noting that if due diligence was performed, it was not reflected in the complaint because of the lack of context surrounding the transfers); In re Trailhead Engineering LLC, 2020 WL 7501938, *7 (Bankr. S.D. Tex. Dec. 21, 2020) (concluding that any pleading requirement was satisfied because the complaint indicated that the chapter 7 trustee reviewed the debtor's books and records, invoices relating to the specific transfer, correspondence between the parties and the underlying contract, and related relationships between the debtor and the defendant transferee). 

Other courts have concluded that a complaint cannot merely recite the language of section 547(b) to satisfy the provision, but must include facts to support due diligence. See, e.g., In re Arete Healthcare, LLC, 2022 WL 362924, *11 (Bankr. W.D. Tex. Feb. 7, 2022) (dismissing a preference claim on other grounds, but stating that "[i]f due diligence is an element, merely paraphrasing the element will not satisfy [Fed. R. Civ. P. 8]"); see also Randolph Hosp., 644 B.R. at 462 (acknowledging that the plaintiff in preference avoidance litigation did "more than recite the introductory sentence of § 547(b)"). 

In In re ECS Ref., Inc., 625 B.R. 425 (Bankr. E.D. Cal. 2020), the bankruptcy court tackled the question head-on in ruling on a motion to dismiss a chapter 7 trustee's complaint seeking, among other things, to avoid prepetition payments by the debtor to an insider creditor. The court concluded that, as amended by the SBRA, section 547(b) now includes a "condition precedent" with "three discrete subparts" that the party seeking avoidance must satisfy before commencing preference litigation: 

(1) reasonable due diligence under "the circumstances of the case"; (2) consideration as to whether a prima facie case for a preference action may be stated; and (3) review of the known or "reasonably knowable" affirmative defenses that the prospective defendant may interpose. 

Id. at 453. Guided by U.S. Supreme Court precedent, the bankruptcy court in ECS also determined that this condition precedent is an element of a preference plaintiff's prima facie case—and may therefore defeat jurisdiction if not adequately pleaded—rather than an affirmative defense that the defendant must plead in opposing avoidance. Id. at 454 (discussing Jones v. Bock, 549 U.S. 199, 212-217 (2007) (interpreting the Prison Litigation Reform Act, which like amended section 547(b), is silent on whether satisfaction of a condition precedent is an element or an affirmative defense and on whether satisfaction of the condition is a pleading requirement)). According to the court, this conclusion is supported by several factors: 

(i) "§ 547 expressly requires that the trustee affirmatively prove due diligence" and, in most instances, if the plaintiff bears the burden of proof of establishing a fact at trial, it is an element, whereas, if the defendant bears the burden of proof, it is an affirmative defense; 

(ii) section 547(b) "defines" avoidable preferences, including the element of due diligence, whereas section 547(c) offers preference defendants nine affirmative defenses; 

(iii) section 547(f) expressly "allocate[s] the burden of proof on the issue of due diligence under § 547(b) to the trustee"; and 

(iv) treating the due diligence requirement as an element falls within the "plain meaning rule" because literally applying it would not "produce a result demonstrably at odds with the intentions of its drafters," but in fact is consistent with Congressional intent.

Id. at 457 (quoting United States v. Ron Pair Enterprises, Inc., 489 U.S. 235, 242 (1989)). Stated differently, the ECS court reasoned that the due diligence requirement would have been included in section 547(c), rather than section 547(b), if lawmakers had intended that the absence of due diligence was an affirmative defense instead of an element of a preference claim.  

Tarantula 

Women's clothing retailer Pinktoe Tarantula Limited ("Pinktoe") and its U.S. affiliates (collectively, the "debtors") were founded by Charlotte Olympia Dellal ("Dellal") in 2013 as the U.S. outlet for the Charlotte Olympia brand of women's apparel. Dellal served as an officer and a director of the debtors until 2018. She was also on the board of certain non-debtor affiliates located in the United Kingdom. 

Sometime after 2013, Pinktoe signed a lease agreement with L&M 65th Madison LLC (the "landlord") for a retail store in New York City. Dellal personally guaranteed Pinktoe's obligations under the lease. Neither the New York store nor the debtors' other U.S. locations ever turned a profit. From February 2017 through January 2018, Pinktoe paid the landlord nearly $450,000 in rent for the New York store. 

On February 17, 2018, the debtors filed for chapter 11 protection in the District of Delaware. The bankruptcy court confirmed a liquidating chapter 11 plan for the debtors approximately one year later. The plan created a liquidating trust for the purpose of prosecuting estate causes of action. 

The liquidating trust commenced an adversary proceeding seeking: (i) in count one, avoidance and recovery under sections 547 and 550 of the nearly $450,000 in rent paid to the landlord during the year preceding the debtors' bankruptcy filing, which payments the trust alleged were transferred "for the benefit of" the "insider" guarantor Dellal and allowed Dellal to receive more than she would have received if the debtors had been liquidated in chapter 7; and (ii) in count two, damages for Dellal's breach of fiduciary duty in, among other things, failing to close the unprofitable New York store (the rental payments for which reduced her guarantee liability), inadequately capitalizing the debtors, refusing to take steps that could have improved the debtors' financial viability, and bolstering her own brand (and the brands of the UK affiliates) at the expense of the debtors and their creditors.

Dellal moved to dismiss the complaint. She argued in part that the trust failed to plead a preference claim properly because the trust did not allege in the complaint that it undertook any due diligence into the merits of its claims or any potential affirmative defenses.

The trust argued that the due diligence requirement was an affirmative defense, which it was "not required to plead around." Alternatively, the trust contended that it did consider potential section 547(c) defenses but concluded that they were not applicable under the circumstances, and that "its diligence is evident on the face of the Complaint."

The Bankruptcy Court's Ruling

The bankruptcy court dismissed both counts of the complaint, but without prejudice and with leave to amend.

U.S. Bankruptcy Judge Laurie Selber Silverstein rejected the trust's arguments. First, she explained, although the amendment to section 547(b) as part of the SBRA took effect approximately three months before the trust filed its adversary proceeding, the complaint did not include any explicit allegations responsive to the new due diligence requirement.

Next, agreeing with the ECS court's reasoning, Judge Silverstein concluded that section 547(b)'s due diligence requirement is an element of a preference claim rather than an affirmative defense based on the structure and language of sections 547(b) (setting out the elements of a preference), 547(c) (setting forth affirmative defenses), and 547(g) (allocating the burden of proof in connection with both). According to Judge Silverstein, "[b]ecause the due diligence requirement appears in subsection (b), not (c), I conclude that the due diligence requirement is an element of the claim, or something that must be proven by the trust[]."

She also determined that the due diligence requirement in section 547(b) is a condition precedent, the pleading of which is governed not by the general pleading requirements stated in Fed. R. Civ. P. 8, but by Fed. R. Civ. P. 9(c) (made applicable in bankruptcy adversary proceedings by Fed. R. Bankr. P. 7009), which provides as follows 

In pleading conditions precedent, it suffices to allege generally that all conditions precedent have occurred or been performed. But when denying that a condition precedent has occurred or been performed, a party must do so with particularity.

Fed. R. Civ. P. 9(c).

Judge Silverstein determined that the complaint failed this pleading standard because the trust did not allege, generally or otherwise, that it performed any due diligence. She accordingly dismissed the preference claim stated in the complaint (count one). However, because the effective date of the amendment to section 547(b) took effect shortly before the trust filed its complaint, the bankruptcy court gave the trust leave to amend the complaint to remedy the defect. The court also dismissed (without prejudice and with leave to amend) the breach of fiduciary duty claim (count two) because, among other reasons, the complaint did not adequately plead a claim for breach of the duty of care or allege that the debtors were insolvent at all relevant times.

Outlook

Tarantula provides welcome guidance regarding the evidentiary burdens borne by plaintiffs and defendants in preference avoidance litigation. This question was muddied by the 2019 amendment to section 547(b) as part of the SBRA and has created considerable confusion in the bankruptcy courts. According to the Tarantula bankruptcy court's reasoning, the due diligence requirement is an element of a preference claim rather than a condition precedent. It remains to be seen whether other courts will embrace this approach.

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