Will Bankruptcy Preference Lawsuits Decline due to Statutory Changes?

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This article also appears on Harvard Law School's Bankruptcy Roundtable here. 

When a creditor is the target of a bankruptcy trustee or debtor’s claim to take back money the debtor paid on a legitimate debt prior to the bankruptcy filing, it’s bitter justice. The concept is fair enough: pulling funds back into the bankruptcy estate so they can be redistributed among all to creditors in accordance with the Bankruptcy Code’s priority scheme on a pro rata basis. In practice, though, it’s hard to see the fairness of giving back money you were entitled to receive. Two statutory amendments that will take effect in late February of 2020 have the potential to put a damper on some preference claims.

THOU SHALT VET ALL PREFERENCE CLAIMS BEFORE FILING SUIT

The first Bankruptcy Code amendment places an express duty on bankruptcy trustees and debtors to conduct a preliminary analysis of the merits of a preference claim before filing suit. Under the new law, a preference claim should be pursued only after doing “reasonable due diligence in the circumstances of the case and taking into account a party's known or reasonably knowable affirmative defenses.”

In theory, the change merely codifies current practice. But for those debtors or trustees who have taken a shotgun approach to asserting preference claims, the change mandates investing time to analyze potential preference claims proportionate to the costs and  benefits to the bankruptcy estate, and discourages pursuing claims when defenses are apparent. For example, a trustee might see that the debtor paid a $50,000 invoice two months prior to filing the bankruptcy petition. If a quick review of records available to the trustee would show that the debtor’s payment was in exchange for goods the creditor delivered to the debtor on the same day payment was made, or that the creditor receiving the payment had a long-standing lien on a piece of the debtor’s equipment worth $100,000, then it wouldn’t be judicious to assert a preference claim.

Introducing an express duty on trustees and debtors to vet preference claims should tip the scales against filing some lawsuits. However, the more predictable consequence is likely to be legal disputes over whether a trustee or debtor in a particular case satisfied the duty to conduct “reasonable due diligence in the circumstances of the case,” whether an affirmative defense was “reasonably knowable,” and whether appropriate consideration was given to such a defense before filing suit. The amendments do not establish any remedy for a trustee or debtor’s violation of the new statutory duty, so disputes over the duty may do nothing more than waste time and resources.

IF YOUR PREFERENCE CLAIM IS UNDER $25,000, YOU’LL FIGHT ON MY TURF

The second Bankruptcy Code amendment that will impact preference claims early next year relates to where a bankruptcy trustee or debtor can file suit for claims to recover preferential payments of business debts under $25,000. Under current law, relatively small claims under $10,000 can be filed only in the federal district court for the district in which the creditor resides. If the creditor resides in a district other than where the bankruptcy case is pending, this venue statute renders it more expensive for a trustee or debtor to file small preference lawsuits, which can mean such lawsuits never get filed. Under the new law, trustees and debtors will need to go to the creditor’s home court to file preference lawsuits seeking under $25,000. This change will discourage the pursuit of many small preference claims.

TAKEAWAY

These two statutory changes impacting preference lawsuits are minor creditor-friendly tweaks that will not drastically reduce the number of lawsuits filed. Given popular distaste for such claims, though, any sweetner makes the bitter pill slightly easier to swallow. 

Lisa Sumner, a Member based in Nexsen Pruet's Raleigh office, is a commercial litigator focusing her practice in the areas of bankruptcy & creditors' rights. She is experienced in representing creditors in a variety of cases, including claims of lender liability, fraudulent transfers and breach of fiduciary duty, as well as in the filing of involuntary bankruptcy petitions.