Small Business Reorganization Act Will Bring Changes to Preference Litigation

The Small Business Reorganization Act of 2019 (the “Act”) will go into effect on February 19, 2020. Most of the attention given to the new law deservedly addresses the impact of those provisions that are intended to streamline the bankruptcy process for “small business debtors” that might not otherwise have the financial resources to reorganize under Chapter 11. Recognizing that a Chapter 11 proceeding has become very expensive, lawmakers have offered small business owners (generally persons or entities engaged in commercial activities and having aggregate debts not exceeding $2,725,625) an opportunity to reorganize under a new Subchapter V of Chapter 11. These provisions reduce the likelihood that an unsecured creditors’ committee will be appointed, lighten reporting requirements, and provide for guidance of a “small business trustee,” among other things. Although critically important, these changes will not have any effect on middle-market and large corporate bankruptcies. Much less attention has been paid to a provision in the Act that is applicable in bankruptcy cases of all sizes and could prove to be of material benefit to a debtor’s vendors.

The Act amends Section 547 of the Bankruptcy Code which governs “preferences” – certain transfers of interests in the debtor’s property made within 90-days of the petition date (or one year in the case of a transfer to an insider). To the extent that such a transfer is made to or for the benefit of a creditor during the applicable period, for or on account of antecedent debt, and while the debtor was insolvent, a debtor-in-possession or trustee, as applicable, may avoid such transfer for the benefit of the estate, subject to certain affirmative defenses. These statutory defenses under Section 547(c) of the Bankruptcy Code arise, generally, where (i) the transfer was made in the ordinary course of business or financial affairs between the parties, and (ii) the transfer was in connection with a contemporaneous exchange for new value, among others. Notwithstanding these and other expansive affirmative defenses that cover many prepetition transfers, it has become common practice for a debtor-in-possession or trustee to commence or threaten preference litigation against the recipients of all material transfers during the 90-days prior to the petition date. Of course, in many instances, such litigation is necessary to recover transfers that are properly voidable under the Bankruptcy Code for the benefit of the estate. In many others, however, actions are commenced for purposes of advancing bargaining leverage in settlement discussions – whether or not the transfer is reasonably likely subject to an affirmative defense. For an estate fiduciary, commencing actions against all material transferees during the applicable period, regardless of likely defenses, may be a good commercial decision. The burden to a transferee with well-founded defenses, however, is likely extensive. In order to establish its affirmative defense, a transferee must retain counsel, collect and produce evidence, and attend hearings, often in far off jurisdictions, among other things. To avoid the considerable cost and expense, transferees often choose to settle rather than litigate, returning funds that it is otherwise entitled to retain. The Act seeks to limit nuisance litigation by requiring a greater level of diligence before an action is brought. An amendment to Section 547(b) of the Bankruptcy Code will now require that a preference action be “based on reasonable due diligence in the circumstances of the case and taking into account a party’s known or reasonably knowable affirmative defenses…” Of course, time is needed before we get clarity on what efforts will constitute “reasonable due diligence” and what actions must be taken to ascertain a transferee’s “known or reasonably knowable” defenses. Courts will provide guidance on a plaintiff’s duty to conduct an analysis of the pre-petition payment history between the debtor and the creditor before bringing suit. They will further offer insight on the obligation of a plaintiff to solicit a transferee of it’s anticipated defenses in advance of an avoidance action. While we wait for this guidance, we are nonetheless confident that the Act implements new hurdles that will have a material, limiting effect on preference actions commenced solely to evoke a settlement.

Another amendment in the Act will make it slightly more difficult (and expensive) for a debtor-in-possession or a trustee to bring certain nominal preference claims (and other debt collection actions). Section 1409 of Title 18 requires that debt collection actions below a threshold amount must be commenced in the district court where the defendant resides. The Act raises this threshold amount from $13,650 to $25,000. As a result, if the recipient of a preference (in an amount less than $25,000) resides in a district that is different than that in which the case is filed, a debtor-in-possession or trustee will need to consider the additional cost and expense of litigating in a different district before commencing an avoidance action.

The bill was enacted into law after being signed by the President on August 23, 2019.