Delaware Decision Clarifies New “Due Diligence” Requirement for Preferences

By Sam Ashuraey (July 12, 2023)

Introduction to Delaware Bankruptcy Court’s Recent Ruling

In a recent decision, the Delaware Bankruptcy Court clarified an important aspect of how the trustee can satisfy the pleading standard for the new “due diligence” requirement in section 547 of the Bankruptcy Code.  The court in Pinktoe Trantula[1] ruled that this new Section 547 requirement is a condition precedent element of bankruptcy preference actions and that a simple statement that the trustee has complied with it satisfies the pleading standard.

This decision is the latest in a series of decisions that have been confronted with the question of whether the new language constitutes a new element of preference actions, though most have declined to rule on the issue.  While this case adds important case law on the pleading standard to satisfy the new requirement, the amount of diligence the trustee must perform or how it must take into account affirmative defenses to comply with the provision is yet to be tested.

Section 547 Due Diligence Amendment and Relevant Background

As part of the Small Business and Reorganization Act (the “SBRA”),[2] the italicized language below was added to the lead-in of section 547(b) of the Bankruptcy Code:

Except as provided in subsections (c) and (i) 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]

The legislative history does not clarify why the new language was added.  As Collier notes, the apparent purpose of the language was to curb the practice of “preference mills” by contingency-fee-based law firms that “file preference actions against all the recipients [who received payments in the 90 days before the bankruptcy filing] without undertaking any investigation of the merits of the causes of action.”[4]  Despite being part of the SBRA, the language does not appear to be targeted specifically to address small businesses issues, though arguably small businesses benefit relatively more from not having to spend the costs defending or settling poorly-prepared preference actions.

How Courts Have Interpreted Due Diligence in Preference Actions

Several courts have ruled on motions to dismiss complaints for failure to properly allege due diligence under Section 547, and have weighed in on whether the new due diligence requirement constitutes an element or an affirmative defense.  In ECS,[5]the court concluded that the due diligence requirement is an element of a prima facie preference action, rather than an affirmative defense.

The court arrived at this conclusion based on the following: (i) 547(b), which contains the due diligence requirement and the traditional elements of a preference action, is the “source of the trustee’s substantive rights”, (ii) section 547 places the burden of proving all elements”in 547(b) on the trustee and the burden of proving the  affirmative defenses in 547(c) on the defendant, and (iii) the treatment of the due diligence requirement as an element is consistent with congressional intent.

As a result, the court held that that the trustee was required to allege this element, i.e., that she had performed due diligence and considered the affirmative defenses.  The court held that the general nature of her pleadings, which “did not expressly recite the efforts she undertook”[6] to satisfy this element, did not properly allege due diligence.  Accordingly, the court granted the defendants’ motion to dismiss but granted the trustee leave to amend.

A subsequent decision, Insys,[7] briefly addressed the issue presented in ECS.  The court found that it did not need to rule on whether due diligence and consideration of affirmative defenses was an element of a preference claim because in the case before it, unlike in ECS, the trustee had plead sufficient facts to satisfy the requirement.

The court pointed out that the complaint stated that the trustee had undertaken a review of the debtor’s books and records, requested affirmative defenses from the defendant and considered those defenses to the extent presented.  The court further noted that the plaintiff is not required to “plead around potential affirmative defenses.”[8]   Accordingly, the court denied the motion to dismiss.

Other courts similarly acknowledged the question of whether the new due diligence requirement is an element, but did not decide it because they found the complaints sufficiently alleged facts to satisfy the due diligence requirement even if it was an element.  In Sommers, the court held that the trustee’s assertion that it reviewed books and records, invoices related to the transfer at issue, correspondence, and the contract governing the transfer, was sufficient.[9]

In Flywheel Sports, the court found the pleading was sufficient because the trustee pled that she had reviewed books and records and other available information. [10]  In Weinman v. Garton, the plaintiff detailed the investigation it undertook, including review of books and records, bank statements and interviews with the debtor’s representative and its counsel, which the court found met the requirements of section 547(b).[11]

Case Focus: The Pinktoe Tarantula Decision

In Pinktoe Tarantula, a liquidating trustee filed a complaint against a former director alleging breach of fiduciary duty and seeking to avoid certain preferential transfers.

In response, the defendant argued that due diligence and considering affirmative defenses constitute an element of a preference action, and the complaint should be dismissed because of the trustee’s failure to explicitly make these allegations.  The plaintiff argued that the due diligence requirement was an affirmative defense that it was not required to plead around.

The court agreed with the defendant and concluded that the due diligence requirement was an element.  In reaching this conclusion, the court reasoned that the Code specifies that a plaintiff has the burden of proving section 547(b) (which includes the traditional elements of a preference action), and that defendant has the burden of proving affirmative defenses under 547(c).  Because the due diligence requirement is part of section 547(b), the court concluded that it is “an element of a claim, or something that must be proven by the trustee.”[12]

The court also found that the due diligence requirement was condition precedent, which falls outside the Iqbal and Twombly pleading standard that requires the pleading to “be more than a formulaic recitation of the elements [and] the factual allegations must be enough to raise a right to relief above the speculative level.”[13]   Rather, as a condition precedent, the trustee need only provide a general allegation that the condition precedent has occurred.  Accordingly, since the trustee did not make the allegation, the court dismissed the complaint with leave to amend.

The Significance and Future Implications of the Due Diligence Ruling

The Pinktoe Tarantula decision provides additional clarity on the pleading standard for the due diligence element.  However, this case and previous cases on the topic do not address when the trustee’s due diligence is so deficient that it could serve as a defense.  Theoretically, even if a trustee could satisfy the relatively low pleading threshold, a defendant could still defeat the preference action by demonstrating that the due diligence was not “reasonable” or that the trustee did not take into account a “reasonably knowable affirmative defense.”[14]

In practice, one situation in which the new due diligence requirement will provide defendants with a possible new defense is where the trustee’s due diligence should have uncovered that an element is missing, but that element only applies to part of the transfer.  In a situation where, for example, only a part of the transfer did not consist of the debtor’s interest in property – a necessary element of a presence claim – a defendant could argue the entire preference action is defeated.

However, in most situations, if a defendant can show that the trustee did not perform reasonable due diligence it would be because an element of a preference action is clearly missing or there is a cut-and-dry affirmative defense the trustee overlooked.  In those cases, the underlying arguments would have been available to defeat the action anyway.  Accordingly, and especially given the relatively forgiving approach courts have taken in enforcing the due diligence requirement, it will likely continue to have minimal impact on the post-pleading preference world.

[1] In re Pinktoe Tarantula Ltd., 2023 WL 2960894 (Bankr. D. Del. Apr. 14, 2023).

[2] The main change introduced by the SBRA is the enactment of subchapter V of chapter 11 of the Bankruptcy Code.

[3] This preamble is followed by a list of the elements of a voidable preferential transfer, which, in the case of a non-insider, can be simplified as follows: (1) a transfer (2) of the debtor’s interest in property (3) to or for the benefit of a creditor (4) for or on account of an antecedent debt (5) made in the 90 days before the petition date (6) while the debtor was insolvent (presumed to be the case in the 90 days before the petition date), (7) which enabled the creditor to receive more than it would in a liquidation.  The following subsection – 547(c) – provides preference defendants with nine affirmative defenses.  In addition, subsection 547(g) states that the trustee has the burden of proving the avoidability of a transfer under section 547(b), and the defendant has the burden of proving the nonavoidability due to an affirmative defense under section 547(c).

[4] 5 Collier on Bankruptcy P 547.02A (16th 2023).

[5] Husted v. Taggart (In re ECS Ref., Inc.), 625 B.R. 425 (Bankr. E.D. Cal. 2020).

[6] Id. at 458.

[7] Insys Liquidation Trust v. Urquhart (In re Insys Therapeutics, Inc.), 2021 Bankr. LEXIS 2965 (Bankr. D. Del. Oct. 28, 2021).

[8] Id. at *10.

[9] Sommers v. Anixter, Inc. (In re Trailhead Eng’g LLC), Nos. 18-32414, 20-3094, 2020 Bankr. LEXIS 3547 (Bankr. S.D. Tex. Dec. 21, 2020).

[10] In re Flywheel Sports Parent, Inc., No. 20-12157 (JPM), 2023 WL 2245382, at *1 (Bankr. S.D.N.Y. Feb. 27, 2023).

[11] Weinman v. Garton (In re Matt Garton & Assocs., LLC), 2022 Bankr. LEXIS 633, *1 (Bankr. D. Colo. Feb. 14, 2022).

[12][12] Id. at *5.

[13] Id. at *4, quoting Bell Atl Corp. v. Twombly, 550 U.S. 544, 545 (internal quotations omitted).

[14] Garton at *32 (the plaintiff “may test [the allegations that the trustee did not perform reasonable due diligence] during the discovery process and may attempt to disprove the allegations at trial”).

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