Delaware Bankruptcy Court Rules that Preference Plaintiffs Must Satisfy Due Diligence Requirement When Bringing a Preference Lawsuit

In 2019, a due diligence requirement was added to the Bankruptcy Code's preference avoidance provision. There is often outcry by preference action defendants that demands are made and lawsuits are initiated to recover allegedly preferential payments without taking into account valid defenses a party may have to such claims. The due diligence requirement was presumably added to the Bankruptcy Code in order to address these issues. However, due to a lack of clarity in the statute about whether a preference plaintiff has the burden to satisfy the due diligence requirement as an element of a preference claim, courts have been left to consider the issue, and the results have been mixed.

As discussed below, in a recent case, In re Pinktoe Tarantula Ltd., the U.S. Bankruptcy Court for the District of Delaware ruled 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. The defendant does not have the burden to prove that the due diligence requirement wasn’t satisfied as an affirmative defense.

What is a Preference Action?

Section 547 of the Bankruptcy Code allows a debtor or bankruptcy trustee, subject to certain defenses, to recover payments made to creditors within 90 days of the filing of the petition. The look-back period for payments is increased to one year for “insiders.” The policy behind preference actions is that they prevent aggressive collection action against a debtor that might force a debtor into bankruptcy, and they also help ensure equal treatment of creditor claims.

The 2019 amendments to the Bankruptcy Code added the due diligence requirement that a preference action must be brought "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)]."

The Court’s Ruling in In re Pinktoe Tarantula Ltd.

In this case, the court ruled in favor of the defendant, and dismissed the preference complaint. The court reasoned that because the due diligence requirement appears in section 547(b) of the Bankruptcy Code, which sets forth the elements of a preference claim, and not in section 547(c), which sets forth affirmative defenses, then the due diligence requirement must be addressed in a preference plaintiff’s complaint—which it was not in this case. According to the court, "[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 [plaintiff]."

Since this was a bankruptcy court ruling, and not a court of appeals ruling, other courts are not bound by this decision. But the court’s analysis on this issue may prove influential, and at a minimum it’s helpful guidance for both preference plaintiffs and defendants moving forward.