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October 06, 2015 Articles

ABI Commission Issues Recommendations on Preference Laws

Read about Chapter 11 reforms in the new report.

By Daniel J. DeFranceschi

After three years of work by numerous bankruptcy professionals, the Commission to Study the Reform of Chapter 11 of the American Bankruptcy Institute (ABI) issued its Final Report and Recommendations (cited below as the ABI Report). The report provides a valuable and comprehensive framework for the discussion of Chapter 11 bankruptcy reform that some believe is needed to keep pace with the changing dynamics of modern Chapter 11 practice. The commission’s goal in producing the report was to “study and propose reforms to Chapter 11 and related statutory provisions that will better balance the goals of effectuating the effective reorganization of business debtors—with the attendant preservation and expansion of jobs—and the maximization and realization of asset values for all creditors and stakeholders.” ABI Report, supra, at 3. According to the commission, this study was undertaken “[i]n light of the expansion of the use of secured credit, the growth of distressed-debt markets and other externalities that have affected the effectiveness of the current Bankruptcy Code.” Id.

The proposed reforms related to preference litigation are of particular relevance to bankruptcy litigators. The underlying rationale for preference claims is well known and understood as providing for more equitable distributions and maximizing estate values. The power of the trustee to “pursue preference claims under section 547 of the Bankruptcy Code preserves value for the estate and tempers the ‘run on the debtor’ that may occur immediately prior to a bankruptcy filing.” ABI Report, supra,at 148. But those exposed to preference litigation also understand that the preference laws may be misused. At the very least, there is a perception among preference defendants and others of such misuse of the current preference laws. According to the report, there is “strong frustration” with current preference law. Id. at 150. At hearings before the commission, there was testimony “that some trustees pursued preference actions with little diligence and without regard to the merits of the underlying claim.” Id. Further, it was suggested that “some trustees appear to file preference actions not necessarily to recover the alleged preference, but to extract a settlement payment.” Id. The commission considered several approaches to the perceived abuses to the preference law and ultimately decided on the following recommendations.

The first recommendation is to amend the Bankruptcy Code to preclude the trustee from issuing a demand letter or filing a preference complaint unless the trustee has taken certain steps designed to ensure that a valid preference action is being pursued. Thus, the commission recommended that such a demand or a complaint should not be issued unless, “based on reasonable due diligence, the trustee believes in good faith that a plausible claim for relief exists against such party under section 547, taking into account the party’s known or reasonably knowable affirmative defenses under section 547(c).” Id. at 148. While some trustees may already take such measures before bringing a preference action, that practice is not the norm. With increased pressures on trustees to recover as much as possible from preference actions—sometimes at the urging of a post-petition secured creditor who was granted a lien on preference claims and recoveries and sometimes because the only distribution for general unsecured creditors may be from preference recoveries—the slippery slope of trustees bringing as many preference claims as possible has developed. While such an approach may well cast a net of recovery around many preference defendants who should be sued, it often traps pre-petition transferees who have solid defenses and probably should not have been sued in the first place.

Explicitly requiring the trustee to satisfy these standards also addresses the reality that many preference defendants do not have the resources to mount an effective defense against such claims through trial, particularly where the amount in issue would not warrant incurring the costs attendant to protracted litigation. In this regard, one could argue that the Federal Rules of Bankruptcy Procedure already provide a basis to stop trustees from filing implausible preference claims. Rule 9011 provides that presenting a preference complaint to the court comes with a certification that, to the best of the presenting person’s “knowledge, information, and belief, formed after an inquiry reasonable under the circumstances,” such complaint “is not being presented for any improper purpose” and the claims have evidentiary support. Fed. R. Bankr. P. 9011(b). Sanctions are available against offending parties. Fed. R. Bankr. P. 9011(c). Of course, the use of Rule 9011 requires motion practice, which costs money that many preference defendants do not want to spend on preference litigation. For that reason, amending the preference laws to impose the proposed affirmative obligations on the trustee before bringing a preference demand or complaint may address a serious perceived problem with the current preference laws, particularly if the standard is clear and doesn’t lead to additional satellite litigation over the trustee’s compliance.

The commission proposes bringing the preference pleading requirements into alignment with recent United States Supreme Court precedent. Thus, the commission recommends that the preference laws be amended to require that the “trustee must plead with particularity factual allegations in the complaint that establish a plausible claim for relief under section 547.” ABI Report, supra, at 148. Mere “legal conclusions or speculative allegations should not be sufficient to support a preference complaint.” Id. This recommendation is in accord with current federal pleading standards under Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007), and Ashcroft v. Iqbal, 556 U.S. 662 (2009). In Twombly, an antitrust case, the Supreme Court held that the plaintiff had failed to allege facts necessary to support a claim of horizontal conspiracy among telecom providers, but in so doing, the Supreme Court did away with the relaxed interpretation of the pleading standard under the Federal Rules of Civil Procedure that derived from prior Supreme Court precedent that “a complaint should not be dismissed for failure to state a claim unless it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief.” Conley v. Gibson, 355 U.S. 41, 45–46 (1957). In Twombly, the Court held that Federal Rule of Civil Procedure 8 required sufficient factual content in the complaint to “plausibly suggest” a violation of antitrust law. In Ashcroft, the Supreme Court extended the plausibility standard to all federal court complaints and not just antitrust actions.

The next proposed reform to the preference laws recommended by the commission would increase the dollar amount for the defense against preference claims provided by section 547(c)(9) of the Code to $25,000 in the aggregate. Under current law, section 547(c)(9) provides that a trustee may not avoid under section 547 a transfer “if, in a case filed by a debtor whose debts are not primarily consumer debts, the aggregate value of all property that constitutes or is affected by such transfer is less than $6,225.” The commission further recommends that the proposed amount continue to be increased in the future based on the Consumer Price Index for All Urban Consumers under section 104(a) of the Code. Increasing the defense limit to $25,000 would certainly be a welcome change for many vendors who currently would be subject to potential preference exposure on relatively small amounts, the defense of which often requires disproportionate litigation defense costs.

Finally, the commission recommends that the general small claims venue provision found in 28 U.S.C. § 1409(b) “should be amended to (i) clarify that the section applies to preference actions under section 547 and (ii) increase the dollar limit for debts (excluding consumer debts) against noninsiders to $50,000 in the aggregate.” ABI Report, supra, at 148. Under current law, section 1409(b) provides that the trustee may commence a proceeding arising in or related to a case under Title 11 to “recover a money judgment of or property worth less than $1,250 or a consumer debt of less than $18,675, or a debt (excluding a consumer debt) against a noninsider of less than $12,475, only in the district court for the district in which the defendant resides.” 28 U.S.C. § 1409(b). Many Chapter 11 debtors are companies with creditors located throughout the country. When such a debtor commences a Chapter 11 case, no matter where that venue may be, some creditors will be located at a great distance from the bankruptcy court, where a preference case would typically be commenced. With the proposed changes, smaller preference cases would be brought by the trustee in districts where the preference defendant resides, thus eliminating any claims of burden or unfairness associated with litigating such cases at a distant courthouse.

The commission considered other possible changes to the preference laws but ultimately concluded that the proposed “changes collectively would mitigate many of the perceived or actual abuses in the preference process.” ABI Report, supra,at 151. The report contains many recommendations on numerous other topics relevant to the Chapter 11 process. Whether the proposed recommendations contained in the report will find their way into new laws passed by Congress remains to be seen. In the meantime, a review of the commission’s report by bankruptcy practitioners is a worthwhile exercise, as it serves as a comprehensive analysis of many of the current issues facing Chapter 11 practitioners.

Keywords: bankruptcy and insolvency litigation, preference, bankruptcy reform, plausible

Daniel J. DeFranceschi – October 6, 2015