As part of a bankruptcy case, a trustee (including a reorganized debtor or liquidating trustee) will make demands or commence actions to recover preferential payments made by a debtor to a creditor within 90 days of the debtor filing for bankruptcy1. Preference actions are intended to discourage debtors from “racing to the courthouse to dismember the debtor” during its slide into bankruptcy, and to “facilitate the prime bankruptcy policy of equality of distribution among the debtor’s creditors2.”
Preference actions are a typical and customary way for a debtor’s bankruptcy estate to recover much needed and critical money because the action largely focuses on the timing of the payment received by the creditor3. While a trustee must consider any “reasonably knowable affirmative defenses” that a creditor can raise before filing a preference action, the action itself does not consider a creditor’s good faith or knowledge of the debtor’s financial condition4. A trustee will almost always file a preference action where the bankruptcy case is pending, rather than where the creditor resides, so that the trustee can get “home court” advantage5. For example, a preference action against a Denver-based company may take place in the Northern District of Ohio if its trade partner filed for bankruptcy in Cleveland and received a payment from the Denver company that qualifies as a preference.
Creditors expend money defending a preference action, and should hire counsel to investigate and assert any number of affirmative defenses provided in the Bankruptcy Code6. Some defenses are easier to prove than others7, but the ultimate burden of proof lies with the creditor8. Litigating in another state only adds to the cost of defending a preference action, and this fact is not lost on trustees -- especially in small-dollar preferences actions, which typically range from $6,850 to $25,000. Creditors should not ignore these small-dollar preference demands. If a creditor ignores a preference demand, it may later find itself in a preference action; and if a creditor ignores a preference action, the court may enter default judgment against it.
What happens if our Colorado company receives a small-dollar preference demand from the trustee of the trade partner’s bankruptcy estate, or worse if the Colorado company is served with a complaint and that action is before the court in Ohio? The trustee seemingly holds all of the cards. The trustee knows the creditor is weighing whether it is even worth the cost of responding to the preference complaint at all, and that any action that is filed outside of Colorado is just another reason for the creditor to capitulate. Even if the parties work to settle a preference demand outside of litigation, the trustee has few incentives to make major concessions -- the trustee knows the creditor has already expended time and money responding to the demand, and thus less likely to expend additional resources in litigation.
The Bankruptcy Code provides some protections to creditors in these situations, such as setting a monetary floor on the amount recoverable as a preference9. However, even with these protections, creditors are often faced with the difficult choice of simply paying the preference (despite having credible defenses to the action) or hoping the settlement amount and defense costs are less than the preference demand. This choice is even more difficult when the litigation is pending in another jurisdiction.
Creditors often turn to 28 U.S.C. § 1409(b) to challenge the trustee’s ability to commence small-dollar preference actions filed outside of the creditor’s jurisdiction. On its face, section 1409(b) appears to require that all small-dollar preference actions be filed only in the district in which the defendant resides. If section 1409(b) applies to small-dollar preference actions, creditors can avoid having to first prove their affirmative defenses, and trustees would lose their “home court” advantage10. In other words, section 1409(b) would allow a creditor to level the playing field by shifting the cost of the action to the trustee.
Courts are split as to whether section 1409(b) applies to small-dollar preference actions. The issue underlying this split in authority generally boils down to whether the term “arising under” was intentionally omitted from the text of section 1409(b)11. A trustee’s ability to commence an action in the district where the underlying bankruptcy case is pending derives from section 1409(a), which applies to actions “arising under” the Bankruptcy Code and “arising in or related to” cases under the Bankruptcy Code12. However, under section 1409(b), a trustee must commence an action “arising in or related to [a] case to recover . . . a debt (excluding a consumer debt) against a noninsider of less than $25,000, only in the district court for the district in which the defendant resides13. Unlike section 1409(a), section 1409(b) applies only to actions “arising in or related to” a case under the Bankruptcy Code, and not to those “arising under” the Bankruptcy Code14. Courts do not dispute that preference actions are actions “arising under” the Bankruptcy Code15. The dispute concerns only whether Congress intentionally omitted “arising under” from section 1409(b).
Courts take different approaches to resolve this issue: some emphasize the statute’s text, whereas others examine the legislative history. Courts taking a textualist approach hold that section 1409(b) does not apply to preference actions16. Courts turning to the legislative history have found support for both sides of the argument17.
The Small Business Reorganization Act of 2019 (the “SBRA”) has injected new life into this nearly forty-year issue18. The SBRA amended section 1409(b) to increase the dollar threshold for non-consumer debts from $13,650 to $25,00019. However, it did not address the “arising under”/”arising in or related to” issue20. Courts addressing the 1409(b) issue for the first time may be increasingly persuaded that section 1409(b) does not include preference actions based on the fact that Congress knew of the split in authority and choose not to address it with the SBRA21.
Unless Congress addresses the 1409(b) issue, it is unlikely to be resolved in the remaining courts because creditors have little incentive to raise or effectively argue that section 1409(b) applies to preference actions. The 1409(b) issue is often put before a court on a motion to dismiss for improper venue. A trustee will be motivated to oppose any 1409(b) disputes for a variety of reasons. First, trustees are compensated upon recoveries achieved in preference actions, so anything that increases the amount of cost for a trustee will diminish the total recovery. Second, a trustee will not want to have bad laws created in a particular jurisdiction regarding the venue question, which may make recoveries in future preference actions more costly. On the other hand, a creditor with few connections to a jurisdiction has no incentive to spend significant dollars challenging the venue question as doing so may make a defense of the preference action uneconomical. Without a financial incentive to raise and effectively argue the 1409(b) issues, this issue is likely to remain unresolved.
Creditors are in a tough spot when defending against small-dollar preference actions. Although a trustee seemingly has the upper hand in these actions, a creditor can still put forth a strong response to a preference demand by highlighting the costs of litigating the 1409(b) issue and by focusing on the more objective defenses, such as the subsequent new value and de minimis transfer defenses under section 547(c)22. Defending against a preference action is more difficult, but the SBRA’s requirement that a trustee considers “a party’s known or reasonably knowable affirmative defenses” provides a creditor with some runway to reduce the preference amount without lengthy litigation23.
For any questions regarding preference actions or other bankruptcy matters, please connect with our Bankruptcy, Restructuring, and Creditors’ Rights team.
A version of this article was published in the Independent Report.
1 11 U.S.C. §§ 547(b), 550.
2 Frontier Farm Credit, PCA v. Norris (In re Norris), Ch. 7 Case No. 05-43551-7, Adv. No. 06-7005, 2007 Bankr. LEXIS 3628, at *7 (Bankr. D. Kan. Oct. 23, 2007) (citation omitted).
3 The elements of a preference consist of the following: (1) a transfer of the debtor’s property; (2) to or for the benefit of a creditor; (3) for or on account of an antecedent debt owed by the debtor before such transfer was made; (4) made while the debtor was insolvent; (5) made on or within ninety days before the date of filing of the bankruptcy petition (or one year if the creditor was an “insider” under 11 U.S.C. § 101(31)); and (6) which enables the favored creditor to receive more than he would have received (a) if the case were a liquidation case, (b) the transfer had not occurred, and (c) such creditor received payment of such debt to the extent provided under the Bankruptcy Code. 11 U.S.C. § 547(b).
4 Id. § 547(b).
5 28 U.S.C. § 1409(b); Webster v. Republic Nat’l Distrib. Co. (In re Tadich Grill of Wash. DC LLC), 598 B.R. 65, 68 (Bankr. D.D.C. 2019).
6 See, e.g., 11 U.S.C. § 547(c).
7 Compare id. § 547(c)(4) with id. § 547(c)(2).
8 See H & E Equip. v. Russell (In re Carlson), BAP No. WY-06-070, 2006 Bankr. LEXIS 2930, at *5 (B.A.P. 10th Cir. 2006).
9 11 U.S.C. § 547(c)(9).
10 See Muskin, Inc. v. Strippit, Inc. (In re Little Lake Indus.), 158 B.R. 478, 480 (B.A.P. 9th Cir. 1993).
22 DynAmerica Mfg., LLC v. Johnson Oil Co., LLC (In re DynAmerica Mfg., LLC), Ch. 11 Case No. 08-11515 (KG), Adv. No. 10-50759 (KG), 2010 Bankr. LEXIS 1384, at *4 (Bankr. D. Del. May 10, 2010). Some courts also examine whether the terms “arising under” and “arising in” are mutually exclusive or whether the terms overlap, such that if cases “arising under” are also cases “arising in,” then section 1409(b) applies to preference actions.
11 See, e.g., N1 Creditors’ Tr. v. Crown Packaging Corp. (In re Nukote Int’l, Inc.), 457 B.R. 668 (Bankr. M.D. Tenn. 2011).
12 28 U.S.C. § 1409(a).
13 Id. § 1409(b) (emphasis added). Section 1409(b) also requires suit in the district where the defendant resides where the trustee seeks to recover “a money judgment of or property worth less than $1,375 or a consumer debtor of less than $20,450.” Id.
14 Id.
15 See, e.g., Redmond v. Gulf City Body & Trailer Works, Inc. (In re Sunbridge Capital, Inc.), 454 B.R. 166, 169 (Bankr. D. Kan. 2011).
16 See, e.g., Bruton v. High Speed Capital, LLC (In re Cirino Constr. Co.), Ch. 7 Case No. 19-51037, Adv. No. 20-06077, 2020 Bankr. LEXIS 1357 (Bankr. M.D.N.C. May 22, 2020); Klein v. ODS Techs., LP (In re J& J Chem., Inc.), 596 B.R. 704 (Bankr. D. Idaho 2019); Redmond, 454 B.R. at 166; Schwab v. Peddinghaus Corp. (In re Excel Storage Prods., L.P.), 458 B.R. 175 (Bankr. M.D. Pa. 2011); Staffi v. Gilco World Wide Mkts. (In re Bamboo Abbott, Inc.), 458 B.R. 701 (Bankr. D.N.J. 2011).
17 For cases where section 1409(b) applies to preference actions, see, e.g., Nukote Int’l, 457 B.R. at 668; Schwab, 458 B.R. at 175; DynAmerica Mfg., 2010 Bankr. LEXIS 1384, at *1; Muskin, 158 B.R. at 478. For cases where section 1409(b) does not apply to preference actions, see, e.g., Webster, 598 B.R. at 65; Redmond, 454 B.R. at 166; Moyer v. Bank of Am. (In re Rosenberger), 400 B.R. 569 (Bankr. W.D. Mich. 2008); Van Huffel Tube Corp. v. A & G Indus. (In re Van Huffel Tube Corp.), 71 B.R. 155 (N.D. Ohio 1987).
18 See Bruton, 2020 Bankr. LEXIS 1357, at *1; In re Greiner, 45 B.R. 715 (Bankr. D.N.D. 1985).
19 28 U.S.C. § 1409(b).
20 Bruton, 2020 Bankr. LEXIS 1357, at *5.
21 See id.
22 11 U.S.C. § 547(c)(4), (9).
23 Id. § 547(b).