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By Bradley D. Blakeley Esq.
Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley LLP

Working with Your Long-Term Customer that is Financially Troubled May help you beat a Preference Action

You are brought in by management to assist with a problem delinquent open account. Your longtime customer, who is a source of significant business, has paid outside of invoice terms over the last several months. Credit purchases are critical for the debtor's cash flow. Management does not want to lose the customer, and agrees to continued open account sales. Your job is to ensure that the debtor pays close to invoice, yet continues to purchase product from your company. You negotiate each sale and vigilantly monitor shipments. You are successful. The debtor pays more promptly. However, the debtor is unable to compete and its business declines. The debtor files chapter 11 in hopes of rehabilitating its business, but the case is later converted to a chapter 7 liquidation. Two years later you receive a letter from the trustee demanding all payments received by the debtor 90 days before the bankruptcy filing. The trustee contends the payments were preferential.

A bankruptcy court recently considered whether a vendor must disgorge payments as a preference from a long-term customer. The court gave special deference to the vendor's ordinary course of business defense in light of the long-term trade relationship between the debtor and vendor, even though the debtor paid well outside of invoice and with post-dated checks. The court's ruling and its meaning to vendors is considered.

The Trade Relationship

The vendor owned radio stations, and the debtor had been a long term advertiser of the vendor's stations. Invoice terms were 30 days net. The debtor consistently paid its invoices between 90 and 120 days. The vendor's other customers usually paid between 60 and 90 days. The vendor and the debtor modified their trade terms wherein the vendor agreed to accept 90 day payment terms, in exchange for additional business. The debtor began post dating checks. The debtor filed chapter 7 liquidation. The bankruptcy trustee sued the vendor to recover payments within 90 days of the bankruptcy filing.

The Preference Action and the Ordinary Course of Business Defense

The Bankruptcy Code vests the debtor (or trustee if one is appointed) with far-reaching powers to avoid transfers of assets and monetary transactions prior to a bankruptcy filing. The power to avoid preferential transfers is one of the most powerful weapons a trustee has. The Bankruptcy Code defines a preference expansively to include nearly every transfer by an insolvent debtor 90 days prior to bankruptcy. The purpose of the preference provision is two-fold. First, unsecured creditors are discouraged from racing to the courthouse to dismember a debtor, thereby hastening its slide into bankruptcy. Second, debtors are deterred from preferring certain unsecured creditors by the requirement that any unsecured creditor that receives a greater payment than similarly situated unsecured creditors disgorge the payment so that like creditors receive an equal distribution of the debtor's assets.

Not all transfers made within the preference period are avoidable. To protect those transactions which replace value to the bankruptcy estate previously transferred, the Bankruptcy Code carves out seven exceptions or defenses to the trustee's recovery powers. The most commonly asserted exception by trade creditors is the ordinary course of business defense. That defense protects payments, in all or part, received by an unsecured creditor within 90 days of the bankruptcy from recovery where the creditor establishes certain elements detailed below. The policy supporting the ordinary course of business defense is two-fold: (1) protect customary transactions, and (2) encourage creditors to continue to extend credit to financially troubled debtors, possibly helping the debtor avoid bankruptcy.

To qualify for the ordinary course of business defense, a creditor must establish that the payment is ordinary as between the parties and that the payment is ordinary in relation to prevailing business standards. The court determines a debtor's ordinariness of payments through comparison with prevailing business standards, which includes common terms used by other trade creditors in the same industry facing similar problems.

The Flexible Ordinary Course of Business Standard

After remand, the court concluded that the relationship between debtor and vendor was long standing and established well before the debtor's slide into bankruptcy. The court held that the vendor was allowed some leeway from the industry standard, and that the timing and method of payment fell within the sliding scale window of industry standards. The court noted that only dealings so idiosyncratic as to fall outside that broad range should be deemed extraordinary. The court also noted that the the purpose of the exception is to leave undisturbed normal financing relations, because it does not detract from the general policy of the preference section to discourage unusual action by either the debtor or his creditors during the debtor's slide into bankruptcy. The court rewarded the vendor for the long-term trade relationship:

"[T]he more cemented, as measured by its duration, the pre-insolvency relationship between the debtor and the creditor, the more the creditor will be allowed to vary its credit terms from the industry norm yet remain within the safe harbor of section 547(c)(2). The likelihood of unfair over-reaching by a creditor, to the disadvantage of other creditors, is reduced if the parties sustained the same relationship for a substantial time frame prior to the debtor's insolvency."

Thus, the court looked at the history of the parties' relationship and credit terms to determine whether these were cemented prior to debtor's slide into bankruptcy.

The Lesson for the Credit Professional

The court's opinion underscores that a credit professional should mount a vigorous preference defense when a preference demand letter or preference complaint is received. The court's opinion provides encouragement for a credit professional that even if the debtor paid well outside of invoice and the debtor paid with post-dated checks during the preference period, even though the debtor had paid this way, the vendor may have an ordinary course of business defense. The court made a special point that the more established the trade relationship between the parties, the more that a vendor will be permitted to deviate from the industry standard and still qualify for the ordinary course of business exception.

2. In re Bee Furniture Co., Inc., 250 B.R. 757 (M.D. Fl. 2000).

Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley LLP Fall 01

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