A fundamental responsibility of a credit executive
is to assess a debtor�s credit risk; and, based on the risk assessment,
a credit executive determines appropriate credit terms. Should that
customer file bankruptcy, the established credit terms, and whether
the debtor honored those terms, are central issues as to whether
you may prevail with an ordinary course of business defense.
Equally important, yet sometimes overlooked by creditors,
is the burden to establish the payment history in the industry, not
just the trade relationship between you and the debtor. The so-called
industry standard prong of the ordinary course of business defense,
or objective test, requires that you as the creditor show the industry
payment history.
What evidence must you produce to establish the objective
standard; and, how may an industry report assist you in establishing
this prong of the defense? A bankruptcy court1 recently
considered the objective standard of the ordinary course of business
and the kind of evidence a creditor must present to carry its burden
with the objective standard of the ordinary course of business defense.
An overview of the preference laws, as follows, is considered as
well as the court�s decision.
A. The Bankruptcy Preference Law
The Bankruptcy Code vests the debtor (or trustee if
one is appointed) with farreaching powers to avoid payments 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, a debtor is deterred from preferring certain creditors by
requiring that a creditor who 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.
B. Beating the Preference Lawsuit: The Ordinary Course
of Business Defense
Not all transfers made within the preference period
may be recaptured. To protect those transactions that 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 preference exception by a creditor
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 three-fold:
-
Protect customary transactions;
-
Encourage creditors to continue to extend credit to financially
troubled debtors, possibly helping the debtor avoid bankruptcy;
and
- Discourage unusual collection practices during the debtor�s
financial demise. Pursuant to section 547(c)(2), the Bankruptcy
Code provides that a transfer may not be avoided if the transfer
was in payment of a debt incurred in the ordinary course of business.
1. The Subjective Inquiry: Payments Must Be In The Ordinary Course
Of Business Between The Debtor And The Creditor
Courts often employ a �baseline of dealings� test to determine whether
the transfer was made in the ordinary course of the business or financial
affairs of the debtor and creditor. The baseline of dealings compares
two time periods to determine the course of dealings between the
debtor and creditor.
The first time period is the course of dealings prior to the 90-day
preference period (�pre -insolvency period�). The second time period
is the preference period that includes the date of the bankruptcy
filing through the 90th day after the date of the bankruptcy petition.
If the course of dealings between the two periods is consistent,
then the payments satisfy the subjective prong of the defense. However,
if the course of dealing between the two periods is not consistent,
then the payment is not made in the ordinary course of business and
may be recovered as a preference.
In addition to the baseline of dealings test, courts review the �ordinariness� of
the transfer between the debtor and creditor in relation to past
practices. Issues that are considered include:
a. The length of time that the parties were engaged in the transaction
at issue;
b. Whether the amount or form of the payment differed from past
practices;
c. Whether the debtor or creditor engaged in any unusual collection
or payment activity; and
d. Whether the creditor took advantage of the debtor�s deteriorating
financial condition. If any of these factors are present, then
a court may find that the transfer does not qualify for an ordinary
course of business defense.
2. The Objective Inquiry: Payments Must Be In The Ordinary Course
Of Industry
The third element requires the vendor to show, by a preponderance
of evidence, that the transaction occurred according to �ordinary
business terms� for the industry. This is often referred to as the
objective test and is the majority approach in evaluating the ordinary
course of business defense. This is the prong that the Smith Road
court considered.
Ordinary business terms for the industry are generally defined as
the range of terms that encompass the practices in which businesses
similar in some way to the creditor in question engage; and, that
only dealings so unusual as to fall outside that range should be
considered extraordinary and outside the scope of the industry. In
addition, the Smith Road court considered the length of the parties� trade
relationship. In the Smith Road case, the court observed that the
vendor (creditor) is required to prove that the preferential transfers
were objectively ordinary in relation to industry standards. Examining
the industry standard requires:
-
�An identification of the relevant industry; and,
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An objective examination of its standards and practices to determine
if this transfer is within the outer boundaries of the industry.� 2 The
Smith Road court noted that the creditor�s industry is the controlling
industry under the objective standard.
- Although the industry standard does not require a creditor to
establish the existence of a uniform set of business terms, it
does require evidence of a prevailing practice among similarly
situated members of the industry facing the same or similar problems.
To establish the industry standard, the creditor must usually rely
on evidence that is external to the debtor and creditor. Generally,
reliance on the testimony of the creditor attesting to the industry
standard may be ineffective as it blurs the distinction between
the objective and subjective elements to the ordinary course of
business exception.
How may an industry report assist the vendor with meeting the objective
prong of the ordinary course of business defense?
The Objective Inquiry and Industry Reports
The objective test requires that you, as the creditor, establish
industry standards through empirical evidence generally in the form
of industry payment history compiled by an independent, authoritative
source. Data, such as that supplied by The Credit Research Foundation
in the quarterly report, �National Summary of Domestic Trade Receivables� sets
forth an index, by industry, based on information assembled from
creditors. The data, which indexes six key metrics such as: Collection
Effectiveness, Days Sales Outstanding, Best Possible DSO, Average
Days Delinquent, Percent of Current AR and Delinquent AR over 91
Days Past Due, provides a valuable tool in establishing the criteria
to meet the objective test to the �ordinary course� in a preference
defense. The objective test, previously discussed, can be built based
on a practical examination of the Best Possible Days Sales Outstanding
index. A correlation can be made between BPDSO and terms based on
the theory that BPDSO is calculated without the influence of past
due receivables. Therefore, since there is no delinquency in the
BPDSO figure, hypothetically all customers are paying according to
terms. Consequently, examination of the BPDSO for any given industry
will show a strong parallel to that industry�s aggregated standard
business terms.
An analysis of each quarter for the last 23 years illustrates that,
across all industries, the median Best Possible DSO is 31.7 days
and the average is 31.8 days. Arguably, the most common standard
term across all industries is 30 days; therefore supporting the theory
that the BPDSO for any given industry correlates to the standard
industry terms.
Further utilizing the CRF data to support a specific industry, we
can illustrate an example from the 1st quarter 2004 report for the
apparel industry. The median BPDSO for that industry in the quarter
January through March 2004 was 37.8 days. The upper quartile was
45.1 and the lower was 27.7 days. Using this data to establish a �standard� for
a creditor in the apparel industry, it could be said that ordinary
business terms range from 28 days to 45 days in the apparel industry.
The Smith Road Decision
In Smith Road, a creditor provided product to a debtor in the bedding
manufacturing industry. The creditor established 10- day terms. The
debtor filed Chapter 11 and brought a preference action to recover
payments made to the creditor during the preference period. The creditor
contended that the payments qualified as an ordinary course of business
defense. The debtor moved for summary judgment.
In considering whether the creditor had an ordinary course of business
defense, the court considered the objective prong of the standard.
The court observed that the industry norm of the debtor�s industry,
bedding manufacturing, was payment 45-50 days from the invoice date
based on the creditor�s expert�s report. The creditor had put the
debtor on terms of 10 days three years prior to the bankruptcy filing.
The debtor contended that as the creditor�s 10 day terms vary from
the industry norm of 30 days, the creditor did not have an ordinary
course of business defense. The court observed that a sliding scale
standard applies to the objective rule:
"The more cemented the preinsolvency relationship between debtor
and the creditor, the more the creditor will be allowed to vary its
credit terms from the industry norm yet remain in the safe harbor
of Section 547(c)(2). The likelihood of unfair overreaching 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. After all, if at the starting point
of the relationship insolvency was a distant prospect, a trade creditor
does not unfairly overreach, impel insolvency, or inequitably advantage
itself at other creditors' expense by tolerating more generous or
commanding more stringent repayment schedules than its competitors."3
Even though the court held that issues existed as to whether the
debtor�s long relationship with the creditor, during which time the
creditor, for three years prior to petition date had required the
debtor to pay the creditor�s invoices within 10 days of invoice date,
was sufficient to permit the creditor to insist on payment within
10 days and still meet the objective standard, the debtor�s motion
for summary judgment was denied.
C. 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 is instructive
for a credit professional of the importance of supporting the objective
prong of the ordinary course of business defense with independent
evidence, such as the Credit Research Foundation�s NSDTR or other
industry data.
The court made a special point that the more established the trade
relationship between the parties, the more that a creditor will be
permitted to deviate from the industry standard and still qualify
for the ordinary course of business exception. However, it is the
creditor�s burden to establish the industry payment standard. For
the vendor to meet its burden with the objective standard, consider
using an industry report to establish the common terms used by other
trade creditors in the same industry facing similar problems.
Executive Summary
-
Creditors often receive a demand on behalf of a bankruptcy
estate (from either a trustee, debtor in possession,
or the creditor�s committee attorney) to repay to the
bankruptcy estate payments the creditor received from
its customer within 90 days of the customer filing bankruptcy.
-
The receipt of a preferential payment is not illegal.
A debtor has a right to pay whichever creditor it may
choose at whatever time it chooses. However, one of the
primary objectives of the Bankruptcy Code is to ensure
that all creditors of a class are treated alike. One
of the ways that the Bankruptcy Code attempts to accomplish
this objective is to recover from the creditor those
payments that meet the statutory definition of a preference.
The trustee can file suit to obtain a judgment against
the creditor for the amount of the alleged preferential
payment(s).
-
The Bankruptcy Code provides for several defenses that
may protect the creditor from returning the alleged preference.
Pursuant to section 547(c) (2) of the Bankruptcy Code,
a transfer may not be recaptured if the transfer was
in payment of a debt incurred in the ordinary course
of business. The ordinary course of business defense
adheres to bankruptcy�s general policy to discourage
unusual collection practices during the debtor�s financial
demise.
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1 In re Smith Road
Furniture, Inc., 304 B.R. 793 (Bankr. S.D. Ohio 2003)
2 Smith Road, 304 B.R. at 796
3 Smith Road, 304 B.R. at 797
Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley
LLP Fall 04 |