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Safe Harbor and Bankruptcy Preferences

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By Shirley Chen
Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley LLP

A long-standing busines's relationship may allow a creditor to depart from the industry norm and still qualify for the ordinary course of business exception. However, instability in the relationship leading up to the debtor’s insolvency will prevent the creditor from invoking this safe harbor, as demonstrated in In re Terry Manufacturing Company, Inc. v. Bonifay Manufacturing, Inc.

In Terry, the trustee brought an adversary proceeding to set aside debtor’s preferential payment to the supplier, a sewing contractor. The companies began their business relationship when the debtor hired the supplier to produce shirts. The supplier relied heavily on the debtor for its continued existence in the garment industry during the economic downturn in the mid-1990s. The debtor had a history of making its payments late. The time between the invoice and date of payment ranged from 98 days to 321 days. The supplier allowed payments so late because it depended on the debtor for business and their long-standing business relationship.

Few months before the debtor filed a voluntary Chapter 11 bankruptcy , the debtor sent the supplier a letter setting forth a payment schedule asking for weekly payments to get current with the supplier. The debtor made these weekly payments for two months. In the ninety days preceding the Chapter 11 filing, the debtor made six payments to the supplier. These payments were made from 138 to 182 days after the invoice date.

The trustee instituted the action against the supplier to avoid the six payments. The sole issue on appeal was whether the bankruptcy court gave appropriate weight to the long-standing business relationship between the debtor and the supplier in determining whether the six payments were made in the regular course of business as defined by 11 U.S.C.A. §547(c)(2). Under this provision, a trustee may not avoid a transfer as preferential if the transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee; made in the ordinary course of business or financial affairs of the transferee; and made according to ordinary business terms.

The supplier satisfied the first two elements. The debt arose in the ordinary course of business because the debtor incurred the debts in exchange for sewing work. The supplier’s decision to accept these six payments was in the ordinary course of business because the supplier regularly allowed the debtor to make payment substantially later than the invoice required.

However, as to the third element, the court adopted the three-step analysis set forth in Molded Acoustical Products in determining whether the transfer was made according to the ordinary business terms. First, the terms between the parties are compared to the range of terms on which firms similar to the supplier provide credit to firms similar to the debtor. Second, if the terms fall outside this industry norm, the court created a “customized window” which took into account the length of the business relationship prior to the debtor’s insolvency. Finally, the court determined whether the relationship remained stable throughout the insolvency period. A relationship is not stable if terms of payment during the preference period vary considerably from the terms throughout the longstanding relationship or if the creditor had made effort to accelerate repayment.

The median for outstanding invoices in the garment industry is 39 to 55 days. In this case, the six payments made by the debtor to the supplier were 138 to 182 days past the invoice date, more than three times later than the industry standard. The supplier’s departed from industry norm by more than 300% could be characterized as a gross departure.

Although there was a 18-year relationship between the debtor and the supplier, the relationship was not stable because there was no typical period of payment existed prior to or during the preference period. Payment were made from 98 days to 321 days after the invoice date prior to the preference period and 138 to 162 days after the invoice date during the preference period. The lack of typicality of paymentswas sufficient to show that the relationship was unstable.

Even if the relationship had been stable, the relationship deteriorated when the supplier attempted to place the debtor on a payment schedule. The required weekly payments were differed from prior practice because the payments were not related to any particular invoices. Placing a debtor on a payment plan indicated a deteriorating creditor-debtor relationship.

Because the relationship between the supplier and the debtor lacked stability due to inconsistent payment terms and an attempt to put the debtor on a payment plan, the six payments made during the preference period were not according to ordinary business terms. Although forbearing creditors of long standing often keep debtors out of bankruptcy, such longstanding business relationship does not always provide a safe harbor to the creditors.

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