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