United States: Debt Restructuring Agreements Finding New Favor In Preference Cases

While debt restructuring agreements were once extraordinary, some recent circuit court decisions have pulled them from the hypothetical and fit them into today’s ordinary business terms. Once case in particular –- Kaypro v. Justus(In re Kaypro), 218 F.3d 1070 (9^th Cir. 2000)–-has stretched the standard of earlier courts, allowing the possibilities that even recently inked restructuring agreements with poorly attended terms may fall within the safe harbor of this avoidable preference exception. As such, Kaypro represents a trend that suppliers and creditors should note, considering the popularity of preference actions.

In Kaypro, the U.S. Court of Appeals for the Ninth Circuit extended the "ordinary course of business" exception to avoidable preferences, carrying that doctrine into new territory.

Taking the Second Circuit’s cue in In re Roblin Industries Inc., 78 F.3d 30,42 (2d Cir. 1996), the Ninth Circuit opened the safe harbor of the ordinary course exception to sporadic payments made under a debt restructuring agreement enacted during the debtor’s slide into bankruptcy. As a result of Kaypro, neither the slide into bankruptcy nor events in workout scenarios preceding the bankruptcy petition’s filing remain solidly "extraordinary." Courts may find creditors’ dealings with soon-to-be debtors "ordinary" if other industry participants have acted similarly, despite the nature of those dealings.

While Bankruptcy Code § 547(b) allows trustees to recapture preferential and extraordinary transfers to creditors made in the 90 days preceding a bankruptcy case’s filing, §547(c)(2)’s ordinary course exception preserves and protects payments made in the context of ordinary business relations. The exception evidences Congress’ encouraging creditors to continue dealing with financially troubled entities as long as they do not abuse that ongoing relationship to exact payments that provide them with an advantage over other creditors.

Since abolishing the 45-day rule that preceded the current § 547(c), Congress left the specifics of the ordinary course exception to a case-by-case determination by the courts. Typically, courts have left payments on "old and cold" invoices unprotected, particularly when such payments occur beyond invoice terms and beyond the parties’ historical relationship.

Kaypro extends § 547(c)(2)’s reach by holding that payments made pursuant to a debt restructuring agreement could fall within the ordinary course of business. The facts are familiar. As debts mounted and its financial situation worsened, Kaypro could not timely pay all of its vendors and entered into debt restructuring agreements with at least two suppliers, which agreements became the subject of preference actions. Those restructuring agreements included the principal’s personal guarantees securing the debt.

Twelve months later, after making fewer than half of the scheduled monthly payments on those agreements, Kaypro filed its Chapter 11 petition. After the case converted to a Chapter 7 liquidation, the trustee sued to recover those restructured payments that fell within the 90-day preference period. The suppliers invoked the ordinary course defense, arguing that the payments made under the restructuring agreement constituted "ordinary course" payments.

The bankruptcy court ruled that, as a matter of law, the safe harbor of the ordinary course exception categorically does not apply to payments under debt restructuring agreements. However, the Ninth Circuit Bankruptcy Appellate Panel reversed and held that the defense hinges on a factual inquiry into the parties’ dealings and industry practice. The Ninth Circuit thereafter affirmed the B.A.P. decision, specifically noting that the bankruptcy court erred in holding that the ordinary course exception does not apply as a matter of law to a category of dealings, holding instead that it may apply, depending on the attendant facts of each case.

In affirming the B.A.P., the Court of Appeals relied heavily on the Second Circuit’s standard articulated in Roblin, which addressed a similar issue four years earlier. "Thus, to apply Sec. 547(c)(2)(C), the court must look to ‘those terms employed by similarly situated debtors and creditors facing the same or similar problems. If the terms in questions are ordinary for industry participants under financial distress, then that is ordinary for the industry.’" Kaypro, 218 F.3d 1070, 1074 (9^th Cir. 2000), quoting Roblin, 78 F.2d at 42.

Kaypro’s potential impact on preference law and creditor policy stems from its reliance on and furtherance of Roblin’s two primary accomplishments: the Second Circuit emphasized the critical importance of objective analysis in resolving § 547(c)(2)issues; and, more important, Roblin clearly sets forth § 547's tolerance of debt restructuring agreements.

In Roblin, the debtor, a manufacturer of specialized steel, entered into a restructuring agreement with its key supplier to pay off its arrears, ensuring the continued flow of scrap metal on which the debtor’s business relied. Unlike the debtor in Kaypro, Roblin made its monthly payments regularly from the time of the agreement in late 1984 until the bankruptcy filing the following summer.

The Court of Appeals in Roblin ruled that the bankruptcy court had not engaged in "objective analysis to determine whether Ford had demonstrated that the payment at issue comported with ordinary business terms in the industry." 78 F.2d at 41. Thus, the Second Circuit held, "We decline to adopt a rule that payments made pursuant to debt restructuring agreements, even when the debt is in default, can never be made according to ordinary business terms as a matter of law." Id.

In explaining the concept that debt restructuring could fall within the ordinary course of business, Roblin noted:

Nevertheless, the Roblin court found that Ford failed to show that the debt restructuring payments at issue fit within regular industry practice, because Ford introduced no evidence at trial regarding industry practice. On this point, the court held that proof of the industry standard required more than testimony concerning the parties’ behavior.

Roblin carefully sided against categorically precluding restructuring agreements from the ordinary course exception. The court noted that because debt restructuring and refinancing may be common practice in some industries, only fact-intensive inquiry will determine the ordinary course exception’s applicability.

While demonstrating facts sufficient to satisfy this burden will vary on case-by-case and circuit-by circuit bases, Roblin broke new ground by hypothetically allowing debt restructuring agreements into § 547(c)(2)(C)’s safe harbor. Roblin thereby set the stage for Kaypro’s outcome.

Just as Kaypro furthered Roblin’s doctrine, Roblin had built on the Seventh Circuit’s Tolona Pizza decision, which set forth that, "‘ordinary business terms’ refers to the range of terms that encompasses the practices in which firms similar in some general way to the creditor in question engage, and that only dealings so idiosyncratic as to fall outside that broad range should be deemed extraordinary and therefore outside the scope of [§ 547(c)(2)(C)]." Matter of Tolona Pizza Products, 3 F.3d 1029, 1033 (7^th Cir. 1993).

In short, Kaypro, Roblin and Tolona Pizza all concur that proper analysis goes well beyond the parties’ dealings, more significantly looking to industry norms for dealing with distressed companies. These cases emphasize § 547(c)(2)(C)’s analysis of the objective business terms of the industry, leaving the subjective ordinary course of business between the parties appropriately to §§ 547(c)(2)(A) and (B). Debt restructuring agreements particularly demand this distinction, as parties presumably do not repeatedly include these agreements in their relationship.

In Kaypro, the Ninth Circuit followed this principle, ultimately reversing the bankruptcy court’s grant of summary judgment and remanding the ordinary course defense for trial on the factual issue of ordinary business terms. Kaypro provides additional guidance to practitioners because, unlike Roblin, Kaypro’s parties placed evidence of the industry’s ordinary course of business before the court, which the court deemed sufficient to raise factual issues for trial. The Kaypro court considered testimony from affidavits of the defendant’s credit manager and the principal of Kaypro, both with extensive experience in the industry. The credit manager testified that, "as part of its ordinary course of business, [the company] routinely enters into workout or debt restructuring agreements with creditors who are unable to meet their obligations." and the debtor’s principal agreed under examination that the debtor’s ordinary operations included personal guaranties and promissory notes. 218 F.3d at 1074-75.

Testimony of the parties typically supports §§ 547(c)(2)(A) and (B)’s subjective analysis by demonstrating the parties’ specific dealings, not global industry standards that § 547(c)(2)(C) requires. However, Kaypro gives no guidance on applying the subjective test of relations between the parties required by § 547(c)(2)(B), because, despite the source of the evidence, the Ninth Circuit focused exclusively on the industry standard objective test. The court merely stated that issues pertaining to the relationship, i.e., lateness of the restructured payments, etc., should be taken up at trial on remand.

In an era when debt restructuring has become more prevalent in many industries, courts may now hold that payments under such agreements fit within the ordinary course of business. Kaypro offers proactive suppliers a broader ability to use the exception’s flexibility to reflect emerging trends in an industry, which in turn, could insulate payments on the "old and cold" from preference attack.

As the doctrines of Kaypro and Roblin become more widely understood and applied, credit managers may well benefit by pursuing debt restructuring agreements instead of accepting sporadic payments on arrears from prospective debtors.