Two recently issued decisions may make it more difficult for a preference defendant to establish the ordinary course of business defense when the defendant revises credit terms with a customer having financial difficulty on the eve of the customer’s bankruptcy.
As background, a preference includes, among other things, a payment from a debtor to a creditor within 90 days of the filing of a bankruptcy petition that allows one creditor to be in a better financial position with regard to the debtor than other similarly situated creditors. One of the most common defenses that a creditor will utilize in defending a preference action is the ordinary course of business defense. In the majority of instances, continuing to comply with historical contract terms within the 90-day preference period will allow a creditor to avail itself of the ordinary course of business defense.
In the recent case of In re Hechinger Investment Company of Delaware, Inc., 489 F.3d 568 (3d Cir. 2007), the Third Circuit held, however, that a creditor which initiated revisions to existing credit terms with a debtor customer four months prior to the bankruptcy filing could not use the ordinary course of business defense in a preference action. Finding that payments from the debtor during the preference period under the revised credit terms resulted from the creditor pressuring the debtor to make accelerated payments to comply with the creditor’s "vigorous enforcement" of its new and revised credit terms, the Third Circuit affirmed the holding of the bankruptcy court that the payments were not ordinary under § 547(c)(2)(B).
Prior to the bankruptcy filing, the debtor and creditor shared a 15-year relationship in which the creditor sold treated lumber products to the debtor, a leading manufacturer of treated lumber products, on credit. The historical credit terms between the parties allowed the debtor to earn a 1% reduction in price for invoices paid within the "discount period" of 10 days, plus a 7-day grace period for those payments that were made by mail, or essentially, within 17 days.
The creditor became concerned about continuing to sell products to the debtor on credit approximately four months prior to the bankruptcy because of the debtor’s declining financial condition. Accordingly, the debtor and creditor entered into revised credit terms whereby the debtor agreed to the following: (i) a reduced credit limit for its future purchases of $1 million; (ii) a shortened discount period of 7 days, plus an 8-day grace period, or 15 days; and (iii) payments by wire transfer instead of check. Under the revised terms, the debtor typically made wire transfers to the debtor every 2.9 days in the amount of the credit limit, which reduced the outstanding balance in the debtor’s account and replenished its credit line so that the debtor could order more goods.
The net effect of the revised credit terms was that daily balances were lowered and payments were made more quickly during the preference period compared to the prior transaction history between the parties. Instead of finding that the revised credit terms were a logical solution to the creditor’s concerns about the debtor’s impending bankruptcy and that the payments during the preference period could qualify for the ordinary course of business defense if the payments were in keeping with the revised terms, the Third Circuit upheld the decision of the bankruptcy court that the transfers were not ordinary because the revised terms were "extreme, and so out of character with the long historical relationship between the parties."
Similarly, the Michigan bankruptcy court held in In re Technologies, LLC, 2007 WL 2138598 (Bankr. E.D. Mich. 2007) that payments to a creditor under new credit terms were "outside the ordinary course of the parties’ pre-preference period terms" where a debtor was placed on a "credit hold" by a creditor.
Prior to the debtor’s bankruptcy in 2004, the debtor would contact the creditor to place an order and the invoice would be mailed to the debtor after the order was shipped. For several years, the debtor paid the customer’s invoices within 30 to 45 days. However, in the year leading up to the bankruptcy filing, after payments started coming in later than they had historically, the debtor’s account was placed on credit hold status. This status meant that the creditor’s employees could not generate a bill of lading as to the goods ordered by the debtor until arrangements regarding outstanding debts could be negotiated with the accounts receivable department of the creditor. The debtor’s outstanding balance with the creditor was also "capped" at $50,000.00.
In ruling for the debtor’s estate against the creditor on the preference claim, the bankruptcy court focused primarily on the fact that payments pursuant to the new credit terms were coming in later than usual. The Court did not find that the imposition of the credit hold on the eve of bankruptcy was per se sufficient to defeat that ordinary course of business defense; it was, however, a factor that the court considered in finding that the course of business had changed.
The pertinent lesson from these decisions is that, if a creditor changes a customer’s credit terms on the eve of the customer’s bankruptcy, it will make it more difficult for the creditor to establish the ordinary course of business defense.
Of course, if the creditor cannot establish the ordinary course of business defense by showing that the relationship between the creditor and the customer during the 90 days prior to bankruptcy is consistent with their previous relationship, the creditor has the option of establishing the defense by establishing that the relationship during the 90 days prior to bankruptcy is consistent with the industry. One problem with this alternative, however, is that it is often a more expensive defense to establish because it requires the creditor to hire an expert witness to testify about the industry standard.
Depending on the relationship of the parties and the circumstances surrounding the financial stress of the impending bankrupt company, the safest bet is often to require cash on delivery or in advance, or, alternatively, to ensure that payment terms remain relatively constant with the historical terms of the parties. In light of these trendsetting preference decisions, bankruptcy counsel should be consulted as part of the process of negotiating any revised credit terms.
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