As a bankruptcy and financial restructuring lawyer, I am often told by businesspeople that they hope to never need my services. While I can understand the desire to avoid needing debtor’s counsel, the truth is that many companies will eventually (or perhaps inevitably) find themselves involved in a bankruptcy case as a creditor. And if a company received payments from a debtor in the 90 days before it filed for bankruptcy, it may find itself a defendant in a lawsuit brought by a trustee for a liquidating debtor.
The Bankruptcy Code permits a debtor to recover from creditors “preference” payments that are made shortly before the bankruptcy filing if those payments gave the creditor more than its “fair share” compared to the recovery of other similarly situated creditors in the bankruptcy case. A creditor facing a preference lawsuit has a number of tools at its disposal, including statutory defenses like the “ordinary course” defense.
In order to present a strong “ordinary course” defense, it is important for companies not to alter their business relationship with a financially-distressed client as a bankruptcy filing becomes imminent (i.e., maintain the “ordinary course of business”). In a recent decision, Judge Lane of the Southern District of New York Bankruptcy Court rejected an ordinary course defense and ruled in favor of the litigation trustee for the Quebecor World Litigation Trust—allowing the Trust to recover over $35,000 from a vendor—largely because of a significant shift in the timing of payments that occurred in the 90 days before the bankruptcy.
Background on Preferences
In bankruptcy, a payment made by a debtor in the 90 days before the bankruptcy filing may be unwound if certain conditions are met:
- The payment must be to or for the benefit of a creditor;
- The payment must be for or on account of an antecedent debt;
- The payment must have been made while the debtor is insolvent (which is presumed during the 90 days before bankruptcy);
- The payment must be made during the 90 days immediately before the bankruptcy filing (with a look back period for insiders of one year); and
- The payment must enable the creditor to recover a greater percentage of its claim than it would have received in distributions in the bankruptcy case with respect to the debt paid.
These payments are referred to as “preferences,” and the power to “avoid” such preferences is an important tool to ensure the like treatment of creditors. The policy behind the avoidance of preferences is to discourage unusual action by either the debtor or its creditors during the debtor’s slide into bankruptcy.
The power to avoid preferences is rarely employed against trade vendors in reorganization cases in which the debtor will seek to continue to do business with those same vendors after the bankruptcy. However, where the debtor’s business is being liquidated, a trustee will often bring lawsuits against all entities that received payments during the 90-day preference period.
In order to avoid unfairly punishing companies that continued to do business with a financially-distressed company, the Bankruptcy Code provides the “ordinary course” defense against preference lawsuits. What is “ordinary” can be measured “objectively” by comparing the defendant’s actions to general industry practices or “subjectively” by comparing the defendant’s actions during the 90-day period to its conduct with the debtor before it became financially distressed. This “ordinary course” defense protects recurring, customary credit transactions that are incurred and paid in the “ordinary course of business or financial affairs of the debtor and the transferee.” 11 U.S.C. § 547(c)(2). Therefore, the continuation of normal financial relations is crucial to a successful ordinary course defense.
Application in Quebecor World
Courts tend to focus on the so-called “subjective” test for the ordinary course of business defense, which examines whether a transfer was ordinary between the parties to the transfer, comparing the alleged preferences to the historical course of dealing. As Judge Lane observed in the Quebecor World decision, “[t]he starting point—and often ending point—involves consideration of the average time of payment after the issuance of the invoice during the pre-preference and post-preference periods, the so-called ‘average lateness’ computation theory.” Although a “narrow band of difference” is acceptable, payments delayed beyond a reasonable amount of time past the pre-preference period average generally do not fall within the ordinary course of business.
In Quebecor World, the Trustee compared the parties’ billing and payment history during the 90-day preference period to the course of dealing in the two years prior to the start of the preference period. Judge Lane observed that the weighted average time to payment increased from about 50 days in the historical period to about 78 days during the preference period, and “effectively none” of the alleged preference payments were transferred on or around the historical 50-day mean. Given that “significant difference in the timing of payments,” Judge Lane rejected the defendant’s ordinary course of business defense.
The following is a (non-exhaustive) list of actions that a business should consider if a client is heading towards bankruptcy:
- Consider changing to a pay-in-advance system, if possible (which may eliminate preference liability entirely because the “antecedent debt” condition noted above would not be satisfied).
- Other than changing to a pay-in-advance system, do not materially change the method of payments. For example, if payment was historically made by check, do not change to wire transfers.
- Do not alter the typical payment schedule with the distressed company.
- Do not seek new concessions for continued service.
- Do not send demand letters.