Because bankruptcy filings were up over the past several years, debtors and trustees in those cases are now at the point of filing preference lawsuits in bankruptcy courts across the country.  Relying on Section 547(b) of the Bankruptcy Code, plaintiffs in these lawsuits seek the return of funds received from the debtor within 90 days before that debtor’s bankruptcy filing.  Section 547(b) specifically provides that transfers made by a debtor within the 90 days preceding the bankruptcy petition may be avoided in bankruptcy as a “preference.”

A typical scenario includes a materials supplier that sold material to a general contractor, sending an invoice payable within 30 days.  Due to any number of factors, the contractor fell 90 days behind on payments, but needed supplies to stay in business.  The supplier also needed to continue to sell to the contractor to preserve the hope of being paid for the past due amounts.  The question in this scenario is what the parties can do to protect their mutual, immediate interests while also protecting the supplier from future preference liability should the contractor find itself in bankruptcy?

Section 547(c) provides defenses to preference actions, and specifically provides for what is commonly referred to as the “ordinary course of business” defense.  To rely on the ordinary course of business defense, the transfer (1) must have been in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee and (2) must have been made within the ordinary course of business or financial affairs of the debtor and the transferee or made according to ordinary business terms.  The majority of preference lawsuits nationwide deal with issue number 2.

If the customer in the scenario described can repay the debt according to the same terms as it paid pre-default, then arguably the payments will be made within the ordinary course of business/financial affairs.  However, if such terms are not realistic given the existing delinquency and the financial condition of the customer, it is of the utmost importance that any restructuring agreement conform to ordinary industry standards – or ordinary industry restructuring standards, if possible.  So long as the payments are ordinary in the particular industry, they can be irregular in the ordinary course of a particular creditor/debtor relationship, yet retain the possibility of being insulated from the risk of recovery as a preferential payment.

While debtors and/or trustees bringing preference lawsuits may argue that any form of restructured payments after default cannot be made within the ordinary course of business, courts around the country have issued opinions setting forth that the applicability of the ordinary course of business defense depends not on whether there has already been a default under the original terms, but whether the workout and/or restructured payments are made in the ordinary course of business for the parties’ particular industry.  As the United States Court of Appeals for the Second Circuit said: “[i]t is not difficult to imagine circumstances where frequent debt rescheduling is ordinary and usual practice within an industry, and creditors operating in such an environment should have the same opportunity to assert the ordinary course of business exception.”    In re Roblin Industries, Inc., 78 F.3d 30, 32 (2nd Cir. 1996).  See also U.S.A. Inns, 9 F.3d 680, 685 (8th Cir. 1993) (it is regular practice in the savings and loan industry to adopt payment plans for delinquent customers).

While getting paid on invoices that are already past due may be of the utmost importance, it is equally important to negotiate with the customer in a non-threatening manner and draft a restructuring agreement that is standard and ordinary within the relevant industry.

By Jill Walters of Poyner Spruill