In Defense of a Preference
By Scott E. Blakeley

A fundamental responsibility of a credit executive is to assess a debtor�s credit risk; and, based on the risk assessment, a credit executive determines appropriate credit terms. Should that customer file bankruptcy, the established credit terms, and whether the debtor honored those terms, are central issues as to whether you may prevail with an ordinary course of business defense.

Equally important, yet sometimes overlooked by creditors, is the burden to establish the payment history in the industry, not just the trade relationship between you and the debtor. The so-called industry standard prong of the ordinary course of business defense, or objective test, requires that you as the creditor show the industry payment history.

What evidence must you produce to establish the objective standard; and, how may an industry report assist you in establishing this prong of the defense? A bankruptcy court₁ recently considered the objective standard of the ordinary course of business and the kind of evidence a creditor must present to carry its burden with the objective standard of the ordinary course of business defense. An overview of the preference laws, as follows, is considered as well as the court�s decision.

A. The Bankruptcy Preference Law

The Bankruptcy Code vests the debtor (or trustee if one is appointed) with farreaching powers to avoid payments 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, a debtor is deterred from preferring certain creditors by requiring that a creditor who 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.

B. Beating the Preference Lawsuit: The Ordinary Course of Business Defense

Not all transfers made within the preference period may be recaptured. To protect those transactions that 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 preference exception by a creditor 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 three-fold:

1. Protect customary transactions;

2. Encourage creditors to continue to extend credit to financially troubled debtors, possibly helping the debtor avoid bankruptcy; and

3. Discourage unusual collection practices during the debtor�s financial demise. Pursuant to section 547(c)(2), the Bankruptcy Code provides that a transfer may not be avoided if the transfer was in payment of a debt incurred in the ordinary course of business.

1. The Subjective Inquiry: Payments Must Be In The Ordinary Course Of Business Between The Debtor And The Creditor

Courts often employ a �baseline of dealings� test to determine whether the transfer was made in the ordinary course of the business or financial affairs of the debtor and creditor. The baseline of dealings compares two time periods to determine the course of dealings between the debtor and creditor.

The first time period is the course of dealings prior to the 90-day preference period (�pre -insolvency period�). The second time period is the preference period that includes the date of the bankruptcy filing through the 90th day after the date of the bankruptcy petition.

If the course of dealings between the two periods is consistent, then the payments satisfy the subjective prong of the defense. However, if the course of dealing between the two periods is not consistent, then the payment is not made in the ordinary course of business and may be recovered as a preference.

In addition to the baseline of dealings test, courts review the �ordinariness� of the transfer between the debtor and creditor in relation to past practices. Issues that are considered include:

a. The length of time that the parties were engaged in the transaction at issue;

b. Whether the amount or form of the payment differed from past practices;

c. Whether the debtor or creditor engaged in any unusual collection or payment activity; and

d. Whether the creditor took advantage of the debtor�s deteriorating financial condition. If any of these factors are present, then a court may find that the transfer does not qualify for an ordinary course of business defense.

2. The Objective Inquiry: Payments Must Be In The Ordinary Course Of Industry

The third element requires the vendor to show, by a preponderance of evidence, that the transaction occurred according to �ordinary business terms� for the industry. This is often referred to as the objective test and is the majority approach in evaluating the ordinary course of business defense. This is the prong that the Smith Road court considered.

Ordinary business terms for the industry are generally defined as the range of terms that encompass the practices in which businesses similar in some way to the creditor in question engage; and, that only dealings so unusual as to fall outside that range should be considered extraordinary and outside the scope of the industry. In addition, the Smith Road court considered the length of the parties� trade relationship. In the Smith Road case, the court observed that the vendor (creditor) is required to prove that the preferential transfers were objectively ordinary in relation to industry standards. Examining the industry standard requires:

1. �An identification of the relevant industry; and,

2. An objective examination of its standards and practices to determine if this transfer is within the outer boundaries of the industry.� ₂ The Smith Road court noted that the creditor�s industry is the controlling industry under the objective standard.

3. Although the industry standard does not require a creditor to establish the existence of a uniform set of business terms, it does require evidence of a prevailing practice among similarly situated members of the industry facing the same or similar problems. To establish the industry standard, the creditor must usually rely on evidence that is external to the debtor and creditor. Generally, reliance on the testimony of the creditor attesting to the industry standard may be ineffective as it blurs the distinction between the objective and subjective elements to the ordinary course of business exception.

How may an industry report assist the vendor with meeting the objective prong of the ordinary course of business defense?

The Objective Inquiry and Industry Reports

The objective test requires that you, as the creditor, establish industry standards through empirical evidence generally in the form of industry payment history compiled by an independent, authoritative source. Data, such as that supplied by The Credit Research Foundation in the quarterly report, �National Summary of Domestic Trade Receivables� sets forth an index, by industry, based on information assembled from creditors. The data, which indexes six key metrics such as: Collection Effectiveness, Days Sales Outstanding, Best Possible DSO, Average Days Delinquent, Percent of Current AR and Delinquent AR over 91 Days Past Due, provides a valuable tool in establishing the criteria to meet the objective test to the �ordinary course� in a preference defense. The objective test, previously discussed, can be built based on a practical examination of the Best Possible Days Sales Outstanding index. A correlation can be made between BPDSO and terms based on the theory that BPDSO is calculated without the influence of past due receivables. Therefore, since there is no delinquency in the BPDSO figure, hypothetically all customers are paying according to terms. Consequently, examination of the BPDSO for any given industry will show a strong parallel to that industry�s aggregated standard business terms.

An analysis of each quarter for the last 23 years illustrates that, across all industries, the median Best Possible DSO is 31.7 days and the average is 31.8 days. Arguably, the most common standard term across all industries is 30 days; therefore supporting the theory that the BPDSO for any given industry correlates to the standard industry terms.

Further utilizing the CRF data to support a specific industry, we can illustrate an example from the 1st quarter 2004 report for the apparel industry. The median BPDSO for that industry in the quarter January through March 2004 was 37.8 days. The upper quartile was 45.1 and the lower was 27.7 days. Using this data to establish a �standard� for a creditor in the apparel industry, it could be said that ordinary business terms range from 28 days to 45 days in the apparel industry.

The Smith Road Decision

In Smith Road, a creditor provided product to a debtor in the bedding manufacturing industry. The creditor established 10- day terms. The debtor filed Chapter 11 and brought a preference action to recover payments made to the creditor during the preference period. The creditor contended that the payments qualified as an ordinary course of business defense. The debtor moved for summary judgment.

In considering whether the creditor had an ordinary course of business defense, the court considered the objective prong of the standard. The court observed that the industry norm of the debtor�s industry, bedding manufacturing, was payment 45-50 days from the invoice date based on the creditor�s expert�s report. The creditor had put the debtor on terms of 10 days three years prior to the bankruptcy filing. The debtor contended that as the creditor�s 10 day terms vary from the industry norm of 30 days, the creditor did not have an ordinary course of business defense. The court observed that a sliding scale standard applies to the objective rule:

"The more cemented the preinsolvency relationship between debtor and the creditor, the more the creditor will be allowed to vary its credit terms from the industry norm yet remain in the safe harbor of Section 547(c)(2). The likelihood of unfair overreaching 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 insolvency. After all, if at the starting point of the relationship insolvency was a distant prospect, a trade creditor does not unfairly overreach, impel insolvency, or inequitably advantage itself at other creditors' expense by tolerating more generous or commanding more stringent repayment schedules than its competitors."₃

Even though the court held that issues existed as to whether the debtor�s long relationship with the creditor, during which time the creditor, for three years prior to petition date had required the debtor to pay the creditor�s invoices within 10 days of invoice date, was sufficient to permit the creditor to insist on payment within 10 days and still meet the objective standard, the debtor�s motion for summary judgment was denied.

C. 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 is instructive for a credit professional of the importance of supporting the objective prong of the ordinary course of business defense with independent evidence, such as the Credit Research Foundation�s NSDTR or other industry data.

The court made a special point that the more established the trade relationship between the parties, the more that a creditor will be permitted to deviate from the industry standard and still qualify for the ordinary course of business exception. However, it is the creditor�s burden to establish the industry payment standard. For the vendor to meet its burden with the objective standard, consider using an industry report to establish the common terms used by other trade creditors in the same industry facing similar problems.

₁ In re Smith Road Furniture, Inc., 304 B.R. 793 (Bankr. S.D. Ohio 2003)
₂ Smith Road, 304 B.R. at 796
₃ Smith Road, 304 B.R. at 797

Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley LLP Fall 04