A Creditor’s Best Bet: Payments In The Ordinary Course

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Everything Was Going Fine Until…

Your customer or borrower has been paying like clockwork and you, the creditor or vendor, have been dispensing goods and services as promised. Then your customer starts to pay a little later, then later still. Why not? Times are tough. So you do the decent thing and take their payments without complaining. Next thing you know, your customer seeks bankruptcy protection, leaving you holding the bag for thousands, tens of thousands, even hundreds of thousands of dollars worth of goods and services. Money you’ll never see again. 

The Worst Part Is (Not) Over

You’re out a lot of material, and now you’ll never get paid. Sure that’s tough to take, but at least the worst part is over, right? Wrong.

All sums paid by customers or clients in the 90 days before a bankruptcy is filed are de facto preferences. In other words, sums paid in the 3 months before a bankruptcy case is filed can be recouped by the Bankruptcy Estate without a guaranty of ever getting that money, or any portion of it, back.

Most creditors think that once a payment is received, all is good and they can move on. This is not the case if a customer filed bankruptcy. Sections 547 and 550 of the Bankruptcy Code allow a Trustee (in Chapter 7 cases) or Debtor in Possession (DIP) in Chapter 13 or 11 cases to recover preferential transfers

Will you have this problem? Was your customer’s payment a preferential transfer? Short answer: “Yes it was” if

  • payment was for the creditor’s benefit    See 547(b)(1)
  • on account of antecedent debt   (i.e. bought on credit)
  • for goods or services that were received  See 547(b)(2)
  • while a Debtor was insolvent as defined  See 547(b)(3)
  • within 90 days before a bankruptcy filing See 547(b)(4)

Note: It is immaterial whether the vendor or creditor knew, had reason to know, or suspected a borrower or customer was about to file for bankruptcy or was insolvent. Once the case is filed the 90-day look-back is automatic. See 547(f)

Taken literally these rules mean creditors ought to stop lending, and vendors stop selling, if there is any concern about the financial health of the borrower or customer. Of course if that happened creditors and vendors could fail themselves. So what should creditors really do? While there is no one-size-fits-all answer, here is a list of 3 Don’ts and 1 Do If a Customer or Borrower Files Bankruptcy:

Don’t 

  • Volunteer to return sums paid by your Customer or Borrower. The case Trustee or DIP must first calculate what is due, decide whether to attempt to recoup it, and file a motion with the Court. 
  • Contact your customer and raise hell – that will only make things worse.
  • Represent your own interests in Bankruptcy Court. You wouldn’t perform brain surgery on yourself, would you?

Do 

  • HIRE A LAWYER 

Why only a single “Do?” And why put it in all caps? Because Bankruptcy Courts already favor the Trustee or DIP. Failing to hire a good lawyer to argue on your behalf if like bringing a knife to a gunfight, partner.

Defenses to a Preference Action

All doom and gloom aside, there are defenses that creditors can use when confronted with a motion to recover preferential transfers.The 2 most common defenses are 

  • Contemporaneous Exchange for Value; and 
  • Payment in the Ordinary Course of Business

A so-called Contemporaneous Exchange is essentially a COD arrangement. The creditor will supply goods and is paid on delivery or within a few days thereafter – functionally at the same time. These payments can be defended as non-preferential transfers.

The Ordinary Course of Business defense is more subjective: it relies on the way the parties treat each other. For instance if a vendor supplies goods to the buyer on a standard basis like Net-30, and the buyer pays as envisioned, then the payments made according to those terms can be defended as non-preferential transfers.

The Limits of the Ordinary Course Defense

Several recent cases have weighed in on the Ordinary Course of Business defense and shed light on the limits of this theory. 

In In re Universal Marketing, 481 B.R. 318 (Penn. E.D. 2012) the Chapter 7 Trustee sought to recover two $25,000 payments made to the Debtor’s financial advisor. An Engagement Letter had been executed before the bankruptcy providing for 7 months worth of service at the rate of $25,000. The Debtor had made its monthly payments, but some had been late: opening the door for for the claim that no ordinary course defense existed. The Court disagreed, and found that the subject payments were made in the ordinary course of business. In its Opinion, the Universal Marketing Court considered the following facts:

  • the existence of an agreement (the engagement letter)
  • the services offered were of the type the debtor needed
  • the creditor was in the business of providing such services
  • length of time during which the arrangement was in place
  • that the payments were typical for such an arrangement
  • that the creditor did not exert undue influence to get paid.

The Court found the payments under consideration to be consistent and proportional to fees charged by the creditor for like services to other customers. This only left the occasional late payment. But the Court noted that this amounted to just a few days: too small of a divergence to transform them into preferential transfers. 

In re Mainline Contracting, 2012 WL 5247173 (N.C. BK 2012) was a Chapter 7 case involving not only late payments by the Debtor but lax collection tactics by the vendor. To begin with, Invoices clearly labeled “Net 30″ had seldom been paid within 30 days by the Debtor. What’s more, in the year leading up to the bankruptcy filing the Debtor took an average of 79 days to pay, with the number creeping up as the Debtor neared its bankruptcy filing date. Then there was testimony that the Debtor actually never paid before 90 days, unless the creditor called or emailed to inquire. There had also been a number of instances in which the Creditor put the Debtor on a COD basis due to its poor payment history, the Debtor would catch up, and the whole process started over. Eventually the Debtor filed for bankruptcy and the Trustee sought to recover certain payments.

The Marine Contracting Court found that the payments in question were not preferences, and thus not avoidable. In reaching its decision the Court noted that

  • although the invoices read “Net 30,” that was not the practice of the parties
  • the creditor would continue to supply materials on credit even when not paid
  • it was only after invoices were 60+ days overdue the creditor demanded payment
  • it was only after invoices were 90+ days overdue that the creditor switched to COD
  • such behavior was consistent over both the baseline period and the preference period 

The weightiest factor in the Court’s analysis was the behavior of the parties during and before the the 90-day preference period.The consistency of that treatment indicated that these were truly payments made in the ordinary course of business.

Take-Away:What Does It All Mean?

The takeaway from this discussion is that creditors should strive to be consistent in the way they treat customers. Talk to cistp,ers about past-due payments. Follow up consistently and in a timely fashion. If payment terms are “Net 30″ for instance, send reminders at 45 and 60 days. And if a customer is a bad payer consider COD or a prepayment arrangement. After all, if credit is not extended there can be no preference action.