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A preference ordinary course of business defense trifecta.

Several recent decisions have addressed the subjective (ordinary between the debtor and creditor) part of the Section 547(c)(2) ordinary course of business defense to preference liability. These cases point out the different approaches to satisfying this defense that could impact a creditor's ability to reduce or avoid preference risk.

For instance, in American Home Mortgage Holdings, pending in Delaware, the bankruptcy court relied upon an historical range of payment analysis, based on days to pay from invoice date, to dismiss a preference complaint based on the subjective component of the ordinary course of business defense. The debtor's payment of invoices 34 to 60 days after invoice date during the preference period was within the range of the debtor's pre-preference period payments of the creditor's invoices from seven days to 67 days after invoice date.

In Philadelphia Newspapers, pending in the Eastern District of Pennsylvania, the bankruptcy court also applied the subjective part of the ordinary course of business to excuse a creditor from preference liability based on a modified historical range of payment of most (but not all) of the debtor's payments to the creditor prior to the preference period. Here, the alleged preferences paid invoices from 30 days to 70 days after invoice date, which was consistent with 80% of the debtor's payments to the creditor prior to the preference period that also paid invoices from 30 days to 70 days after invoice date.

However, the United States Bankruptcy Court for the Eastern District of Virginia, in In re Circuit City Stores, Inc., adopted a far different and more restrictive approach in ruling that a creditor did not satisfy the subjective component of the ordinary course of business defense. The court relied on only a part of the debtors' and creditor's history when the debtors were financially sound and were paying invoices within a narrow range of 31 days to 41 days after invoice date, and disregarded the debtors' later payments to the creditor, during the nine months prior to the preference period, when the debtors had cash flow issues. Since the alleged preferences paid invoices later than the court-approved 31-day to 41-day time frame, they were found to be "not ordinary" and did not satisfy the ordinary course of business defense.

What explains these differing views on the ordinary course of business defense?

The Ordinary Course of Business Defense to Preference Claims

After a trustee satisfies all of the elements of a preference claim contained in Bankruptcy Code Section 547(b), a creditor seeking to avoid preference liability has the burden of proving one or more of the preference defenses contained in Section 547(c). The ordinary course of business defense, contained in Bankruptcy Code Section 547(c)(2), is a frequently invoked preference defense. It is supposed to encourage creditors to continue doing business with their financially distressed customers.

A creditor must prove that an alleged preference paid indebtedness incurred in the ordinary course of the debtor's and creditor's business or financial affairs, and the payment was either (1) made in the ordinary course of the debtor's and creditor's business or financial affairs, or (2) made according to ordinary business terms. The first requirement, the incurrence of debt in the ordinary course of the debtor's and creditor's business, is straightforward and can be easily proved by the creditor's extension of trade credit to the debtor.

The second part of the defense, the debtor's payment in the ordinary course of the debtor's and creditor's businesses, is a subjective requirement. A creditor must prove some consistency between the alleged preference payment and the debtor's and creditor's payment history and other aspects of their relationship. The courts have considered (1) the length of time the parties did business, (2) the amount of the debtor's payments during and prior to the preference period, (3) the manner in which the debtor made the payments both before and during the preference period, and (4) any unusual action by the debtor or creditor concerning payment or collection of the creditor's claim.

A creditor can also prove the ordinary course of business defense by satisfying the objective component of the defense. That requires proving the alleged preference payment was made according to "ordinary business terms" and was consistent with the payment practices and range of terms in the creditor's industry, the debtor's industry, or some set of either or both.

The American Home Mortgage Case

On August 6, 2007 (the AHM petition date), American Home Mortgage Corp. (AHM) and its affiliated companies filed their Chapter 11 cases in Delaware. Prior to the AHM petition date, Vector Consulting, Inc. had provided programming services to AHM.

On July 28, 2009, the creditors' committee commenced a lawsuit against Vector for the recovery of four payments, totaling $29,920 that Vector had received from AHM during the 90-day period prior to the AHM petition date. The plan trustee was substituted as plaintiff in the lawsuit following the court's approval of a Chapter 11 liquidation plan.

On October 29, 2009, Vector filed its answer, alleging a complete defense to the preference claim based on the subjective ordinary between the parties component of the ordinary course of business defense. Vector relied on its full eight-month payment history with AHM in arguing that AHM had paid Vector in a consistent manner both prior to and during the preference period.

The AHM court ruled that Vector had satisfied the subjective piece of the ordinary course of business defense and dismissed the preference complaint. The court noted the consistency of AHM's four payments of between $5,440 and $12,920 to Vector during the preference period with AHM'S 10 payments to Vector, between $4,675 and $12,240 during the prior five months. Also, Vector's invoices, in amounts ranging from $5,440 and $7,480 that AHM had paid during the preference period, were comparable to Vector's invoices, in amounts between $4,675 and $8,160 that AHM had previously paid. Finally, AHM's payment of Vector's invoices from 34 to 62 days after invoice date during the preference period was within the range of AHM's payments of Vector's invoices, between seven days and 67 days after invoice date, prior to the preference period.

AHM and Vector had also dealt in the same manner both prior to and during the preference period. AHM had paid only by check throughout their business relationship. Vector had also not taken any unusual action to collect its unpaid invoices during the preference period. Vector merely engaged in the same collection practice both prior to and during the preference period of "politely" inquiring about outstanding invoices by facsimile and telephone.

The AHM court rejected the trustees argument that the alleged preference payments did not satisfy the subjective piece of the ordinary course of business defense because they were paid later than AHM had paid Vector's invoices prior to the preference period. It did not matter that AHM had paid 80% of the invoices (four of the five invoices) late during the preference period compared to only two of 10 (or 20%) of the invoices that AHM had previously paid late. The AHM court attributed AHM'S later payments during the preference period to AHM's delayed processing of Vector's invoices for payment resulting from AHM's project manager (who was responsible for arranging payment of Vector's invoices) being out for maternity leave?

The Philadelphia Newspapers Case

On February 22, 2009, (the PN petition date), Philadelphia Newspapers and its affiliates (collectively Philadelphia Newspapers) filed their Chapter 11 cases in the United States Bankruptcy Court for the Eastern District of Pennsylvania. Philadelphia Newspapers owned and operated Philadelphia's two major newspapers, the Philadelphia Inquirer and Philadelphia Daily News, as well as Philly.com.

Philadelphia Newspapers ultimately sold their businesses and obtained approval of a Chapter 11 plan under which a liquidating trustee was appointed. The trustee commenced a lawsuit against Inserts East, Inc. to recover payments totaling $118,163.81 that Inserts East had received from Philadelphia Newspapers during the 90-day period prior to the PN petition date.

Philadelphia Newspapers and Inserts East did business over several years starting around February 2003. From February 2003 until the beginning of the preference period on November 24, 2008, Philadelphia Newspapers had paid 93 of Inserts East's invoices from seven days to 112 days after invoice date. Philadelphia Newspapers made 80%, or 74 out of 93 of these payments, from 30 days to 70 days after invoice date.

The trustee used an average days to pay approach in arguing that some of the alleged preference payments did not satisfy the subjective part of the ordinary course of business defense. Prior to the preference period, Philadelphia Newspapers had, on average, paid Inserts East's invoices within 50 days of invoice date. The trustee then created an historical range of payments, based on a 10-day deviation off this 50-day average, to compare to the alleged preference payments, and conceded that only those alleged preferences that paid invoices from 40 days to 60 days after invoice date satisfied the subjective element of the defense.

That still left the $65,655.26 owing on the preference claim, after also taking the new value defense into account. The trustee ultimately moved for partial summary judgment for recovery of $65,655.26 from Inserts East.

Inserts East rejected the trustees narrow range of payments from 40 days to 60 days after invoice date, and asserted a full defense to preference liability based on the subjective piece of the ordinary course of business defense. Inserts East relied on an expanded payment period, from 30 days to 70 days after invoice date, (which allowed for a 20-day deviation off an average of 50 days to pay) because prior to the preference period, 80% of Philadelphia Newspapers' payments to Inserts East were also for invoices that were outstanding from 30 days to 70 days after invoice date.

The Philadelphia Newspapers court held that the alleged preference payments were consistent with the modified payment history asserted by Inserts East, and, therefore, satisfied the subjective component of the ordinary course of business defense. The court preferred a broader range of invoice payments, from 30 days to 70 days after invoice date, than the

narrower 40-day to 60-day range sought by the trustee, because Philadelphia Newspapers had been paying invoices within the same days-to-pay range (30 days to 70 days after invoice date) 80% of the time prior to the preference period.

The trustees argument for a narrower ordinary course range of 40 days to 60 days of the invoice date was further undercut by the fact that prior to the preference period, only one-third of the payments (31 out of 93), were made in the same 40-day to 60-day range. This did not adequately show the parties' course of dealings prior to the preference period where Philadelphia Newspapers was paying from 30 days to 70 days after invoice date 80% of the time.

The Circuit City Stores Case

On November 10, 2008, Circuit City filed a Chapter 11 petition in the United States Bankruptcy Court for the Eastern District of Virginia. Circuit City was a leading specialty retailer of consumer electronics that had operated 712 retail stores and nine outlet stores throughout the United States and Puerto Rico. Circuit City dosed down its business shortly after its bankruptcy filing, and, thereafter, obtained court approval of a plan of liquidation under which a liquidating trustee was appointed.

Russellville Steel Company, Inc. sold steel products to Circuit City starting after August 30, 2006. Russellville billed Circuit City on "Net 30" terms. Circuit City paid 86 of Russellville's invoices over the entire course of their business relationship. Circuit City promptly paid invoices from 31 days to 41 days after invoice date (for an average days-to-pay of 33.49) from the inception of their relationship until the end of October 2007.

Circuit City's liquidity significantly deteriorated in and after November 2007 (which the court referred to as the "liquidity event") when Circuit City delayed paying its vendors. Following the liquidity event and prior to the beginning of the 90-day preference period on August 11, 2008, Circuit City had paid virtually all of Russellville's invoices much later, from 44 days to 51 days after invoice date, for an average days-to-pay of 46.74.

Circuit City made four payments to Russellville, totaling $124,261, during the preference period. Circuit City paid Russellville's invoice no. 27414, in the amount of $3,432, 189 days after invoice date, which Russellville conceded was too late to qualify for the ordinary course of business defense. Circuit City also paid Russellville's invoice no. 27514, in the amount of $1,100, 51 days after invoice date, invoice no. 27509, in the amount of$112,922, 45 days after invoice date and invoice no. 27548, in the amount of $7,978, 46 days after invoice date. The average days for Circuit City to pay RussellviUe's invoices during the preference period tripled to 82.75 days, compared to the time it took Circuit City to pay RussellviUe's invoices, 33.49 days, prior to the liquidity event in November, 2007.

The trustee commenced a lawsuit against Russellville to recover Circuit City's payments, totaling $124,261, to Russellville during the preference period. Russellville invoked the subjective ordinary between the parties component of the ordinary course of business defense for three of the four alleged preference payments. Russellville relied on the parties' payment history during the 12 months before the preference period to argue that Russellville had satisfied the subjective part of the ordinary course of business defense because the three alleged preferences paid invoices within the same range of days outstanding as Russellville's invoices were paid during that 12-month period. Unfortunately for Russellville, that history included approximately nine months when Circuit City had liquidity problems and slowed down its payment of Russellville's invoices.

The trustee rejected any consideration of Circuit City's payments to Russellville during the nine months prior to the preference period in determining the applicability of the subjective part of the ordinary course of business defense. The trustee argued for consideration of only Circuit City's payments to Russellville from the outset of their relationship, in August 2006, until the liquidity event, in November 2007 when Circuit City was financially sound. That meant disregarding all later payments from November 2007 through the beginning of the preference period in August 2008.

The Circuit City court held that Russellville was subject to preference liability for the three alleged preference payments because Russellville did not satisfy the subjective part of the ordinary course of business defense. The court evaluated the applicability of the defense based only on Russellville's payment history with Circuit City when Circuit City had sufficient liquidity prior to the liquidity event in November 2007. That meant considering only Circuit City's prompt payment of Russellville's invoices, from 31 days to 41 days after invoice date (for an average of 33.49 days after invoice date), from August 2006 until the Liquidity Event in November 2007.

The court disregarded Circuit City's payments to Russellville after the liquidity event when, as a result of inadequate cash flow, Circuit City had markedly slowed down in payment of Russellville's invoices to an average 46.74 days after invoice date, with no payment made less than 41 days after invoice date. The two-week delay in Circuit City's payments of Russellville's invoices following the liquidity event and the lack of any overlap in the number of days between invoice date and payment date prior to and following the liquidity event precluded the court from considering the post liquidity event payments in evaluating the applicability of the ordinary course of business defense.

The court also noted that Circuit City's 82.75 average days to pay Russellville's invoices during the preference period was nearly three times Circuit City's 33.49 average days to pay Russellville's invoices prior to the liquidity event. Moreover, Circuit City paid the three alleged preference payments, that Russellville claimed were subject to the ordinary course of business defense, 12 to 18 days later than Circuit City's average days to pay of 33.49 days prior to the liquidity event. This significant slowdown in Circuit City's payment of Russellville's invoices after the liquidity event reflected Circuit City's strategy to delay payments to its vendors in order to continue operating and fend off bankruptcy.

As such, and based on the court-approved narrow 31-41 days to pay range, none of the alleged preference payments were ordinary between the parties. As a result Russellville could not satisfy the subjective component of the ordinary course of business defense to free itself from preference liability.

Conclusion

The holdings in American Home Mortgage, Philadelphia Newspapers, and Circuit City point out the varying manner in which the courts have analyzed the subjective ordinary between the parties component of the ordinary course of business defense that had a direct bearing on a creditor's preference liability. The

AHM court considered the more generous historical range of payments by the debtor to the creditor and the Philadelphia Newspapers court considered a slightly less generous modified range of payments encompassing 80% of the debtor's payments to the creditor prior to the preference period to eliminate preference liability. On the other hand, the Circuit City court ruled against the creditor based on a very narrow historical range of pre-preference period payments made when Circuit City was financially sound. These inconsistent holdings point out the unpredictability of the outcome and the difficulties trade creditors face in attempting to prove the subjective part of the ordinary course of business defense. The Circuit City court's more restrictive approach in analyzing the ordinary course defense is all the more striking considering the court's refusal to consider Circuit City's later payments to Russellville during the nine months prior to the preference period.

Oh well, that's what makes practicing law so much fun!

(1.) The court also looked to industry practice to confirm that an eight-month business relationship was typical in Vector's industry.

(2.) The AHM court also ruled that Vector had satisfied the objective, ordinary business terms part of the ordinary course of business defense. The court relied on the testimony of Vector's chief executive officer and a certified public accountant (who claimed to be familiar with the standard payment practices of the information technology staffing industry in which Vector conducted business) that the alleged preference payments were made according to ordinary business terms in Vector's industry.

Bruce Nathan, Esq. is a partner in the New York City office of the law firm of Lowenstein Sandier PC He is a member of NACM and is on the Board of Directors of the American Bankruptcy Institute and is a former co-chair of ABI's Unsecured Trade Creditors Committee. He can be reached via email at bnathan@lowenstein.com.
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Title Annotation:SELECTED TOPIC
Author:Nathan, Bruce
Publication:Business Credit
Geographic Code:1U2PA
Date:Jul 1, 2012
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