Even though the debtor paid its bills on time, a supplier who hounded the debtor for payment may be unable to prove the “ordinary course” defense and can be liable for a preference, as shown in an opinion by Chief Bankruptcy Judge Jeffrey J. Graham of Indianapolis.

As Judge Graham said in his January 13 opinion, a supplier may not have the ordinary course defense if the evidence shows that the debtor “prioritized paying [the preference defendant] over other creditors.”

Trial counsel for plaintiffs and defendants in preference suits should read Judge Graham’s opinion in full text for tips on the more effective evidence to be introduced at trial.

The time for appeal has not begun to run because Judge Graham is yet to rule on the amount of prejudgment interest. If there are one or more appeals, the outcome will indicate whether a supplier can be liable for a preference, even though payments were never late.

The ‘Ordinary Course’ Defense

The debtor was a 220-store appliance and electronics retailer. The supplier was one of the debtor’s primary providers of consumer electronics and the sole supplier of some products. The debtor’s same-store sales began declining about three years before the chapter 11 filing.

The creditors’ committee was given the right to pursue preferences. The committee sued the supplier for about $4.7 million in preferences received in the three months before filing. On summary judgment, the committee had established all of the elements of a preference under Section 547(b). Disputed facts precluded summary judgment on the supplier’s “ordinary course” defense.

Judge Graham held a trial regarding the “ordinary course” defense under Section 547(c)(2). The subsection gives the supplier a defense:

to the extent that such transfer was 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 such transfer was—

(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or

(B) made according to ordinary business terms. [Emphasis added. Note the word “or,” making “A” and “B” disjunctive.]

Judge Graham meticulously recited the trial testimony about the ordinary course defense. We shall mention only a few pivotal facts.

Three years before bankruptcy, the debtor’s credit limit with the supplier was $12 million. Over the ensuing years, the supplier reduced the credit limit until it was $1 million. So the debtor could purchase $2 million in goods a month, the supplier gave the debtor 15-day terms. Leading up to bankruptcy, the debtor increased its purchases from the supplier because other suppliers were restricting or cutting off credit.

When the debtor filed bankruptcy, the supplier had been paid in full. In fact, the supplier paid the debtor $365,000 after filing on account of vendor credits.

The supplier did not file a claim but consented to permitting the bankruptcy court to enter final judgment.

The Tests for ‘Ordinary Course’

Judge Graham laid out the law on what he referred to as the “subjective” ordinary course defense, where the supplier shoulders the burden of proof by a preponderance of the evidence. The supplier, he said, must establish a “baseline of dealing” to show whether the payments were “consistent with the parties’ practice before the preference period.” The testing period, he said, should be based on a time when the debtor “was financially healthy.”

For the testing period, Judge Graham eliminated the 15 months before the chapter 11 filing when the debtor was in financial distress. The limitation didn’t matter, he said, because 98% of the invoices within the preference period were paid either before or within the required 15 days of invoicing.

Judge Graham therefore found that the payments in the preference period “remained consistent” with payments in the testing period. He found other facts in favor of the supplier. For example, the supplier never (1) withheld shipments, (2) sought personal guarantees, (3) threatened to turn the receivables over to a collection agent, or (4) threatened litigation.

Still, the supplier was unable to prove the defense by a preponderance of the evidence because (a) the supplier “consistently” sought payment by communicating “frequently” with the debtor’s senior management, (b) the supplier threatened to withhold shipments if payments were not made, (c) the debtor’s employees “advocated” for payment to the supplier because they “valued their relationship” with the supplier, and (d) the supplier “significantly” reduced the debtor’s credit to $1 million “at a time when the Debtor’s business with [the supplier] was at an all-time high.”

Judge Graham said the outcome was “not an easy call.” The evidence on both sides was in balance. He tipped the scale in favor of the debtor in view of the supplier’s “concerted effort to limit [its] exposure,” the significant reduction in the credit limit, and the supplier’s frequent communications seeking payment.

The facts led Judge Graham to the “inescapable conclusion” that the debtor “prioritized paying [the supplier] over other creditors. And this is what Congress meant to remedy when drafting Section 547(b).”

Because the supplier failed to prove the defense by a preponderance of the evidence, Judge Graham gave the debtor a judgment for a net preference of about $3.5 million, given the supplier’s $1.2 million offset for new value.

Observations

Is there anything wrong with this picture?

The supplier provided badly needed goods when other suppliers would not. For vigilantly policing the receivables, the supplier was slapped with a $3.5 million preference judgment.

When a debtor’s finances are precarious, should suppliers be at risk of receiving preferences for restricting credit terms, even though the debtor pays on time?

Section 547 was designed to encourage suppliers to deal with companies in financial distress. Should suppliers be liable for hounding debtors for payment, or should suppliers remain silent and cut debtors off when they don’t pay?

The foregoing are policy considerations, which don’t matter much these days. The statute matters.

In terms of the statute, hounding the debtor for payments may not be in the ordinary course of business between the two parties, but did the supplier nonetheless qualify for the defense under Section 547(c)(2)(B)?

The credit terms were 15 days, and the debtor always paid within 15 days. Are 15 days not “ordinary business terms” for a retailer in financial distress? Were the terms not ordinary because the supplier hounded the debtor for payment?