Restructuring Agreements and the Ordinary Course of Business Exception

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Mar 2001

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Prior to filing a bankruptcy petition, debtors and creditors often attempt a "workout"
to cure arrearage or other defaults. Often, a workout comes after the initiation of
a lawsuit, in the form of a settlement agreement. Sometimes, however, a workout
derives from a debt restructuring, such as a bank's troubled debt restructuring
methods.

When the workout fails, or other financial problems result in the debtor's
bankruptcy, payments made pursuant to the workout are often challenged as preferential
transfers. While the "ordinary course of business" defense is often raised, it is not
always successful. Recently, however, certain courts have issued opinions to the effect
that the success of the ordinary course of business defense depends on the structure
of the workout, and the reality of whether the challenged transfer was made in the
ordinary course of business.

<h3>The Ordinary Course of Business Defense</h3>

Pursuant to <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §547(c)(2)</a>, a transfer is not avoidable, i.e.,

an affirmative defense exists, if the transfer was (a) in payment of a debt incurred
by the debtor in the ordinary course of business or financial affairs of the debtor
and the transferee, (b) made in the ordinary course of business or financial affairs
of the debtor and the transferee, and (c) made according to ordinary business terms.
By its own terms, the ordinary course of business defense is intended to apply to
transfers made in the ordinary course of business. Specifically, courts have held that
payments made pursuant to a settlement agreement that are the result of prior disputes
between the parties are not in the ordinary course of business. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Valley
Steel Products Co. Inc., 214 B.R. 202, 207 (E.D. Mo. 1997)</a>.
The ordinary course of business exception, after all, is intended to protect
recurring, customary trade transactions, not payments in settlement of contractual
claims. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;; see, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Wilde (In re Southern Industrial Banking
Co.), 173 B.R. 901, 905 (Bankr. E.D. Tenn. 1994)</a> (debts
incurred by settlement of a dispute, pursuant to legal action or otherwise, are
incurred outside the ordinary course of business, as settlement agreements themselves are
unusual); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Corp. v. MID Corp. (In re Daikin Miami Overseas Inc.),

65 B.R. 396, 398 (S.D. Fla. 1986)</a> (payments made pursuant to
settlement of previous debt are not in the ordinary course of business).

Thus, crafting debt restructuring terms and conditions that are inside the ordinary
course of business is of the utmost importance. Fortunately, recent circuit court
opinions are giving guidance by recognizing the increasing use of debt restructuring
agreements as part and partial of today's ordinary business relations. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v.
Justus (In re Kaypro), 218 F.3d 1070 (9th Cir. 2000)</a>.

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[P]ractitioners should consider factors previous courts have
considered in distinguishing between settlements and debt
restructurings.
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<h3>Debt Restructuring as the Ordinary Course of Business</h3>

In Kaypro, the debtor had large trade debts that it sought to restructure by
executing certain promissory notes. Shortly after execution of the promissory notes, the
debtor filed bankruptcy. Upon the filing of a preference action, the creditor/defendant
asserted the ordinary course of business defense and claimed that despite the fact that
the restructuring agreement altered the debtor's payment terms, it was done in the
ordinary course of business.

The bankruptcy court granted summary judgment against the creditor/defendant, finding
that the ordinary course of business defense did not apply as a matter of law, which
the Ninth Circuit Bankruptcy Appellate Panel (BAP) affirmed. The Ninth Circuit
Court of Appeals examined the application of the ordinary course of business defense
to determine whether a genuine issue of material fact existed, and held that a court
must look to "those terms employed by similarly situated debtors and creditors facing
the same or similar problems. If the terms in question are ordinary for industry
participants under financial distress, then that is ordinary for the industry." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;
218 F.3d at 1074</a>; citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Roblin Industries Inc., 78 F.3d
30, 42 (2d Cir. 1996)</a>.

In reaching its decision, the Ninth Circuit relied heavily on the Second Circuit's
opinion in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Roblin Industries Inc., 78 F.3d 30, 42 (2d Cir.
1996)</a>. In Roblin, the Second Circuit held, "we decline to adopt a rule that
payments made pursuant to debt-restructuring agreements, even when the debt is in
default, can never be made according to ordinary business terms. After all, it is
not difficult to imagine circumstances where frequent debt restructuring 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. Indeed,
if the industry practice is to restructure defaulted debt, it would make little
practical sense to require creditors to comply with any other standard in order to meet
the requirement of §547(c)(2)(<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; In re Roblin Industries Inc., 78
F.3d 30, 42 (2d Cir. 1996)</a>; see, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re USA Inns, 9
F.3d 680, 685 (8th Cir. 1993)</a> (holding that it was regular practice
in the savings-and-loan industry to adopt payment plans for delinquent customers);

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. John Deere Co. (In re Gilbertson), 90 B.R. 1006,
1012 (Bankr. D. N.D. 1988)</a> (finding that deferral agreements were common
in the retail farm-implement sales industry).

Based on the holdings in Roblin and Kaypro, a creditor that agrees to restructure
a debt in a manner consistent with industry practice does not lose the benefit of the
ordinary course of business exception. Indeed, courts have distinguished between
settlement agreements and debt restructuring agreements by holding that payments made
pursuant to a debt-restructuring agreement are in the ordinary course of business if
such agreements are industry practice. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Software Corp. v. Micro Education
Corp. of America, 103 B.R. 359, 360-61 (D. Mass. 1988)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
re Gilbertson, 98 B.R. at 1011-12</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Magic Circle Energy Corp.,

64 B.R. 269, 274-75 (Bankr. W.D. Okla. 1986)</a>. Thus, when
crafting such an agreement, practitioners should consider factors previous courts have
considered in distinguishing between settlements and debt restructurings.

<h3>Applying the Restructuring Standard</h3>

One signal that an agreement is a debt restructuring agreement, as opposed to a
settlement agreement, is that new debt instruments are executed, and threatening
circumstances do not surround the creation of the agreement. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Signal Capital
Corp. (In re Mastercraft Graphics Inc.), 157 B.R. 914, 920-21
(Bankr. S.D. Fla. 1993)</a>; see, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Circle, 64 B.R. at
274-75</a> (where the court held that execution of a consolidated promissory note at
8 percent interest over the course of seven years was well within the ordinary course
of business). Payments made pursuant to creditor pressure, on the other hand, are
generally not made in the ordinary course of business. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Graphics, 157
B.R. at 919-20</a>.

Other factors to consider are (a) the creditor's routine execution of
debt-restructuring agreements with debtors that are unable to meet their obligations;
(b) the terms of the creditor's typical restructuring agreement, such as debt
consolidation and execution of a promissory note; (c) the commonality of such
restructuring agreements in the industry and with the particular creditor; and (d)
whether the creditor typically requires security or guarantees from restructuring debtors.
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 218 F.3d at 1073-75</a>.

In connection with the execution of new debt instruments, ordinary course is further
demonstrated by active negotiations in formulating the debt restructuring agreement, as
well as the debtor giving consideration, such as a restructuring fee or deferral
interest, in consideration therefore. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Gilbertson, 98 B.R. at
1011-12</a>.

The existence of these factors will not alone support the ordinary-course-of-business
defense as its application is made on a case-by-case basis. Above all,
practitioners must consider the importance of industry practice in determining whether
the challenged transfers were made in the ordinary course of business.

<h3>Conclusion</h3>

The holdings of both Kaypro and Roblin not only clarify the application of the
ordinary course of business defense, but also encourage the use of debt restructuring
by alleviating concerns of preference actions. Not all such agreements will fall under
the ordinary-course-of-business exception, as it is a very fact-intensive
consideration.

Due to increased recognition of debt-restructuring agreements as common in
debtor/creditor relationships, and the importance of using such agreements in modern
commerce, courts are providing guidelines for crafting debt restructuring agreements.
Practitioners should therefore take heed of such cases, particularly when the industries
and facts are similar.

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Journal Authors

Bruce H. White

William L. Medford

Journal Date

Thursday, March 1, 2001 - 12:00

Bankruptcy Rule

2001