The Seventh Circuit, reversing the bankruptcy court, interpreted the so-called ordinary course defense to benefit suppliers by helping them fend off preference suits.
According to the June 10 opinion by Circuit Judge Diane S. Sykes, the bankruptcy court should have allowed the defense for payments in the preference period that fell within the range representing 88% of payments before the onset of financial difficulties.
In a chapter 11 case, the creditors’ committee sued a supplier for $587,000 in preferences on 23 invoices paid within 90 days of bankruptcy. The bankruptcy judge held that the creditor received about $306,000 in preferences after applying the ordinary course defense in Section 547(c)(2)(A), which absolves a creditor from liability for receipt of a preference made in the ordinary course of business or made according to ordinary business terms. Subtracting some $63,000 in new value defenses, the bankruptcy judge entered judgment for about $243,000 against the creditor.
When Judge Sykes got through explaining why the bankruptcy judge misapplied the ordinary course defense, the creditor had no liability whatsoever.
The “subjective ordinary course defense,” according to Judge Sykes, inquires as to whether payments to the creditor during the preference period “are consistent with the parties’ practice before the preference period.” The court therefore must establish a “baseline” to “reflect the payment practices that the companies established before the onset of any financial difficulties.”
To determine the baseline, Judge Sykes said that courts either use the “average lateness method” or the “total-range method.” The average approach uses the average invoice age in the historical period, while the total-range method “uses the minimum and maximum invoice ages during the historical period to define an acceptable range of payments.” She said it was not error for the bankruptcy judge to have used the average age method.
To establish a baseline for payments before the onset of financial trouble, the bankruptcy judge calculated the average invoice age as 22 days and added six days to both ends. Consequently, payments were not eligible for the ordinary course defense unless they were made within 16 to 28 days, according to the bankruptcy judge.
Judges Sykes said the bankruptcy court erred in applying the average age method. She said it was “clear error” to limit the defense to six days on either side of the average, because that spread would cover only 64% of payments in the historical period. Significantly, she said the bankruptcy judge gave “no explanation” for the narrow range.
By adding two days to the bankruptcy court’s spread, thus making the defense applicable to payments within 14 and 30 days, 88% of payments in the historical period would have been immunized. Judge Sykes thus concluded that the 16- to 28-day window was “not only excessively narrow but also arbitrary.”
Even the 14- to 30-day window was not inflexible. Judge Sykes held that payments “just outside” of that time frame are also covered by the defense. As a result, she made the defense applicable to a payment in 31 days.
In conclusion, Judge Sykes held that the defense did not apply only to payments 37 and 38 days after the invoices were issued, making the creditor liable for about $61,000. Since the creditor had some $63,000 in new value defenses, the creditor walked away from the appeal with no liability at all.
Bankruptcy Judge Sean H. Lane of Manhattan came off looking good. Judge Sykes approvingly cited his Quebecor World opinion several times for his approach to the ordinary course defense.