Preference Exposure for Workout Payments

This article addresses potential preference exposure for workout payments made pursuant to restructuring agreements between a creditor and debtor. Specifically, this article will address whether these payments are free from avoidance under the “ordinary course of business” defense.

The Ordinary Course of Business Defense in General

The “ordinary course of business” defense set forth in §547(c)(2) of the Bankruptcy Code provides:

(c) The trustee may not avoid under this section a transfer--

(2) 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.

11 U.S.C. §547(c)(2).

The purpose of the ordinary course exception is “to leave undisturbed normal financing relations, because it does not detract from the general policy of the preference section to discourage unusual action by either the debtor or his creditors during the debtor’s slide into bankruptcy.” S.Rep. No. 989, 95th Cong., 2d Sess. 88 (1978), 1978 U.S.C.C.A.N. 5787, 5874.

This section was amended in 2005 pursuant to the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA).[1] Prior to BAPCPA, in order to prove that transfers fell within the ordinary course exception, a creditor had to show, by a preponderance of the evidence, that the transaction was ordinary as between the parties and ordinary in the industry examined as a whole. In re Midway Airlines, Inc., 69 F.3d 792, 797 (7th Cir. 1995). With respect to industry practice, such a “determination is a question of fact that depends on the nature of the industry practice in each particular case, a factual inquiry that is appropriately left to the bankruptcy court.” Roblin Indus., Inc. v. Ford Motor Co. (In re Roblin Indus., Inc.), 78 F.3d 30, 41 (2d Cir. 1996).

Post-BAPCPA, the analysis is largely the same with one exception: rather than having to show that the transaction is both ordinary as between the parties and ordinary in the industry, now a creditor must only show one or the other.[2] See SGSM Acquisition Co., LLC v. Sharp (In re SGSM Acquisition Co., LLC), 439 F.3d 233, 240 n.4 (5th Cir. 2006) (“Under the BAPCPA, the second and third prongs of the ordinary course defense have become disjunctive rather than…conjunctive.”). Reviewing the effect of the BAPCPA amendments, the Ninth Circuit explained: “Because of [the BAPCPA] change, first-time transfers can come within the exception if they meet the ‘ordinary business terms’ requirement, measured by industry practice, even if there is no course of business between the parties.” Ahaza Sys., Inc. v. Stratos Product Dev., LLC (In re Ahaza Sys., Inc.), 482 F.3d 1118, 1123 n.4 (9th Cir. 2007).

Accordingly, the ordinary-course-of-business defense is now, in fact, easier to satisfy than it previously was in that the ordinariness of the transaction in question can be established either by the practice between the debtor and creditor or by the practice in the relevant industry.

The “Ordinary Course of Business” Defense as Applied to Workout Payments

Some courts have held that payments made pursuant to workout or similar debt restructuring agreements are per se non-ordinary. For instance, in Red Way Cartage Co. v. Kubicki (In re Red Way Cartage Co.), 84 B.R. 459 (Bankr. E.D. Mich. 1988), the court held that “[t]he fact that parties negotiated an agreement for the payment of the antecedent debt and made payments pursuant to that agreement does not bring the payments within the 547(c)(2) exception.” Id. at 461. The court reasoned that the promissory note, which included a payment schedule, was an antecedent debt incurred as a result of the failure to make the stipulated payments under the lease. Id. at 461-62. The court concluded that such a payment could not fall within the ordinary-course-of-business exception. Id. This ruling is often cited for the proposition that debt-restructuring agreements are per se non-ordinary. Indeed, a number of courts have held that payments made pursuant to settlement or workout agreements do not fall within the ordinary-course-of-business exception. See, e.g., Carrier Corp. v. Mid Corp. (In re Daikin Miami Overseas, Inc.), 65 B.R. 396, 398 (S.D. Fla. 1986); Barber v. Bettendorf Bank, N.A. (In re Pearson Indus. Inc.), 152 B.R. 546, 552-53, 555-56 (Bankr. C.D. Ill. 1993); Maloney-Crawford, Inc. v. Huntco Steel Inc., 144 B.R. 531, 536-37 (Bankr. N.D. Okla. 1992); Rajala v. Holland Corp. (In re Chesapeake Assocs. Ltd. P’ship), 141 B.R. 737, 747-48 (Bankr. D. Kan. 1992); Intercontinental Publ’ns, Inc. v. Perry, 131 B.R. 544, 550 (Bankr. D. Conn. 1991); Barber v. Lego (In re Indus. & Mun. Eng’g Inc.), 127 B.R. 848, 850 (Bankr. C.D. Ill. 1990); Durant’s Rental Ctr. Inc. v. United Truck Leasing Inc., 116 B.R. 362, 365 (Bankr. D. Conn. 1990); Prod. Steel Inc. v. Sumitomo Corp. of Am. (In re Prod. Steel Inc.), 54 B.R. 417, 423-24 (Bankr. M.D. Tenn. 1985).
           
Nevertheless, the modern trend appears to be a rejection of the per se non-ordinary rule and a focus on a fact-intensive inquiry on whether the transfer in question was made in the ordinary course of business. See, e.g., Seaver v. Allstate Sales & Leasing Corp. (In re Sibilrud), 308 B.R. 388, 394 (Bankr. D. Minn. 2004) (stating that “the Court is not inclined to rule that every debt restructuring situation renders the debt new and distinct from the underlying debt that was in fact incurred in the ordinary course”); Ice Cream Liquidation Inc. v. Niagara Mohawk Power Corp. (In re Ice Cream Liquidation Inc.), 320 B.R. 242, 252-53 (Bankr. D. Conn. 2005) (stating that “the fact that payments were made on a defaulted debt pursuant to a restructuring agreement is not per se disqualifying for Section 547(c)(2)(B) purposes”); Mills v. LTI Aviation Fin. Co. (In re Airline Training Acad. Inc.), 2005 WL 852536, *3-4 (Bankr. M.D. Fla. Mar. 9, 2005) (stating that “[t]he mere restructuring of a debt does not take a resulting payment outside of the ordinary course of business”).

The following cases are instructive on the issue of how a court would likely analyze the ordinary-course-of-business defense in the context of payments made pursuant to workout or debt restructuring agreements.

In U.S.A. Inns of Eureka Springs, Ark., Inc. v. United Savings & Loan Assoc. (In re U.S.A. Inns of Eureka Springs, Ark., Inc.), 9 F.3d 680 (8th Cir. 1993), the court analyzed what must be established to show that a particular transaction was customary within the relevant industry. According to the court, “[w]hat constitutes ‘ordinary business terms’ will vary widely from industry to industry… Subsection (c)(2)(C) does not require a creditor to establish the existence of some uniform set of business terms within the industry in order to satisfy its burden. It requires evidence of a prevailing practice among similarly-situated members of the industry facing the same or similar problems.” Id. at 685. Ultimately, the court concluded that “[t]he terms on which United dealt with U.S.A. Inns were not so ‘idiosyncratic’ or ‘extraordinary’ as to fall outside” the ordinary-course-of-business exception. Id. at 685-86. In so doing, the court found the payments to be protected by the ordinary-course-of-business defense inasmuch as it was the regular practice in the savings and loan industry to adopt payment plans for delinquent customers. Id. at 685.

In Roblin Indus. Inc. v. Ford Motor Co. (In re Roblin Indus. Inc.), 78 F.3d 30, 41 (2d Cir. 1996), the court ruled that the “industry practice” prong of §547(c)(2) “requires a creditor to demonstrate that the terms of a payment for which it seeks the protection of the ordinary course of business exception fall within the bounds of ordinary practice of others similarly situated.” Id. at 41. Moreover, the determination of whether workout payments fall within the ordinary-course defense is “a question of fact that depends on the nature of industry practice in each particular case,” and such a determination should be left to the bankruptcy court. Id. at 41-42. The court declined 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 as a matter of law.” Id. at 41. The court also noted that “[i]t is not difficult to imagine circumstances where frequent debt rescheduling 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.” Id. at 42. Thus, the court concluded that in determining whether the ordinary-course-of-business defense can protect workout payments, the relevant inquiry is whether the terms in question are ordinary for industry participants under financial distress. Id.

In Arrow Elecs., Inc. v. Justus (In re Kaypro), 218 F.3d 1070 (9th Cir. 2000), the court rejected the per se non-ordinary rule and, in so doing, stated, “such determination is a question of fact that depends on the nature of industry practice.” Id. at 1073. A court must consider “‘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.’” Id. at 1074 (quoting Roblin Indus., 78 F.3d at 42). In examining the relationship between the parties, the court held that the restructuring agreements at issue were within the ordinary course of business for the creditor inasmuch as the creditor routinely entered into such agreements. Id. at 1075. In examining the industry practice, the court concluded that restructuring agreements were common in the industry. Id.

In Swallen’s v. Corken Steel Prods. Co. (In re Swallen’s Inc.), 266 B.R. 807 (Bankr. S.D. Ohio 2000), the court, relying on the reasoning in Kaypro, held that it would look to “the separate kinds of payments provided for in the [restructuring] agreement, and the issue of whether payments were made in the ordinary course of business is not ipso facto determined by the fact that there was a restructuring agreement.” Id. at 813. Analyzing “current payments” on account of shipments of goods under an open line of credit that was the normal course for the debtor and creditor, the court found that the rigid payment schedule provided in the restructuring agreement was a departure from prior practice between the parties, and thus not in the ordinary course. Swallen’s Inc., 266 B.R. at 813-14. The court also found that the “arrearage payments” provided for in the restructuring agreement were not made in the ordinary course insofar as there was no “history of payment of arrearages within twelve months, an obligation imposed upon [the debtor under the restructuring agreement].” Id. at 815.

In Gonzales v. DPI Food Prods. Co. (In re Furrs Supermarkets Inc.), 296 B.R. 33 (Bankr. D. N.M. 2003), the court held that the standard to be applied when analyzing the ordinary course of the debtor should be the ordinary course of a healthy business, not the ordinary course of a distressed debtor. Id. at 41-43. The court acknowledged that to determine “ordinary business terms,” the court must look to those “used in ‘normal financing relations’; the kind of terms that creditors and debtors use in ordinary circumstances, when debtors are healthy.” Furrs Supermarkets, 296 B.R. at 41-42 (emphasis in original) (quoting Clark v. Balcor Real Estate Fin., Inc. (In re Meridith Hoffman Partners), 12 F.3d 1549, 1553 (10th Cir. 1993)). The court recognized, however, that “[t]he Tenth Circuit does seem to be somewhat unique among the circuits in explicitly requiring an industry standard using a healthy debtor,” as other circuits have extended the scope of “ordinary business terms” to payments made by distressed debtors. Id. at 42. Ultimately, the court ruled that the creditor must successfully raise and prove that the workout payments were or are “consistent with the (presumably broad) range of arrangements that take place between creditors and healthy debtors in the applicable segment of the industry.” Id. at 45.

Conclusion

Based on the foregoing, it is unlikely that a bankruptcy court would hold that payments made pursuant to a debt restructuring agreement are per se non-ordinary. However, creditors should be aware that payments made pursuant to restructuring agreements nevertheless have serious preference exposure. In order to properly assert an ordinary-course-of-business defense to a preference lawsuit, a creditor would have to demonstrate that such agreements are either common as between the debtor and creditor, Kaypro, 218 F.3d at 1075 (holding that restructuring agreements at issue were within the ordinary course of business for the creditor because the creditor routinely entered into such agreements), or common in the relevant industry. U.S.A. Inns, 9 F.3d at 685 (holding that payments were protected by ordinary-course-of-business defense inasmuch as it was regular practice in savings and loan industry to adopt payment plans for delinquent customers); Kaypro, 218 F.3d at 1075 (holding that payments are protected by ordinary-course-of-business defense when restructuring agreements are common in the relevant industry); In re Magic Circle Energy Corp., 64 B.R. 269, 274-75 (Bankr. W.D. Okla. 1986) (workout payments made pursuant to “ordinary business terms” of oil and gas industry were not avoidable as preferential transfers pursuant to ordinary-course-of-business defense). Moreover, in cases arising post-BAPCPA, “first-time transfers can come within the exception if they meet the ‘ordinary business terms’ requirement, measured by industry practice, even if there is no course of business between the parties.” Ahaza, 482 F.3d at 1123 n.4.

One issue of uncertainty, however, is how a bankruptcy court will define the relevant industry. For instance, a court could require, like the Tenth Circuit, that the relevant industry be examined with respect to the industry practice of “healthy debtors.” See Furrs Supermarkets, 296 B.R. at 41-42. By contrast, the court could follow the Second Circuit’s lead and conclude that the relevant inquiry is whether the terms in question are ordinary for industry participants under financial distress. See Roblin Indus., 78 F.3d at 42. Although it can not be said with certainty, it appears likely that a bankruptcy court sitting outside the Tenth Circuit would follow the approach enunciated by the Second Circuit in Roblin Industries. See Furrs Supermarkets, 296 B.R. at 42 (recognizing that “[t]he Tenth Circuit does seem to be somewhat unique among the circuits in explicitly requiring an industry standard using a healthy debtor”).