Trade creditors will undoubtedly want to take steps to protect themselves when dealing with financially distressed customers that are potentially heading toward bankruptcy — such as by decreasing credit limits, tightening payment terms or otherwise ramping up collection efforts. However, those same steps may come with the unintended consequence of compromising a creditor’s ordinary-course-of-business defense in the event that the customer files bankruptcy and the creditor is sued for a preference claim. This catch-22 was recently exemplified by a January 2022 decision in the U.S. Bankruptcy Court for the Southern District of Indiana in an adversary proceeding commenced in the chapter 11 cases of In re hhgregg Inc. [1] Although the defendant-creditor had established, in connection with its ordinary-course-of-business defense, that the timing of the alleged preference payments was nearly identical to the timing of the payments made by the debtors prior to the 90-day preference period, the court ultimately held that the defendant had failed to “tip the scales in its favor,” largely because the creditor had increased its collection efforts during the period leading up to the debtors’ bankruptcy filing.
Relevant Background on the “OCB” Defense and hhgregg Decision
Section 547(b) of the Bankruptcy Code allows a trustee or debtor-in-possession to avoid and recover, as a “preference,” certain transfers made to creditors within the 90-day period prior to the debtor’s bankruptcy filing. One of the most prominent defenses to a preference claim is the ordinary course of business, or “OCB,” defense under § 547(c)(2) of the Bankruptcy Code. To prove this defense, the creditor-defendant must establish that the alleged preference payment satisfied a debt incurred in the ordinary course of business between the debtor and creditor and was made either (a) in the ordinary course of business between the debtor and the creditor (i.e., the “subjective” prong of the OCB defense, which the creditor usually proves by showing that the timing and manner of the payments made during the 90-day preference period were consistent with the parties’ pre-preference period payment history), or (b) in accordance with ordinary business terms (i.e., the “objective” prong of the OCB defense, which the creditor usually proves by showing that the alleged preference payments were consistent with payment practices and terms in the creditor’s industry, the debtor’s industry, or a combination of both).
The subjective prong of the OCB defense was at issue in the hhgregg decision. In hhgregg, the creditors’ committee (the plaintiff) filed a complaint against one the debtor’s key suppliers, D&H Distributing Company (D&H), seeking to recover a total of $4,697,308.30 in payments made during the 90-day preference period — i.e., from Dec. 6, 2016, through the March 6, 2017, petition date (the preference period). D&H asserted that the payments were shielded by the OCB defense. D&H presented evidence at trial indicating that the timing of the debtors’ payments to D&H remained nearly identical prior to, and during, the preference period. In fact, the evidence showed that 98% of the payments during the historical pre-preference period of Jan. 3, 2015, to Dec. 3, 2016, were made between five days prior to and 15 days after their applicable due dates, and that during the preference period, more than 95% of the payments were also made between the same range.
However, D&H had ramped up its collection efforts during the year or so prior to the petition date, largely in response to the debtors’ poor financial performance and commensurate decline in share price referenced in the debtors’ Q4 2015 financial reports. While D&H had provided the debtors with a credit limit of between $10-$12 million in 2014, due to the debtors’ financial issues, it began steadily decreasing that credit limit in 2015 such that by January 2016, the credit limit had been reduced to only $1 million. Moreover, D&H reduced the debtors’ credit terms from net 60 until November 2015, to net 30 until February 2016, and finally to .25% 15, net 16, until the petition date.
D&H also exerted more collection pressure in its communications with the debtors during and slightly prior to the preference period. While these collection-related communications had historically been solely between the companies’ respective accounting departments, senior executives of D&H had begun to send collection correspondence to the debtors and would either copy or send the correspondence directly to the debtors’ senior executives. D&H also started threatening to stop deliveries in the event that the debtors failed to pay outstanding invoices or send a payment schedule to D&H. In fact, one of the debtors’ chief executives testified at trial that his colleagues “took a lot of pride” in managing the debtors’ relationship with D&H, and that the debtors prioritized payments to D&H. That said, D&H neither threatened litigation nor actually withheld product from the debtors, and one of the debtors’ senior vice presidents testified that he did not take D&H’s threats to withhold product seriously.
On May 6, 2020, the bankruptcy court entered an order granting summary judgment in the plaintiff’s favor as to its prima facie case to avoid the alleged preference payments under § 547(b). The court reserved for trial the issue of whether the payments were shielded by the subjective OCB defense.
The Bankruptcy Court Rules Against D&H
In what the court admitted was “not an easy call,” the court held after trial that D&H had failed to prove its subjective OCB defense and that D&H was liable and required to turn over payments in the aggregate amount of approximately $3.5 million (net of new value), plus prejudgment interest. The court acknowledged that the pre-preference period and preference period payment histories were largely consistent [2] and that a number of other factors weighed in favor of D&H’s subjective OCB defense — such as the fact that D&H never withheld shipments, threatened to commence litigation, or sought guarantees from the debtors’ principals or officers. The court also noted that D&H had increased sales to the debtors during the preference period despite the debtors’ extreme financial distress, which is what Congress sought to encourage when it established the OCB defense.
However, the court held that at least as much evidence weighed against D&H’s subjective OCB defense. D&H had changed terms and reduced the debtors’ credit limit dramatically running up to and during the preference period. D&H had also escalated its collection correspondence by copying or directing the correspondence to the debtors’ senior management and threatening to withhold deliveries in the event of nonpayment. Due to this, the court concluded that neither party had “noticeably tipped the scales in their favor” based on the evidence presented. This was fatal to D&H’s defense, since the defendant carries the burden of proving its defense by a preponderance of the evidence (i.e., establishing by more than a 50% chance), and D&H had failed to do so.
Conclusion
The hhgregg decision is not binding on other bankruptcy courts, and, given the subjective nature of the OCB defense and corresponding analysis, it is quite possible that another court may rule differently on similar facts and circumstances. Still, the hhgregg decision serves as a cautionary tale for trade creditors that are seeking to manage credit risk. While it is certainly important to minimize credit risk and take the necessary steps to do so, the hhgregg decision emphasizes the need to balance those steps against the potential risk of creating preference exposure — particularly where those steps may not have impacted the timing of the debtor’s payments in any event, as appears to have been the case in the hhgregg decision.
[1] See In re hhgregg Inc., 2022 WL 370279 (Bankr. S.D. Ind. Jan. 13, 2022).
[2] Interestingly, the court concluded that the historical period used for purposes of establishing D&H’s subjective OCB defense should be truncated so as to not include the 10-month period immediately prior to the 90-day preference period because, as evidenced by the debtors’ Q4 2015 financial reports, the debtors were in a “liquidity crisis” during that period. The court reasoned that the historical “baseline” period against which to compare the preference period payments should be established on a case-by-case basis and reflect a time period when the debtor was “financially healthy.” In any event, the court concluded that it was likely that the historical payment history presented by D&H (which included the 10-month period immediately preceding the preference period) would “largely hold up” even if the history were truncated, since the court was not presented with any evidence to indicate otherwise and the pre-preference period and preference period payments were overwhelmingly consistent. It is also worth noting that the court rejected an argument by the plaintiff that D&H’s analysis improperly relied on the days taken to pay from the due date of each invoice (a “days late” analysis) rather than on the interval between the invoice date and payment date (a “days-to-pay” analysis). The court concluded — “albeit reluctantly” — that a day’s late analysis was more appropriate, since the parties’ credit terms had changed during the historical period and therefore a days-to-pay analysis would not have yielded a reliable comparison throughout the historical period.