Early Payments to Trade Creditors May Fall Outside the “Ordinary Course of Business” Defense to a Preference Action

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Contributed by Edward Wu

The Bankruptcy Court for the Southern District of New York recently issued a decision in the case of M. Fabrikant & Sons that may make it more difficult for trade creditors, among others, to defend against a preference action under section 547 of the Bankruptcy Code.

As preference actions can only be used to avoid payments made by a debtor on account of antecedent debt, if a debtor and an unsecured trade creditor simultaneously exchange payment for goods, there can be no preference recovery.  If payment was delayed but made soon after to render the exchange nearly simultaneous, the payment also should be unavoidable because of the “contemporaneous exchange for new value” defense.  Once a payment to a trade creditor is outside the “contemporaneous exchange” window, if the payment was received within 90 days before the debtor’s bankruptcy filing, the trade creditor may risk that the payment constitutes an avoidable preference under section 547.  In that situation, trade creditors often attempt to defeat a preference action by raising the “ordinary course of business” defense under section 547(c)(2) of the Bankruptcy Code.

To successfully invoke section 547(c)(2), a trade creditor must establish that, not only was the underlying debt incurred in the ordinary course by the debtor, but also one of two alternative prongs: that payment on the debt was made in the ordinary course of business between the debtor and the trade creditor, or that it was made according to ordinary business terms.

In M. Fabrikant & Sons, the court only considered the first prong because the trade creditor presented no evidence of industry practice in order to show that the payment was made according to ordinary business terms.  With respect to the first prong, Judge Bernstein held that, notwithstanding the terms of an invoice specifying when payment was due, a debtor’s payment is not in the ordinary course between the debtor and a trade creditor if it was made either early or late as compared to an historical baseline of payments between those two parties.

After finding that the debtor (in the business of selling jewelry) made payment on average 65 days after the invoice date for jewelry received from Gramercy (a jewelry manufacturer), the court ruled that a payment received within 30 days after the invoice date and another payment received 95 days after the invoice date were both made outside the ordinary course between the debtor and Gramercy.  While the court easily found that the payment received after 95 days was outside the ordinary course of the parties’ relationship, notably, the payment received within 30 days was consistent with the payment terms set forth in the invoice.  By holding that even payments within the contractually required time-frame may be outside the ordinary course of business, the decision reduces the period during which payments are unavoidable due to the “ordinary course of business” defense.

While Judge Bernstein’s decision with respect to early payments may be controversial, it can be defended from a policy standpoint.  The legislative history of section 547(c)(2) indicates that the purpose of the defense is to “leave undisturbed normal financial 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.”  A flurry of early payments to trade creditors by a debtor during a time when its financial condition is precarious is a strong indication that the debtor is succumbing to the same sort of conduct that preference law was designed to deter — the proverbial race to the courthouse by fearful creditors, which accelerates the debtor’s slide into bankruptcy.

It might even be argued that the avoidance of early payments is more justifiable than the avoidance of late payments because, while the latter might be a deviation from ordinary practice, it is less apparent that a trade creditor is being preferred when it receives its payment late, which has the effect of actually prolonging a debtor’s prepetition existence.  Indeed, to its own detriment, a trade creditor may even purposely afford a debtor extra time to make payment in the hope that the debtor’s financial condition will improve.  After a certain point in time, however, such a payment has the quintessential attribute of being a lingering debt that receives preferential treatment at a time when many others will not.  Controversial or not, M. Fabrikant & Sons certainly furthers one of the policies underlying the broad avoidance actions powers afforded to trustees and debtors in possession — the equitable treatment of all creditors on the eve of bankruptcy.