Contributed by Jessica Diab
A recent decision from the United States Bankruptcy Court for the Western District of Texas caught our eye because of the unconventional opening line:
“Summers are hot in Texas, so pools are a hot item. But not hot enough to help a pool installer [ . . . ] avoid bankruptcy”
– Judge Tony M. Davis, United States Bankruptcy Judge.
The decision itself is not as unusual as its opening line, but it is a useful reminder of the necessary requirements for establishing the “ordinary course of business” defense to an action to recover transfers as preferential under section 547 of the Bankruptcy Code.
Sterry Industries, Inc., a pool installer, had a long standing business relationship with a subcontractor who installed the permanent liner in the pools it constructed. For some time prior to the bankruptcy, Sterry would fax a work order to the subcontractor, specifying where and when to install the liner, and the subcontractor would then install the liner and send an invoice to Sterry. The invoice stated that payment was “net 30” (i.e., due within thirty days). Most often, Sterry would mail a check to the subcontractor upon receiving the invoice but, occasionally, one of the subcontractor’s representatives would pick up the check at Sterry’s offices. Despite payment being due within thirty days of receipt of the invoice, evidence showed that Sterry was generally not paying the subcontractor within thirty days.
Approximately six months before Sterry commenced its case under chapter 7 of the Bankruptcy Code, the subcontractor was sold to a new owner. The business practices between Sterry and the new subcontractor changed in two ways: first, the payment for services rendered by the subcontractor became due upon receipt of the invoice (though, Sterry continued to take between four and twenty-two days to make payment) and, second, a representative would pick up each check at Sterry’s offices (there was no option to mail the check to the subcontractor). These changes were observed consistently during the six-month period from the change in ownership to the bankruptcy filing.
Postpetition, the chapter 7 trustee commenced an adversary proceeding seeking to recover payments made to the subcontractor, in an aggregate amount of $18,536, in the three-month period prior to the bankruptcy filing as preferential transfers. Pursuant to section 547(b) of the Bankruptcy Code, a trustee may avoid and recover as a “preferential transfer” any transfer of a debtor’s property made to a creditor for debt owed by the debtor, while the debtor was insolvent and within the preference period (i.e., within ninety days of the petition date). A creditor can avoid such an avoidance action (no pun attended) by demonstrating that the payments were in the ordinary course of the debtor’s business in accordance with section 547(c) of the Bankruptcy Code. The issue before the court was whether a creditor can establish an “ordinary course of business” defense to a preference action where a change in ownership of the creditor six months before the bankruptcy filing caused the debtor’s ordinary course of the business with the subcontractor to change. In other words, can terms on which parties do business constitute “ordinary course of business” when they have only been in effect for six months prior to the bankruptcy filing and where they do not mirror the historical terms upon which a predecessor vendor did business?
To establish the ordinary course of business defense set forth in section 547(c) of the Bankruptcy Code, a creditor has the burden of proving that the payments were either (1) “made in the ordinary course or financial affairs of the debtor and the transferee” or (2) “made according to ordinary business terms.” The former is considered to be a subjective analysis whereas the latter is considered to be an objective one.
The court considered whether the transfers (i.e., payments made) to the subcontractor could satisfy the subjective test. In doing so, the court identified factors that are typically considered when undertaking this analysis including, the length of time the parties were engaged in the transaction at issue, whether the amount or form of tender differed from past practices, whether the creditor engaged in any unusual collection activity, and the circumstances under which the payment was made. Here, the timing and manner of the payments between Sterry and the subcontractor in the three months prior to the preference period were substantially the same as during the preference period; however, the court acknowledged that if it were to look at the entire payment history between Sterry and the subcontractor, without considering ownership changes, the payments at issue might look preferential and not in the ordinary course of business because Sterry began paying its invoices in under thirty days (thereby improving the payment rights of its subcontractor) only three months prior to the preference period. The court determined, however, that it could not ignore the ownership change in conducting this subjective analysis — with the ownership change came a new business relationship which only began three months prior to the preference period. Accordingly, it was the three-month period prior to the preference period that would serve as the relevant baseline for determining whether conduct taken during the preference period was in the ordinary course of business. On this basis, the court was satisfied that payments made to the subcontractor during the preference period were protected by the “ordinary course of business” defense.
In a last ditch attempt to claw back the payments made to the subcontractor, the trustee argued that sending someone to collect checks in person is a coercive practice that would take the payments outside of the ordinary course of business. The court did not find this argument persuasive finding that, although the test is a subjective one, coercive practices tend to include threatening to shut down the business unless payment is made or terminating contracts and refusing to perform under an agreement. The court found that although sending someone to pick up the check is more “coercive” than simply allowing Sterry to mail the check, it did not rise to the level of coercion that would take the payments outside of the ordinary course of business.
This decision may not be as eye-catching as its opening line, but it is a good reminder to practitioners that the determination of what constitutes “ordinary course of business” for purposes of defending a preference action is a fact-specific analysis that is not necessarily limited by the historic or long-term practice of the debtor, but rather will adapt to the circumstances at hand.
Jessica Diab is an Associate at Weil Gotshal & Manges, LLP in New York.
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