The Seventh Circuit Court of Appeals in Unsecured Creditors Committee of Sparrer Sausage Co., Inc. v. Jason’s Foods, Inc., 2016 WL 3213090 (7th Cir. June 10, 2016) expanded the scope of the ordinary course defense in a bankruptcy preference action.  This case provides an excellent road map for a creditors’ rights attorney defending a preference suit and suggests arguments for increasing the payments a creditor can retain even if those payments were made during the 90-day preference period.

Here are the facts in Jason’s Foods.  During the 90-day preference period, the debtor paid invoices it received from Jason’s Foods totaling about $587,000.00.  The Unsecured Creditors’ Committee filed suit asking the bankruptcy court to avoid all payments made within the 90-day preference period.  The bankruptcy court ruled that prior to the preference period, the debtor generally paid the invoices to Jason’s Foods within 16 to 28 days.  Accordingly, of the 23 invoices paid during the preference period, 12 were within the range and 11 were outside the range.  Thus, the bankruptcy court concluded that $306,110.23 of the payments were not made in the ordinary course.  The issue for the Seventh Circuit was whether the bankruptcy court set the range of ordinary course (within 16 to 28 days) too narrowly.  Jason’s Foods challenged the bankruptcy court’s decision in two ways.  First, it challenged the court’s use of an abbreviated historical period rather than the company’s entire payment history.  Second, it argued that the baseline comprises a too-narrow range of days surrounding the average invoice age during the historical period.

The Seventh Circuit acknowledged that it is the job of the bankruptcy court to determine the appropriate pre-preference time period to use in establishing a baseline between the debtor and the creditor. The requirement does not mean that the bankruptcy court will truncate the historical period well before the beginning of the preference period, but simply underscores that the baseline should reflect payment practices that the debtor and the creditor established before the onset of any financial distress associated with the debtor’s impending bankruptcy.  In other words, error will not be found if the bankruptcy court established the historical baseline on a time frame when the debtor was financially healthy.

Therefore, if the debtor’s financial difficulties have already substantially altered its dealings with the creditor before the preference period, then truncation may be appropriate. If such is not the case, then it may be appropriate to consider the entire pre-preference period.

In Jason’s Foods, the parties stipulated that the pre-preference period encompassed the entire credit history between the parties.  The bankruptcy court rejected this stipulation and the Seventh Circuit concluded that the bankruptcy court had the power to reject the stipulation and make its own determination of the appropriate pre-preference period for the historical comparison.  The bankruptcy court applied a truncation methodology to establish the historical baseline.

The Seventh Circuit considered the two methods used to arrive at the historical baseline: the average-lateness method and the total-range method.

The average-lateness method uses the average invoice age during the historical period to determine which payments are ordinary. The total-range method uses the minimum and maximum invoice ages during the historical period to define an acceptable range of payments.  If the bankruptcy court has a good reason for selecting one of the methods, an appellate court will most likely not reverse the selection.

In Jason’s Foods, the bankruptcy court selected the average-lateness method.  Once the appropriate method is selected, the bankruptcy court must correctly apply the method.  This is the point where the bankruptcy court made an error.  The bankruptcy court first calculated that the average invoice age rose from 22 days during the historical period to 27 days during the preference period.  The Seventh Circuit was skeptical that a five-day difference in the average invoice age was substantial enough to take any of the preference-period payments outside the ordinary course.  However, because the bankruptcy court is the fact-finder, the court was unwilling to upset the judge’s decision on this basis.  Nevertheless, as the first line of defense, a creditor should assert that any payments within the five-day difference are not outside the ordinary course.  Although this might not be the winning argument, it may help to establish a foundation for success on a later argument.

This is exactly what happened in Jason’s Foods.  The Seventh Circuit held it was clear error for the bankruptcy judge to find that invoices paid more than six days on either side of the 22-day average were outside the ordinary.  Although agreeing that the bankruptcy court could group historical-period invoices “in buckets by age”, the Seventh Circuit concluded that the range was too narrow.  A 16 to 28-day baseline range encompassed just 64% of the invoices that the debtor paid during the historical period.  The Seventh Circuit found it problematic that the bankruptcy court did not offer an explanation for the narrowness of this range.

The bottom line is that the narrow range used by the bankruptcy court did not comply with the ordinary course defense which is designed to protect recurrent transactions that generally adhere to the terms of a well-established commercial relationship. Accordingly, the Seventh Circuit increased the baseline range to 14 to 30 days and thus reduced the preference liability to $60,679.00.  This liability was extinguished because the subsequent new value defense exceeded the preference liability.

The decision in Jason’s Foods is important because it suggests an approach for creditors to protect those payments made to a creditor during the preference period.  It also provides a pre-bankruptcy warning to creditors regarding the need to monitor the payment practices of their debtors to avoid or reduce an involuntary slippage in the ordinary course payment practices.