The U.S. Court of Appeals for the Third Circuit has issued a recent decision that is instructive as to what creditors should not do when a customer is having a hard time paying its bills.

In In re Hechinger, 2007 WL 1630004 (3d Cir. June 7, 2007), the debtor, a purchaser of treated lumber products, faced financial difficulty prior to filing for chapter 11 protection. A creditor (Universal Forest Products or “UFP”), who had done business with the debtor for 15 years, sought to assuage its concerns regarding selling to the debtor on credit by entering into a new credit agreement containing tighter terms with the debtor.

This, however, is one of the last things that a creditor concerned about a financially troubled debtor should do. Entering into new payment arrangements with a potential debtor is a bad idea is because “new credit terms” is not a defense to a preference action. Many creditors think that tightening credit terms on a debtor, especially when such an arrangement is in writing, will insulate them from preference exposure. This is not at all the case. In fact, entering into new terms will eliminate one defense to preference actions—the ordinary course defense.

The only way to protect against preference exposure is to do C.O.D. or cash in advance. Otherwise, if the creditor intends to continue providing goods on credit to the debtor, the creditor should examine the payment history with the debtor over the past few years and insist that the payment terms remain the same. The safest course if one is concerned with a customer’s financial struggles is to consult bankruptcy counsel because the rules are not intuitive.

Hechinger’s History

In Hechinger, the terms of the credit relationship between the debtor and creditor had been 1 percent 10 days, net 30, with a seven-day mail float. The Third Circuit took note that, “[d]uring the three years prior to Hechinger’s bankruptcy filing, Hechinger made most of its payments to [creditor] within the ‘discount period.’

As of Feb. 4, 1999 [the date creditor met with debtor to discuss its financial condition], Hechinger’s account reflected no amount past due, and $37,148 coming due within the next 30 days,” the court stated. The agreement entered into after this date “changed the terms of Hechinger’s credit arrangements with UFP [and] required Hechinger to make larger and more frequent payments to UFP….”

The change immediately made these payments subject to attack as preference payments.1* This is amply demonstrated by the fact that that UFP’s defense to the preference action was that the payments were actual C.O.D. or cash in advance and therefore were not preferential. The bankruptcy court ruled that because some of the cash in advance payments were made in relation to a credit agreement, they could not be considered exempt from preference recovery.

The Third Circuit rejected this view and stated that whether a payment is related to a credit agreement is not the determining factor, rather the relevant issue is whether the payments were cash in advance or a contemporaneous exchange for new value. This is the proper standard by which to evaluate such payments because if payments are cash in advance or a contemporaneous exchange, then by definition they are not payments on account of an antecedent debt and are therefore not preferential, the court stated.

“The critical inquiry in determining whether there has been a contemporaneous exchange for new value is whether the parties intended such an exchange,” stated the court, quoting In re Spada, 903 F.2d 971, 975 (3d Cir. 1990). The Third Circuit remanded the matter to the bankruptcy court in order to determine “whether Hechinger and UFP intended the transfers at issue to be contemporaneous exchanges for new value, with the understanding that transfers made under ‘credit’ terms are not, as a matter of law, categorically excluded the scope of the § 547(c)(1) defense to avoidance.”

On the issue of ordinary course, the court was quite harsh with UFP and its new negotiated credit terms. Entering into new terms on the eve of bankruptcy is perhaps the single worst thing a creditor can do to protect itself. The Third Circuit blasted any notion of these new terms being ordinary course by describing them as “extreme and so out of character with the long historical relationship between these parties.” The Third Circuit opined that changing the credit terms during the preference period can render those terms by definition outside the ordinary course.

The message to creditors in this case is to (1) consult with a bankruptcy attorney to make sure that credit changes actually will protect the creditor going forward; and (2) to remember that the only guaranteed protection against a preference is cash in advance and C.O.D.