Imagine a scenario in which you have a long standing relationship with an important customer and you learn that this customer is running into financial difficulties. In the current economic cycle, this is probably not a hypothetical, but, rather, an everyday reality. During the course of the relationship, this important customer has from time to time fallen behind in paying invoices and has even reached or exceeded the credit limits your company has imposed on this customer. As things currently stand, this customer is about to once again exceed its credit limit and has requested new credit terms and a higher credit limit. You are concerned about taking aggressive collection efforts since you have some understanding that collection efforts or changes in the relationship might preclude your company from asserting an ordinary course of business defense to a preference lawsuit, should this customer file for bankruptcy protection.

In this situation, should you just sit on your hands or are you able to take any action to protect your position? While the answer to this question is not always straightforward, there have been some important decisions from the Delaware courts that suggest a company in this situation is not always required to sit idly while the customer slides into bankruptcy.

From your perspective, a request for more lenient payment terms and a higher credit limit substantially increases the risk that your company might not get paid. However, to the extent you do agree to changes and manage to receive payment in the 90 days preceding the bankruptcy filing, your company might very well get sued for the return of these payments under the preference provisions of the Bankruptcy Code. Section 547(b) of the Bankruptcy Code gives a debtor in bankruptcy the right to avoid and recover certain payments (“preferences”) made before the bankruptcy filing. As it applies to this situation, section 547(b) provides that your customer (now a debtor) may recover all payments it has made to your business within the 90 days before the filing, subject to certain defenses. While the subsequent new value defense is an important defense to the return of payments and there are other defenses available depending on the nature of the relationship with the debtor, this article will focus on the ordinary course of business defense.

As a initial matter, you might ask why you should worry at all, since you do not believe that your customer is “preferring” you over its other creditors. Rather, you are doing your customer a favor by helping it with its cash flow problems if you extend payment terms and increase the credit limit. Even if the customer pays late, why should you have to worry, since the customer appears to be doing the opposite of preferring you by not paying promptly. Case law, however, is clear that even late payments may be preferences where, during the course of the relationship, your company has rarely, if ever, received late payments. This is due to the fact that, from other another creditor’s perspective, the fact that you managed to get an older invoice paid off near the date of the bankruptcy filing might very well mean that their invoice was left unpaid. In other words, even though you received a late payment, you were still preferred over other creditors.

The “ordinary course” defense to preference claims is set forth in section 547(c)(2) of the Bankruptcy Code, which states that:

The [debtor] may not avoid under this section a transfer –

(2) to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was –

(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or

(B) made according to ordinary business terms.

By its terms, the language of section 547(c)(2) makes problematic any change in the course of business between the debtor and creditor, including mutual or even unilateral changes by the debtor that are clearly to its benefit. Changes in payment terms, the time between invoice and payment, the number of invoices included in each payment, the form of payment (e.g., check, bank check, wire transfer) could potentially take a payment out of the “ordinary course” and make it subject to avoidance in bankruptcy, even if the change is at the debtor’s request.

In this situation, and based on the plain language of the Bankruptcy Code, the question becomes whether you can take any actions knowing that your customer is in financial distress while at the same time preserving a potential ordinary course of business defense. At least in Delaware, to the extent you can demonstrate that the actions you took in the 90 days before the bankruptcy filing were consistent with past actions, you might be able to assert a successful ordinary course of business defense and defeat claims for the return of funds you received in the 90-day preference period preceding the debtor’s bankruptcy filing.

In one of the earlier cases decided in 2003, Troisio v. E.B. Eddy Forest Products Ltd. (In re Global Tissue, L.L.C.)1, the U.S. District Court for the District of Delaware dealt with an appeal from a bankruptcy court order that found preference period transfers made to the defendant were protected from avoidance by the ordinary course of business defense. In this case, the trustee (debtor) contended that the payment history showed that during the preference period, the debtor paid invoices faster than was usual in the pre-preference period. The trustee also argued that during the preference period, the defendant increased pressure on the debtor, and that the defendant had not produced any evidence to show that the payments were consistent with payment practices in the industry generally. The defendant countered that the evidence showed a constant pattern of late payments by the debtor during both the preference and pre-preference periods. In addition, the defendant argued that the ‘economic pressure’ complained of by the trustee was comprised of phone calls, which was a common practice and not an undue collection effort. In this particular case, the court was persuaded by the defendant’s arguments and upheld the ruling of the lower court. Although the opinion did not set forth a comparison of the “lag times” between invoice and payment during the pre-preference and preference periods, it found the payments to be ordinary, where the preference period transfers were made “a bit faster” than payments had previously been made. Further, the appeals court was not persuaded that making calls concerning late payments constituted pressure such that the ordinary course of business defense was no longer available.

In a more recent case, decided in March 2010, In re Elrod Holdings Corp.2, debtors established a long-lasting business relationship with the defendant several years prior to its bankruptcy. Defendant provided and shipped steel and steel-related materials to the debtors for their seat manufacturing business. During the course of their business relationship, debtors and defendant established a billing and payment procedure where debtors would submit payments on a single check approximately two months after the defendant issued its invoices. Instead of submitting payment upon receipt of defendant’s invoices, the debtors, as well as defendant’s other customers, regularly paid at the completion of a project. This practice, while common in the steel industry, remained consistent throughout debtors’ and defendant’s relationship prior to the bankruptcy filing dating as far back as May 1998. The debtors and defendant memorialized their payment and billing procedure in writing when the debtors sent an account application to defendant and recommended that payment should be made within 60 days from the invoice date. After receiving debtors’ request, the defendant sent its own form to the debtors that required payment to be made within 30 days from the invoice date. However, when debtors signed defendant’s form, debtors’ employee crossed out the 30-day term and wrote in “forty-five” days as a substitute. Debtors, however, continued to submit payment to defendant based on the understanding that payment would be accepted between 30 and 73 days pursuant to the various oral and written terms.

In May, June and July of 2006, defendant asked debtors on multiple occasions about several unpaid invoices. For each unpaid invoice, the debtors submitted payment in accordance with its regular payment practices with the defendant. From 2004 until June 2006, debtors regularly submitted payments between 35 and 73 days from the invoice date (averaging approximately two months from the invoice date). During the 90 days prior to the bankruptcy, debtors submitted payments to defendant between 30 and 74 days.

The trustee’s primary argument in this case was that defendant’s threats to withhold future shipments from the debtors constituted unusual collection activity. In support, the trustee cited to defendant’s call logs where defendant told the debtors that it would not wait one week for payment and that defendant would hold the debtors’ order until it received payment. Based on this perceived threat, the trustee contended that all payments fell outside of the ordinary course of business.

Disagreeing with the trustee, the Delaware bankruptcy court placed great weight on the fact that the debtors and defendant successfully conducted business without interruption for more than 10 years. According to the court, while the timing of payments during the 10-year relationship varied, debtors consistently and regularly made payments to the defendant averaging two months from the date of the invoice during the ordinary course of their business. Further, as evidenced by the defendant’s records, debtors regularly paid multiple invoices by submitting a single check. This payment method existed for more than 10 years and was the same method debtors used to make payments during the ninety day preference period. In addressing the trustee’s argument, the court found that the defendant took no unusual action in attempting to collect unpaid invoices. Throughout its ten year relationship with the debtors, defendant customarily called several times to collect unpaid invoices and threatened to withhold shipment. As with the method of payment, the court concluded that this was also the same practice used within the preference period. Furthermore, there was no evidence presented that suggested defendant took advantage of the debtors’ deteriorating financial condition leading up to their bankruptcies. In fact, defendant was not even aware that the debtors filed for bankruptcy until informed by a business associate.

Finally, in In re Archway Cookies3, a case decided in September 2010, DFI provided goods to Archway, the debtor, for use in its businesses prior to Archway’s bankruptcy filing. DFI and the debtors began their business relationship in October 2006. DFI provided net 20 day payment terms to the debtors, and such payment terms were stated on each invoice sent by DFI. On April 2, 2007, Peter Martz, DFI’s former CFO/Controller, sent a memorandum to the debtors (referring to a previous letter sent on March 19) regarding the financial condition of Archway, expressing concerns that Archway paid many invoices beyond DFI’s “20 day net payment terms,” and advising Archway that starting April 9, 2007, DFI “will only release product to be shipped if the account is current.” The debtors continued to order product from DFI through the bankruptcy filing.

The average number of days elapsing between the invoice date and payment was approximately 42 days during the period of October 2006 through July 7, 2008, (the “historical period”) ranging from 21 to 177 days. In comparison, the average number of days between the invoice date and the payment date for transfers during the July 8, 2008 through Oct. 6, 2008, (the “preference period”) was 47 days, ranging from 33 to 64 days.

In finding the payments protected by the ordinary course of business defense, an important fact for the court was that the parties’ business relationship lasted over two years and involved 117 transactions. The court found that the transactions made in the historical period were sufficiently similar to those made in the preference period, as there was no evidence that the amounts paid by the debtor during the preference period were inconsistent with their historical practices, all 117 payments were made by check, and the supplier’s practices of pressuring the debtors into payment were consistent with their historical dealings. In addition, the 107 transfers that occurred during the historical period were made between 21 and 177 days after the issuance of invoices, with an average days-to-pay of 42.3 days, while the 10 transfers made in the preference period ranged from 41 to 64 days after the issuance of invoice, with an average of 47.2 days-to-pay.

In terms of the pressure placed on the defendant, the court was not persuaded that pressuring the debtors into payment by requiring payment on past due invoices before shipment of new goods constituted unusual collection activity in the course of the parties’ relationship sufficient to take away an ordinary course of business defense. According to the court, the April letter sent to the debtors merely evidenced that DFI’s terms were enforced by refusal to ship goods until the debtors’ account was current.

While these three cases are helpful in establishing an ordinary course of business defense, it appears that all three courts were persuaded by the fact that the parties had longstanding relationships and that such relationships did not materially change as the debtor approached bankruptcy. In situations where the parties do not have a longstanding relationship or make material changes during the 90 day preference period, a preference defendant will likely have a harder time proving up an ordinary course of business defense if it withholds shipment, changes credit terms or enforces credit limits. A perfect example of this comes from the 3rd U.S. Circuit Court of Appeals decision in Hechinger4, a case which is binding on the Delaware courts. In this case, the 3rd Circuit concluded that the ordinary course of business defense was not available due to the fact that the debtor was pressured to make accelerated payments during the 90-day preference period because of supplier’s vigorous enforcement of its credit limit, and for the first time in their business relationship, the supplier required lump sum wire transfers as debtor approached this limit, and it shortened the time that debtor had to pay its invoices.

As a final word of caution, many courts outside of Delaware have gone out of their way to find the ordinary course of business defense unavailable in cases where the amount of pressure or variation in the relationship might appear to be slight. Since it is rare to have inside information concerning the specific jurisdiction where your customer might decide to file, it is generally advisable to consult with an experienced bankruptcy practitioner before taking any aggressive action whenever you have an important customer facing financial difficulties.