“Summers are hot in Texas, so pools are a hot item. But not hot enough to help a pool installer named Sterry avoid bankruptcy.” After the debtor filed bankruptcy, the chapter 7 trustee sought to recover payments made to a subcontractor shortly before bankruptcy as a preference. The subcontractor raised an “ordinary course” defense.
The debtor used the subcontractor to put a permanent liner in pools that it constructed. The debtor would fax a work order to the subcontractor; the subcontractor would install the liner and send an invoice to the debtor; and then the debtor would fill the pool and look for payment from the owner.
Originally the subcontractor’s invoice stated that the payment was “Net 30” – meaning payment was due within 30 days. Usually the debtor would mail a check, although sometimes the subcontractor would pick the check up at the debtor’s offices.
This procedure changed about six months before the bankruptcy after there was a change in ownership of the subcontractor. In particular, the new invoices stated that they were “Due upon Request,” and the subcontractor routinely picked up its checks at the debtor’s offices
Under section 547 of the Bankruptcy Code a trustee can avoid a preferential transfer, which generally involves a transfer made (1) to a creditor (2) on account of an antecedent debt (3) while the debtor was insolvent (4) within 90 days prior to bankruptcy (5) that allows the creditor to receive more than it would if the payments had been made in a chapter 7 liquidation. (There is a presumption that the debtor was insolvent during the 90 days.)
However, there are several defenses, including an “ordinary course” defense. The theory is that there is a desire to avoid a race to the courthouse on the eve of bankruptcy, but there is also a desire to have vendors and customers continue to do business with troubled companies.
To establish the defense the creditor must show:
(1) the debt was incurred in the ordinary course of business, and
(2) the payment was either
(a) “made in the ordinary course or financial affairs of the debtor and the transferee” – referred to as the subjective test, or
(b) “made according to ordinary business terms” – referred to as the objective test.
In this case it was clear that the debt was incurred in the ordinary course of business between the parties. So the issue was whether the payments were made in the ordinary course under either the subjective or objective tests.
The trustee argued that changing the invoice terms from “Net 30” to “Due upon Receipt” constituted a change that took payments under the new invoices outside the ordinary course of business. However, according to witnesses for both parties these terms meant the same thing. The court accepted this testimony and concluded that the change did not alter the course of business between the debtor and subcontractor.
The trustee next argued that the change to routinely sending someone to pick up the checks was a coercive practice that took the payments outside the ordinary course. However, in the court’s view it could not ignore the change in ownership. Thus it looked only to the payment practices under the new owners and did not consider the prior practices. Given that perspective, there was no change and there was a consistent approach both before and during the 90 day preference period.
On the issue of whether collecting the checks in person was coercive, the court noted various practices that courts have been found to be coercive, including: (1) imposing and vigorously enforcing credit limits that a court found to be “extreme,” (2) threatening to shut down the debtor unless it paid, and (3) terminating contracts and refusing to perform until the debtor paid. However, the court reiterated that the test is subjective and even these sorts of actions can be ordinary course if that is the normal practice of the parties.
In this case the court found that the personal collection method was within the ordinary course: First, the practice was consistent during the entire period that the subcontractor was under new ownership. More importantly, collections slowed down during the preference period, which suggested that the practice was not in fact coercive. The court went on to note that picking up checks might also be ordinary course under the objective standard since it appeared that other vendors did the same thing.
Thus, the court concluded that the payments made by the debtor to the subcontractor during the preference period were made in the ordinary course and could not be avoided.
Developing a strategy for collecting money from a troubled business requires weighing the risk that payment might be clawed back as a preference if the debtor files bankruptcy against the value of having the money. I remember that often the advice of my experienced bankruptcy partners was “”Nem di gelt.” (Get the money.)
Vicki R Harding, Esq.