PREFERENCES: “ESCAPE HATCHES FROM RECAPTURE”
One of the most difficult to accept realities that confronts credit managers from time to time is being subject to a Section 547 Preference Recapture Action by a U.S. Bankruptcy Trustee. Specifically, Section 547 empowers a Bankruptcy Trustee to go back and “recapture” a transfer that was made to or for the benefit of a creditor on an account reflecting an antecedent debt owed by the debtor before such transfer is made, while the debtor was insolvent, and made within 90 days of the filing of a petition for protection from the creditors in Bankruptcy Court. Furthermore, the 90 day window is extended to the term of one year for any creditor who was an insider at the time of the subject transfer to the transferee.
The question presented by many credit managers revolves around whether the Section 547 Preference Provision allows the Bankruptcy Trustee to recapture all transfers incurred during the 90 day “window period.” The answer to this question is a resounding no. There are numerous “safe harbors” and exceptions, and this article will seek to outline the most popular and seemingly broad exclusions or safe harbor provisions within the text of Section 547. Next will come two hypothetical situations requiring an analysis of the ordinary course exclusion.
The most commonly utilized exclusion is found within Section 547/C2-a. This exception is commonly referred to as the “ordinary course of business exclusion.” The ordinary course of business exclusion provides that in the event the transfer was: i) the product of a debt which was incurred within the ordinary course and financial affairs of the debtor and the transferee and ii) within the ordinary course and financial affairs of the debtor and transferee and iii) was made within the ordinary business terms.
What the requirements equate to is that there are three relevant threshold questions that must be asked in analyzing an ordinary course of business exception problem. These questions are as follows:
i) Did the debt arise in accordance with the ordinary financial affairs of the debtor and the transferee?
ii) Was the payment made in conjunction with historical affairs between the debtor and the transferee?
iii) Was the payment consistent with traditional payment habits/standards within this particular industry and with the particular parties?
If the answer to each of these questions is “yes,” then you have, at minimum, a basis to analyze the ordinary course of business exclusion. Not all situations which appear to warrant exclusion will so qualify. For example, consider the following hypothetical transfer.
Tinker Inc. buys product on open terms from ABC Supply. The terms are 30 days; however, the industry payment terms are in the 50 day range. ABC has sold to Tinker on a COD basis for the past three years. The current sale is one of two open account sales which have occurred during the past three years. Tinker pays the ABC invoice at 40 days and subsequently files a chapter proceeding in Bankruptcy Court 85 days later. The trustee attempts to “avoid” or “recapture” the previous payment to ABC.
ABC will assert that the trustee’s action falls within the ordinary course of business exception to the Section 547 reference action. Should ABC continue to resist payment, the trustee may file an adversarial proceeding in Bankruptcy Court to collect upon the alleged preference. In the event the defense is litigated, ABC will, in all likelihood, lose and be ordered to pay back the subject funds into the bankrupt “estate.”
In this hypothetical situation, it appears that all elements are present. However, in the facts is information that ABC had historically done business on a COD basis with Tinker. The open terms were not, arguably, within the ordinary course of business between the debtor (Tinker) and the transferee (ABC). Therefore, in all likelihood, a judicial evaluation will support the recapture of the payment and hold in favor of the trustee.
The safe harbor can be extremely technical in its application. Consider another hypothetical situation.
Tinker Inc. is involved in the business of retailing office furniture. ABC Inc. is, likewise, an office furniture manufacturer engaged in the manufacturing and distribution of various office components. Over the course of five years, Tinker makes numerous purchases on open credit terms from ABC and makes, in turn, payment on these obligations, on average, after 75 days. Exactly 80 days after one such transfer, Tinker files its chapter proceeding in Bankruptcy Court. Industry standard payments are consistent with the 75 days.
Again, under these particular facts, ABC may attempt to assert the ordinary course of business exception to any subsequent recapture action by the trustee. In this case, the transfer was consistent with habits within the industry and all requirements under Section 547C2a-c are seemingly present.
Although the ordinary course exception is broad, the bottom line is that it can have difficult and unforeseen applications. The entire area of preferences is a “trap” for the unwary; however, the “trap” does have “escape hatches.” For further information, please consult with your counsel or see Moores on Bankruptcy Practice – Preferences.