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Preference Claims and the Ordinary Course Defense: A Tale of Two Suppliers

March 23, 2022

By

Emily L. Pagorski
Member, Stoll Keenon Ogden PLLC
(502) 568-5763
emily.pagorski@skofirm.com

Suppliers beware:  Even if the timing of a customer’s payments does not materially change during the customer’s slide into bankruptcy, increased efforts by the supplier to manage the credit risk could result in disgorgement of the payments to a bankruptcy trustee.  Two recent decisions, with starkly different results, demonstrate the challenges suppliers have in managing preference risks.  For more on this cautionary tale, continue reading below.

As many businesses are unfortunately aware, Section 547 of the Bankruptcy Code generally permits a bankruptcy trustee (or a debtor-in-possession) to recover payments made by a debtor during the 90-day period preceding its bankruptcy filing.  Such payments are generally known as “preferences.”  In theory, clawing back these payments prevents a debtor from “preferring” or favoring its most important suppliers ahead of other creditors who would otherwise be left to foot the bill during the debtor’s slide into bankruptcy.

One of the most common defenses to a preference is a subjective ordinary course of business defense – that the payments were made in the ordinary course of business between that supplier and that customer.  The creditor bears the burden of proving this defense by a preponderance of the evidence, which often involves using the debtor’s payment history to calculate a baseline for the parties’ dealings and then comparing the timing of the preference period payments to this historical baseline.

The February 3, 2022 Ryniker v. Bravo Fabrics Inc. (In re Décor Holdings Inc.) decision from the Bankruptcy Court for the Eastern District of New York[1] illustrates how this defense is “ ‘intended to protect recurring, customary credit transactions’ ” between the debtor and the supplier.[2]  In Ryniker, the preference period payments to the defendant suppliers ranged between approximately four days early to approximately seven days late when compared to the parties’ prior payment history.  Consistent with other court decisions involving long-standing relationships, such as the ones before it, the Ryniker Court ruled that all of the preference payments were “close enough” to the historical baseline to have been made within the parties’ ordinary course of business.  In other words, the suppliers were not required to return the payments. 

Now for the cautionary portion of our tale.  In Official Committee of Unsecured Creditors of Gregg Appliances, Inc. v. D & H Distributing Company (In re hhgregg, Inc. et al.),[3] the United States Bankruptcy Court for the Southern District of Indiana recently rejected a supplier’s ordinary course defense even though the vast majority of the payments had been received by the supplier within 15 days of the invoice due date, consistent with the parties’ prior payment history.  Stating that its decision was “not an easy call”, the Court found that the regularity of the payments was not enough to counteract the supplier’s increased efforts to limit the credit risk of dealing with the floundering debtors. Such efforts included a significant reduction of the debtors’ credit limit at a time when their desire for product was greatest coupled with a shift in collection activity.  While the supplier had communicated with the debtors about payment of their invoices in the past, the tone of those communications escalated during the preference period to include repeated threats to withhold shipments absent payment.  Notably, the debtors’ own employees testified that they valued their relationship with the supplier and advocated for its payment leaving the Court with the “inescapable conclusion” that the debtors prioritized paying the supplier over other of its creditors.  Therefore, the Court ruled that approximately $3.5 million in payments were preferential and had to be returned by the supplier.

These recent decisions demonstrate that even payments that are otherwise “ordinary” from a timing perspective may be subject to disgorgement if the supplier increases or more aggressively attempts to manage the credit risk.  So might a debtor’s decision to prioritize payments to a supplier – even if the timing of the payments themselves doesn’t change.  That said, protective strategies for suppliers do exist and additional defenses may be available.

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Stoll Keenon Ogden’s Bankruptcy & Financial Restructuring practice advises clients in all aspects of troubled credit situations, in and out of bankruptcy courts, including helping to formulate strategies designed to mitigate potential preference claims while also defending against them in courts all over the country.  You work hard for your money, and we’re here to help you keep it.

[1] Ryniker v. Bravo Fabrics, Inc. (In re Décor Holdings, Inc.), Adv. Pro. No. 20-08125 (REG) (Bankr. E.D.N.Y.).

[2] Id. at page 2, quoting Jacobs v. Gramercy Jewelry Mrg. Corp. (In re M. Fabrikant & Sons, Inc.), Adv. No. 08-1690, 2010 WL 4622449 *2 (Banrk. S.D.N.Y. Nov. 4, 2010 (citing 5 Collier on Bankruptcy ¶547.04[2], at 547-51 (15th Ed. 2010).

[3] Official Committee of Unsecured Creditors of Gregg Appliances, Inc. v. D&H Distributing Company (In re hhgregg, Inc., et al.), 2022 Bankr. LEXIS 371 (Bankr. S.D. Ind. 2022).