When Being a Preferred Creditor Is Not Preferable

Many suppliers of goods have long-standing credit relationships with certain purchasers. A recent decision by the United States Bankruptcy Court for the District of Massachusetts illustrates the precarious situation a supplier can find itself in when it alters the terms of a credit agreement after learning the purchaser is in financial difficulty.

The decision involved a commercial purchaser (“Purchaser”) and a commercial seller (“Seller”) of seafood. After twenty years in the seafood business, the Purchaser filed a Chapter 7 bankruptcy. In the ninety days before the bankruptcy filing, the Purchaser paid the Seller $285,000 (“Payment”). After the bankruptcy filing, the Trustee sought to recoup or claw back the Payment as “preferential.” The concept of a preferential payment in bankruptcy serves two purposes: (1) to fairly and equitably distribute the debtor’s assets; and (2) to discourage creditors from aggressively pursuing the debtor before the anticipated bankruptcy filing.

With that in mind, preferential payments contain five elements. To qualify as a “preferential payment,” the transfer or payment: (1) must be to or for the benefit of the creditor; (2) must be for a debt owed before the transfer or payment was made (e.g., not a contemporaneous exchange); (3) must be made while the debtor was insolvent; (4) must be made within ninety days of the bankruptcy filing; and (5) must enable the creditor to receive more than other similarly situated creditors.

The Bankruptcy Code, however, provides several safe harbors including the “ordinary course of business” exception. The “ordinary course of business” exception provides a safe harbor for payments or transfers made: (1) for a debt incurred in the ordinary course of the debtor’s business or financial affairs; and (2) in the ordinary course of the business or financial affairs between the debtor and the creditor. The “ordinary course of business” exception is intended to leave undisturbed normal commercial and financial relationships. The hallmark of the “ordinary course of business” exception is consistency with prior practice.

In response to the Trustee’s claim, the Seller conceded the Payment qualified as a preferential payment but argued the Payment fell within the “ordinary course of business” exception. The Seller and the Trustee agreed the debt was incurred in the ordinary course of the Purchaser’s business but disagreed whether the Payment was made in the ordinary course of the business and financial affairs between Purchaser and Seller. More specifically, the Trustee argued that the credit terms between the Purchaser and the Seller were too inconsistent to establish a historical baseline. The Trustee particularly focused on the changes to the credit terms made by the Seller after learning of the Purchaser’s financial difficulty.

The Bankruptcy Court rejected the Trustee’s argument, expressing concern about arbitrarily restricting a creditor’s ability to adapt to real world business exigencies. In the end, the Court adopted a hybrid approach and established a historical base line by reviewing both the two-year period before the bankruptcy filing as well as the period before the Seller learned of the Purchaser’s financial difficulty. Based on this analysis, the Court determined that much of the Payment was not preferential because it was made in the ordinary course of the business and financial affairs between the Purchaser and Seller (e.g., made within the average time of payment). A small portion of the Payment qualified as a preferential payment because it was based on “unusual collection” practices.