A New Way to Fight Back Against Preference Action Claims

Timing is everything. It’s cliché, but it’s so true, especially in the business world. A recent decision from the 7th Circuit Court of Appeals (the federal court between our local Wisconsin courts and the United States Supreme Court) shows just how important timing is when you have done business with a party that has now filed for bankruptcy.

A Little Background

When one of the businesses you sell to files for bankruptcy, your business may end up having to give back some of the money the now bankrupt business has paid you. At first blush, this seems really unfair (Why should you be punished because one of your buyers went bankrupt?), but this is part of the bankruptcy code because the government reasoned that it wasn’t fair for some recent creditors to get paid while others didn’t, especially if making a payment to you was, so to speak, the straw the broke the camel’s back.

This whole process of clawing back payments is known as a preference action, and it applies to payments made within 90 days of bankruptcy.

Thankfully, if you get a “Notice of Bankruptcy Case Filing” letter from one of your customers, there are a few things you can do prepare to defend against any preference action claims. The first and most important thing to do, is to pull together a record of your financial interactions with the bankrupt party.

Having a record of past payments is important because the best defense against a preference action is being able to prove that the payment or payments you received from the bankrupt party within 90 days of their bankruptcy were “made in the ordinary course of business or financial affairs of the debtor and the transferee.”

And this is where the recent 7th Circuit decision comes in. The quote above comes from the bankruptcy statute, but courts across the country have interpreted it in different ways.

What’s New?

In Unsecured Creditors Comm. of Sparrer Sausage Co. v. Jason’s Foods, Inc., No. 15-2356, 2016 WL 3213096 (7th Cir. June 10, 2016), the court clarified how bankruptcy courts in this jurisdiction are supposed to determine if a payment was made in the “ordinary course of business.”

First, the court examines the bankrupt business’s financial records going back to the time it was not having financial difficulty. It then takes all the transactions during the historic period where there was no financial difficulty and compares them to those made in the 90 days before bankruptcy.

If a payment made in the preference action time period is similar to a payment made in the historic period, the creditor can argue that the more recent action was made in the ordinary course of business and does not need to be clawed back.

There are two ways methods the court can use to determine if a preference action period payment is similar to a historic period payment. It can look at the minimum and maximum invoice ages during the historic period and use that as a range. Or, it can average the invoice ages during the historic period and use that number plus a certain number of days on either end as a range.

In Jason’s Foods, the Bankruptcy court used the averaging method, but the 7th Circuit determined that it had made the range too narrow. The higher court tacked a few more days on each side of the range so that 88% of all invoices were considered to have been paid in the ordinary course of business.

This 88% number may end up being a new rule of thumb that businesses can use as a defense when facing a preference action claim because that percentage of claims was also used in a case out in New York that the 7th Circuit referenced in its decision. We’ll have to wait and see if 88% becomes a sort of short cut for determining which payments are ordinary.