Seventh Circuit Examines “Ordinary Course” Preference Defense: Making Sausage
It is relatively rare when a Circuit Court issues an opinion on the preference defenses under section 547(c) of the Bankruptcy Code. It is even more unusual when a decision examines the fact-focused “ordinary course” defense under section 547(c)(2). The ordinary course defense shields payments determined to have been made in the “ordinary course of business” of both the debtor and the creditor. In its recent decision in The Unsecured Creditors Committee of Sparrer Sausage Company Inc., v. Jason’s Foods, Inc., the Seventh Circuit has provided a useful analysis on the application of several aspects of the ordinary course preference defense.
The first issue raised by the appellant in Sparrer Sausage was the bankruptcy court’s selection of the baseline period of conduct for comparison to that during the 90-day preference period. In the proceedings below, the bankruptcy court had truncated the comparison period based on its finding that toward the end of the time outside the 90-day preference period, the debtor had already begun to experience economic distress that had distorted the parties’ behavior. On appeal, the Circuit Court noted that this decision ignored the baseline period that had been stipulated by the parties in the action and also noted that the signs of distress were not necessarily definitive. However, the appellate court declined to upset the determination made by the bankruptcy judge because he had “offered a reasoned explanation for his decision, and his reasons were grounded in Sparrer Sausage’s payment history and supported by the record.”
A second issue addressed on appeal was the permissible range of ordinary course conduct during the preference period. Considering its selected baseline timeframe, the bankruptcy court determined that the relevant invoices had been paid in an average of 22 days. The bankruptcy court then added six days to either side of that average to calculate the permissible range of ordinary course transactions.
The Seventh Circuit began its review on this aspect by discussing the two possible methods for evaluating payments: the “total-range method” considering the total days an invoice was outstanding and the “average-lateness method” comparing the timing of payments to their due date. It characterized the method selected by the Bankruptcy Court as “average-lateness,” although an examination of the facts seems to suggest that it was “total-range.” In either event, the appellate court noted that each methodology has strengths and weaknesses and did not feel it necessary to upset the bankruptcy court’s chosen methodology.
In the application of that methodology, however, the Seventh Circuit found that the six-day upward and downward adjustment was “clear error.” The court noted that the range applied by the bankruptcy court accounted for only 64% of the payments during the baseline comparison period. By adding two more days to each side of that range, one could account for 88% of the baseline transactions. The Seventh Circuit noted that the bankruptcy court had offered no rationale for its selection of the six-day variable and concluded that the ordinary course range chosen by the bankruptcy court “appears not only excessively narrow but also arbitrary.” Finally, the Seventh Circuit also swept in one additional payment that was one day beyond its expanded range. In doing so, it allowed that payment as ordinary course despite its falling “just outside the 14-to-30-day range” that had been applied by the reviewing court. When the Seventh Circuit coupled this expanded ordinary course defense with the creditor’s “subsequent new value” defense under section 547(c)(4), it turned a $250,000 preference recovery to $0.
The Seventh Circuit’s decision in Sparrer Sausage allows several helpful conclusions for parties in preference litigation. The first is that the selection of a baseline comparison timeframe can be important to the ultimate outcome of the case. Parties will want to evaluate the implications of various possible comparison periods, in order to advocate for the one most beneficial to their position. Parties may also wish to consider stipulating as to the comparison timeframe, although such a stipulation did not protect the creditor in this instance.
Second, the election between “total-range” and “average- lateness” can also impact the application of an ordinary course defense. Average-lateness would seem to better account for possible variations in invoice payment terms. A 45-day payment on a 30-day invoice is the same as a 60-day payment on a 45-day invoice, but would be distorted somewhat by the use of a total-range analysis. Average-lateness may also produce a range of ordinary course conduct more sympathetic to creditors.
Finally, parties should carefully consider the variation to be permitted from an average-lateness calculation. As indicated in the Seventh Circuit’s decision in Sparrer Sausage, an effort should be made so that the range selected will take account of as many of the transactions in the comparison period as possible.
The ordinary course defense of section 547(c)(2) is necessarily a subjective process, fraught with the potential for uncertainty. At the same time, that subjective element presents an opportunity for capable counsel to marshal the facts and the law in order to obtain the best possible outcome for their client.