Doing business with a customer in the shadow of bankruptcy is risky.

A hallmark of bankruptcy law is equal treatment of similarly-situated creditors.  The Bankruptcy Code frowns upon a debtor who, while insolvent, pays some creditors but not others in the run-up to bankruptcy – whether voluntarily or due to pressure.  Under the Bankruptcy Code, payments by an insolvent debtor to creditors in the 90 days before bankruptcy, on account of an antecedent debt, are presumptively avoidable.  That means if you get one of these "preference payments," you may be forced to return it. 

There are, however, defenses to a preference payment, one of which is the "ordinary course of business" defense.  A recent decision from a bankruptcy court in Delaware provides an illuminating case study on behavior that will and won't be considered "ordinary course."  In doing so, it educates companies on best practices in dealing with a customer headed towards bankruptcy and suggests the likelihood that a bankruptcy court would order you to disgorge preference payments you received.

The Delaware case involved Fred's, a chain of retail stores like Dollar General.  C.H. Robinson provided transportation and logistics to Fred's under a $3 million credit line.  Fred's was required to pay invoices within 30 days.  When Fred's started closing stores and struggling to make payments, C.H. Robinson tightened the credit terms by reducing the credit line to $1.75 million and then $1 million.  C.H. Robinson also warned Fred's that it would not ship Fred's product if Fred's did not pay to catch-up on past-due invoices.  C.H. Robinson also threatened to reduce the credit terms to a 14-day payment on invoices. 

Fred's ultimately filed bankruptcy and confirmed a liquidating plan.  The court-appointed liquidating trustee sued C.H. Robinson to recover 15 payments totaling over $3.4 million it received from Fred's during the 90-day preference period.

In defense, C.H. Robinson raised the "ordinary course" defense.  They argued that it was standard practice in the transportation and logistics industry to tighten credit limits based on changes in a client's financial status and predicted future performance, so any payments resulting from that tightening were in the "ordinary course of business."

The Bankruptcy Code requires the recipient of a preference payment to show that the debt itself was incurred in the ordinary course of the business of both parties and that the payment of that debt was (a) made in the ordinary course of the business of both parties (what is sometimes described as the “subjective” test) or (b) made according to ordinary business terms (the “objective” test). The phrase “ordinary business terms” in the objective test looks to the general norms of the creditor’s industry.

The Court stressed that "ordinary course" and "ordinary business terms" mean conduct that is ordinary when dealing with a healthy company.  "Ordinary course" does not apply to how either the defendant or the industry treats a distressed company.  Thus, preference payments made under a payment plan are not "ordinary course," nor are payments resulting from pressure tactics.  The relevant yardstick is a healthy debtor, not a distressed one.

The upshot is that "ordinary course" means business as usual.  A distressed debtor can pay you the way they always paid you.  But if the distressed debtor singles you out as special among all his creditors and brings your past-due obligation current before bankruptcy, it might not be ordinary course.  And if you resorted to a demand letter, threat, workout agreement, or full nelson to get the distressed debtor to cough up his payments, then it's probably not ordinary course.

Doing business with a distressed debtor can pose a dilemma for companies.  When faced with this situation, seek all the financial information you can get your hands on to understand the debtor's situation.  Continuing to provide the debtor credit or goods and services under ordinary terms may save it from bankruptcy.  And if they stop paying you, you can do everything allowed under your contract to collect.  But you need to be prepared for a preference claim if the debtor files bankruptcy.