Seventh Circuit Reverses Bankruptcy and District Courts in Delineating the Ordinary Course of Business’s Baseline of Dealings Requirement  in In re Sparrer Sausage Co.

By Evan T. Miller, Esq.

The United States Court of Appeals for the Seventh Circuit (the “Seventh Circuit”) recently reversed a Bankruptcy Court ruling and District Court affirmation (both in the Northern District of Illinois, and collectively, the “Lower Courts”) that had given only partial credit to a preference defendant’s section 547(c)(2)(A) ordinary course of business defense.  The case, Committee v. Jason’s Foods, Inc. (In re Sparrer Sausage Co.), 2016 WL 3213096 (7th Cir. June 10, 2016), found that the Bankruptcy Court’s application of the defense arbitrarily used a narrower range of payments as a historical “baseline of dealings” than was warranted.  The Seventh Circuit found that under the Bankruptcy Court’s application, only 64% of the invoices that the Debtor paid would be captured; by contrast, the Seventh Circuit ruled that a minimal expansion of this range would have captured 88% of the invoices that the Debtor paid during the Historical Period – a figure that the Seventh Circuit found to be much more in line with case law on the subject.  Using this revised range, and taking into account Defendant’s subsequent new value defense, Defendant’s preference exposure was entirely offset.

The Parties’ Prepetition Relationship

For more than two years prior to February 7, 2012 (the “Petition Date”), Jason’s Foods (“Defendant”) had supplied unprocessed meat products to Chapter 11 debtor Sparrer Sausage Company (“Debtor”), a sausage manufacturing company.  During the ninety (90) days prior to the Petition Date (the “Preference Period”), the Debtor had paid 23 invoices from Defendant, totaling $586,658.10 (the “Transfers”).

In September 2013, the Unsecured Creditors Committee (“Plaintiff”) filed a complaint (“Complaint”) to recover the Transfers.  Defendant raised defenses to the Complaint under sections 547(c)(2) (ordinary course of business) and (c)(4) (subsequent new value).

Bankruptcy and District Court Decisions

The Bankruptcy Court first considered the ordinary course of business defense, making the following comparison between the Parties’ practices during the Historical and Preference Periods:

Factor Historical Period

Preference Period

Payment Range (Timing) “generally” 16 to 28 days 14 to 38 days
Average Invoice Age 22 days 27 days

The Bankruptcy Court found that only 12 of the 23 invoices that the Debtor paid during the Preference Period fell within the 16 to 28 day range the court found to be the baseline of dealings in the Historical Period.

As to new value, the Bankruptcy Court fund that the Debtor had not paid for $63,514.91 worth of product during the Preference Period, which acted as an offset against any preference liability.  As such, the Bankruptcy Court ruled in favor of Plaintiff in the amount of $242,595.32.  The District Court affirmed on appeal.

The Seventh Circuit Appeal

On appeal to the Seventh Circuit, Defendant argued that the Bankruptcy Court (i) improperly used an abbreviated Historical Period rather than the companies’ entire payment history and (ii) that the “baseline of dealings” comprised a too-narrow range of days surrounding the average invoice age during the historical period.

(i) The Historical Period

The Seventh Circuit noted that in establishing the Historical Period, “some cases may require truncating the historical period before the start of the preference period if the debtor’s financial difficulties have already substantially altered its dealings with the creditors… [and] in other cases it will be necessary to consider the entire pre-preference period… but in all cases the contours of the historical period should be grounded in the companies’ payment history rather than dictated by a fixed or arbitrary cutoff date.”

In the instant case, the parties stipulated to a Historical Period spanning February 2, 2010 to November 7, 2011, which encompassed all 235 invoices that the Debtor paid pre-Preference Period; the stipulated history reveals a payment range (timing) of 8 to 49 days, with an average days to pay of 25 days.  The Bankruptcy Court apparently disregarded the Parties’ stipulation, changing the payment range (timing) to 8 to 38 days, and an average days to pay of 22 days.  The Seventh Circuit, however, rejected Defendant’s contention that the Bankruptcy Court’s truncation was clearly erroneous, as the seven-month period immediately pre-Preference Period “did not accurately reflect the norm when [the Debtor] was financially healthy,” by evidence of a steady increase in days to pay during that time.  Thus, notwithstanding the lack of other indicia of the Debtor’s financial distress, it was not clear error for the Bankruptcy Court to find said distress began seven months pre-Preference Period.

(ii) The Baseline of Dealings

As to the baseline of dealings during the (truncated) Historical Period, the Bankruptcy Court had taken the average invoice age during that time and added six days on either side of that average, resulting in a range of 16 to 28 days.  Defendant argued that the total range of invoices was more appropriate, or 8 to 38 days.

The Seventh Circuit noted that “[b]ankruptcy courts typically calculate the baseline payment practice between a creditor and debtor in one of two ways: the average-lateness method or the total-range method. The average-lateness method uses the average invoice age during the historical period to determine which payments are ordinary, while the total-range method uses the minimum and maximum invoice ages during the historical period to define an acceptable range of payments.”  After citing to a Southern District of New York decision which utilizes the average lateness method (In re Quebecor World (USA), Inc.) and a District of Delaware opinion which utilizes the total-range method (In re Am. Home Mort. Holdings, Inc.), the Seventh Circuit found no need to disturb the Bankruptcy Court’s decision to use the former method.

Notwithstanding, the Seventh Circuit found the Bankruptcy Court’s application of the average-lateness method to be more problematic.  First, the Seventh Circuit was skeptical that the 5-day difference in days to pay between the Historical and Preference Periods is material, citing to, inter alia, In re Archway Cookies, 435 B.R. 234 (Bankr. D. Del. 2010) for support, but was ultimately deferential to the Bankruptcy Court’s contextual finding.

Even so, the Seventh Circuit found clear error in the Bankruptcy Court’s decision to deem invoices paid more than 6 days on either side of the 22-day average outside the ordinary course. The problem lay in the Bankruptcy Court’s application of Quebecor World – in that case, the bankruptcy court identified a range that captured the debtors’ payment of 88% of its invoices during the historical period, then added 5 days as the outer limit of “ordinariness”.  By contrast, the Bankruptcy Court’s baseline range captured just 64% of the invoices that the Debtor paid during the Historical Period, when adding just 2 days to either end of the range would have brought the percentage much more in line with Quebecor World.  The Seventh Circuit was further concerned by the lack of explanation for the Bankruptcy Court’s “arbitrary” narrowness.

Establishing a revised baseline of 14-to-30-days, the Seventh Circuit found all but two invoices were paid within or just outside the range.  The two invoices excluded were paid 37 and 38 days after they were issued, “substantially outside the 14-to-30-day baseline.”  Thus, the Seventh Circuit limited the liability to those two payments.

(iii) New Value

The Seventh Circuit lastly applied Defendant’s new value defense under section 547(c)(4).  Unlike some jurisdictions, in the Seventh Circuit, creditors are given credit for extending new value to the debtor without receiving payment, as the creditor “has effectively replenished the bankruptcy estate in the same way that returning a preferential transfer would.”  In this case, all of Defendant’s remaining exposure (i.e. after application of the ordinary course of business analysis) was offset by the value of products supplied to the Debtors.

Thus, the Court reversed and remanded the Lower Courts’ judgments.

Conclusion

For jurisdictions or courts following the average-lateness approach, this opinion is instructive as to where an appropriate percentage should fall for purposes of establishing a baseline of dealings.  Even with the subjectivity of the ordinary course defense, any concrete figure like this can be helpful in preparing a 547(c)(2) analysis.

This opinion also serves as a reminder that in the Seventh Circuit, the standard remains that subsequent new value must remain unpaid as of the petition date; in other jurisdictions, including Delaware, new value need not remain unpaid to utilize section 547(c)(4).

A copy of the Sparrer Sausage Opinion can be found here.

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