Prior to filing a bankruptcy petition, debtors and creditors often attempt a "workout" to cure arrearage or other defaults. Often, a workout comes after the initiation of a lawsuit, in the form of a settlement agreement. Sometimes, however, a workout derives from a debt restructuring, such as a bank's troubled debt restructuring methods.

When the workout fails, or other financial problems result in the debtor's bankruptcy, payments made pursuant to the workout are often challenged as preferential transfers. While the "ordinary course of business" defense is often raised, it is not always successful. Recently, however, certain courts have issued opinions to the effect that the success of the ordinary course of business defense depends on the structure of the workout, and the reality of whether the challenged transfer was made in the ordinary course of business.

The Ordinary Course of Business Defense

Pursuant to 11 U.S.C. §547(c)(2), a transfer is not avoidable, i.e., an affirmative defense exists, if the transfer was (a) in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, (b) made in the ordinary course of business or financial affairs of the debtor and the transferee, and (c) made according to ordinary business terms. By its own terms, the ordinary course of business defense is intended to apply to transfers made in the ordinary course of business. Specifically, courts have held that payments made pursuant to a settlement agreement that are the result of prior disputes between the parties are not in the ordinary course of business. See In re Valley Steel Products Co. Inc., 214 B.R. 202, 207 (E.D. Mo. 1997). The ordinary course of business exception, after all, is intended to protect recurring, customary trade transactions, not payments in settlement of contractual claims. Id.; see, also, Duvoisin v. Wilde (In re Southern Industrial Banking Co.), 173 B.R. 901, 905 (Bankr. E.D. Tenn. 1994) (debts incurred by settlement of a dispute, pursuant to legal action or otherwise, are incurred outside the ordinary course of business, as settlement agreements themselves are unusual); Carrier Corp. v. MID Corp. (In re Daikin Miami Overseas Inc.), 65 B.R. 396, 398 (S.D. Fla. 1986) (payments made pursuant to settlement of previous debt are not in the ordinary course of business).

Thus, crafting debt restructuring terms and conditions that are inside the ordinary course of business is of the utmost importance. Fortunately, recent circuit court opinions are giving guidance by recognizing the increasing use of debt restructuring agreements as part and partial of today's ordinary business relations. See Kaypro v. Justus (In re Kaypro), 218 F.3d 1070 (9th Cir. 2000).

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[P]ractitioners should consider factors previous courts have considered in distinguishing between settlements and debt restructurings.

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Debt Restructuring as the Ordinary Course of Business

In Kaypro, the debtor had large trade debts that it sought to restructure by executing certain promissory notes. Shortly after execution of the promissory notes, the debtor filed bankruptcy. Upon the filing of a preference action, the creditor/defendant asserted the ordinary course of business defense and claimed that despite the fact that the restructuring agreement altered the debtor's payment terms, it was done in the ordinary course of business.

The bankruptcy court granted summary judgment against the creditor/defendant, finding that the ordinary course of business defense did not apply as a matter of law, which the Ninth Circuit Bankruptcy Appellate Panel (BAP) affirmed. The Ninth Circuit Court of Appeals examined the application of the ordinary course of business defense to determine whether a genuine issue of material fact existed, and held that a court must look to "those terms employed by similarly situated debtors and creditors facing the same or similar problems. If the terms in question are ordinary for industry participants under financial distress, then that is ordinary for the industry." Kaypro, 218 F.3d at 1074; citing In re Roblin Industries Inc., 78 F.3d 30, 42 (2d Cir. 1996).

In reaching its decision, the Ninth Circuit relied heavily on the Second Circuit's opinion in In re Roblin Industries Inc., 78 F.3d 30, 42 (2d Cir. 1996). In Roblin, the Second Circuit held, "we decline to adopt a rule that payments made pursuant to debt-restructuring agreements, even when the debt is in default, can never be made according to ordinary business terms. After all, it is not difficult to imagine circumstances where frequent debt restructuring is ordinary and usual practice within an industry, and creditors operating in such an environment should have the same opportunity to assert the ordinary-course-of-business exception. Indeed, if the industry practice is to restructure defaulted debt, it would make little practical sense to require creditors to comply with any other standard in order to meet the requirement of §547(c)(2)(C)." In re Roblin Industries Inc., 78 F.3d 30, 42 (2d Cir. 1996); see, also, In re USA Inns, 9 F.3d 680, 685 (8th Cir. 1993) (holding that it was regular practice in the savings-and-loan industry to adopt payment plans for delinquent customers); Armstrong v. John Deere Co. (In re Gilbertson), 90 B.R. 1006, 1012 (Bankr. D. N.D. 1988) (finding that deferral agreements were common in the retail farm-implement sales industry).

Based on the holdings in Roblin and Kaypro, a creditor that agrees to restructure a debt in a manner consistent with industry practice does not lose the benefit of the ordinary course of business exception. Indeed, courts have distinguished between settlement agreements and debt restructuring agreements by holding that payments made pursuant to a debt-restructuring agreement are in the ordinary course of business if such agreements are industry practice. See First Software Corp. v. Micro Education Corp. of America, 103 B.R. 359, 360-61 (D. Mass. 1988); In re Gilbertson, 98 B.R. at 1011-12; In re Magic Circle Energy Corp., 64 B.R. 269, 274-75 (Bankr. W.D. Okla. 1986). Thus, when crafting such an agreement, practitioners should consider factors previous courts have considered in distinguishing between settlements and debt restructurings.

Applying the Restructuring Standard

One signal that an agreement is a debt restructuring agreement, as opposed to a settlement agreement, is that new debt instruments are executed, and threatening circumstances do not surround the creation of the agreement. Tolz v. Signal Capital Corp. (In re Mastercraft Graphics Inc.), 157 B.R. 914, 920-21 (Bankr. S.D. Fla. 1993); see, also, Magic Circle, 64 B.R. at 274-75 (where the court held that execution of a consolidated promissory note at 8 percent interest over the course of seven years was well within the ordinary course of business). Payments made pursuant to creditor pressure, on the other hand, are generally not made in the ordinary course of business. Mastercraft Graphics, 157 B.R. at 919-20.

Other factors to consider are (a) the creditor's routine execution of debt-restructuring agreements with debtors that are unable to meet their obligations; (b) the terms of the creditor's typical restructuring agreement, such as debt consolidation and execution of a promissory note; (c) the commonality of such restructuring agreements in the industry and with the particular creditor; and (d) whether the creditor typically requires security or guarantees from restructuring debtors. Kaypro, 218 F.3d at 1073-75.

In connection with the execution of new debt instruments, ordinary course is further demonstrated by active negotiations in formulating the debt restructuring agreement, as well as the debtor giving consideration, such as a restructuring fee or deferral interest, in consideration therefore. In re Gilbertson, 98 B.R. at 1011-12.

The existence of these factors will not alone support the ordinary-course-of-business defense as its application is made on a case-by-case basis. Above all, practitioners must consider the importance of industry practice in determining whether the challenged transfers were made in the ordinary course of business.

Conclusion

The holdings of both Kaypro and Roblin not only clarify the application of the ordinary course of business defense, but also encourage the use of debt restructuring by alleviating concerns of preference actions. Not all such agreements will fall under the ordinary-course-of-business exception, as it is a very fact-intensive consideration.

Due to increased recognition of debt-restructuring agreements as common in debtor/creditor relationships, and the importance of using such agreements in modern commerce, courts are providing guidelines for crafting debt restructuring agreements. Practitioners should therefore take heed of such cases, particularly when the industries and facts are similar.

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