But Judge, Operating in the Red was Ordinary Course for this Debtor!

Contributed by Cristine Pirro
Among the more entertaining opinions we’ve read over the last few weeks is H. Kenneth Lefoldt, Liquidating Agent for Prevalence Health, LLC v. Michael L. Anthony (In re Prevalence Health, LLC), Case No. 11-00068-ee (Bankr. S.D. Miss. Nov. 7, 2012) (ECF 42), in which the defendant, an insider in a preference action to recover payments on loans made during the year prepetition, argued the debtor was not insolvent at the time of the subject transfers because “operating in the red was ordinary for the debtor.”  While the debtor might have been operating “in the red,” this fact wasn’t enough to convince a bankruptcy court in the Southern District of Mississippi that the debtor was solvent at the time of the transfer within the meaning of section 547(b)(3) of the Bankruptcy Code.
Michael L. Anthony was the president and chief operating officer of Prevalence Health, LLC, a provider of medication and disease management services.  He also sat on the board of directors for Prevalence.  During his time as an insider of Prevalence, Anthony made two loans to the company.  The first loan was made in 2006 in the amount of $200,000, which amount was payable on demand and would bear interest at a rate of 8%.  To fund the loan, Anthony borrowed money from First Commercial Bank via two separate lines of credit.  Prevalence first made an interest payment to Anthony in the amount of $1,553.05, which Anthony transferred to First Commercial.  After Anthony made a demand for repayment, Prevalence paid the amount remaining to Anthony, who once again transferred the funds to First Commercial.  Anthony made the second of the two loans in two parts:  First, Anthony paid Prevalence $125,000 in exchange for a promissory note payable on demand that was executed the next day.  The promissory note provided for payment of $175,000 plus 7% interest per annum.  About a month later, Anthony paid the additional $50,000 to fully fund the loan.  In August of 2008, Anthony made a demand for repayment.  Prevalence paid the full $175,000 directly to First Commercial Bank in satisfaction of the personal loan obtained by Anthony to fund the 2008 loan.
Despite these loans, the financial performance of Prevalence continued to decline.  After a series of unsuccessful acquisitions to expand operations and increase customer bases, Prevalence filed for bankruptcy on June 9, 2009.  In August of 2010, the court entered an order approving a chapter 11 plan of liquidation and providing for the appointment of a liquidating trustee.  In June of 2011, the liquidating trustee brought an action to avoid and recover the $175,000 paid to Anthony on account of the second loan.
The Preference Actions
To succeed in a preference action, the liquidating trustee needed to show that the payment he wanted to avoid was (1) to or for the benefit of a creditor, (2) for or on account of an antecedent debt owed by the debtor before such transfer was made; (3) made while the debtor was insolvent; (4) made on or within 90 days before the filing of the petition or between 90 days and one year before the date of the filing of the petition for transfers to an insider, and (5) enabled the creditor to receive more than such creditor would receive if the case were a case under chapter 7, the transfer had not been made, and the creditor received payment of such debt to the extent provided by the bankruptcy code.  To prove the third requirement (that the transfer occurred while the debtor was insolvent), the liquidating trustee needed to show that the transfer was made during the 90 days immediately preceding the petition date, during which time the debtor is presumed to be insolvent, or that the debtor could meet a balance sheet test for the period between 90 days and one year prepetition.  It was undisputed that Prevalence “virtually always operated while balance sheet insolvent.”  Nevertheless, Anthony audaciously argued that because “operating in the red was ordinary for the debtor,” the debtor was conducting business as usual during the time of the loan payoff and was not insolvent.  Unsurprisingly, the court denied this argument and agreed that the payment was an avoidable preference.
In yet another attempt to keep the $175,000, Anthony argued the payment fell under one of the exceptions to the general rule of avoidability.  Section 547(c)(2) provides that the trustee may not avoid a transfer to the extent the transfer was made in the ordinary course of business or according to ordinary business terms.   This defense is intended to encourage the continuation of business by suppliers with a person on the verge of a bankruptcy filing.   While there is no one legal test for the ordinary course defense, a court focuses primarily on whether the transaction was within a baseline of dealing that the debtor had with a creditor (the subjective test) or conformed to ordinary business terms (the objective test).  To establish a baseline of dealing, a creditor must show that the transactions and payments made during the preference period were similar to the payments before the preference period.  The four primary factors courts consider in determining the consistency of the parties’ conduct is (1) the length of time the parties were engaged in the transaction at issue, (2) whether the amount or form of tender differed from past practices, (3) whether the debtor or creditor engaged in any unusual collection or payment activity, and (4) the circumstances under which the payment was made.
In examining these factors, the court compared the two loans Anthony made to Prevalence.  The court noted the significant difference between the two loans, including the difference in timing of the payments to Anthony, the difference in the duration of the loans, and the difference in the interest rates of the loans.  The court also considered the terms of the loans, where the money was coming from, and in how many disbursements the proceeds of the loan were paid to the debtor.  The court explained several important ways in which the amount and form of tender differed between the two loans:  (1) the 2006 loan was fully funded around the time the note was signed, whereas the 2008 loan was funded by Anthony in two disbursements a month apart, (2) the debtor made payments directly to Anthony for the 2006 loan and paid Anthony more than he was owed according to the terms of the loan, while the debtor made payments directly to First Commercial and paid Anthony less than he was owed on the 2008 loan, and (3) when the debtor repaid the 2006 loan, it repaid principal and accrued interest, while when the debtor repaid the 2008 loan, it repaid only the principal amount of the loan.
The court also found that Anthony failed to meet the objective test because Anthony did not offer any evidence to show that the repayment was in line with what other debtors and creditors in a similar market were making.  Because the court could not find an undisputed baseline of dealing between Anthony and the debtor to show that the 2008 loan was repaid in the ordinary course of business, it dismissed Anthony’s assertion that section 547(c)(2) offered protection against the trustee’s preference action.
This case serves as a reminder that, although it may be a creative theory, there is no “ordinary course” exception to the solvency requirement contained in section 547.