The Law of Unintended Consequences

By Dorman Wood, CEW, CCE

"The Law of Unintended Consequences is an adage or idiomatic warning that an intervention in a complex system always creates unanticipated and often undesirable outcomes." …'Akin to Murphy's Law, it is commonly used as a wry or humorous warning against the hubristic belief that humans can fully control the world around them. Many fields of study in the sciences and humanities embrace this concept, including economics, history, philosophy, political science and sociology.'¹

"The concept has long existed but was named and popularized in the 20th century by the American sociologist Robert K. Merton. Unintended consequences can be roughly grouped into three types: 1) A positive, unexpected benefit (usually referred to as serendipity or a windfall); 2) A negative, unexpected detriment occurring in addition to the desired effect or the policy…; 3) A perverse effect contrary to what was originally intended (when an intended solution makes a problem worse), such as when a policy has a perverse incentive that causes actions opposite to what was intended."²

At this point credit professionals may be saying, "OK, this is all well and good, but what does it have to do with me and/or my daily job?" The answer to this question should become apparent as you read the Court decisions rendered in the following bankruptcy preference cases:

In re Deborah C. Menotte, Trustee v. Oxcyde Chemicals (Bankr. S.D. FL 2010). The case involved the attempt to avoid and recover an alleged preferential transfer and the creditor's defense of "ordinary course of business" or "new value." The transfer at issue was a check dated within 90 days before the filing in payment of an invoice dated a few months earlier. The Court's decision stated in part that "although the Court found that the payment was within the range of the debtor's ordinary course of late payments, it found that the circumstances surrounding the payment indicated "unusual debt collection" and therefore took it outside the ordinary course of business. In making this finding, the Court compared emails between the parties during the preference and pre-preference periods and found 'warning or imposition of prepaid credit status" requested for next day payment and placement of a "credit hold" which triggered the payment herein, were substantively different types of collection activities.

In re Kieran F. Ryan, Trustee v. Foxworth Galbraith Lumber Co., (Bankr. D. MN 2011). The Court's decision reads in part…."The Court must examine the following: 1) the length of time the parties 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 activity; and 4) the circumstances under which the payment was made"…..Foxworth has shown that the parties were engaged in similar transactions with similar terms for seventeen years. Debtor always paid late but averaged about 115 days. It always paid by check and always lumped invoices together. Foxworth did not engage in any unusual collection activity. There is no evidence Foxworth put debtor on credit hold or threatened or filed suit. The payments were made in ordinary circumstances. The Plaintiff did not meet the burden to overcome Foxworth's showing."

In re Interstate Bakeries Corp., et.al., U.S. Bank Nat'l. Ass'n., Trustee v. Spectra Marketing Systems, et. al. (Bankr. W.D. MO 2011), the Court found that Plaintiff's timing of payments to defendant changed during the preference period. Plaintiff provided an analysis that indicated payments were made on average of 30 days after invoice prior to the preference period and that average payments during the preference period increased to 48.5 days. In terms of percentages, Plaintiff paid 94% of invoices with 45 days prior to the preference period and only 56.8% during the preference period. Based on this data, the Court held that transfers were inconsistent with pre-preference period practice. The Court also found the Defendant's collection efforts were more aggressive during the preference period then they had been in the past. The Court's decision states that Defendant's call logs indicate no collection calls were made prior to the preference period and that 3 such calls were made during the preference period. Voice mail messages left by Defendant's employees confirmed the calls. For these reasons, the Court held that the transfers fell outside the parties ordinary course of business for purposes of § 547(c)(2)(B).

In re Roberds, Inc. (Bankr. S.D. OH 2004), The Court held that the Creditor failed to prove the transfers
were made and received in the ordinary course of the parties respective businesses under § 547(c)(2)(B) because the creditor changed the parties credit agreement during the preference period. During the period after the change: 1) the credit limit of $750,000 was vigorously enforced by the Creditor; 2) credit holds, involving individual negotiations resulting in payments satisfactory to the Creditor prior to the shipment of furniture, were in effect; 3) payment terms were changed; 4) the Debtor paid, on average earlier than Net 30 terms; and 5) other creditors were being sufficiently delayed, or denied, in the receipt of their payments while this Creditor was receiving accelerated payments and none of these events had ever occurred in the parties' history. Based on these factual findings, the Court concluded that the creditor failed to prove the transfers that occurred during this portion of the preference period were made and received in the ordinary course.

In re Smith Min. and Material, LLC (Bankr. W.D. KY 2009), payments made by a Chapter 11 debtor to its supplier during the preference period were held not to be in the ordinary course of business between the parties or according to ordinary business terms. The payments were not protected from avoidance under the ordinary course of business defense to the trustee's preferential transfer claim. The average 67-day period for the payment of the creditor's invoices after receipt increased to 76 days and the debtor's regular practice of paying outstanding invoices first changed once the debtor began having cash flow problems. The supplier threatened to suspend fuel deliveries unless the debtor made payment for the current fuel deliveries.

By now, credit professional readers are most likely thinking, OMG! It is not the writer's intent to cause any reader to have an anxiety attack, or worse yet, a heart attack or stroke. Providing the results of the bankruptcy cases cited is intended to cause credit professional readers to pause and consider whether the internal policies and procedures of their respective employers might be in need of review and updating. Just about every activity related to how you deal with your customers on a daily basis can be held under the microscope when defending a bankruptcy preference claim. Your best efforts to reduce the accounts receivable balance owing from any of your customers becomes especially critical during the alleged preference period should a customer file for bankruptcy.

The following brief recaps of bankruptcy preference cases are examples of how the law of unintended consequences may come into play:

In re Intermet Corp. (Bankr. E.D. MI 2007), debtor's account was placed on 'credit hold' status after payments to the creditor slowed, in an attempt to limit the creditor's credit exposure to $50K, so the manner in which payments were made during the preference period was not consistent with the parties' preprefernce period payments terms.

In re Custom Forest Produces, Inc., et.al. (Bankr. W.D. TX 2007), Plaintiff claimed that supplier had not observed its own corporate credit policy, thereby extended more credit by a supplier than its policy authorized.

In re Carini (Bankr. E.D. WI 2000), the Court held that repeated telephone calls constituted an extraordinary collection effort.

In re Thompson Boat Co. (Bankr. E.D. MI 1996), despite the long-standing pattern of late payments between debtor and creditor, the creditor's change of collection policy rendered the transaction not in the ordinary course of business.

In re Molded Acoustical Prods., Inc. (Bankr. 3rd Circuit 1994), the Court held that preference-period payments were not made according to ordinary course of business where creditor altered its collection practices by attempting to institute a payment plan an by applying pressure on debtor to make larger payments as a precondition to future shipments.

In re JSL Chem. Corp. (Bankr. S.D. FL 2010), the Court found that a creditor's threat to place debtor on "credit hold" destroyed the creditor's ability to invoke the ordinary course defense.

In re Hechinger Investment Co. of Delaware, Inc., et.al. (Bankr. 3rd Circuit, 2007), the Court's decision stated in part…."In essence, a month before the beginning of the preference period, creditor tightened its credit terms, imposed a credit limit, requiring debtor to make payments by wire transfer in large, lumpsum amounts, and required debtor to send remittance advices after making payments on invoices. The Court found these actions to be "out of character" with the long historical relationship between the parties.

In re Indus. Supply Corp. (Bankr. M.D. FL 1990), creditor refused to deliver new merchandise unless debtor hand-delivered payment.

In re Bridge Information Systems (Bankr. E.D. MO 2003), the Court ruled that creditor had not proved ordinary course of business when relying only upon the testimony of company personnel for industry practices. The court's ruling was upheld on appeal.

When BAPCPA (Bankruptcy Abuse Prevention And Consumer Protection Act 2005) became effective, creditors initially believed that finally a revision to the bankruptcy law would work in their favor. With the revision to §547(c)(2), creditors believed they would have an easier task of defending preference claims by mounting an affirmative ordinary course of business defense.

Prior to BAPCPA, A creditor's ordinary course of business defense pre-BAPCPA was required to meet a three-prong test to show that a payment received within the 90-day period prior to, and including, the bankruptcy petition date was: 1) made upon a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and transferee (creditor), 2) made in the ordinary course of business or financial affairs of the parties, and 3) made according to ordinary business terms. Prongs 1 and 2 were referred to as the "subjective test" of the parties dealings. Prong 3 was referred to as the "objective test" of the standards observed in the relevant industry.

BAPCPA revision of §547(c)(2) was initially believed to lessen the creditor's burden of proof as it replaces the conjunctive "and" after prong 2 with "or." This revision is interpreted as giving the creditor the option of meeting the "subjective test" of the dealings between the parties, or the "objective test" of the standards observed within the relevant industry in their defense of a preference action.

The court cases cited in this article seem to indicate little has changed post-BAPCPA. Creditors are still faced with the challenge of protecting their accounts receivable assets while walking a tightrope between the daily requirements involved in maintaining ongoing business dealings with their customers v defending these same requirements in a preference claim. The Law of Unintended Consequences looms large over their shoulders on a daily basis and as credit professionals go about their daily routines. There is a portion of the Miranda Warning which states, "Anything you say or do can and will be held against you in the court of law." Although the Miranda Warning applies to criminal matters, credit professionals might want to keep it in mind when dealing with their customers.

Bankruptcy Preference Activities: DORMAN WOOD associates, Inc. has recently participated in adversary preference actions in the following bankruptcies: Circuit City; AXIUM Int'l., Hardwood P-G, Inc.; INTERMET, PC Liquidation Corp.; Bridge Information Systems; Gruppo Antico ; PC Liwuidation Corp.; Auburn Foundry; EXDS, Inc. (multiple clients), and MarchFirst. For details of these and other cases, click on www.witness4u.com.