Defending Preference Actions: Ordinary Course of Business

Robert S. Bernstein, Esquire
Bernstein-Burkley, P.C.
Creditworthy News

The second principal defense which a creditor can raise to a bankruptcy trustee’s preference action is known as the ordinary course of business defense.

Section 547(c)(2) provides:

(c) The Trustee may not avoid under this section a transfer —

(2) to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was –

(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or

(B) made according to ordinary business terms.

The burden of proving this defense is placed upon the creditor. The ordinary course exception to the preference rule is formulated to induce creditors to continue dealing with a distressed debtor so as to kindle its chances of survival without a costly detour through, or a humbling ending in, the sticky web of bankruptcy.

The first element of the ordinary course defense requires the creditor to show that the debt, which was paid during the preference period, was a debt which was incurred in the ordinary course of business or financial affairs between the parties. See Section 547(c)(2). This element of the defense is not often contested by the trustee. A creditor can easily prove this element by establishing that the debt paid related to the way the debtor and the creditor did business. For example, the debt which was paid related to the shipment of goods which were invoiced with payment terms net 30 days.

The second and third elements of the ordinary course defense have received the most attention by the courts. These elements are known as the “subjective test” and “objective test”. It is important to note that the changes to the Bankruptcy Code put into effect in October 2005 now only require that the creditor establish either the “subjective test” or “objective test” ordinary course defense. Prior to the 2005 BAPCPA law, creditors had to prove both that the transfer was made in the ordinary course of business between the debtor and the transferee and made according to ordinary business terms.

The subjective test, Section 547(c)(2)(A), refers to the course of dealing specific to the debtor and the creditor. Thus, this test examines only the ordinary course of business between “the debtor and the transferee.” In conducting this analysis, courts must compare the relationship between the parties inside and outside the preference period. If the creditor, for example, instituted coercive collection efforts inside the preference period to force payment, then such circumstances may generally take the relationship outside the ordinary course of their normal dealings. When proving this element, creditors should compare the timing of payments from the debtor prior to the preference period and during the preference period. If the creditor can show that the timing of the payments averaged about the same during both periods of time and there were no coercive efforts, then the conclusion is that the payments were made in accordance with normal terms.

Courts have considered normal terms to include terms which deviate from those set forth in the documents between the parties, when the parties in fact ordinarily transacted business outside the express terms of the documents. For example, a creditor ships goods monthly to a debtor net 30 days per the invoices. Over the course of two years the debtor always paid the creditor between 45-50 days. During the preference period, the debtor also paid the creditor between 45-50 days. Thus, notwithstanding the net 30 day terms, the normal course of payment between the debtor and the creditor was 45 days. Since the payments during the preference period were also within this time frame, the creditor has met this element of the preference defense.

Most “ordinary course” preference cases involve a dispute over the objective test, or whether the debtor and the creditor have deviated from the ordinary business terms in the industry. The courts have not always been consistent with their interpretation of Section 547(c)(2)(B). Generally, however, “ordinary business terms” refers to the range of terms that encompasses the practices in which firms similar in some general way to the creditor in question engage, and that only dealings so idiosyncratic as to fall outside that broad range should be deemed extraordinary and, therefore, outside the scope of subsection (B). Similarly, other courts have focused on whether the terms are “unusual” and “extraordinary” so as to fall outside the broad range of practices of firms similar to the creditor.

In proving the objective test of the ordinary course defense, it is advisable that the creditor obtain an expert witness with knowledge of the industry business standards. It is crucial to note that business terms within an industry are viewed by courts with considerable latitude. Only those payments which are extraordinary or unusual in comparison to the industry’s broad range are considered preferential.

An expert witness should examine the collection period within a given industry. Some courts have expanded the range to include a “sliding scale” approach which allows a creditor to vary even further from the broad range of terms within an industry when the pre-preference business relationship between the creditor and debtor is a lengthy one.

The following are examples of court decisions which have found in favor of the creditor on the objective test:

A. debtor’s late payments are not outside the ordinary course when 10% of creditor’s customers fall within that late range;

B. payments received over 100 days late are not outside the ordinary course when testimony establishes that late payments are common in the industry;

C. payments in preference period ranging 110 days late are not outside the ordinary course although average with 15 days greater than two years before and 27 days greater than the average one year before.

The ordinary course of business is one of the most litigated defenses to a preference action. The creditor asserting this defense should seek a credible expert witness with considerable knowledge of its industry. The creditor should also go back and examine the payment history of the debtor during the entire business relationship it had with the debtor. Gathering this information and synthesizing it to meet all three elements of the defense will allow a creditor to put forth its best case to beat the trustee’s preference action.

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