When a company files for bankruptcy, creditors receive a notice from the bankruptcy court and must halt all collection efforts, including legal proceedings, outside of the confines of the bankruptcy forum. See our article on Bankruptcy: the Constitutional Right to Start Over.
This can come as quite a shock to the company which has extended credit to the now bankrupt company, but that is nothing to the shock that can arise a few months later when the creditor receives notice (or is subject to litigation begun in the bankruptcy court) alleging “preferential” payments were made and that the creditor has to repay to the bankruptcy trustee or creditor’s committee all sums received from the debtor for the ninety days prior to bankruptcy.
This can be a staggering blow to a business which has received sizable payments from the debtor and the outrage of the creditor business is predictable. It is not usual for millions of dollars to be reclaimed by the trustee in bankruptcy and if not promptly repaid, the trustee will soon file suit in the Federal court having jurisdiction of the debtor and that can be thousands of miles from the locale of the creditor.
There are valid defenses to a claim to retrieve “preferential payments” and this article shall outline one way in which the creditor can resist the claims. Of course, competent legal counsel and excellent business records will be essential for any business seeking to allege this defense.The New Value Defense to Preferential Claims in Bankruptcy is discussed in a companion article.
The Basic Preference Laws in Bankruptcy:
The preference laws are intended to further the bankruptcy policy of equality of treatment between creditors. Within the 90-day period prior to filing bankruptcy (the “Preference Period”), some creditors receive payment but many do not. By forcing the return of transfers made during the Preference Period, the debtor-trustee ensures that the assets of the bankruptcy estate are increased. The assets of the estate are then distributed to creditors on a pro rata basis in accordance with the distribution priorities set forth in the Bankruptcy Code. In this manner, creditors that were not “preferred” have a better chance to recover a percentage of their claims. The key is payments made in the 90 days prior to bankruptcy filing.
Normally, any payment received during the ninety days prior to filing bankruptcy are to be repaid to the trustee in bankruptcy for such pro rata distribution and if the creditor refuses to repay the sums, suit is brought against the creditor in the bankruptcy court. Most bankruptcy trustees are quite aggressive in filing such actions and pursuing them to judgment. They do not care how much was owed the creditor-defendant nor what promises were made by the debtor as to the payments prior to filing bankruptcy. Large bankruptcies commonly have a dozen or more such preferential payment retrieval actions filed.
But there are valid defenses and the one discussed herein is the Ordinary Course of Business Defense.
The Ordinary Course of Business Defense:
A common exception or defense to a preference action is that the payments were made in a manner consistent with the prior course of dealing between the creditor and the debtor or that the course of dealing was ordinary in relation to an industry standard (the “Ordinary Course of Business” defense). 11 U.S.C. §547(c)(2). The rationale is that the payments were not efforts to reduce past indebtedness (at a greater amount than the creditor would receive pro rata in bankruptcy) but simply what had occurred between the creditor and vendor over a long period of business and part of their ongoing business.
To qualify for the Ordinary Course of Business defense under 11 U.S.C. § 547(c)(2), a creditor must prove by a preponderance of the evidence that
(1) the payment was on account of a debt incurred in the ordinary course of business or financial affairs of the debtor and the creditor;
(2) that payment was made in the ordinary course of dealings between the debtor and the creditor; or
(3) that payment was made according to ordinary business terms.
Under the second element above, the transfer must have been made in the ordinary course of dealings between the debtor and the creditor. This involves a subjective inquiry as to what was normal between the parties, not what general practices are in the relevant industry unlike the third category. In viewing the transaction from a subjective perspective, the court will generally take into account such factors as (1) the length of time the parties have engaged in the type of dealings at issue; (2) whether the subject transfer was in an amount more than usually paid; (3) whether the payments were tendered in a manner different from previous payments; (4) whether there appears any unusual action by either the debtor or the creditor to collect or pay on the debt; and (5) whether the creditor did anything to gain an advantage in light of the debtor’s deteriorating financial condition.
The amount, manner and timing of payments must be scrutinized to see if the transfers made during the preference period fell within the range of the party’s normal dealings. A comparison between the past payment history and the timing of the preferential payments often constitutes persuasive evidence of the parties’ course of dealing. The pre-preference period conduct of the parties often has been described as a “base line of dealings” from which to determine the ordinariness of the preference payments.
This defense to preferential payment claims seeks to advance the theory that the transfer was in payment of a debt incurred by the debtor in the “ordinary course of business” or financial affairs of the debtor and transferee, and the transfer was made:
—in the ordinary course of business or financial affairs of the debtor and transferee; or
—according to ordinary business terms.
11 U.S.C. § 547(c) (2)(A) & (B).
Note that a defendant can prevail by showing that, although the transaction was not made according to ordinary business terms generally, it was made according to the ordinary business terms between the parties. However, the defense is still limited to debts incurred in the ordinary course of business or financial affairs of the debtor and the transferee.
The ordinary course of business defense protects ordinary commercial transactions and encourages creditors to deal with financially troubled debtors. See In re Fulghum Const. Corp. (6th Cir. 1989) 872 F.2d 739, 743.
A § 547(c)(2) defense generally applies to short-term trade debt. See Union Bank v. Wolas (1991) 502 U.S. 151, 158–159, 112 S.Ct. 527, 531–532 (discussing reasoning for enactment of § 547(c)(2)). Even a first-time transaction between the debtor and a third party can come within the “ordinary course of business” exception where the transaction is “ordinary” in relation to past practices of the debtor and creditor with other, similarly situated parties. In re Ahaza Systems, Inc. (9th Cir. 2007) 482 F.3d 1118, 1123–1126 (“ordinary course” showing not made); see also Kleven v. Household Bank F.S.B. (7th Cir. 2003) 334 F.3d 638, 642–643—first-time “tax refund anticipation loans” provided by lender to debtor were in ordinary course.
Note that courts have held that debt may have been incurred in the “ordinary course” even though it is not of a regularly recurring nature. In re Finn, supra, 909 F2d at 908;In re Russell Cave Co., Inc. (B.C. E.D. Ky. 2001) 259 B.R. 879, 883–884; see also J.P. Fyfe, Inc. of Florida v. Bradco Supply Corp. (3rd Cir. 1989) 891 F.2d 66, 68 )“A transaction can be ordinary and still occur only occasionally”).
The first step in establishing the defense is to show that the transfer was in payment of a debt incurred in the ordinary course of business or financial affairs between the debtor and transferee. See 11 U.S.C. § 547(c)(2).
This “reflects the actual parties’ practices insofar as that is possible and focuses on the issuance of the debt itself.” In re Ahaza Systems, Inc. (9th Cir. 2007) 482 F.3d 1118, 1126 (decided under prior law).
After showing that the transfer paid a debt incurred in the ordinary course of business or financial affairs between the parties, defendant must show that the transfer was made either (i) in the ordinary course of business or financial affairs between the parties, or (ii) “according to ordinary business terms.” 11 U.S.C. § 547(c)(2)(A) & (B).
As noted above, there are two ways to invoke the ordinary course of business defense.
1) Option one -Transfer Made in Ordinary Course of Business Between the Parties
This option is a subjective analysis that requires proof that the relevant payments were ordinary in relation to past practices between the creditor (transferee) and debtor. In re Healthcentral.com (9th Cir. 2007) 504 F.3d 775, 790. This subjective approach looks to the history of the transactions between the parties, and is distinguished from the objective second option, that involves an analysis of the creditor’s industry.
Under this first option, the creditor must show a baseline of past practices between itself and the debtor and that the relevant transfers were “ordinary” in relation to those past practices. This is most commonly done by demonstrating that the relevant transfers:
—did not differ from past payments in amount or form;
—were not the result of unusual collection or payment activities or did not come as a result of the creditor taking advantage of the debtor’s deteriorating financial condition. In re Healthcentral.com, supra, 504 F.3d at 790 (collecting cases); see also In re Jolly “N”, Inc. (B.C. D. N.J. 1991) 122 B.R. 897, 906.
When tasked with determining whether a payment or payments were made in the ordinary course of business, courts generally look to the following factors:
• the length of time the parties have engaged in the type of dealing at issue;
• whether the transfers were in amounts more than usually paid;
• whether the payments were tendered in a manner different from previous payments;
• whether there appears any unusual action by either the debtor or creditor to collect or pay on the debt; and
• whether the creditor did anything to gain an advantage (such as gain additional security) in light of the debtor’s deteriorating financial condition.
In re Richardson (B.C. E.D. PA 1988) 94 B.R. 56, 60; In re Grand Chevrolet, Inc. (9th Cir. 1994) 25 F.3d 728, 732.
If the creditor exerted some collection pressure prior to receiving payment it does not automatically mean the payment could not have been in the ordinary course of business. See In re Rave Communications, Inc. (B.C. S.D. N.Y. 1991) 128 B.R. 369, 373 (tacit threat not to deliver more goods unless balance paid did not defeat ordinary course nature of payment where creditor had no reason to believe debtor was insolvent); In re Kahn & Assocs., Inc. (B.C. W.D. PA 1991) 135 B.R. 251, 254 (payment found to be in ordinary course despite modification of past practices to require past balances be paid before further credit extended); but see Matter of Seawinds Ltd. (9th Cir. 1989) 888 F.2d 640, 641 (creditor who terminates its contracts with struggling debtor, demands immediate payment and return of equipment and raises rates on remaining equipment is not acting in ordinary course of business).
See also In re NorthPoint Communications Group, Inc. In that case, the court held that prepetition payments made by the debtor to the contractor on four construction contracts were made in the ordinary course of business. The court noted that even though the contractor sent the debtor a letter regarding an overdue invoice that referred to its mechanic’s lien rights, the letter was sent in response to the debtor’s inquiry and did not threaten legal action. In addition, the court held that the payments did not result from either unusual collection action by the contractor or any intent of the debtor to prefer the contractor over other creditors, but rather were intended to preserve the debtor’s valuable leases. [In re NorthPoint Communications Group, Inc. (B.C. N.D. CA 2007) 361 B.R. 149, 158–160 (construing prior law); but see In re Ogden (10th Cir. 2002) 314 F.3d 1190, 1201 (effect of transfer rather than intent controls preference analysis).
None of these factors is absolutely controlling. Generally, the manner of payment must be consistent with the parties' past dealings. In re Grand Chevrolet, Inc., supra, 25 F3d at 732.
a. Late Payments do Not Automatically Invalidate Ordinary Course of Business Defense
Some courts have held that payments made later than required by contract are generally not made in the ordinary course of business. In re Craig Oil Co. (11th Cir. 1986) 785 F.2d 1563, 1567–1568 (“Lateness is particularly relevant in determining whether payments should be protected by the ordinary course of business exception”); In re Food Catering & Housing, Inc. (9th Cir. 1992) 971 F.2d 396, 398 (“Delay is particularly relevant in taking a payment outside the ordinary course of business exception”).
However, late payments made in conformity with the prior course of dealing may be in the ordinary course: “Even if the debtor’s business transactions were irregular, they may be considered ‘ordinary’ for purposes of 547(c)(2) if those transactions were consistent with the course of dealings between the particular parties.” [In re Yurika Foods Corp. (6th Cir. 1989) 888 F.2d 42, 45 (internal citation and brackets omitted); see also In re Big Wheel Holding Co., Inc. (B.C. D. DE 1998) 223 B.R. 669, 674). Note that this latter case is in the relevant jurisdiction.
See also In re Central Valley Processing, Inc. In that case, a court held that although the debtor paid the creditor 10–to–15 days beyond the 30–day period specified in the creditor’s invoices (which was slightly longer than the 30–day period within which the debtor historically paid the creditor), the payments were in the “ordinary course” of the debtor’s and the creditor’s businesses. Moreover, the debtor and the creditor stipulated the payments were made in a manner consistent with industry norms, and the creditor engaged in no collection activity. In re Central Valley Processing, Inc. (B.C. E.D. CA 2007) 360 B.R. 676, 678–679.
If a contract has been terminated and payment demanded, the payment will not be in the ordinary course of business. In re AppOnline.com, Inc. (B.C. E.D. NY 2004) 315 B.R. 259, 285; In re Seawinds Ltd. (N.D. CA 1988) 91 B.R. 88, 92–93. We will need to know if the contract was ever terminated.
Case law that provides some additional guidance.
In re Grand Chevrolet, Inc. 25 F.3d 728, 732 C.A.9 (Cal. 1994): stating that “we have held that “[d]elay is particularly relevant in taking a payment outside the ordinary course of business exception.” In re Food Catering, 971 F.2d at 398 . We have not, however, adopted a per se rule that late payments can never be ordinary. Other circuits have held that late payments can fall within theordinarycourse ofbusiness exception if the prior course of conduct between the parties demonstrates that those types of payments were ordinarily made late. See Lovett v. St. Johnsbury Trucking, 931 F.2d 494, 497 (8th Cir.1991); In re Yurika Foods Corp., 888 F.2d 42, 44 (6th Cir.1989). We now join those circuits.
2) Option two -Transfer Made in Accordance with Ordinary Business Terms
Another option is to demonstrate that the payments were made in accordance with ordinary industry wide business terms. Whether a challenged transfer is “ordinary” is tested objectively: i.e., the transfer must comport with practices common to businesses similarly situated to the debtor and creditor. Matter of Tolona Pizza Products Corp. (7th Cir. 1993) 3 F.3d 1029, 1033 (transfer need only fall within “range of terms” covering practices usual to the creditor’s industry); In re Jan Weilert RV, Inc. (9th Cir. 2003) 315 F.3d 1192, 1197.
The test is a two-step process that requires the creditor to:
—establish the broad range of business terms employed by similarly-situated debtors and creditors (including those in financial distress) during the relevant period; and
—show that the transfers were ordinary in relation to those prevailing business terms. In re Healthcentral.com (9th Cir. 2007) 504 F.3d 775, 791 (decided under prior law).
To establish that a preferential transfer was made according to ordinary business terms, the creditor must introduce competent evidence of the practice in the industry. In re Roblin Indus., Inc. (2nd Cir. 1996) 78 F.3d 30, 42–43; Matter of Midway Airlines, Inc. (7th Cir. 1995) 69 F.3d 792, 797–799.
Typical Questions for the Defendant
Based on the foregoing, the typical questions include the following.
- When did payments first begin?
- How much were they?
- What were the payments for?
- Were the payments on time or late?
- Was the contract terminated? By whom? At what time? Why?
- Was there anything unusual about any circumstance regarding any of the payments (amount, time, place, method, manner, etc.)?
- With respect to the industry generally, were the payments in accordance with ordinary business terms?
- With respect to the industry generally, how usual or unusual is it for creditors to be paid as late as the client was in these instances by the bankrupt?
The idea is to demonstrate that there was nothing unusual about the payments that are currently being attempted to be set aside.
Essentially, the defendant is trying to establish that the payments were not the result of unusual collection or payment activities or did not come as a result of the client taking advantage of the bankrupt’s deteriorating financial condition. In re Healthcentral.com, supra, 504 F.3d at 790 (collecting cases); see also In re Jolly “N”, Inc. (B.C. D. N.J. 1991) 122 B.R. 897, 906.
Conclusion:
In addition to the New Value defense, the Ordinary Course of Business Defense can achieve effective relief against the trustee who seeks to reclaim sums previously paid to a creditor. It requires a good deal of paper work to demonstrate and close cooperation between the finance department of the creditor, accountants and attorneys, but is a defense readily accepted by the courts…and sometimes even by the trustee…if the documentation can be assembled and provided.
The trustee has nothing to lose by seeking to reclaim any preferential payments. Recall his or her fee is predicated on the gross amount in the bankrupt’s estate and the complaint is easy to draft and file. It may be expected that any bankruptcy who files within ninety days of payment will result in such a claim by the trustee being advanced and the wise business will be sure to maintain sufficient documentation to meet such claims.