Everything You Need To Know About The “Ordinary Course of ...

Everything You Need To Know About The "Ordinary Course of Business" Preference Defense, And More! By: Bruce S. Nathan, Esq. David M. Banker, Esq. Terence D. Watson, Esq.

Abstract

Congress enacted the ordinary course of business defense to the avoidance of preferential transfers to protect recurring, customary transactions in order to encourage the continuation of business with and the extension of credit to a financially distressed customer. However, creditors defending a preference litigation have had difficulty exploiting the ordinary course of business defense as a result of the inconsistency by which the courts have applied the defense due in large part to the myriad of factors they have considered in determining its applicability. The ordinary course of business defense has, therefore, become both unpredictable, and difficult and very costly to prove. Even worse, the inability to reasonably predict how courts will apply the ordinary course of business defense and the factors the courts might consider may discourage the continuation of business with or the extension of credit to a company as it seeks to avoid a bankruptcy filing, which is directly contrary to the legislative intent behind the enactment of the ordinary course of business defense in the first place.

This article identifies the most significant areas of judicial inconsistency, and illustrates the potential reasons why courts have reached differing conclusions regarding the applicability of the ordinary course of business defense. It should, therefore, assist creditors defending a preference litigation in determining whether they can satisfy this defense.

The Statutory Elements Of An Avoidable Preferential Transfer

Under 11 U.S.C. ? 547(b) of the Bankruptcy Code, a trustee or debtor in possession may avoid as a preference, a transfer of a debtor's interest in property which satisfies each of the following elements:

a) The transfer was made to or for the benefit of a creditor (11 U.S.C. ? 547(b)(1));

b) The transfer was made for or on account of an antecedent debt owed by the debtor at the time the transfer was made (11 U.S.C. ? 547(b)(2));

c) The transfer was made when the debtor was insolvent based on the balance sheet definition of liabilities exceeding assets (11 U.S.C. ? 547(b)(3));1

d) The transfer was made during the ninety day preference period in the case of transfers to non-insider creditors, and within one year of the bankruptcy filing for transfers to the debtor's insiders, such as the debtor's officers, directors, controlling shareholders and affiliated companies (11 U.S.C. ? 547(b)(4)); and

e) The transfer enabled the creditor to receive more than the creditor would have recovered on the subject claim in a chapter 7 liquidation of the debtor (11 U.S.C. ? 547(b)(5)).2

Once a trustee proves the statutory elements of 11 U.S.C. ? 547(b), the burden shifts to the creditor defending a preference claim to prove one or more of the affirmative defenses contained in 11 U.S.C. ? 547(c) to reduce or completely eliminate its preference exposure. This article focuses on the ordinary course of business ("OCB") affirmative defense under 11 U.S.C. ? 547(c)(2), which is the most frequently litigated statutory affirmative defense to the avoidance of preferential transfers.

The OCB defense is intended to protect recurring, customary transactions, and to encourage the continuation of business with (and the extension of credit to) an entity that is sliding into, but seeking to avoid, a bankruptcy filing. Assuming a payment is made in a manner that is consistent with the parties' history and/or with how payments are made in the applicable industry, the payment should not be subject to avoidance as a preference because of the OCB defense. Nevertheless, the courts have been inconsistent and unpredictable in the manner in which they are applying the OCB defense.

The Ordinary Course Of Business Affirmative Defense

The OCB defense requires proof, by a preponderance of the evidence, that (1) the alleged preferential transfer paid a debt that was incurred in the ordinary course of the debtor's and creditor's business or financial affairs, and (2) that the transfer was either (a) made in the ordinary course of the debtor's and creditor's business or financial affairs, or (b) made according to ordinary business terms. 11 U.S.C. ?547(g) places the burden of proof on the creditor to satisfy the elements of the OCB defense.

Proving that the debt paid by the alleged preferential transfer was incurred in the ordinary course of business of the debtor and creditor is straightforward. A creditor satisfies this OCB requirement by proof of the creditor's extension of credit terms to the debtor. Next, the creditor must prove either the "subjective" or "objective" component (or prong) of the OCB defense.

1 There is a rebuttable statutory presumption that the debtor was insolvent on and during the 90-days immediately preceding the filing of its bankruptcy petition (the "preference period") 11 U.S.C. ?547 (f). 2 This requirement is always satisfied where the preference target was an unsecured creditor unless all of the debtor's other unsecured creditors receive full payment of their claims, which is rare because an entity is unlikely to commence a bankruptcy proceeding where its assets are sufficient to pay all unsecured creditors in full.

The subjective component requires a showing that the transfer was made in the ordinary course of the debtor's and creditor's businesses. This requires proof of consistency between the alleged preferential transfers and the transfers the debtor made to the creditor prior to the preference period, which is frequently referred to as the "pre-preference period."

Alternatively, a creditor may satisfy the OCB defense by proving that the alleged preferential transfer was made according to "ordinary business terms." This requires proof that the payment was consistent with the payment practices and range of terms in the creditor's industry, the debtor's industry, or both. This is usually referred to as the "objective" component (or prong) of the OCB defense.3

The Subjective Element Of The Ordinary Course Of Business Defense

The phrase "ordinary course of business" is not defined in 11 U.S.C. ? 547 or anywhere else in the Bankruptcy Code. According to case law, however, a creditor relying, in whole or in part, on the subjective prong of the OCB defense must first prove a pre-preference period "baseline of dealing" between the debtor and the creditor, against which the court can compare the alleged preferential transfers. Once the court determines the pre-preference period baseline, it usually then considers the following factors in determining whether the alleged preferential transfers are protected by the subjective prong of the OCB defense: (i) the length of time the parties were engaged in the type of dealing at issue; (ii) whether the amounts of the alleged preferential transfers were larger than prior payments; (iii) whether the payments were tendered in a manner different from previous payments; (iv) whether there was any unusual action by either the debtor or the creditor to collect or pay the debt; and (v) whether the creditor did anything to gain an advantage in light of the debtor's deteriorating financial condition.

As these factors indicate, there are generally two components to a court's determination of whether the alleged preferential transfers are protected by the subjective prong of the OCB defense: (i) a statistical analysis primarily focused on the timing of the alleged preferential transfers, and (ii) a determination of whether the factual circumstances surrounding the alleged preferential transfers were unusual, including, but not limited to, the amount of, and any collection efforts or other pressure employed by the creditor to obtain payment of, the alleged preferential transfers. However, these components of the court's analysis do not carry equal weight, as the OCB defense may be inapplicable where an otherwise preferential transfer was made in response to payment pressure even if a court finds, under a statistical analysis, that the timing of the transfer was consistent with the timing of transfers made by the debtor to the creditor during the pre-preference period.

3 Prior to the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA"), which became effective on October 17, 2005, a defendant relying on the OCB defense was required to satisfy both the subjective and objective prongs of the OCB defense. In other words, the OCB defense required proof that: (1) the alleged preferential transfer paid an indebtedness incurred by a debtor in the ordinary course of business or financial affairs of the debtor and the creditor; (2) the payment was made in the ordinary course of the debtor's and creditor's business or financial affairs; and (3) the payment was made according to ordinary business terms. Section 547(c)(2) was amended by BAPCPA and is now written in the alternative to require satisfaction of either the subjective prong (11 U.S.C. ? 547(c)(2)(A)) or the objective prong (11 U.S.C. ? 547(c)(2)(B)), along with proof that the debt paid was incurred in the ordinary course of the debtor's and creditor's business or financial affairs.

Below are cases illustrating the statistical analysis under the subjective prong of the OCB defense, followed by cases highlighting the factual circumstances that may render a favorable comparison under the statistical analysis irrelevant for purposes of the subjective OCB defense.

The Statistical Analysis A consistent historical pattern of late payments (in relation to the stated credit terms between the parties) can establish an ordinary course of late payments between the parties such that untimely transfers made during the preference period may be protected by the subjective OCB defense. Consequently, most disputes concerning the subjective prong of the OCB defense involve considering whether the alleged preferential transfers were either consistently made within the credit terms agreed upon by the parties, or, even if tendered later, were otherwise consistent with the prior course of dealing between the parties. In making the latter determination, the courts have undertaken various forms of statistical analyses and approaches to determine the applicability of the subjective OCB defense. For example, the courts have compared the timing of the payments made during and prior to the preference period based on (i) average, (ii) median, (iii) deviation off of average or median, (iv) range (or ranges), (v) regularity of payments based on percentages, or (vi) a combination of one or more of the above. 4 In addition, as the cases first discussed below demonstrate, the courts have also differed on the length of time to be considered in establishing the historical baseline course of dealing between the parties against which the alleged preferential transfers are to be compared for subjective OCB purposes.

Pre-preference Period ? How Long is Long Enough?

The courts considering the applicability of the subjective OCB defense have differed in determining the appropriate amount of time for establishing the baseline of the parties' historical course of dealing, against which to compare the alleged preferential transfers. However, the courts have generally refused or otherwise deemed it unnecessary to consider the entire prepreference period relationship between the parties in establishing the historical baseline.

The United States Bankruptcy Court for the Eastern District of North Carolina held, in Sparkman v. Martin Marietta, Inc. (In re Mainline Contracting, Inc.), that a two year period prior to the preference period was sufficient to establish a baseline for purposes of the subjective OCB defense. The United States Bankruptcy Court for the Eastern District of Michigan, in American CamShaft Specialties, Inc. ("American CamShaft"), however, ruled that the preference defendant, Gerdau MacSteel, Inc. ("Gerdau"), satisfied the subjective prong of the OCB defense despite relying on only a one year period prior to the beginning of the preference period to establish the baseline, even though Gerdau's business relationship with American CamShaft exceeded twenty years prior to its bankruptcy filing.

The United States Bankruptcy Court for the Eastern District of Pennsylvania held, in Goldstein v. Starnet Capital Group, LLC (In re Universal Marketing, Inc.), that an eight (8) month relationship prior to the petition date, during which only five payments were made, was

4 Timing is frequently calculated as "days to pay" based on the number of days from invoice date to payment date, or as "days late" based on the number of days from due date and actual date of payment. Days late is frequently used in ordinary course analyses where the debtor's and creditor's relationship involved multiple different payment terms. For example, payment in 40 days of an invoice that required payment on net 30 day terms, as well as payment in 70 days of an invoice that required payment on net 60 day terms are both 10 days late.

sufficient to establish a baseline for subjective OCB purposes. The court specifically ruled that "the transaction history is sufficient to demonstrate a general pattern of behavior in the DebtorStarnet relationship and it is unnecessary to look to supplemental evidence in order to compare the payments made during the preference period with the pre-preference period transfers." Moreover, the court held that the untimely alleged preferential transfers were subjectively ordinary because, notwithstanding the very limited pre-preference period history between the debtor and the defendant, the debtor had a history of making late payments. Specifically, although all payments were due by the first of the following month, the debtor paid the five prepreference period payments between nine and twenty-two days late, for an average of fifteen days late. The two alleged preferential transfers, in turn, were made seventeen and twenty-two days late, for an average of approximately nineteen days late. The court held that "[t]his amounts to a four (4) day difference in the average lag between due date and receipt in comparing the payments in the preference period to the pre-preference period. This difference does not warrant avoidance of the two (2) transfers at issue."

Nevertheless, questions remain as to the proper scope of this inquiry. The United States Bankruptcy Court for the District of Delaware (the "Delaware Bankruptcy Court") held, in Burtch v. Revchem Composites, Inc. (In re Sierra Concrete Design, Inc.), that an eleven month pre-preference period relationship, consisting of seventeen checks paying sixty-eight invoices, was "simply insufficient evidence for the creditor/defendants to meet their burden [with respect to the OCB defense]."

A different and far more restrictive approach was adopted by the United States Bankruptcy Court for the Eastern District of Virginia in In re Circuit City Stores, Inc. The court limited its inquiry in determining the baseline for the parties' prior course of dealings to only the pre-preference period transfers made when the debtors were financially sound, and disregarded the debtors' later pre-preference period payments (during the nine months prior to the preference period) that were made when the debtors were experiencing liquidity issues and delaying payments to their vendors. Therefore, although the alleged preferential transfers were paid consistently with the payments made during the nine month period prior to the preference period, the alleged preferential transfers were not protected by the subjective prong of the OCB defense.

Consistency Of Timing

The courts have also differed on the statistical analyses and approaches taken to determine consistency of timing of payment for subjective OCB defense purposes. In American Home Mortgage Holdings ("AMH"), the United States Bankruptcy Court for the District of Delaware (the "Delaware Bankruptcy Court") applied a relatively straight-forward historical range of payment analysis. The court dismissed a preference complaint after comparing the timing and amounts of the alleged preferential payments with the pre-preference period payments, as well as the manner in which the parties conducted business, both prior to and during the preference period.

The following chart shows the timing and amounts of the payments AMH had made to the defendant (Vector) during their entire eight month pre-preference period relationship:

The Pre-preference Period Transfers

Invoice Date Invoice Invoice Amount

Number

10/18/2006 23160 $4,675.00

11/3/2006

23212 $8,160.00

11/22/2006 23256 $7,480.00

12/6/2006

23311 $6,120.00

12/20/2006 23337 $7,480.00

1/3/2007

23337 $6,120.00

1/18/2007

23421 $6,120.00

2/1/2007

23467 $7,480.00

2/21/2007

23528 $7,480.00

3/23/2007

23625 $7,480.00

Date Payment Received 11/8/2006 1/8/2007 11/30/2006 12/18/2006 2/12/2007 1/25/2007 1/25/2007 2/21/2007 3/1/2007 4/11/2007

Payment Amount $4,675.00 $8,160.00 $7,480.00 $6,120.00 $7,480.00 $6,120.00 $6,120.00 $7,480.00 $7,480.00 $7,480.00

Days To Pay 21 67 8 12 54 22 7 20 9 19

The following chart shows the timing and amounts of the payments AMH had made to Vector during the preference period:

The Alleged Preferential Transfers

Invoice Date Invoice Invoice Amount

Number

3/8/2007

23577 $5,440.00

4/3/2007

23653 $7,480.00

4/20/2007

23702 $5,440.00

5/4/2007

23737 $6,120.00

5/18/2007

23799 $5,440.00

Date Payment Received 5/7/2007 5/7/2007 6/6/2007 7/5/2007 7/9/2007

Payment Amount $5,440.00 $7,480.00 $5,440.00 $6,120.00 $5,440.00

Days To Pay 60 34 47 62 52

The court in AHM held that the alleged preferential payments were subject to the subjective prong of the OCB defense because the timing of their payment (made between thirty-four and sixty-two days after invoice date), was within the historical range of AHM's payments (made between seven days and sixty-seven days after invoice date). In this regard, it did not matter to the court that the alleged preferential payments paid 80% of Vector's invoices (four out of five invoices) late, compared to only 20% of Vector's invoices (two out of ten invoices) that were paid late during the pre-preference period.

With respect to the amounts of the payments, the court held that the four alleged preferential payments, in amounts between $5,440 and $12,920,5 were consistent with AHM's ten transfers to Vector made during the pre-preference period, in amounts between $4,675 and $12,240. Similarly, the invoices paid by the alleged preferential payments, in amounts ranging between $5,440 and $7,480, were comparable to Vector's invoices paid during the pre-preference period, which ranged between $4,675 and $8,160.

5 Invoices numbered 23577 and 23653 were paid by a single transfer on May 7, 2007 in the amount of $12,920.

Finally, the court held that the manner in which AHM and Vector had conducted business remained consistent during both the pre-preference and preference periods.6 In other words, the

alleged preferential payments were not made in response to any unusual collection activities by

Vector.

In Philadelphia Newspapers, the United States Bankruptcy Court for the Eastern District of Pennsylvania applied a modified historical range of payment analysis. The court compared the regularity of the historical payments to the preference period payments. The court applied the subjective OCB defense to the alleged preferential payments made by Philadelphia Newspapers because their timing was consistent with the timing of payment of 80% of the pre-preference period transfers.

During the parties' approximately five year business relationship, Philadelphia Newspapers paid the invoices of the defendant (Inserts East) an average of fifty days after invoice date. Rather than compare the timing of payment of the alleged preferential transfers to this fifty days to pay average, the court relied on the following chart that depicted the frequency with which Philadelphia Newspapers paid Insert East's invoices at certain timing intervals:

The Pre-preference Period Transfers

Days after Frequency of Days after

Invoice

times

invoice

Frequency of Days after

times

invoice

Frequency of times

7

1

22

1

27

2

31

2

34

6

39

2

44

1

48

1

53

1

57

1

61

3

64

1

70

3

77

1

82

1

96

1

18

1

24

2

28

1

32

3

35

4

41

2

45

5

49

5

54

3

58

1

62

7

67

1

74

1

78

1

86

1

112

1

20

1

25

1

29

1

33

1

36

3

42

4

47

1

50

1

55

3

60

2

63

3

69

2

76

1

81

1

87

1

6 The AHM court also ruled that Vector satisfied the objective prong of the OCB defense based on the testimony of Vector's chief executive officer and a certified public accountant (who testified that he was familiar with the standard payment practices of the information technology staffing industry in which Vector conducted business) that the alleged preferential transfers were made according to ordinary business terms in Vector's industry.

The court also relied on the following chart relative to the alleged preferential payments:

The Alleged Preferential Transfers

Invoice Invoice Date Payment

No.

Date

1 20558 10/16/08 12/05/08

2 20616 10/24/08 12/22/08

3 20615 10/25/08 01/02/08

4 20707 11/05/08 01/08/09

5 20753 11/05/08 01/22/09

6 20763 11/12/08 01/22/09

7 20752 11/11/08 01/12/09

8 20827 11/20/08 01/12/09

9 20753 11/20/08 01/16/09

10 20883 12/02/08 02/02/09

11 20896 12/04/08 02/02/09

12 20897 12/04/08 02/02/09

13 20988 12/19/08 02/09/11

14 21086 01/14/09 01/22/09

15 21082 01/14/09 02/18/09

16 21227 02/04/09 02/20/09

17 21254 02/06/09 02/20/09

Days Invoice 50 62 69 64 78 71 62 53 57 62 60 60 52 8 35 16 14

after Amount of Invoice

$ 3,077.50 $ 3,320.52 $10,037.10 $ 2,655.14 $ 4,980.00 $ 2,640.50 $ 1,595.00 $ 6,120.50 $ 4,980.00 $ 2,655.14 $ 2,935.00 $ 695.00 $ 4,405.83 $58,672.00 $ 8,310.00 $ 461.70 $ 622.88

The trustee argued that the ordinary course range should be forty to sixty days to pay (i.e., a +/ten day deviation from the fifty day pre-preference period average days to pay between Philadelphia Newspapers and Inserts East). Based on that range, the subjective OCB defense would have protected only the payments listed on the above Alleged Preferential Transfers chart numbered 1, 8, 9, 11, 12 and 13.

The court, however, held that the expanded range of thirty days to seventy days to pay (i.e., a twenty day deviation from the fifty day average) advocated by Inserts East was appropriate as the baseline of the parties' prior course of dealings because 80% of Philadelphia Newspapers' payments to Inserts East during the pre-preference period were made between thirty and seventy days to pay (emboldened in the above Pre-preference Period Transfers chart). Consequently, the court held that the payments listed on the above Alleged Preferential Transfers chart numbered 2, 3, 4, 7, 10 and 15 were protected by the subjective OCB defense, as well as the payments that the trustee had conceded were protected by the subjective OCB defense (payments numbered 1, 8, 9, 11, 12 and 13). The narrower forty to sixty day range that the trustee advocated was undermined by the fact that prior to the preference period, only one-third of the payments made by Philadelphia Newspapers to Inserts East fell within that narrow range. The court recognized that such a relatively small percentage did not warrant being considered as the baseline for the parties' prior course of dealings.

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