Introduction
Relations between one company and another do not always follow a consistent and steady course over time. As the economy, industry dynamics, material prices, and politics change, the relationship between the customer and suppliers will also often change.
Many times, this can result in changes to the payment practices of the customer as its financial condition changes, its products change, or its people change. In other instances, a situation may develop that requires an alternative payment arrangement. These circumstances may not happen often, but the reaction may be either ordinary in the industry or consistent with the supplier or customer’s past practice.
For example, Company A is a large, international manufacturer of assorted widgets. Company B is a mid-size purchaser of widgets from Company A. Consistent with its ordinary practice, Company A reviews the payment history of its customers on a periodic basis and finds that Company B’s payments have been getting extended as the economy has faltered. As Company B’s payments continue to be delayed, Company A eventually contacts Company B and places them on C.O.D. (cash on delivery) terms for all future shipments and will require a payment plan to reduce the outstanding balance of prior invoices. 30 days later, Company B files for bankruptcy. The trustee for Company B reviews the payments in the 90 days prior to bankruptcy and requests that all of the expedited payments made after the payment terms were changed be returned as preference payments. Company A asserts that in the ordinary course of its business, it always reviews payment history and would put any customer on C.O.D. terms but admits that it doesn’t do it very often, as few customers have exhibited the level of payment delay shown by Company B.
This article discusses recent and long-standing opinions of various U.S. courts regarding these circumstances and provides guidelines for information that may be helpful in establishing that such arrangements and payments may indeed be “ordinary.”
Background
According to §547 of the Bankruptcy Code, after filing for bankruptcy, the debtor may recover transfers occurring in the 90 days prior to the filing, provided the transfers meet certain criteria. Conversely, the creditor has several defenses at its disposal, which it may use to defend against preference claims in order to retain transfers previously received.
By definition, a preferential transfer in bankruptcy is any “transfer” to or for the benefit of the creditor during the 90 day period counting backwards from the bankruptcy filing date. A “transfer” is anything of value, whether or not tangible, that the bankrupt customer gave any creditor or gave up for the benefit of a creditor for any reason.
A payment is just one type of transfer. There are many other types of transfers. For example, if the customer gives a supplier a security interest in its inventory (even inventory originally provided by the supplier), the giving of that security interest is a transfer. Also, if during the bankruptcy preference period, the bankrupt customer returns goods that it cannot pay for to a supplier, that return is a transfer.1
Creditor Approaches to Defending Preference Claims
The creditor has the burden of proving that the alleged transfers are not preferential and thus not recoverable by the debtor. There are several approaches to defending preference actions. One such defense is the ordinary course defense, where the creditor seeks to demonstrate that the transfers occurred consistent with the ordinary course a) in the industry or b) in the relationship between the parties.
Prior to 2005, in the defense of preference actions it was necessary for the creditor to show that the transfers were made according to the ordinary course in the industry and between the parties. The Bankruptcy Abuse Prevention And Consumer Protection Act (“BAPCPA”) of 2005 amended §547(c)(2) of the Bankruptcy Code, making it necessary only to prove the transfers occurred in the ordinary course within the industry or between the parties, attempting to make the ordinary course preference defense easier and less costly.2
While the creditor may defend against preference actions through the ordinary course defense as well as arguments for new value and contemporaneous exchange, this article will focus on issues pertaining to the ordinary course defense. However, the arguments of new value and contemporaneous exchange are also important to consider as defenses to preference claims.
Ordinary Course Defense to Preference Claims
Ordinary Between the Parties
In establishing the ordinary course defense relating to the relationship between parties, the timing and method of transfers between the parties is often of primary importance. Preference period transfers are typically analyzed to establish whether they were consistent with transfers made historically. If the timing and method of transfers from the debtor to the creditor during the preference period are similar to the timing and method of transfers in the historical period, the basis for an ordinary course defense may be established. In general, issues commonly considered by courts in determining whether the alleged preferential transfers were ordinary include, but are not limited to:
- The length of time the parties were engaged in the transaction at issue
- Whether the amount or form of the transfer differed from past practices
- Whether the debtor or creditor engaged in any unusual collection or payment activity
- Whether the creditor took advantage of the debtor’s deteriorating financial condition. If any of these factors are present, then a court may find that the transfer does not qualify for an ordinary course of business defense.3
The Eighth Circuit noted in Lovett v. St. Johnsbury Trucking4 that when considering transactions between the parties, there is not a precise test that can be performed to determine whether it is ordinary. Rather, as noted in the bankruptcy of Bridge Information Systems5 “the court should use a “peculiarly factual” analysis in its consideration of whether transactions are ordinary between the parties. The court went on to note “The central focus of the fact intensive analysis under Section 547(c)(2)(B) is to ensure that neither the creditor nor the debtor engaged in unusual activity during the debtor’s slide into bankruptcy to benefit the transferee creditor.”6
In this same opinion, the Court references Central Hardware7 indicating “evidence that either party undertook some unusual activity to benefit the preferred creditor during the preference period will take the payments outside of the ordinary course of business.” Further, it cites Frank v. Volvo Pento of the Am.8 in noting “this is true even if the timing of the payments during the preference period was statistically consistent with the timing during the pre-preference period.”
As noted in these opinions, the courts are careful to apply the intent of bankruptcy code in evaluating whether payments are ordinary. In addition, the courts are careful to evaluate the proofs when understanding whether transactions are ordinary, particularly when unique circumstances have altered the payment arrangements. However, as noted below, courts do appear willing to consider whether unique payment arrangements are ordinary in the industry, provided certain circumstances.
Ordinary in the Industry
Comparisons to industry standards are also often used to establish a reasonable basis for ordinary course. As stated by Scott Blakeley and Terry Callahan of the Credit Research Foundation, when establishing the industry ordinary course defense, “although the industry standard does not require a creditor to establish the existence of a uniform set of business terms, it does require evidence of a prevailing practice among similarly situated members of the industry facing the same or similar problems.”9
A 2010 opinion in the Ghassan H. Kabbara10 bankruptcy highlighted the consensus among the courts regarding what “ordinary business terms” are. The Court noted “In Luper, the Sixth Circuit joined the “clear consensus” among the other courts of appeals that the definition of “ordinary business terms” [under Section 547(c)(2)(C)] means that the transaction was not so unusual as to render it an aberration in the relevant industry.”
Many factors may impact the court’s ruling of whether the alleged preferential transfers occurred within industry “ordinary course.” In the bankruptcy case of Smith Road Furniture, the court made the point that “the more established the trade relationship between the parties, the more that a creditor will be permitted to deviate from the industry standard and still qualify for the ordinary course of business exception. However, it is the creditor’s burden to establish the industry payment standard.”11 This clearly pertains to both ordinary between the parties as well as within the industry, but underscores the importance of determining what is ordinary in the industry.
As noted in the bankruptcy of Bridge Information Systems12 “although Section 547(c)(2)(C) does not require the creditor to establish the existence of a uniform set of business terms within the industry, it does require the creditor to demonstrate that the payments in question fit within the general range of terms prevailing among similarly situated firms.” [emphasis added]
The Eighth Circuit also noted in the bankruptcy of U.S.A. Inns of Eureka Springs, Arkansas, Inc.13 “What constitutes “ordinary business terms” will vary widely from industry to industry.” It went on to note “Subsection (c)(2)(C) does not require a creditor to establish the existence of some set of business terms within the industry in order to satisfy its burden. It requires evidence of a prevailing practice among similarly situated members of the industry facing the same or similar problems.” [emphasis added]
In the recent bankruptcy of Erie County Plastics Corporation,14 the Court was presented with the argument from creditor defendant Dow Chemical Co. that “it, as well as other suppliers in the industry, treat other customers similar to the Debtor, who have large balances that they are unable to pay on a current basis, similarly to its treatment of the Debtor in this case, i.e., continue to make shipment of product on a cash on delivery basis or cash in advance basis while requiring payments on the delinquent balance.” The Court found support for Dow’s contention citing several cases, including the U.S.A. Inns of Eureka Springs case mentioned above. It also quoted In re Roblin Indus., Inc. 78 F.3d 30, 42 (2d Cir.1996) in noting “If the terms in question are ordinary for industry participants under financial distress, then that is ordinary for the industry.” [emphasis added] The Court also described the “healthy debtor” perspective taken by certain courts in which industry norms should be considered when debtors are financially “healthy.”
In the bankruptcy of Energy Cooperative,15 the Court evaluated whether payments made related to a contract breach and settlement were ordinary in the industry. Creditor SOCAP International, LTD. argued that such payments were ordinary in the industry and would be expected to be made by a small supplier in its industry to maintain credibility in the industry. The Court noted “Although a transaction need not occur often to be in the ordinary course of business, a creditor asserting Section 547(c)(2) must show that the debtor incurred its debt and paid the creditor in ways similar to other transactions.” [emphasis added] Ultimately, the Court found that “without more of a showing” the payments were “simply not in the ordinary course of business.”
The Energy Cooperative opinion and the Erie County opinion both support the notion that infrequent circumstances can still result in payments that are ordinary. However, the Courts appear to be in agreement that the Creditor must do more than simply assert this. Rather, there must be a showing of reasonable facts or opinions to support this.
Establishing the Ordinary Nature of Infrequent Events
As noted above, demonstrating that a company’s practices are “ordinary” when unique circumstances may have called for a change in prior practice may require a proactive showing of industry information. To do so, one should first establish the circumstances surrounding the payment practices observed. With this understanding, one can better develop industry information that is similar to these circumstances.
That being said, it can often be difficult to identify publicly available research for similarly situated and likely privately held companies. Sources of industry information may include, but are not limited to:
Scholarly publications regarding the industry and reactions that market participants have taken
Equity or bond analyst reports that detail the reactions of certain companies or industry participants
Public records searches through news publications and other sources detailing the reactions of companies to similar unique circumstances in the industry
Industry trade publications detailing common practices and reactions within the industry
Evidence from other creditors that may have taken similar steps in their collection efforts with the debtor during the preference period or at other times
A careful examination of these types of records and information can often demonstrate that the course of action taken by a particular creditor is indeed ordinary in the industry, given the particular facts and circumstances.
Conclusion
Provided the upheaval in the national and global economy over the last two years, many customer and supplier relationships have been strained and were strained prior to a customer bankruptcy. Often, such changes resulted in modifications to the payment practices of the customer as its financial condition, products, or people changed.
The courts have suggested that they are willing to consider these unique circumstances as “ordinary” albeit infrequent. However, the creditor must carefully consider the burden it has in establishing what was ordinary between the parties, as well as what is ordinary in the industry.
1 “The Preferential Payment or Transfer,” 2 December 2008, Burbage & Weddell, 10 July 2009, <www.burbageweddell.com>.
2 Andrew C. Kassner, “The Bankruptcy Abuse Prevention And Consumer Protection Act Of 2005: The Impact On Chapter 11 Re-Organization - Part II,”
The Metropolitan Counsel, 1 June 2006.
3 Scott Blakeley and Terry Callahan, “In Defense of a Preference,” The Credit Research Foundation, 2004.
4 Lovett v. St. Johnsbury Trucking, 931 F.2d 494, 497 (8th Cir.1991)
5 In re Bridge Information Systems, Inc., Bankruptcy No. 01-41593-293, U.S. Bankruptcy Court, E.D. Missouri, Eastern Division (March 3, 2008)
6 In re Bridge Information Systems, Inc., Bankruptcy No. 01-41593-293, U.S. Bankruptcy Court, E.D. Missouri, Eastern Division (March 3, 2008)
7 Central Hardware, 153 F.3d at 905
8 Frank v. Volvo Penta of the Am. (In re Thompson Boat Co.), 199 B.R. 908, 913-14 (Bankr.E.D.Mich.1996)
9 Scott Blakeley and Terry Callahan, “In Defense of a Preference,” The Credit Research Foundation, 2004.
10 2010 WL 4365699 (Bkrtcy.N.D.Ohio), In re Ghassan H. Kabbara
11 Scott Blakeley and Terry Callahan, “In Defense of a Preference,” The Credit Research Foundation, 2004. In re Smith Road Furniture, Inc., 304 B.R. 793 (Bankr. S.D. Ohio 2003).
12 In re Bridge Information Systems, Inc., Bankruptcy No. 01-41593-293, U.S. Bankruptcy Court, E.D. Missouri, Eastern Division (March 3, 2008)
13 9 F.3d 680, In re U.S.A. Inss of Eureka Springs, Arkansas, Inc.
14 438 B.R. 89, In re Erie County Plastics Corporation
15 832 F.2d 997, 17, In re Energy Cooperative, Inc.
