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.
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