Ordinary Course of Business
The ordinary course of business exception in 11 U.S.C. § 547(c)(2) is not difficult to understand, though its application is fact-driven and consequently may be difficult to predict and unlikely to be overturned on appeal. The policy underlying the exception focuses a little less on the depletion of the estate, and more on encouraging normal business relationships, which favors creditors who work with struggling businesses. The "ordinary course" defense typically arises in preference claims where a trustee seeks to avoid payments to trade vendors such as utilities, goods suppliers, service professionals, and landlords who routinely provided the debtor with goods and services used in the course of the debtor's business prior to bankruptcy.
The 2005 amendments to the Bankruptcy Code made it easier for creditors to prevail using this exception by decoupling two elements of the defense. Under both versions of the statute, a creditor must prove that the debt paid by the preferential payment arose in the ordinary course of the debtor's business. This element focuses on whether the debt was incurred as part of the debtor's normal business operations. Most debts satisfy this criterion such as debts owed to trade vendors. But if the debt is an aberration for a business, such as a construction company that incurs a debt to purchase a yacht for the company's president, then payments on that debt will not qualify for the defense.
Prior to 2005, creditors also had to prove that the transfer was made "in the ordinary course of business" and was "made according to ordinary business terms." After 2005, creditors need only prove one or the other of these elements.
Whether a transfer was made in the ordinary course of business is referred to as the subjective test. Under it, courts evaluate whether the course of dealing between the debtor and the specific creditor indicates that the transfer was not unusual. The creditor must establish the baseline of past practices between it and the debtor so that the court has something to compare the transfer to. After the baseline is established, the court determines whether the amount, form, timing, method of collection, or any other characteristic of the transfer is different from past transfers. In many cases, the question of whether a transfer was made in the ordinary course of business comes down to whether the timing of the preferential payment versus the payment due date is consistent with the timing of prior payments by the debtor to the creditor. For example, if a creditor routinely sent the debtor invoices due "net 30 days," and the debtor timely made these payments in the past, then a payment within the preference period made within 30 days of the invoice date is protected from avoidance.
Unusual patterns of activity are not enough, in and of themselves, to overcome the defense. For example, if a creditor has a history of accepting late payments from the debtor, then a late payment made within the preference period will still qualify as "ordinary course" as long as the timing of that payment fits within the established pattern. Thus, even if a payment is made much later than is normal in the industry, so long as the payment is still within the bounds of the past billing and payment practices of the debtor and creditor, the defense applies.
Even if a payment represents the first transaction between the parties, it may still fall within the exception. The exception is not intended to protect only creditors with long-standing relationships with a debtor. Rather, the exception is designed to protect normal financial relationships. If taking on a debt would not be out of the ordinary for a person in the debtor's shoes, the exception applies if the payments that follow are also ordinary.
The overall focus is on whether the transfer is arm's length, routine, and ordinary. Accordingly, payment of long-term and short-term debt generally qualifies. But, as was the case in In re Hechinger Investment Company of Delaware, Inc., 489 F.3d 568 (3d Cir. 2007), if a creditor takes steps such as accelerating a debtor's payments; reducing its credit limit; forcing it to make large, lump-sum payments by wire transfer; and/or sending the debtor dunning letters, the exception may be held inapplicable because the payment will be "out of character with the long historical relationship between the parties."
If the course of performance between the parties cannot be proven, perhaps because of poor record keeping, a creditor also can try to prove that a transfer was "made according to ordinary business terms." This is referred to as the objective test. Courts look to industry standards to determine whether the transfer was normal, and oftentimes expert testimony is necessary to establish what is common in the industry. Despite the "objective" moniker, the test is fairly flexible and easy to satisfy. Only transactions that are an aberration in a particular industry would fall out of the exception. The test takes into account a broad range of business terms, including those that would be common in cases where debtors are in financial distress. Thus, if expert testimony establishes that the industry standard is to pay invoices within a wide range of days after the billing date, and the challenged transfers paid invoices within that range, the ordinary course exception may apply, despite the fact that late payments are usually viewed with suspicion.
The primary "new value" exceptions can be found in section 547(c)(1) and (4) of the Bankruptcy Code. They generally prevent the trustee from avoiding preferential transfers when the transfer was made in exchange for something that increases, or at least does not deplete, the debtor's assets. New value can take virtually any form, including cash, property, or release of a lien, but does not include the swap of an existing obligation for a new one.
The "substantially contemporaneous exchange for new value" exception applies where a debtor pays a creditor for goods or services contemporaneously with the supply of those goods and services. COD payments are classic examples of these types of protected payments. Consistent with the purpose of the exception, the trustee may only be prevented from clawing back a transfer to the extent of the new value provided. If a debtor pays more than something is worth, the trustee may seek to recover the excess. The applicability of the exception depends to some extent on whether the transaction resembles one based on credit rather than a contemporaneous transfer, but all transfers falling under the exception are necessarily preceded by a debt for some length of time, or they wouldn't be preferential transfers in the first place. Thus, the mere passage of time is not the end of the analysis.
The intent of the parties is the most important consideration, and the exchange need only be "substantially contemporaneous." However, even when there is intent for a transfer to be for new value, it may be avoided in certain circumstances. For example, where payment for services is made by check, and a bank later dishonors the check, courts have held that the transfer falls out of the contemporaneous exchange exception.
Creditors also may be successful in retaining preferential transfers under the "subsequent new value" exception. A creditor's liability for a preferential transfer may be offset by the creditor's giving the debtor new value (often in the form of goods and services) subsequent to the contested payment. For instance, where a vendor has received a preferential payment from a customer, such as payment for goods previously shipped, if the vendor subsequently provides more goods to the customer on credit, the value of the newly shipped goods can be used to set off dollar-for-dollar the vendor's liability on the previous preferential payment. The critical point is that the vendor must not have received payment for the newly shipped goods prior to the customer filing bankruptcy. As explained in In re Inland Global Medical Group, Inc., 362 B.R. 459 (Bankr. C.D. Cal. 2006), the principle underlying the exception is that new value replenishes the estate, and recovery of the preference is not necessary to place creditors on equal footing. If the customer/debtor in fact paid for the subsequent goods, however, then the vendor effectively did not provide any new value to the customer because the repayment depleted the estate.
It is important to recognize that subsequent value must be just that—subsequent. A creditor cannot simply aggregate the value of the goods or services it provided during the preference period and offset this value directly against the amount of preferential transfers it has received. For example, if a creditor receives a preferential transfer of $5,000 and later provides $10,000 worth of new value, the subsequent new value exception prevents the trustee from avoiding any of the preference. If, after these transactions, the creditor had received another preferential transfer of $5,000, the trustee could avoid that $5,000 because there was no subsequent new value provided by the creditor.
The Code treats insiders differently than other creditors. Insiders include a debtor's corporate officers, their family members, general partners, as well as corporate affiliates of the debtor. Transfers made to these creditors are subject to a look-back period of one year rather than the standard 90 days. However, the presumption that the debtor is insolvent applies only to the 90-day window. Thus, if the trustee sues an insider for return of a transfer made more than 90 days before the filing of the petition, the trustee must prove that the debtor was insolvent at the time of the transfer.
After the 2005 amendments, transfers to a noninsider that occur between 90 days and one year of the petition filing that are avoided as benefitting an insider creditor are only avoided as to the insider. So if a debtor transfers money to a noninsider bank to pay down a loan 100 days prior to filing bankruptcy, any avoidance of the transfer would operate against an insider who guaranteed the loan, but not against the bank.
Though many payments a debtor makes to creditors on the eve of bankruptcy may be preferential transfers under the Bankruptcy Code, creditors should not assume that a payment will be later avoided. Generally speaking, if a creditor can get payment from a debtor, even a debtor tottering on the edge of bankruptcy, the creditor should do so. This is true if the payment is preferential and the creditor may not qualify for one of the statutory exceptions. That is because there is no guarantee that the creditor will face a preference suit down the road. Preference actions are not automatic: a trustee or a debtor-in-possession has to affirmatively file suit and pursue litigation to recover preferences. Many factors can impact whether a trustee or debtor-in-possession ever brings such an action. Even if a creditor is sued for a preference, the creditor may defend such an action, argue the exceptions, and perhaps settle the claim for much less than the amount of the payment. Meanwhile, the creditor will have the use of the funds it received from the debtor prior to bankruptcy. In any case, the potential of a preference claim counsels creditors dealing with financially troubled debtors to keep adequate records to prove when payments were received, what value they provided to debtors, and what the ordinary course of business is between the parties.