Ordinary-Course Preference Defense

The Amendment's Potential Benefits to Creditors

Tightening Credit to Industry Standards

A company's financial problems are sometimes well known, and some bankruptcies are highly anticipated. In such circumstances, diligent creditors typically begin to shorten the time within which they require payments from a financially troubled debtor to avoid a large outstanding receivable upon a bankruptcy filing. There are circumstances under the new ordinary-course defense in which a creditor's tightening payment terms may not be considered a preference. This would appear to be true where the new, shorter payment terms, although not subjectively ordinary course between the creditor and the company, are ordinary course in the industry. This result seems contrary to the congressionally espoused purpose of the ordinary course of business preference defense of maintaining 'normal financing relations,' but it appears to be required by the unambiguous language of the statute. Furthermore, a creditor could argue that a change in terms to allow the creditor to be paid in line with its industry peers furthers the preference policy of equality of distribution.

For example, Creditor supplies BrokeCo. with goods under a contract that gives BrokeCo. 60 days to pay ' a more generous payment term than the 30-day industry standard. Creditor then learns of BrokeCo.'s financial problems, deems itself insecure, and begins requiring payment within 30 days. BrokeCo. files for bankruptcy several months after this change in terms. Assume that during the 90-day preference period preceding Broke-Co.'s bankruptcy Creditor received payments from BrokeCo. an average of 33 days after invoice, 30 days sooner than the average 63 days within which Creditor had received payment from BrokeCo. before the preference period. BrokeCo. then sues Creditor to recover as preferential the payments BrokeCo. made to Creditor during the 90 days preceding BrokeCo.'s bankruptcy.

The expedited payments would likely be preferential under the old law because the payments were not subjectively ordinary course ' that is, not ordinary course between BrokeCo. and Creditor. The fact that Creditor's receipt of payment within 33 days is objectively ordinary course'that is, standard in the industry ' would not be dispositive. However, under the new law these payments should not be preferential because they meet the objective standard.

Tightening Credit Early to Establish a Course of Dealing

The changes to the ordinary-course defense may also encourage getting tough early with a problem customer. Under the new law, any payment terms, regardless of how onerous or consistent with industry standards, would appear to insulate a creditor from preference exposure provided they have been in existence long enough to be deemed a subjectively ordinary course between the creditor and potential debtor.

For example, what if Creditor had been more aggressive with BrokeCo. and required cash on delivery or net immediate payment terms, and BrokeCo. did not file for bankruptcy until 18 months after the change in payment terms? In that case, Creditor should have a valid ordinary course of business defense under the new law because the immediate payment terms, in effect for a year and a half, were subjectively ordinary course. This is true despite the fact that Creditor obtained payment over 30 days earlier than is standard in the industry, which would have proven fatal pre-BAPCPA, because the BAPCPA does not require proving the objective component where a transfer is subjectively ordinary course. This result is also contrary to the preference law's intention of encouraging creditors to work with a struggling company to perhaps make a bankruptcy filing unnecessary. The new law is clear, however, that payments made to a creditor in the ordinary course of its business with the debtor are protected.

The risk of tightening credit to establish a new course of dealing is, of course, that the debtor may file for bankruptcy before a court would deem a new subjective ordinary course of dealing to have been established. Creditors will likely consider this risk to be one worth taking given the upside of reducing or eliminating their pre-petition receivable, potentially without preference liability.

Expert Witness Not Always Necessary

The change in the law also aids the creditor defendant by reducing the instances in which an expert witness will be necessary to establish an ordinary course defense. Pre-BAPCPA, debtors had substantial leverage over a preference defendant asserting an ordinary course of business defense because the creditor had to prove that it received the transfer from debtor both subjectively and objectively in the ordinary course, and proving objective ordinary course typically requires the retention of an expert witness to establish prevailing standards in the relevant industry. Since most pre-BAPCPA ordinary course cases involved experts battling over whether a transfer was made in line with industry norms, creditors asserting a factually solid ordinary course preference defense in settlement negotiations were often met with a debtor's response of, 'You're probably right on the facts, but pay my demand because it will cost you a lot of money to retain an expert and prove your case.' The practical difficulties in proving the objective prong of the defense often led to settlements disproportionately favorable to the debtor when looking solely at the merits of the creditor's ordinary course defense.

Post-BAPCPA preference defendants who defend on the ground of subjective ordinary course should not need an expert to establish that the transfer was made in the ordinary course of business or financial affairs of the debtor and the creditor. Documentary evidence and lay testimony, for example from the creditor's and/or debtor's employees, should be sufficient to prove a transfer was made in the ordinary course between the debtor and the creditor. There-fore, preference defendants defending on subjective ordinary course should now have an ability to go to trial without the time and added expense of expert reports and depositions. As a result, debtors are likely to see the nuisance value of subjective ordinary course cases decrease.

Conclusion

The BAPCPA's one-word change to the ordinary course of business preference defense significantly expands the defense's utility to the typical unsecured creditor. The change provides a creditor additional options to reduce its pre-petition receivable in the shadows of bankruptcy and, once sued as a preference defendant, makes asserting an ordinary course defense easier and likely less expensive.

Scott A. Wolfson ([email protected]) is a partner in the Detroit office of Honigman Miller Schwartz and Cohn LLP, and is a member of the firm's Bankruptcy, Reorganization and Commercial Department.

Congress' one-word change to the ordinary course of business preference defense will make this already common preference defense even more prevalent. The Bankruptcy Abuse Prevention and Consumer Protection Act's ('BAPCPA') substitution of an 'and' for an 'or' to the defense's elements should significantly assist the typical unsecured creditor in defending a preference claim, and, in most cases, enable the creditor to defend the claim without an expert witness.

Section 547(c)(2): Ordinary Course of Business Defense

The legislative history behind ' 547(c)(2)'s ordinary course of business defense states that its purpose 'is to leave undisturbed normal financing relations because it does not detract from the general policy of the preference section to discourage unusual action by either the debtor or [its] creditors during the debtor's slide into bankruptcy.' HR Rep No 95-595 at 373, as reprinted in 1978 USCCAN 5963. The defense, as amended by the BAPCPA, provides that a transfer may not be avoided to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was '

(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or (B) made according to ordinary business terms. (Emphasis denotes new language).

Like prior law, the BAPCPA continues the requirement that the debt be incurred in the ordinary course of business of the debtor and the transferee. However, the amended language now provides that meeting either subsection (A) or subsection (B) is sufficient. Courts have interpreted the requirements of (A) to be a subjective test ' ie, that the transfer be ordinary in relation to the other business dealings between that creditor and that debtor. Courts have interpreted the requirements of (B) to be an objective test ' ie, that the transfer be ordinary in relation to prevailing standards in the relevant industry. Prior to the BAPCPA, the ordinary-course defense was written in the conjunctive; a creditor had to show that the transaction was ordinary both subjectively and objectively. The BAPCPA's one-word change significantly relaxes the standard for a transfer to be considered ordinary course because a transfer now need only be subjectively or objectively ordinary course to qualify for the defense. The BAPCPA's changes to the ordinary course defense apply to bankruptcy cases commenced on or after Oct. 17, 2005. Thus, conduct today will be subject to the amended statute.

The Amendment's Potential Benefits to Creditors

Tightening Credit to Industry Standards

A company's financial problems are sometimes well known, and some bankruptcies are highly anticipated. In such circumstances, diligent creditors typically begin to shorten the time within which they require payments from a financially troubled debtor to avoid a large outstanding receivable upon a bankruptcy filing. There are circumstances under the new ordinary-course defense in which a creditor's tightening payment terms may not be considered a preference. This would appear to be true where the new, shorter payment terms, although not subjectively ordinary course between the creditor and the company, are ordinary course in the industry. This result seems contrary to the congressionally espoused purpose of the ordinary course of business preference defense of maintaining 'normal financing relations,' but it appears to be required by the unambiguous language of the statute. Furthermore, a creditor could argue that a change in terms to allow the creditor to be paid in line with its industry peers furthers the preference policy of equality of distribution.

For example, Creditor supplies BrokeCo. with goods under a contract that gives BrokeCo. 60 days to pay ' a more generous payment term than the 30-day industry standard. Creditor then learns of BrokeCo.'s financial problems, deems itself insecure, and begins requiring payment within 30 days. BrokeCo. files for bankruptcy several months after this change in terms. Assume that during the 90-day preference period preceding Broke-Co.'s bankruptcy Creditor received payments from BrokeCo. an average of 33 days after invoice, 30 days sooner than the average 63 days within which Creditor had received payment from BrokeCo. before the preference period. BrokeCo. then sues Creditor to recover as preferential the payments BrokeCo. made to Creditor during the 90 days preceding BrokeCo.'s bankruptcy.

The expedited payments would likely be preferential under the old law because the payments were not subjectively ordinary course ' that is, not ordinary course between BrokeCo. and Creditor. The fact that Creditor's receipt of payment within 33 days is objectively ordinary course'that is, standard in the industry ' would not be dispositive. However, under the new law these payments should not be preferential because they meet the objective standard.

Tightening Credit Early to Establish a Course of Dealing

The changes to the ordinary-course defense may also encourage getting tough early with a problem customer. Under the new law, any payment terms, regardless of how onerous or consistent with industry standards, would appear to insulate a creditor from preference exposure provided they have been in existence long enough to be deemed a subjectively ordinary course between the creditor and potential debtor.

For example, what if Creditor had been more aggressive with BrokeCo. and required cash on delivery or net immediate payment terms, and BrokeCo. did not file for bankruptcy until 18 months after the change in payment terms? In that case, Creditor should have a valid ordinary course of business defense under the new law because the immediate payment terms, in effect for a year and a half, were subjectively ordinary course. This is true despite the fact that Creditor obtained payment over 30 days earlier than is standard in the industry, which would have proven fatal pre-BAPCPA, because the BAPCPA does not require proving the objective component where a transfer is subjectively ordinary course. This result is also contrary to the preference law's intention of encouraging creditors to work with a struggling company to perhaps make a bankruptcy filing unnecessary. The new law is clear, however, that payments made to a creditor in the ordinary course of its business with the debtor are protected.

The risk of tightening credit to establish a new course of dealing is, of course, that the debtor may file for bankruptcy before a court would deem a new subjective ordinary course of dealing to have been established. Creditors will likely consider this risk to be one worth taking given the upside of reducing or eliminating their pre-petition receivable, potentially without preference liability.

Expert Witness Not Always Necessary

The change in the law also aids the creditor defendant by reducing the instances in which an expert witness will be necessary to establish an ordinary course defense. Pre-BAPCPA, debtors had substantial leverage over a preference defendant asserting an ordinary course of business defense because the creditor had to prove that it received the transfer from debtor both subjectively and objectively in the ordinary course, and proving objective ordinary course typically requires the retention of an expert witness to establish prevailing standards in the relevant industry. Since most pre-BAPCPA ordinary course cases involved experts battling over whether a transfer was made in line with industry norms, creditors asserting a factually solid ordinary course preference defense in settlement negotiations were often met with a debtor's response of, 'You're probably right on the facts, but pay my demand because it will cost you a lot of money to retain an expert and prove your case.' The practical difficulties in proving the objective prong of the defense often led to settlements disproportionately favorable to the debtor when looking solely at the merits of the creditor's ordinary course defense.

Post-BAPCPA preference defendants who defend on the ground of subjective ordinary course should not need an expert to establish that the transfer was made in the ordinary course of business or financial affairs of the debtor and the creditor. Documentary evidence and lay testimony, for example from the creditor's and/or debtor's employees, should be sufficient to prove a transfer was made in the ordinary course between the debtor and the creditor. There-fore, preference defendants defending on subjective ordinary course should now have an ability to go to trial without the time and added expense of expert reports and depositions. As a result, debtors are likely to see the nuisance value of subjective ordinary course cases decrease.

Conclusion

The BAPCPA's one-word change to the ordinary course of business preference defense significantly expands the defense's utility to the typical unsecured creditor. The change provides a creditor additional options to reduce its pre-petition receivable in the shadows of bankruptcy and, once sued as a preference defendant, makes asserting an ordinary course defense easier and likely less expensive.

Scott A. Wolfson ([email protected]) is a partner in the Detroit office of Honigman Miller Schwartz and Cohn LLP, and is a member of the firm's Bankruptcy, Reorganization and Commercial Department.