If you are the subject of demand by a trustee or other party, whether in a pre-suit demand letter or in a filed adversary proceeding, for the return of money paid to you by an individual or business which is now in bankruptcy, you may be able to keep the money if you can prove that the payments at issue fall within the ordinary course of business exception for preference payments. This is one of the most, if not the most, widely used defense in preference cases, and defendants are successful with it with some frequency. (There are other defenses to preference actions in the Bankruptcy Code, which are not discussed in this post).
Unless the payments at issue are to an “insider,” as defined by the Bankruptcy Code, only payments made within the 90-day period before a debtor files bankruptcy can be attacked as preferences. In addition to proving that the payments were made within the 90-day period, the trustee, or other party making the claim, has the burden of proving a few other elements in order to establish that the payments at issue were preferences. Once that burden is met, the creditor who received the payments can avoid having to disgorge the money at issue if it carries its burden of proof that the payments, though preferences, fall within the ordinary course of business exception in the Bankruptcy Code (11 U.S.C.A. §547(c)(2)).
To help readers better understand this exception, this blog discusses two cases — one in which the defense was successful, and the other in which it was not. Before discussing those cases, it is helpful to understand some basic rules about this exception. Here they are:
- The exception can be met by a creditor (who received a preferential payment) proving either the subjective component of the exception or the objective component of the exception.
- The subjective component of the exception considers whether the transfer, and the debt for which it was transferred, were made in the ordinary course of business of the debtor and creditor. Like the American Camshaft case discussed below, in many cases, there will be no dispute that the debt incurred by the debtor was incurred in the ordinary course of business, but there will be a dispute about whether the payment for that debt was in the ordinary course of business of the debtor and creditor.
- The objective component of the exception considers whether the debt was incurred in the ordinary course of the business of the debtor and creditor and whether the transfer that was the payment for the debt was made “according to ordinary business terms,” meaning ordinary business terms in the industry of the debtor and creditor.
- The Bankruptcy Code does not define “ordinary course of business” or “ordinary business terms” and the Sixth Circuit (which is the Circuit in which Tennessee bankruptcy courts are located) has said that there is no “precise legal test” to apply to determine whether either term has been satisfied. Instead, each preference case in which the ordinary course of business defense is raised turns on its own, unique facts.
- For the subjective component of the exception, in many cases, the most important factor that a Tennessee bankruptcy court will look at is the timing of the payments made by the debtor to the creditor that occurred within the 90-day preference period compared to the timing of the payments that occurred more than 90 days before the debtor filed bankruptcy.
- Under the subjective component of the exception, a creditor’s chances of success will be diminished, if not foreclosed, if it engaged in collection activity during the 90-day preference window that it did not engage in prior to 90 days before the debtor filed for bankruptcy.
In American Camshaft Specialties, Inc. (Bankr. E.D. Mich. 2011), the creditor (“Creditor”) was able to avoid repayment of preferential payments under both the subjective and objective components of the ordinary course of business defense. In that case, the Creditor supplied steel to the debtor (“Debtor”). The trustee for the Debtor filed suit against Creditor to recover a number of payments which had been made to the Creditor during the 90-day preference window. The payments had been made for steel supplied to the Debtor by Creditor. There was no dispute that the debt for the steel was incurred in the ordinary course of the business of the Debtor and Creditor.