The Ordinary Course of Business Defense to Preferential Payment Actions

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:

1. 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.
2. 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.
3. 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.
4. 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.
5. 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.
6. 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.

The trustee disputed that the payments made for the debts incurred for the steel were in the ordinary course of business of the Debtor and Creditor (the subjective component), and disputed that they were made according to ordinary business terms in the relevant industry (the objective component). The proof was that, during the 90-day preference window, the Debtor paid the Creditor’s invoices, on average, 63 days after the date of the invoices. The proof was that, in the one year period immediately preceding the 90-day preference period, the Debtor paid the Creditor’s invoices, on average, 59 days after the date of the invoices.

In American Camshaft, there was proof that, during the 90-day preference period, for the first time, the Debtor had made some payments by wire as opposed to by check, and that, in two instances, it had paid more than one invoice with a lump sum payment instead of paying each invoice separately as it has done prior to the 90-day preference window.

The court in American Camshaft held that Creditor had carried its burden of proof as to the subjective component of the ordinary course of business defense.  It found that the differences in the timing of the payments within the 90-day preference window and before it were immaterial.  It found that the fact that, for the first time during the preference period, some payments had been made by wire, and that two lump sum payments had been made, was not sufficient to establish that the payments were not in the ordinary course of the relationship of the Debtor and Creditor.  As the court put it, to invoke the defense successfully, a creditor does not have to prove that the payments inside and outside the preference period were identical in every respect.

The court in the American Camshaft case also found that Creditor had met the objective component of the ordinary course of business defense based on the expert testimony it presented. Its expert had testified, based on information available through Dunn & Bradstreet, that, for the preferential payments, the time between the invoice date of the Creditor’s invoices at issue and payments was not “aberrational, unusual, or idiosyncratic” compared to industry averages.

Unlike in the American Camshaft case, in the case of Smith Mining and Material, LLC (Bankr. W.D. Ky. 2009), the creditor was not successful with the ordinary course of business defense. In that case, there was proof that, during the preference period, the debtor in that case paid the creditor’s invoices, on average, 76 days after issuance, whereas, before that period, it had paid them, on average, within 67 days of receipt. There was also evidence that, during the preference period, the creditor had pressured the debtor to pay invoices and had threatened to suspend delivery of its products.

Relying on the ordinary course of business defense, or many other available defenses in the Bankruptcy Code, a creditor may be able to avoid having to repay monies paid to it by a bankrupt company. If you are the subject of a demand or lawsuit for preference payments, before making any decisions or settlements, you should consult with an experienced commercial litigation attorney.