Bankruptcy Litigation Committee

ABI Committee News

Litigating the “Ordinary Course” Defense Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005

As we await the effective date of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (2005 Act), there is much discussion of the Act’s high-profile provisions, such as its restrictions on eligibility for chapter 7 relief via “means testing,” and the limitations on the scope of state law homestead exemptions. However, this expansive legislation includes many other provisions—mostly pro-creditor—that have largely slipped “under the radar.”

One such provision of significance to bankruptcy litigators is the expansion of the “ordinary course” preference defense under §547(c)(2) of the Code. As discussed herein, the 2005 Act de-emphasizes (and arguably eliminates) the requirement that the alleged preference payment be made according to “ordinary business terms.” This amendment to §547(c)(2) will apply in cases filed after the effective date of the 2005 Act, October 17, 2005. It should considerably simplify the task of defense counsel in preference cases.

Current Law: Payment Must Be Subjectively and Objectively “Ordinary”

The ordinary course defense under current §547(c)(2) has three prongs: The recipient of an otherwise avoidable preferential payment has a complete defense to the extent that the preferential transfer was

  1. in payment of the debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee;
  2. made in the ordinary course of business or financial affairs of the debtor and the transferee; and
  3. made according to ordinary course business terms.

Thus, the debt itself must be subjectively “ordinary” (per the parties’ course of dealings) and the transfer (i.e., payment of the debt) must be both subjectively ordinary (per the parties’ course of dealings) and objectively ordinary (“made according to ordinary business terms”).

The defendant has the burden of proving all three prongs. In re M Group Inc., 308 B.R. 697 (Bankr. D. Del. 2004). The final prong—the “objective” test requiring proof that payment was made “according to ordinary business terms”—has assumed greater importance in recent years, with many courts emphasizing the need for proof that the timing of payments were within an established industry standard. This entails identification of the relevant “industry,” followed by proof of the “industry standard” as to timing of payments. To pass the objective test, defense counsel typically must present independent expert testimony, often to skeptical courts. See, e.g, In re U.S. Interactive Inc., ___B.R.___, 2005 WL 589588 (Bankr. D. Del. 2005) (rejecting expert testimony that “industry standard” was 60 days past invoice where conclusion was not supported by statistics or other objective basis) and cases cited therein.

New Law: Payment Must Be Subjectively or Objectively “Ordinary”

Section 409 of the 2005 Act amends §547(c)(2) of the Code, and reverses this pro-trustee trend in the case law. As revised, §547(c)(2) retains the requirement—which in practice is rarely an issue—that the debt be incurred in the ordinary course of the parties’ affairs. The defendant, however, must prove only one of the remaining prongs, i.e., that the payment was either subjectively or objectively “ordinary.” The defendant need not prove that payment was made according to “ordinary business terms” as long as it can prove that payment was made according to the parties’ ordinary course of business affairs.

Tactical Considerations

The practical effect of the amendment will likely be the virtual elimination of the “ordinary business terms” prong of the defense. Defendants will rely on the subjective test, because proof that payment was made in the ordinary course of the parties’ business affairs will not require presentation of expert testimony; the defendant can simply sponsor its own business records showing the parties’ billing and payment history. Thus, the amendment considerably simplifies defendant’s counsel’s task.

Plaintiffs’ counsel’s response in these cases should be to try to block the use of the subjective test, thereby forcing the defendant back into the more onerous objective test. The factors considered by courts in determining whether a payment was within the ordinary course of the parties’ business affairs (the subjective test) are:

  1. the length of time the parties were engaged in the transaction at issue;
  2. whether the amount or form of payment differed from past practices;
  3. whether the debtor or creditor engaged in any unusual collection or payment activities; and
  4. the circumstances under which the payment was made.

In re Sunset Sales Inc., 220 B.R. 1005 (10th Cir. BAP 1998). Courts have generally been satisfied if there is “some consistency” between the preferential payment and the parties’ other business transactions. See, e.g., In re Child World Inc., 173 B.R. 473 (Bankr. S.D.N.Y. 1994). Indeed, they have been surprisingly lenient in their application of the subjective test, often finding that a single transaction—indeed, the challenged transaction itself—is sufficient to establish an “ordinary course” of dealing as between the parties. In re Finn, 909 F.2d 903 (6th Cir. 1988); Kleven v. Household Bank F.S.B., 334 F.3d 638 (7th Cir. 2003).

Ironically, the courts have held that, in such cases where the parties do not have a long history of transactions, the proof of an industry standard under the objective test “plays a more prominent role.” In re U.S. Interactive Inc., supra, 2005 WL 589588 at *2. It will be interesting to see if a stricter interpretation of the subjective test evolves if the 2005 Act removes the objective test as a mandatory element of the defendant’s proof. If not, then it is likely that the objective test will remain a part of the ordinary course defense in name only.