Southern California Bankruptcy Law Blog

Preferential Transfers IV: Defenses to Preference Avoidance Actions (Part II)

Posted in Chapter 11, Chapter 13, Chapter 7

This is the second post devoted to defenses against preference avoidance actions.  It covers the so-called ordinary course of business defense.

Defenses To Preference Avoidance Actions, Part II:

The Ordinary Course Of Business Defense

Suppose a corporate debtor in Chapter 11 has a lease on the building in which it conducts its business.  Suppose the debtor has lease payments of $25,000 per month.  If it makes its usual on-time payments during the ninety-day prepetition period — i.e., a total of $75,000 — will the DIP (the Debtor-in-Possession, who is the debtor serving as a quasi-trustee) successfully avoid those payments?  Based on 11 U.S.C. § 547(c)(2), the answer is “no”:

The trustee may not avoid under this section a transfer — . . . 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.

Although this Code subsection appears to have two possible conditions ((A) and (B)), each of which focuses on the nature of the payments, there is a third crucial requirement embedded in the introductory language:  the underlying debt itself must have been incurred in the ordinary course of business. 

A once-in-a-lifetime long-term debt may or may not be incurred in the ordinary course of the debtor’s business or financial affairs.  The key factor is not whether or not the debt is long-term.  Payments on either long-term or short-term debt may qualify for the § 547(c)(2) defense.  See Union Bank v. Wolas, 502 U.S. 151 (1991).  The Sixth Circuit Court of Appeals held that the necessary analysis is very fact specific:

A more difficult question is whether a particular loan can be incurred “in the ordinary course of financial affairs” if the borrower has not taken out a number of such loans, or a number of such loans from the same institution.  Obviously, it is easier to find “ordinary course” if a transaction is indeed one of the “recurring, customary credit transactions” with regard to the particular borrower . . .  Obviously every borrower who does something in the ordinary course of her affairs must, at some point, have done it for the first time.  We hold that, as a general rule, subject to the individual fact-finding powers of the district court in a specific inquiry, a transaction can be in the ordinary course of financial affairs even if it is the first such transaction undertaken by the customer.  This rule holds where the transaction would not be out of the ordinary for a person in the borrower’s position.

In re Finn, 909 F. 2d 903, 908 (6th Cir. 1990).

For example, if the debtor is operating a Ponzi scheme and makes a payment during the preference period, the payment is recoverable.  This is because Ponzi schemes are not legitimate businesses, so they cannot incur debt in the ordinary course of business.  See In re Bishop, Baldwin, Rewald, Dillingham & Wong, 819 F. 2d 214 (9th Cir. 1987).

As for the payments, they too must be made in the ordinary course of business, or made according to normal ordinary business terms.  Context is crucial.  What may be ordinary for one business or individual may not be ordinary for another.  Therefore, it is incumbent on the recipient of the transfer to present evidence of the standard for the business in question.  See Sigma Micro Corp. v. Healthcentral.com (In re Healthcentral.com), 504 F.3d 775 (9th Cir. 2007) (summary judgment against transferee’s § 547(c)(2) defense reversed due to insufficient evidence of industry standard).  See also In re Roblin Industries, 78 F.3d 30 (2d Cir. 1996) (burden is on the transferee to establish the exception with supporting evidence).

In the consumer context a simple example may help to illustrate the idea of ordinary payments.  Suppose a debtor has a monthly car payment of $400.  The debtor’s rich uncle gives $6,000 towards the car, so the debtor makes a one-time payment of $6,000 during the 90-day preference period.  (Remember, the uncle is not the recipient, instead it’s the lender who’s the recipient.)  $1,200 (= $400 × 3) of that payment was in the ordinary course of the debtor’s affairs, and was not a preference.  However, $4,800 was out of the ordinary, and was therefore a preference.

Unusually late payments that under normal circumstances might have fallen under the § 547(c)(2) exception can be preferential transfers.  See, e.g., Matter of Xonics Imaging, Inc., 837 F.2d 763 (7th Cir. 1998) (late rent payment after end of the grace period not in the ordinary course of business).  But see Matter of Tolona Pizza Products Corp., 3 F.3d 1029 (9th Cir. 1993) (late payments may fall within § 547(c)(2)’s exception if they are consistent with pattern of prior payments and consistent with ordinary practice of similar firms).

Payments made under duress are also excepted from avoidance under § 547(c)(2).  See, e.g., Matter of Seawinds, Ltd., 888 F.2d 640 (9th Cir. 1989) (payments made under pressure not in the ordinary course of business).

And payments made pursuant to a settlement agreement can be outside the ordinary course of the debtor’s business.  See, e.g., In re Richardson, 94 B.R. 56 (Bankr. E.D. Pa. 1988) (public housing tenant’s payment made pursuant to a settlement of an eviction action was a preference).

If you’re facing a preference avoidance action, and need an analysis of your case and the possible application of the ordinary course of business defense to your case, contact a highly skilled bankruptcy attorney to help you.