Chapter 6 Ordinary Between the Parties (The "Subjective Test")

• Jurisdiction: United States

Chapter 6 Ordinary Between the Parties (The "Subjective Test")

second, alternative prong to the ordinary-course defense requires providing proof that the alleged transfers were consistent with payment and collection practices observed between the parties historically. Unlike the objective analysis pertaining to industry ordinary course, the subjective analysis involving ordinary course between the parties is typically based on documentation maintained by the creditor and debtor and produced during the course of litigation (rather than external industry research or other data). At least one court has noted that transactions must be examined from both the debtor and transferee perspectives in supporting that they were indeed ordinary.¹⁸⁵

This chapter details a variety of factors that impact the court's consideration of the subjective test and also provides considerations for the presentation of this defense.

Background of the Subjective Test

A key goal of preference law is to protect financially distressed debtors facing the possibility of bankruptcy from abnormal or extreme demands from creditors.¹⁸⁶ Creditors may place such demands on distressed customers due to fears of not receiving payment in the event of bankruptcy. However, such actions often accelerate the debtor's slide into bankruptcy and may seriously impair the debtor's chances of survival, thereby negatively impacting the debtor and its other creditors. This framework is an important consideration when evaluating the analysis of ordinary between the parties, as discussed below.

In Sierra Concrete Design, Judge Sontchi provided a detailed explanation of the underlying problem that preference law seeks to combat:

The basic problem that bankruptcy law is designed to address is that the system of individual creditor remedies, i.e., "first come; first served," may harm creditors as a whole when there are insufficient assets to pay all of them in full. This is a variant of the prisoner's dilemma or common pool problem. The "first come; first served" rules create an incentive on the part of individual creditors — when they fear that a debtor may be insolvent — to get in line today because, if the creditor doesn't, it risks getting nothing....¹⁸⁷

Preference law is meant to discourage this disruptive activity that sometimes arises in dealings with distressed customers. However, preference law is not meant to allow for the avoidance of routine transfers from the debtor to the creditor. To do so would eliminate the incentive for creditors to continue their ongoing relationship with their distressed customer. This is the primary reason for the ordinary-course defense. With this defense at their disposal, creditors can continue their dealings with distressed companies without "obviating any worry that a subsequent bankruptcy filing might require the creditor to disgorge as a preference an earlier received payment."¹⁸⁸ That is, of course, as long as such dealings, and the related payment practices, are carried out in a manner consistent with the parties' historical relationship.

As stated by Judge Sontchi, "[t]he ordinary course of business defense removes from preference attack routine payments to creditors. These are payments that are made in ordinary course on debts incurred in ordinary course according to ordinary business terms. Without this defense the trustee would have the power to avoid many routine transactions...."¹⁸⁹

As stated in another case, the "purpose of this exception is to leave undisturbed normal financial relations, because [permitting the continuation of normal relations] does not detract from the general policy of the preference section to discourage unusual action by either the debtor or his creditors during the debtor's slide into bankruptcy."¹⁹⁰

Tests Applied by Courts in Considering the Subjective Test

The analysis of ordinary course between the parties typically focuses on whether the payment behavior between the parties during the preference period was consistent with the behavior prior to the preference period. If there are notable differences in behavior, it may be the case that the creditor engaged in abnormal behavior in an effort to ensure payment as the debtor was sliding into bankruptcy.

Similar to an analysis of ordinary course in the industry, the analysis of ordinary between the parties will often focus on the calculation of metrics for the preference period for comparison to the historical period. The analysis of ordinary course between the parties is often more straightforward than industry analyses as it is generally based on data specific to the debtor and creditor. However, the focus under the subjective test is often not on the data sources and mechanics of the calculation, but on the process involved in selecting the appropriate time period and data to analyze, and in drawing appropriate conclusions.

In analyzing the subjective test, the timing and method of transfers between the parties historically and during the preference period is often of primary importance. Many factors may impact the court's ruling on whether the alleged preferential transfers occurred in the "ordinary course" between the parties.

Issues commonly considered by courts in determining whether the alleged preferential transfers were ordinary include, but are not limited to:

• the length of time the parties maintained a business relationship;
• whether the debtor always paid invoices by check, wire or cashier's check, etc.;
• the typical time period from date of invoice to payment received;
• whether the debtor typically paid several invoices in one payment;
• whether the creditor pressured the debtor to pay the invoices at issue;
• whether the creditor restricted credit to the debtor during the 90-day period preceding the petition date;
• whether the creditor was aware of the debtor's deteriorating financial condition;
• whether the creditor varied its credit terms during the 90-day period preceding the petition date;
• whether the creditor threatened to cut off the debtor or refuse to supply the debtor because of the time it was taking the debtor to pay invoices; and
• the regularity with which the debtor typically made payments.

In general, issues commonly considered by courts in determining whether the alleged preferential transfers were ordinary include, but are not limited to:

• the length of time the parties maintained a business relationship;
• whether the amount or form of the transfer differed from past practices;
• whether the debtor or creditor engaged in any unusual collection or payment activity; and
• whether the creditor took advantage of the debtor's deteriorating financial condition.

The court may analyze each of the above factors in determining whether the transfer qualifies for an ordinary course of business defense.¹⁹¹ However, for example, unless "late payments are first shown to be ordinary on the basis on their timing or 'lateness,' the defense will fail and it will be unnecessary to consider other facts."¹⁹² The existence of some favorable factors does not necessarily compensate for a large shift in mean time to payment.¹⁹³ In order for a history of late payments to be established as the ordinary course of business between parties, certain courts have sought a demonstrated consistency in payments both before and during the 90-day preference period.¹⁹⁴To show consistency, courts require a "fine-grained analysis," and "[u]nder no theory is the conclusory incantation 'late payments are ordinary course,' standing alone, sufficient...."¹⁹⁵ In In re PMC Mktg. Corp., the court rejected copies of a 35-page payment ledger as evidence of consistent late payments because the defendant had failed to supply any kind of supporting analysis of the data to demonstrate degree of lateness during the preference and pre-preference periods, or to establish a baseline period.¹⁹⁶

The Length of Time the Parties Maintained a Business Relationship

The court's consideration of an ordinary-course defense is often influenced by the length of the parties' relationship. At one end of the spectrum, the creditor and debtor may have had a multi-year relationship in which frequent transactions were made relating to all relevant products or services. In such situations, a detailed analysis of the payment practices between the parties will likely be possible. Such an analysis may consider transfers occurring on a daily basis over time, with consideration given to observed differences for payments involving different product types, transaction amounts or forms of payment. If such payment history is available, each of the alleged transfers can be compared to numerous transactions of the same type, which facilitates the analysis required for the ordinary-course defense.

The lack of an established history often poses challenges in the analysis of the subjective test. However, while a multi-year history between the parties can assist in the analysis and presentation, such a history is not always a requirement. Some courts have ruled that a relationship over a significantly shorter period of time and involving a relatively small number of transactions may form an adequate basis for an ordinary-course defense.

For example, in one case, the history between the parties was comprised of only eight months of history, which included 4 payments during the preference period and 10 before. The court found that this history was sufficient to define and establish the ordinary course of conduct between the parties.¹⁹⁷ In other situations in which there was virtually no history between the parties, courts have deferred to the contract or invoice terms such that all late payments would be outside of ordinary (as it relates to the subjective test).¹⁹⁸ Courts have similarly found that if the parties' relationship was very short, there may not be sufficient grounds to establish an ordinary course of dealing outside of the contractual due dates.¹⁹⁹

Another case involved a single...