Chapter 5 Ordinary in the Industry (The "Objective Test")

• Jurisdiction: United States

Chapter 5 Ordinary in the Industry (The "Objective Test")

As discussed in earlier chapters, a thorough understanding of accounts receivable and payable practices, purchasing and accounting systems and related factors can be important in establishing the context under which the transfers occurred. However, the determination of whether payments are "ordinary" is also influenced significantly by the calculation of certain metrics with respect to the payments, as well as a comparison to similar metrics observed between the parties historically (the subjective test) or among industry participants (the objective test).

Whether the analysis is focused on ordinary course in the industry or between the parties, there is typically some degree of quantitative analysis required that uses the calculation of certain payment metrics. For industry ordinary course, this analysis often begins with research using a variety of industry sources that publish data relating to the payment practices of industry participants.

Often, a well-founded analysis of the transfers will also consider a variety of metrics based on information specific to both the creditor and debtor and their respective industries. However, there are distinctions that should be considered before making direct comparisons using these metrics or drawing conclusions based on only one of these methodologies.

The Burden of Proof in Industry Ordinary Course Analyses

Chapter 4 detailed the reasonable certainty standard and its applicability to an analysis of preference payments. While there is no clearly defined threshold or criteria for how to meet the reasonable certainty standard for industry ordinary course, courts have generally opined that the creditor must only establish that the transfers in question did not deviate significantly from payment practices observed in the industry:

...[t]he "clear consensus" among the other courts of appeals [is] that the definition of "ordinary business terms" [under § 547(c)(2)(C)] means that the transaction was not so unusual as to render it an aberration in the relevant industry.¹²⁹
We conclude that 'ordinary business terms' refers to the range of terms that encompasses the practices in which firms similar in some general way to the creditor in question engage, and that only dealings so idiosyncratic as to fall outside that broad range should be deemed extraordinary and therefore outside the scope of subsection C.¹³⁰

Expert Testimony

In the past, courts' application of the industry ordinary course defense was often more stringent where relationships between the debtor and creditor were of recent origin. Following the amendment of the statute in 2005, which eliminated the "and" nature of the ordinary course of business (OCB) test, the courts review the evidence of the industry ordinary course under the normal summary-judgment standard.¹³¹

Depending on the facts and circumstances of the dispute, a creditor may seek to establish ordinary business terms through the testimony of its own business personnel. In Gulf City Seafoods, the Fifth Circuit noted that the defendant "may satisfy its burden [under § 547(c)(2)(C)] through testimony by its own company representatives about the practices of other creditors and debtors in the industry, subject of course to applicable evidentiary rules."¹³² Similarly, in a preference dispute in the apparel industry, the defendant's general manager and others familiar with the industry and the defendant's competitors' payment practices satisfied the industry standard inquiry.¹³³

However, testimony from witnesses who have worked in the company and in the industry will often only be useful if "the court determines that the employees are credible and have significant and relevant industry experience."¹³⁴ The Third Circuit opined that

T]he evidence consists of mere undetailed allegations from Mr. Alford about various acceptable ranges of payment dates in the construction industry, which, much like the evidence provided within U.S. Interactive, lack an objective basis or any statistical analysis. While Mr. Alford may have relevant and significant industry experience, details on his experience have not been described to the court, except for a vague expression of his nine years of industry experience.¹³⁵

Furthermore, some courts have required independent expert testimony of industry standard business terms to meet the threshold. Specifically, the U.S. Bankruptcy Court for the District of Delaware held:

Use of circumstantial evidence contained in the fair market value report from which prevailing business standards "could be inferred" is insufficient to prove industry standards because the report did not contain any particular timing of payment inferences; establishing payment standards "would presumably require expert testimony and none was offered at trial."¹³⁶

Similarly, the U.S. Bankruptcy Court for the Middle District of Tennessee held:

[T]here is an inherent problem with the defendant's president attempting to testify about the industry's ordinary business terms. Mr. Tinsley may be qualifiable as an expert on those terms but not in his own defense, because to so allow that testimony leads to the result in Hawes; that is, it is to be expected that the defendant's president would testify favorably to the defendant's position, In re Hawes, 957 F.2d at 246 n. 8. The court is not saying that Mr. Tinsley was a witness lacking credibility, but Mr. Tinsley was not a disinterested witness.¹³⁷

The above opinions indicate that in certain cases, the use of an independent third-party expert may be necessary if the independence, impartiality or credibility of company personnel is called into question. When a third-party expert is utilized, there are often certain expectations and requirements for his or her testimony. "At a minimum, Defendant's expert by affidavit should provide specific facts to support his expertise, a supported definition of the applicable industry, and specific descriptions of the applicable ordinary business terms of the industry and of Defendant and Debtors."¹³⁸ As described below, in meeting this burden, a creditor and its expert may consult numerous sources of industry payment information and consider a variety of payment metrics.

Common Metrics Considered in Ordinary Course Analyses Payment Days

One metric commonly considered in assessing ordinary course is "payment days," which is calculated by measuring elapsed time from invoice date to payment date. For example, if an invoice was issued on Jan. 2, 2012, and was paid on Feb. 6, 2012, the payment days on that individual invoice would be 36 days. Payment days for transfers made during the preference period are commonly compared to published values for a variety of metrics published for industry participants.

While the calculation of payment days is relatively simple, as detailed in Chapters 3 and 4, additional considerations may be necessary to better appreciate and understand trends observed in the data. For instance, internal accounting systems for the creditor and debtor may result in subtle differences between the date of receipt of payment and the date of actual application and posting. Further, in certain instances, outliers may be observed in the data. For example, it may be the case that all invoices did not have the same payment terms or that some of the transfers were related to the contemporaneous exchange of goods. In such cases, the debtor may have taken a significantly longer or shorter time to make certain payments as a result of the corresponding terms and payment arrangements.

Additionally, as detailed in Chapter 3, credits issued by the creditor, historically and during the preference period, may require special consideration. Credits subsequently applied to the alleged preferential transfers should be considered as offsets to these amounts. Further, when considering historical data for comparison to the alleged preferential transfers, it is often appropriate to consider credits differently. Credit transfers may occur significantly later than the indicated terms or significantly after the original payments on the invoices, as the parties may take time to negotiate disputed amounts. Therefore, the nature of these transfers should be considered throughout the analysis, as in many cases it would not be appropriate to consider these transfers for comparison to the alleged preferential transfers.

While payment days is a direct measure of the timing of individual payments, the use of this metric is often limited, especially in the case of the industry ordinary course analysis. In a perfect world with complete and readily accessible information from all industry participants, the most complete and accurate analysis of industry ordinary course would rely upon an assessment of payment days between the parties in comparison to payment days on individual invoices occurring in the industry. However, such information is not typically available publicly. It is this lack of information relating to payment days that necessitates the use of alternative measures of payment practices, which are an indirect indication of the actual payment days on individual invoices.

Days Sales Outstanding

One key alternative metric utilized in assessing the ordinary course between parties and in the industry is days sales outstanding, commonly referred to as "accounts receivable days outstanding" or simply "days receivables." The preference period transfers may be analyzed in relation to creditor's observed days sales outstanding from the historical period, as well as the reported industry days sales outstanding over the relevant time period. This metric can be calculated in a numbers of ways, two of which are (1) the weighted average method and (2) the turnover method. Regardless of the calculation, days sales outstanding is a measure of payment behavior in the aggregate and is not a direct measure of the timing of payments on individual invoices...