Chapter 3 THE "ORDINARY COURSE OF BUSINESS" DEFENSE UNDER § 547(c)(2)

• Jurisdiction: United States

Chapter 3 THE "ORDINARY COURSE OF BUSINESS" DEFENSE UNDER § 547(c)(2)

The Statute

After BAPCPA, § 547(c) states:

The trustee may not avoid under this section a transfer —

...
(1) 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[.]

How do the various circuit courts of appeals interpret this defense? Prior to BAPCPA, defendants were required to prove that the transfer was ordinary between the debtor and creditor and ordinary in the industry itself.¹⁸ For post-BAPCPA cases, the requirements have changed slightly. Now, to assert the defense successfully, the defendant must prove that the transfer was ordinary between debtor and creditor or was ordinary in the industry. In other words, the defendant is required to prove only one of the elements, not both. Despite this change, the analysis contained in this book will include pre-2005 cases because they are still applicable to cases filed pre-BAPCPA. Reported decisions rendered by the courts are summarized below by circuit. A chart summarizing the various circuit cases is found in Appendix I.

18 Section 547(c)(2) of the Bankruptcy Code previously stated:

(c) The trustee may not avoid under this section a transfer —

(2) to the extent that such transfer was —

(A) in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee;
(B) made in the ordinary course of business or financial affairs of the debtor and the transferee; and
(C) made according to ordinary business terms[.]

First Circuit

1. Brandt v. Repeo Printers & Lithographies Inc. (In re Healthco Int'l Inc.), 132 F.3d 104 (1st Cir. 1997).

Noting that § 547(c)(2) does not define the term "ordinary course of business," the court cited several factors to be considered in determining whether a particular transfer warrants protection under the statute. The factors include "the amount transferred, the timing of the payment, the historic course of dealings between the debtor and the transferee, and the circumstances under which the transfer was effected."¹⁹

Applying these factors, the court found that the payment from the debtor to the creditor, Repco, was "uncommonly large" (nearly 10 times the amount of the average payment) and that the timing of the payment was "highly suspicious."²⁰ The payment also represented a string of firsts between the parties: the first time the debtor attempted to pay all of its outstanding Rep-co invoices, the first time that payments were wired to Repco, and the first time the debtor's chief financial officer interceded to effectuate a payment to Repco. Finally, the court noted that the debtor had special relationships with all three of the creditors that received payments during the preference period, including Repco.

The court concluded that the "debtor deviated sharply from its customary business practices to favor a select trio of creditors, Repco included."²¹ Consequently, the court held that the transfer was not made in the ordinary course of business.

2. WJM Inc. v. Massachusetts Department of Public Welfare, 840 F.2d 996 (1st Cir. 1988).

The court explained that the ordinary-course-of-business exception requires proof of three distinct elements: "the subject transfer must be in payment of a debt that was incurred by the debtor in the ordinary course of its affairs with the creditor, the [payment] must have been made during the ordinary course of these affairs, and the [payment] must have been made according to ordinary business terms."²² The court also noted that the purpose of the exception is to protect "recurring, customary credit transactions that are incurred and paid in the ordinary course of business of the debtor and the debtor's transferee."²³

The preferential transfers at issue arose when the Department of Public Welfare offset amounts owed by two nursing homes against amounts the Department was to pay to two other nursing homes (all of which were jointly owned by the same individuals). Because the purpose of the offsets was to recoup overpayments made two to three years previously and because the offsets were involuntary, the court questioned whether the or-dinary-course-of-business exception had any applicability to the disputed transfers. The court disposed of the issue, however, by noting that the Department of Public Welfare had failed to prove that it was ordinary or customary for the Department to collect the debts of two nursing homes by deducting these monies from payments otherwise targeted for two different nursing homes. Thus, the court concluded that the transfers were not protected by the ordinary-course-of-business exception.

Second Circuit

1. McCarthy v. Navistar Financial Corp. (In re Vogel Van & Storage Inc.), 142 F.3d 571 (2d Cir. 1998) (per curiam).

The Second Circuit affirmed the lower court's holding that the debtor's payment was made in the ordinary course of business and was not avoidable. The debtor made payment approximately 48 days after delivery, or 18 days past due. This payment was made outside of the terms found in the contract, which required 30-day payment terms after delivery. The bankruptcy court found that on average, payment to Navistar by its customers was made 45 days from delivery. There was also testimony that within the industry for large fleet customers, payment was often beyond the 30-day net period. The plaintiff had also argued that Navistar exerted unusual pressure on the debtor to make the payment. After a payment "bounced," Navistar employees called the debtor every other day demanding payment, and this resulted in payment. The bankruptcy court, affirmed by the appellate court, found that this did not constitute unusual collection efforts. Finally, the appellate court also affirmed the lower court in holding that the actual transfer to Navistar was not outside of the ordinary course of business, as the check was delivered by hand to a Navistar employee at the debtor's place of business instead of being sent to the lockbox as with other prior payments.

2. Lawson v. Ford Motor Co. (In re Roblin Industries Inc.), 78 F.3d 30 (2d Cir. 1996).

Noting that the elements of § 547(c)(2) were unsettled within the Second Circuit, the court set forth the appropriate standard to be used in evaluating disputed transfers under § 547(c)(2)(C). The court explained that with one exception, each circuit court to consider the meaning of "ordinary business terms" had concluded that the "phrase refers broadly to customary terms and conditions used by other parties in the same industry facing the same or similar problems."²⁴

The court agreed with the approach taken by the Seventh Circuit in Matter of Tolona Pizza Prods. Corp.²⁵ and held that, assuming that § 547(c)(2)(A) and (B) are satisfied, "only when a payment is ordinary from the perspective of the industry will the ordinary course of business defense be available for an otherwise voidable preference."²⁶ According to the court, defining the relevant industry is a fact-intensive inquiry best left to the bankruptcy court's determination.

Applying these principles, the court held that a creditor must prove that "the terms of a payment for which it seeks the protection of the ordinary-course-of-business exception fall within the bounds of ordinary practice of others similarly situated."²⁷ Because the creditor had failed to introduce evidence of industry practice or custom at trial, the ordinary-course-of-busi-ness defense was not available in this instance.

Third Circuit

1. Hechinger Investment Company of Delaware Inc. v. Universal Forest Products Inc. (In re Hechinger Investment Company of Delaware Inc.), 489 F.3d 568 (3d Cir. 2007).

The Third Circuit affirmed the holdings of the lower courts related to the ordinary-course-of-business defense. The Delaware Bankruptcy Court had examined the relationship between the parties and concluded that the payments made by Hechinger to Universal Forest Products (UFP) were not made in the ordinary course of business of the financial affairs of the debtor and the transferee within the meaning of § 547(c)(2)(B) because the changes UFP had imposed on Hechinger were "so extreme, and so out of character with the long historical relationship between these parties."²⁸ The court was persuaded that the fact that UFP had changed credit terms immediately prior to the beginning of the preference period. This resulted in accelerated payments to UFP by Hechinger. The court also noted that the credit limit that was established, the shortening of payment terms and the requirement that payment be made by wire transfer took the payments outside of the ordinary course for the parties under § 547(c)(2)(B).²⁹

2. United States Trustee v. First Jersey Securities Inc. (In re First Jersey Securities Inc.), 180 F.3d 504 (3d Cir. 1999).

In this case, the court applied the three statutory factors under § 547(c)(2) to a debtor's transfer of restricted securities to its counsel in payment for pre-petition legal services. The transfer occurred on the eve of the debtor's bankruptcy filing.

Noting that the debt for legal services was incurred in the normal course of business, satisfying § 547(c)(2)(A), the court focused its inquiry on the second two subsections. Under § 547(c)(2)(B), the court made a subjective inquiry and considered "whether the transfer was ordinary as between the debtor and the creditor."³⁰ For this court, relevant factors included the timing of the transfer and the amount and manner in which the transaction was paid.³¹ The court found that the stock transfer did not meet these criteria. The payment deviated from the established pattern of payments between the parties during the six months preceding the...