Everything You Need To Know About The Ordinary Course of Business - - PDF document

Everything You Need To Know About The “Ordinary Course of Business” Preference Defense, And More! By: Bruce S. Nathan, Esq. David M. Banker, Esq. Terence D. Watson, Esq.

Abstract

Congress enacted the ordinary course of business defense to the avoidance of preferential transfers to protect recurring, customary transactions in order to encourage the continuation of business with and the extension of credit to a financially distressed customer. However, creditors defending a preference litigation have had difficulty exploiting the ordinary course of business defense as a result of the inconsistency by which the courts have applied the defense due in large part to the myriad of factors they have considered in determining its applicability. The ordinary course of business defense has, therefore, become both unpredictable, and difficult and very costly to prove. Even worse, the inability to reasonably predict how courts will apply the

• rdinary course of business defense and the factors the courts might consider may discourage

the continuation of business with or the extension of credit to a company as it seeks to avoid a bankruptcy filing, which is directly contrary to the legislative intent behind the enactment of the

• rdinary course of business defense in the first place.

This article identifies the most significant areas of judicial inconsistency, and illustrates the potential reasons why courts have reached differing conclusions regarding the applicability of the ordinary course of business defense. It should, therefore, assist creditors defending a preference litigation in determining whether they can satisfy this defense.

The Statutory Elements Of An Avoidable Preferential Transfer

Under 11 U.S.C. § 547(b) of the Bankruptcy Code, a trustee or debtor in possession may avoid as a preference, a transfer of a debtor’s interest in property which satisfies each of the following elements: a) The transfer was made to or for the benefit of a creditor (11 U.S.C. § 547(b)(1));

b) The transfer was made for or on account of an antecedent debt owed by the debtor at the time the transfer was made (11 U.S.C. § 547(b)(2)); c) The transfer was made when the debtor was insolvent based on the balance sheet definition of liabilities exceeding assets (11 U.S.C. § 547(b)(3));1 d) The transfer was made during the ninety day preference period in the case of transfers to non-insider creditors, and within one year of the bankruptcy filing for transfers to the debtor’s insiders, such as the debtor’s officers, directors, controlling shareholders and affiliated companies (11 U.S.C. § 547(b)(4)); and e) The transfer enabled the creditor to receive more than the creditor would have recovered

• n the subject claim in a chapter 7 liquidation of the debtor (11 U.S.C. § 547(b)(5)).2

Once a trustee proves the statutory elements of 11 U.S.C. § 547(b), the burden shifts to the creditor defending a preference claim to prove one or more of the affirmative defenses contained in 11 U.S.C. § 547(c) to reduce or completely eliminate its preference exposure. This article focuses on the ordinary course of business (“OCB”) affirmative defense under 11 U.S.C. § 547(c)(2), which is the most frequently litigated statutory affirmative defense to the avoidance of preferential transfers. The OCB defense is intended to protect recurring, customary transactions, and to encourage the continuation of business with (and the extension of credit to) an entity that is sliding into, but seeking to avoid, a bankruptcy filing. Assuming a payment is made in a manner that is consistent with the parties’ history and/or with how payments are made in the applicable industry, the payment should not be subject to avoidance as a preference because of the OCB defense. Nevertheless, the courts have been inconsistent and unpredictable in the manner in which they are applying the OCB defense.

The Ordinary Course Of Business Affirmative Defense

The OCB defense requires proof, by a preponderance of the evidence, that (1) the alleged preferential transfer paid a debt that was incurred in the ordinary course of the debtor’s and creditor’s business or financial affairs, and (2) that the transfer was either (a) made in the

• rdinary course of the debtor’s and creditor’s business or financial affairs, or (b) made according

to ordinary business terms. 11 U.S.C. §547(g) places the burden of proof on the creditor to satisfy the elements of the OCB defense. Proving that the debt paid by the alleged preferential transfer was incurred in the ordinary course

• f business of the debtor and creditor is straightforward. A creditor satisfies this OCB

requirement by proof of the creditor’s extension of credit terms to the debtor. Next, the creditor must prove either the “subjective” or “objective” component (or prong) of the OCB defense.

1 There is a rebuttable statutory presumption that the debtor was insolvent on and during the 90-days immediately

preceding the filing of its bankruptcy petition (the “preference period”) 11 U.S.C. §547 (f).

2 This requirement is always satisfied where the preference target was an unsecured creditor unless all of the

debtor’s other unsecured creditors receive full payment of their claims, which is rare because an entity is unlikely to commence a bankruptcy proceeding where its assets are sufficient to pay all unsecured creditors in full.

The subjective component requires a showing that the transfer was made in the ordinary course

• f the debtor’s and creditor’s businesses. This requires proof of consistency between the alleged

preferential transfers and the transfers the debtor made to the creditor prior to the preference period, which is frequently referred to as the “pre-preference period.” Alternatively, a creditor may satisfy the OCB defense by proving that the alleged preferential transfer was made according to “ordinary business terms.” This requires proof that the payment was consistent with the payment practices and range of terms in the creditor’s industry, the debtor’s industry, or both. This is usually referred to as the “objective” component (or prong) of the OCB defense.3

The Subjective Element Of The Ordinary Course Of Business Defense

The phrase “ordinary course of business” is not defined in 11 U.S.C. § 547 or anywhere else in the Bankruptcy Code. According to case law, however, a creditor relying, in whole or in part, on the subjective prong of the OCB defense must first prove a pre-preference period “baseline of dealing” between the debtor and the creditor, against which the court can compare the alleged preferential transfers. Once the court determines the pre-preference period baseline, it usually then considers the following factors in determining whether the alleged preferential transfers are protected by the subjective prong of the OCB defense: (i) the length of time the parties were engaged in the type of dealing at issue; (ii) whether the amounts of the alleged preferential transfers were larger than prior payments; (iii) whether the payments were tendered in a manner different from previous payments; (iv) whether there was any unusual action by either the debtor

• r the creditor to collect or pay the debt; and (v) whether the creditor did anything to gain an

advantage in light of the debtor’s deteriorating financial condition. As these factors indicate, there are generally two components to a court’s determination of whether the alleged preferential transfers are protected by the subjective prong of the OCB defense: (i) a statistical analysis primarily focused on the timing of the alleged preferential transfers, and (ii) a determination of whether the factual circumstances surrounding the alleged preferential transfers were unusual, including, but not limited to, the amount of, and any collection efforts or other pressure employed by the creditor to obtain payment of, the alleged preferential transfers. However, these components of the court’s analysis do not carry equal weight, as the OCB defense may be inapplicable where an otherwise preferential transfer was made in response to payment pressure even if a court finds, under a statistical analysis, that the timing of the transfer was consistent with the timing of transfers made by the debtor to the creditor during the pre-preference period.

3 Prior to the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”),

which became effective on October 17, 2005, a defendant relying on the OCB defense was required to satisfy both the subjective and objective prongs of the OCB defense. In other words, the OCB defense required proof that: (1) the alleged preferential transfer paid an indebtedness incurred by a debtor in the ordinary course of business or financial affairs of the debtor and the creditor; (2) the payment was made in the ordinary course of the debtor’s and creditor’s business or financial affairs; and (3) the payment was made according to ordinary business terms. Section 547(c)(2) was amended by BAPCPA and is now written in the alternative to require satisfaction of either the subjective prong (11 U.S.C. § 547(c)(2)(A)) or the objective prong (11 U.S.C. § 547(c)(2)(B)), along with proof that the debt paid was incurred in the ordinary course of the debtor’s and creditor’s business or financial affairs.

Below are cases illustrating the statistical analysis under the subjective prong of the OCB defense, followed by cases highlighting the factual circumstances that may render a favorable comparison under the statistical analysis irrelevant for purposes of the subjective OCB defense. The Statistical Analysis A consistent historical pattern of late payments (in relation to the stated credit terms between the parties) can establish an ordinary course of late payments between the parties such that untimely transfers made during the preference period may be protected by the subjective OCB defense. Consequently, most disputes concerning the subjective prong of the OCB defense involve considering whether the alleged preferential transfers were either consistently made within the credit terms agreed upon by the parties, or, even if tendered later, were otherwise consistent with the prior course of dealing between the parties. In making the latter determination, the courts have undertaken various forms of statistical analyses and approaches to determine the applicability of the subjective OCB defense. For example, the courts have compared the timing

• f the payments made during and prior to the preference period based on (i) average, (ii) median,

(iii) deviation off of average or median, (iv) range (or ranges), (v) regularity of payments based

• n percentages, or (vi) a combination of one or more of the above. 4 In addition, as the cases first

discussed below demonstrate, the courts have also differed on the length of time to be considered in establishing the historical baseline course of dealing between the parties against which the alleged preferential transfers are to be compared for subjective OCB purposes. Pre-preference Period – How Long is Long Enough? The courts considering the applicability of the subjective OCB defense have differed in determining the appropriate amount of time for establishing the baseline of the parties’ historical course of dealing, against which to compare the alleged preferential transfers. However, the courts have generally refused or otherwise deemed it unnecessary to consider the entire pre- preference period relationship between the parties in establishing the historical baseline. The United States Bankruptcy Court for the Eastern District of North Carolina held, in Sparkman

• v. Martin Marietta, Inc. (In re Mainline Contracting, Inc.), that a two year period prior to the

preference period was sufficient to establish a baseline for purposes of the subjective OCB

• defense. The United States Bankruptcy Court for the Eastern District of Michigan, in American

CamShaft Specialties, Inc. (“American CamShaft”), however, ruled that the preference defendant, Gerdau MacSteel, Inc. (“Gerdau”), satisfied the subjective prong of the OCB defense despite relying on only a one year period prior to the beginning of the preference period to establish the baseline, even though Gerdau’s business relationship with American CamShaft exceeded twenty years prior to its bankruptcy filing. The United States Bankruptcy Court for the Eastern District of Pennsylvania held, in Goldstein v. Starnet Capital Group, LLC (In re Universal Marketing, Inc.), that an eight (8) month relationship prior to the petition date, during which only five payments were made, was

4 Timing is frequently calculated as “days to pay” based on the number of days from invoice date to payment date,

• r as “days late” based on the number of days from due date and actual date of payment. Days late is frequently

used in ordinary course analyses where the debtor’s and creditor’s relationship involved multiple different payment

• terms. For example, payment in 40 days of an invoice that required payment on net 30 day terms, as well as

payment in 70 days of an invoice that required payment on net 60 day terms are both 10 days late.

sufficient to establish a baseline for subjective OCB purposes. The court specifically ruled that “the transaction history is sufficient to demonstrate a general pattern of behavior in the Debtor- Starnet relationship and it is unnecessary to look to supplemental evidence in order to compare the payments made during the preference period with the pre-preference period transfers.” Moreover, the court held that the untimely alleged preferential transfers were subjectively

• rdinary because, notwithstanding the very limited pre-preference period history between the

debtor and the defendant, the debtor had a history of making late payments. Specifically, although all payments were due by the first of the following month, the debtor paid the five pre- preference period payments between nine and twenty-two days late, for an average of fifteen days late. The two alleged preferential transfers, in turn, were made seventeen and twenty-two days late, for an average of approximately nineteen days late. The court held that “[t]his amounts to a four (4) day difference in the average lag between due date and receipt in comparing the payments in the preference period to the pre-preference period. This difference does not warrant avoidance of the two (2) transfers at issue.” Nevertheless, questions remain as to the proper scope of this inquiry. The United States Bankruptcy Court for the District of Delaware (the “Delaware Bankruptcy Court”) held, in Burtch v. Revchem Composites, Inc. (In re Sierra Concrete Design, Inc.), that an eleven month pre-preference period relationship, consisting of seventeen checks paying sixty-eight invoices, was “simply insufficient evidence for the creditor/defendants to meet their burden [with respect to the OCB defense].” A different and far more restrictive approach was adopted by the United States Bankruptcy Court for the Eastern District of Virginia in In re Circuit City Stores, Inc. The court limited its inquiry in determining the baseline for the parties’ prior course of dealings to only the pre-preference period transfers made when the debtors were financially sound, and disregarded the debtors’ later pre-preference period payments (during the nine months prior to the preference period) that were made when the debtors were experiencing liquidity issues and delaying payments to their

• vendors. Therefore, although the alleged preferential transfers were paid consistently with the

payments made during the nine month period prior to the preference period, the alleged preferential transfers were not protected by the subjective prong of the OCB defense. Consistency Of Timing The courts have also differed on the statistical analyses and approaches taken to determine consistency of timing of payment for subjective OCB defense purposes. In American Home Mortgage Holdings (“AMH”), the United States Bankruptcy Court for the District of Delaware (the “Delaware Bankruptcy Court”) applied a relatively straight-forward historical range of payment analysis. The court dismissed a preference complaint after comparing the timing and amounts of the alleged preferential payments with the pre-preference period payments, as well as the manner in which the parties conducted business, both prior to and during the preference period. The following chart shows the timing and amounts of the payments AMH had made to the defendant (Vector) during their entire eight month pre-preference period relationship:

The Pre-preference Period Transfers Invoice Date Invoice Number Invoice Amount Date Payment Received Payment Amount Days To Pay 10/18/2006 23160 $4,675.00 11/8/2006 $4,675.00 21 11/3/2006 23212 $8,160.00 1/8/2007 $8,160.00 67 11/22/2006 23256 $7,480.00 11/30/2006 $7,480.00 8 12/6/2006 23311 $6,120.00 12/18/2006 $6,120.00 12 12/20/2006 23337 $7,480.00 2/12/2007 $7,480.00 54 1/3/2007 23337 $6,120.00 1/25/2007 $6,120.00 22 1/18/2007 23421 $6,120.00 1/25/2007 $6,120.00 7 2/1/2007 23467 $7,480.00 2/21/2007 $7,480.00 20 2/21/2007 23528 $7,480.00 3/1/2007 $7,480.00 9 3/23/2007 23625 $7,480.00 4/11/2007 $7,480.00 19 The following chart shows the timing and amounts of the payments AMH had made to Vector during the preference period: The Alleged Preferential Transfers Invoice Date Invoice Number Invoice Amount Date Payment Received Payment Amount Days To Pay 3/8/2007 23577 $5,440.00 5/7/2007 $5,440.00 60 4/3/2007 23653 $7,480.00 5/7/2007 $7,480.00 34 4/20/2007 23702 $5,440.00 6/6/2007 $5,440.00 47 5/4/2007 23737 $6,120.00 7/5/2007 $6,120.00 62 5/18/2007 23799 $5,440.00 7/9/2007 $5,440.00 52 The court in AHM held that the alleged preferential payments were subject to the subjective prong of the OCB defense because the timing of their payment (made between thirty-four and sixty-two days after invoice date), was within the historical range of AHM’s payments (made between seven days and sixty-seven days after invoice date). In this regard, it did not matter to the court that the alleged preferential payments paid 80% of Vector’s invoices (four out of five invoices) late, compared to only 20% of Vector’s invoices (two out of ten invoices) that were paid late during the pre-preference period. With respect to the amounts of the payments, the court held that the four alleged preferential payments, in amounts between $5,440 and $12,920,5 were consistent with AHM’s ten transfers to Vector made during the pre-preference period, in amounts between $4,675 and $12,240. Similarly, the invoices paid by the alleged preferential payments, in amounts ranging between $5,440 and $7,480, were comparable to Vector’s invoices paid during the pre-preference period, which ranged between $4,675 and $8,160.

5 Invoices numbered 23577 and 23653 were paid by a single transfer on May 7, 2007 in the amount of $12,920.

Finally, the court held that the manner in which AHM and Vector had conducted business remained consistent during both the pre-preference and preference periods.6 In other words, the alleged preferential payments were not made in response to any unusual collection activities by Vector. In Philadelphia Newspapers, the United States Bankruptcy Court for the Eastern District of Pennsylvania applied a modified historical range of payment analysis. The court compared the regularity of the historical payments to the preference period payments. The court applied the subjective OCB defense to the alleged preferential payments made by Philadelphia Newspapers because their timing was consistent with the timing of payment of 80% of the pre-preference period transfers. During the parties’ approximately five year business relationship, Philadelphia Newspapers paid the invoices of the defendant (Inserts East) an average of fifty days after invoice date. Rather than compare the timing of payment of the alleged preferential transfers to this fifty days to pay average, the court relied on the following chart that depicted the frequency with which Philadelphia Newspapers paid Insert East’s invoices at certain timing intervals: The Pre-preference Period Transfers Days after Invoice Frequency of times Days after invoice Frequency of times Days after invoice Frequency of times 7 1 18 1 20 1 22 1 24 2 25 1 27 2 28 1 29 1 31 2 32 3 33 1 34 6 35 4 36 3 39 2 41 2 42 4 44 1 45 5 47 1 48 1 49 5 50 1 53 1 54 3 55 3 57 1 58 1 60 2 61 3 62 7 63 3 64 1 67 1 69 2 70 3 74 1 76 1 77 1 78 1 81 1 82 1 86 1 87 1 96 1 112 1

6 The AHM court also ruled that Vector satisfied the objective prong of the OCB defense based on the testimony of

Vector’s chief executive officer and a certified public accountant (who testified that he was familiar with the standard payment practices of the information technology staffing industry in which Vector conducted business) that the alleged preferential transfers were made according to ordinary business terms in Vector’s industry.

The court also relied on the following chart relative to the alleged preferential payments: The Alleged Preferential Transfers Invoice No. Invoice Date Payment Date Days after Invoice Amount of Invoice 1 20558 10/16/08 12/05/08 50 $ 3,077.50 2 20616 10/24/08 12/22/08 62 $ 3,320.52 3 20615 10/25/08 01/02/08 69 $10,037.10 4 20707 11/05/08 01/08/09 64 $ 2,655.14 5 20753 11/05/08 01/22/09 78 $ 4,980.00 6 20763 11/12/08 01/22/09 71 $ 2,640.50 7 20752 11/11/08 01/12/09 62 $ 1,595.00 8 20827 11/20/08 01/12/09 53 $ 6,120.50 9 20753 11/20/08 01/16/09 57 $ 4,980.00 10 20883 12/02/08 02/02/09 62 $ 2,655.14 11 20896 12/04/08 02/02/09 60 $ 2,935.00 12 20897 12/04/08 02/02/09 60 $ 695.00 13 20988 12/19/08 02/09/11 52 $ 4,405.83 14 21086 01/14/09 01/22/09 8 $58,672.00 15 21082 01/14/09 02/18/09 35 $ 8,310.00 16 21227 02/04/09 02/20/09 16 $ 461.70 17 21254 02/06/09 02/20/09 14 $ 622.88 The trustee argued that the ordinary course range should be forty to sixty days to pay (i.e., a +/- ten day deviation from the fifty day pre-preference period average days to pay between Philadelphia Newspapers and Inserts East). Based on that range, the subjective OCB defense would have protected only the payments listed on the above Alleged Preferential Transfers chart numbered 1, 8, 9, 11, 12 and 13. The court, however, held that the expanded range of thirty days to seventy days to pay (i.e., a twenty day deviation from the fifty day average) advocated by Inserts East was appropriate as the baseline of the parties’ prior course of dealings because 80% of Philadelphia Newspapers’ payments to Inserts East during the pre-preference period were made between thirty and seventy days to pay (emboldened in the above Pre-preference Period Transfers chart). Consequently, the court held that the payments listed on the above Alleged Preferential Transfers chart numbered 2, 3, 4, 7, 10 and 15 were protected by the subjective OCB defense, as well as the payments that the trustee had conceded were protected by the subjective OCB defense (payments numbered 1, 8, 9, 11, 12 and 13). The narrower forty to sixty day range that the trustee advocated was undermined by the fact that prior to the preference period, only one-third of the payments made by Philadelphia Newspapers to Inserts East fell within that narrow range. The court recognized that such a relatively small percentage did not warrant being considered as the baseline for the parties’ prior course of dealings.

In Sparkman v. Queenscape, Inc. (In re Anderson Homes, Inc.), the United States Bankruptcy Court for the Eastern District of North Carolina based its ordinary course analysis on the “invoice to payment” approach, which the court described as treating “the delay in payment for each invoice equally, irrespective of the amount of that invoice, and look[ed] at the time span between the invoice date and payment date.” Next, the court compared the historical average of the “invoice to payment” for the two years prior to the preference period versus the average of the “invoice to payment” for the preference period. Following this analysis, the court found that the alleged preferential payments were not subjectively ordinary because: “[i]n this case, the average time elapsed between invoice and payment during the Preference Period (108.88 days) exceeds the total pre-preference period average (48.63 days) by 123.89%.” The Delaware Bankruptcy Court, in In re Archway Cookies, also compared average days to pay invoices in considering the applicability of the subjective OCB defense. The Archway court held that the alleged preferential payments made on average of 47.2 days after invoice date were shielded by the subjective OCB defense where the pre-preference period average days to pay was 42.3 days after invoice date. Isolated or No Pre-preference Period Payment History Although the foregoing decisions make clear that comparing the alleged preferential transfers to the pre-preference history is the hallmark of the subjective prong of the OCB defense, there is also a well-established body of case law that the absence of any pre-preference period transfers will not automatically preclude the applicability of the subjective OCB defense. Where there is little or no payment history with which to compare the alleged preferential transfers, the courts generally consider the terms of the parties’ agreement to determine the applicability of the subjective prong of the OCB defense. The courts may also look to other evidence that the payment was consistent with the parties’ agreement. For example, in In re Gulf Fleet Holdings, Inc., decided by the United States Bankruptcy Court for the Western District of Louisiana, a preference defendant defeated a trustee’s motion for summary judgment where the alleged preferential transfer was the first payment to the creditor and was untimely based on the invoice terms. The defendant, however, submitted an affidavit stating that (notwithstanding the terms of the invoice), it had agreed to extend the time for the debtor to make the payment. The court considered such evidence as creating an issue of material fact that precluded the entry of summary judgment in the trustee’s favor. The Tenth Circuit Bankruptcy Appellate Panel, in Tomlins v. BRW Paper Co. (In re Tulsa Litho Co.), and the United States Bankruptcy Courts for the District of South Carolina, in Hovis v. Stambaugh Aviation, Inc. (In re Air South Airlines), the Western District of Pennsylvania, in Bohm v. Golden Knitting Mills, Inc. (In re Forman Enterprises, Inc.), and the Western District of Michigan, in Remes v. ASC Meat Imports, Ltd. (In re Morren Meat & Poultry Co.), have each also applied the subjective OCB defense, notwithstanding untimely isolated payments. However, other courts disagree with this view and have either adopted a per se rule that first- time or isolated transfers cannot be protected by the subjective OCB defense, or have otherwise required first-time or isolated transfers to be made timely based on the applicable payment terms in order to be protected by the subjective OCB defense. For example, the United States

Bankruptcy Court for the Northern District of Georgia, in In re Brown Transp. Truckload, Inc., held that the subjective OCB defense was inapplicable in the absence of any prior course of dealings between the debtor and the creditor. Likewise, the United States Bankruptcy Court for the Eastern District of Kentucky, in In re Winters, opined that the subjective OCB defense was

• nly applicable where the debtor and the transferee had an ongoing, “recurring” business

relationship, and did not apply to first-time or isolated transactions. The United States Bankruptcy Court for the District of Kansas similarly held, in In re Wild W. World, L.L.C., that the subjective OCB defense was inapplicable because the parties had no transactional history prior to the preference period, and the alleged preferential transfers were untimely according to the applicable payment terms. Unusual Collection Actions Notwithstanding the foregoing discussion regarding the use of statistical analysis, a decision by the United States Bankruptcy Court for the Eastern District of Texas, in Goldberg v. Grabar

• Elec. Co., Inc. (In re ACP-Ameritech Acquisition), reminds us that the subjective OCB defense

entails more than “a mathematical equation.” Rather, the court in Goldberg declined to grant a trustee’s summary judgment motion relative to the subjective OCB defense based solely on a statistical analysis because other factual issues may impact the subjective prong of the OCB

• defense. Some of these issues are discussed below.

A creditor’s use of unusual collection actions to extract payments from a financially distressed customer during the preference period might negate the applicability of the subjective OCB defense, even where the timing of the alleged preferential transfers is consistent with the parties’ prior course of dealings under a statistical analysis. The type of collection actions that will negate an otherwise applicable subjective OCB defense include an increased frequency of requests for payment, placing a debtor on credit hold, and refusing shipments or services until outstanding invoices are paid. The timing of a creditor’s undertaking collection actions may also impact the applicability of the subjective OCB defense. For example, an otherwise lost subjective OCB defense may be salvaged if a creditor is able to show that the collection actions taken during the preference period were consistent with such actions undertaken historically during the parties’ business

• relationship. Indeed, courts are less likely to penalize trade creditors for preference liability

where their actions to collect outstanding claims were consistent with their prior course of dealing and were not unusual efforts. In this regard, collection efforts initiated prior to but near the commencement of the preference period, and continued during the preference period, are unlikely to be considered as part of the parties’ historical course of dealing, and more likely to preclude applicability of the subjective OCB defense. In Elrod Holdings, the Delaware Bankruptcy Court provides a good illustration of how the subjective OCB defense is applied in this context. Prior to the preference period, the debtor, Elrod Holdings Corp. (“Elrod”), had a long-standing business relationship with the defendant, Westfield Steel Inc. (“Westfield”). In the approximately two years prior to bankruptcy, Elrod regularly paid Westfield for debts incurred in the ordinary course between thirty-five and seventy-three days after invoice date, with days to payment of invoices averaging two months from the invoice date. During the preference period, Elrod made payments to Westfield between

thirty and seventy-four days after the invoice date. The chapter 7 trustee of Elrod’s estate sought to avoid and recover these payments as alleged preferential transfers. The trustee argued that the subjective OCB defense was inapplicable despite the consistency of the timing of the payments received prior to and during the preference period because Westfield had threatened to withhold shipments during the preference period unless Elrod paid older invoices owing to Westfield. The trustee argued that Westfield’s threats to stop shipments to Elrod amounted to “unusual collection activity” that prevented Westfield from satisfying the subjective OCB defense. The court, however, granted Westfield’s motion for summary judgment and dismissed the complaint based on the subjective OCB because (1) of the consistency in the timing of the alleged preferential payments and the payments made by Elrod to Westfield prior to the preference period, and (2) prior to the preference period, Westfield had frequently called Elrod to collect unpaid invoices and had previously threatened to withhold shipments to Elrod until outstanding invoices were paid. Consequently, Westfield’s threats to withhold shipments made during the preference period were deemed consistent with the parties’ prior course of dealing. Similarly, in Sparkman v. Martin Marietta, Inc. (In re Mainline Contracting, Inc.), the United States Bankruptcy Court for the Eastern District of North Carolina held that payments made where it was understood that the debtor would be placed on cash on delivery (“COD”) terms unless outstanding invoices were paid were nevertheless protected by the subjective OCB

• defense. The court relied on the fact that prior to the preference period, the defendant had

received payments from the debtor after imposing COD terms on the debtor on at least two instances, and after threatening to impose COD terms on at least one other occasion. Moreover, there was no evidence to suggest that the frequency of the defendant’s demands for payments increased during the preference period. By comparison, the United States Bankruptcy Court for the Southern District of Florida in In re JSL Chemical Corp. held that the subjective OCB defense was inapplicable where the defendant’s collection activity during the preference period was more aggressive than its actions prior to the preference period. The debtor’s (“JSL”) chapter 7 trustee had sued a chemical supplier (“Oxyde”) for the avoidance and recovery of a single transfer that Oxyde received twenty-nine days late during the preference period. The court initially accepted Oxyde’s calculations that the alleged preferential transfer was “within the 0 to 33 day range of consistently late pre-preference payments made by [JSL] to [Oxyde].” Despite the consistency in timing, however, the court addressed the issue of whether Oxyde’s actions just prior to the preference period constituted “unusual collection efforts” which negated the applicability of the OCB defense. Specifically, the court considered the impact of an e-mail that Oxyde’s CFO had sent to JSL’s president just prior to the preference period which stated that Oxyde was placing JSL on credit hold until Oxyde received a response to Oxyde’s inquiry concerning outstanding invoices. Oxyde argued that this e-mail was consistent with its past collection practices with JSL, and produced numerous e-mails between the parties’ accounting departments concerning the status of JSL’s outstanding balances. Oxyde relied, in particular, on an earlier e-mail that Oxyde’s office manager had sent to JSL, nearly a year prior to the preference period, which stated that in order

for JSL to avoid being placed on prepaid credit status, checks for outstanding invoices would have to be delivered to Oxyde the following morning. Oxyde, therefore, argued that its CFO’s e- mail sent just prior to the preference period was no different than the earlier e-mail, in that both e-mails were “warnings” that JSL must pay outstanding invoices. The court, however, concluded that Oxyde’s CFO’s e-mail stated that JSL is being placed on credit hold until Oxyde received a response to its inquiry regarding outstanding invoices. This was in contrast to the earlier e-mail that was interpreted as conveying a warning. The court also distinguished the e-mails by their senders, explaining that “although Oxyde’s office manager routinely sent emails inquiring about payments, [Oxyde]’s Chief Financial Officer did not routinely send emails to [JSL]’s president informing him that [JSL] had been placed on credit hold.” The court found the difference between the two e-mails sufficiently significant evidence that the alleged preferential transfer was not made in the ordinary course of business, but was rather made in response to unusual collection activity and, therefore, was not protected by the subjective OCB defense. The United States Bankruptcy Court for the Eastern District of Michigan, in In re Intermet Corp., reached a similar conclusion. The debtor, Ganton Technologies, LLC (“Ganton”), and creditor Chemtool, Inc. (“Chemtool”) had a business relationship that lasted more than four years, and the debtor generally paid Chemtool’s invoices between thirty and forty-five days after invoice date. The court held that the subjective OCB defense was inapplicable because the alleged preferential transfers were paid between forty-nine and sixty-eight days after invoice

• date. Moreover, Chemtool had placed Ganton’s account on credit hold status for the first time

during the year in which Ganton filed for bankruptcy, which prevented Chemtool from shipping goods to the debtor and capped Chemtool’s exposure at $50,000. The court found that Ganton’s “account was placed on credit hold in order to more carefully monitor outstanding debt.” As a result, the court concluded that as a result of Chemtool’s credit hold, the manner in which Ganton had made payments to Chemtool was inconsistent with their prior practices and entered judgment in favor of the debtor. Modification Of Payment Terms Modification of payment terms during or shortly before the preference period, such as the tightening of credit terms, might also impact the applicability of the subjective OCB defense. The Delaware Bankruptcy in In re Pillowtex Corporation is instructive with respect to the impact a modification of payment terms may have on the applicability of the subjective OCB defense. Classic Packaging Company (“Classic”) had moved for summary judgment to dismiss the preference complaint filed against it by the trustee for the liquidation trust of the debtor, Pillowtex Corporation (“Pillowtex”), based on the subjective OCB defense. Classic claimed that it had offered Pillowtex the same payment terms of net 30 days, with a 1% early payment discount if payment was made within 10 days, during the two years prior to and continuing into the preference period. Classic also noted that Pillowtex always paid Classic according to terms prior to the preference period, with Classic receiving payments on average within thirty-four days after invoice date. Despite being paid sooner during the preference period, Classic had claimed that Pillowtex continued to pay according to the parties’ terms, and in this regard,

argued that Pillowtex was merely taking advantage of the parties’ previously agreed-upon 1% early payment discount. The trustee disagreed, and argued that the alleged preferential transfers were not subject to the OCB defense because Pillowtex started paying Classic much sooner (with some payments being made as early as two days after invoice date) only one month prior to the beginning of the preference period. Also, while Classic claimed its terms were always net 30 days with a 1% early payment discount, the trustee asserted that the payment terms changed shortly before the preference period, from net 30 days with no discount to net 20 days with a 1% early payment

• discount. Classic then argued that even assuming a change in payment terms had occurred, that

would not defeat its OCB defense, provided the change was not made in response to any “overly zealous” collection efforts. The court, however, refused to rule on this issue, or decide the terms that were in place between the parties, until there was a fully developed record following an evidentiary hearing. Consequently, the court found that disputed issues of material fact regarding the applicable payment terms, whether there was a change in terms, and if so, when any such changes took effect, precluded the entry of summary judgment in Classic’s favor. Other courts, however, have held that alleged preferential transfers made after a change in payment terms are not subject to the subjective OCB defense. For example, the Third Circuit in In re Hechinger Investment Company held that alleged preferential transfers made after a change in the parties’ payment terms were not protected by the subjective OCB defense. In Hechinger, the debtor had a 15 year business relationship with the defendant, Universal Forest Products (“UFP”). During the majority of the parties’ business relationship, the applicable payment terms were “1% 10 days, net 30, with a 7-day mail float,” meaning that Hechinger could earn a 1% price reduction for invoices paid within the “discount period,” namely, 10 days plus a seven-day grace period for payments made by mail. Hechinger paid UFP by check accompanied by remittance advices that matched each payment to particular invoices. A little more than a month before Hechinger’s bankruptcy filing, UFP presented Hechinger with four different payment options to enable the business relationship to continue. Hechinger agreed to a $1 million credit limit for future purchases and its credit terms were reduced to “1%, 7 days, net 8,” meaning that Hechinger could earn a 1% price reduction for invoices paid within the 7 day “discount period,” and had up to 8 days to pay in order for the payment to be considered

• prompt. Hechinger also agreed to remit payments to UFP by wire transfer, instead of by check.

Hechinger wired payments in lump sum amounts of $500,000 or $1 million, prior to sending remittance advices to UFP. The changed terms of Hechinger’s credit arrangements with UFP required Hechinger to make larger and more frequent payments to UFP because Hechinger had placed orders for between $160,000 and $250,000 worth of product per day. Hechinger made a total of 22 wire transfers to UFP during the preference period, which equated to a wire transfer nearly every 2.9 days. Hechinger commenced an adversary proceeding against UFP seeking the avoidance and recovery

• f the alleged preferential transfers. The bankruptcy court held in favor of Hechinger after

finding that the alleged preferential transfers were not subject to the subjective OCB defense. After a similar holding by the district court, the Third Circuit held that the alleged preferential transfers did not satisfy the subjective OCB defense because the changes in credit terms UFP had

imposed upon Hechinger were “so extreme, and so out of character with the long historical relationship between these parties.” The Third Circuit distinguished cases involving mere untimely payments, with cases when a change in credit terms occurred during or immediately prior to the preference period. In this regard, the Third Circuit held that “Hechinger was pressured to make accelerated payments during the preference period because of UFP’s vigourous enforecment of its [new] credit limit.” For example, during the preference period, 96.5% of Hechinger’s payments were made between 0-10 days after invoice date, while previously, only 10% of Hechinger’s payments were made between 0-10 days after invoice date. The United States Bankruptcy Court for the Southern District of Ohio reached the same conclusion in Roberds, Inc. v. Broyhill Furniture (In re Roberds, Inc.). In refusing to apply the subjective OCB defense, the court relied on the following facts (1) the payment terms were changed during the preference period, (2) the defendant began to enforce a previously established credit limit of $750,000, (3) credit holds were imposed prompting payments to the defendant prior to their shipment of furniture, (4) the debtor paid, on average, earlier than the historical net 30 terms in effect, (5) payments to other creditors were being significantly delayed while the defendant was receiving accelerated payments, and (6) none of these events had ever

• ccurred in the parties’ history prior to the preference period.

Changes In The Debtor’s Method Of Payment Unusual actions that will eliminate an otherwise applicable subjective OCB defense are not limited to actions taken by creditors. The debtor’s actions during or shortly before the preference period might also negate the applicability of the subjective OCB defense. For example, changes in the method by which payments were made might render the subjective OCB defense inapplicable. This point is illustrated in the decision of the United States Bankruptcy Court for the Southern District of New York in In re Ames Department Stores, Inc. The debtor, Ames Merchandising

• Corp. (“Ames”), entered into an agreement to purchase towels from Revere Mills, Inc.

(“Revere”). Prior to the preference period, “Ames used a computerized system, in the normal course of its business that generated checks for all domestic invoices for which Ames had confirmation of receipt of merchandise.” The Ames accounts payable department routinely mailed the checks to creditors as they were generated. Just prior to the preference period, however, Ames stopped sending checks to creditors as they were printed. Instead, in an effort to conserve liquidity, Ames’ executives conducted daily meetings during which “participants would discuss which payments to disburse, which to delay, which to accelerate, which to pay partially, and which not to pay at all.” The unmailed checks were kept in a “mail bucket” inside the office of the director of payables. Ames commenced an adversary proceeding against Revere and, as part of its claim, sought to avoid and recover, as preferential transfers, two checks sent to Revere during the preference

• period. Revere argued, in part, that the alleged preferential transfers were subject to the

subjective OCB defense.

The court disagreed, and held that Ames “broke from its ordinary business practices by retaining the checks and deciding who should and should not be paid, rather than mailing the checks as they were printed when payment became due.” Consequently, the court entered judgment in favor of Ames on the basis that the transfers were not subject to the subjective OCB defense. Ames commenced a separate adversary proceeding against CellMark Paper Inc. (“CellMark”), its principal paper supplier, to avoid and recover $1.9 million as alleged preferences. Following a trial, the court ruled that the alleged preferential payments were not protected by the subjective OCB defense, based primarily on the unusual manner in which the payments were generated and made by Ames. In addition, the alleged preferential transfers were not only untimely, but also partially paid certain invoices or paid multiple invoices through a singe check, which contrasted with the manner in which Ames had paid CellMark’s invoices prior to the preference period. The Second Circuit affirmed the ruling that the alleged preferential transfers were not subject to the subjective OCB defense. However, in American CamShaft discussed above, the United States Bankruptcy Court for Eastern District of Michigan did not deem the alleged preferential payments made by wire transfer to be beyond the scope of the subjective OCB defense, despite the fact that American CamShaft had not made any payment to Gerdau by wire transfer prior to the preference period. The court reached this conclusion because American CamShaft unilaterally decided to make the wire transfers during the preference period, without any prodding, pressure or threats from

• Gerdau. The court was similarly not swayed by the fact that two of the alleged preferential

transfers paid by wire transfer were lump sum payments that did not pay specific invoice amounts, in contrast to all of American CamShaft’s other payments to Gerdau, that were applied to specific invoices. Rather, the court noted that the subjective part of the OCB defense did not require Gerdau to prove that the alleged preferential transfers were identical in all respects to every other payment American CamShaft had made to Gerdau prior to the preference period. Generally, however, a change in method of payment is likely to take an alleged preferential transfer beyond the scope of the subjective OCB defense. For example, in Valley Petroleum, LLC v. Garrow Oil Corp. (In re Valley Petroleum, LLC), the United States Bankruptcy Court for the Eastern District of Wisconsin held that the alleged preferential payments did not satisfy the subjective OCB defense because, among other reasons, the transfers were made by check and historically, pursuant to the terms of the agreement between the parties, the debtor had paid the creditor by electronic funds transfer. Similarly, in In re Valley Steel Corp., the United States Bankruptcy Court for the Western District of Virginia held that an alleged preferential payment made by wire transfer was beyond the scope of the subjective OCB defense because all prior transfers by the debtor to the defendant were made by check.

The Objective Ordinary Course Of Business Defense

As mentioned above, there is another way for a defendant to prove the OCB defense by satisfaction of the objective prong of the defense. That requires a creditor to show that the alleged preferential transfer both paid indebtedness incurred in the ordinary course of business of the debtor and creditor (the identical requirement as the subjective prong of the defense discussed above) and was made according to “ordinary business terms.” A creditor can satisfy the ordinary business terms requirement by proving consistency of the payment with the

payment practices and range of terms in the creditor’s industry, the debtor’s industry, or some set

• f either or both.

The American CamShaft case discussed above provides a good illustration of the type of evidence necessary to prove consistency with ordinary business terms. The preference action against Gerdau sought the avoidance and recovery of alleged preferential payments in the aggregate amount of $3,126,021.93. Gerdau argued that the alleged preferential transfers were made according to ordinary business terms. In support of this contention, Gerdau presented Dun & Bradstreet (“D&B”) and Risk Management Association (“RMA”) industry reports to show the consistency of the alleged preferential payments with the range of payments in the iron and steel industry. The court focused on the collection information in the D&B and RMA reports for the 75th percentile of businesses in the iron and steel mill industry. These reports showed collection periods of 56.6, 60 and 69.7 days to payment from invoice date, with an average collection period of 62.1 days. This was consistent with the timing of the alleged preferential transfers which paid invoices between fifty-six and seventy days from invoice date, with an average of 63 days. The trustee also argued that American CamShaft’s payments by wire transfer during the preference period were inconsistent with “ordinary business terms,” because American CamShaft had not paid by wire transfer prior to the preference period (which is an inquiry under the subjective part of the OCB defense). The court rejected this argument by relying on the 2007 Electronic Payments Survey by the Association for Financial Professionals (the “AFP Survey”), and in particular, to payments made by businesses with annual revenues of under $1 billion (which most closely resembled American CamShaft). According to the AFP survey, businesses like American CamShaft had paid their suppliers by check 71% of the time and by wire transfer 10% of the time. This percentage was sufficient for the court to conclude that American CamShaft’s wire payments to Gerdau during the preference period were not “aberrational, unusual or idiosyncratic,” and, therefore, were made according to ordinary business terms. Likewise, the Sixth Circuit, in Luper v. Columbia Gas of Ohio, Inc. (In re Carled, Inc.), held that a simple showing that 8 to 10% percent of the defendant’s customers followed a similar payment schedule to the debtor was sufficient to prove ordinary business terms. The court noted that it was unnecessary for the defendant to prove that a significant percentage of customers paid a certain number of days late in order to successfully assert that payments were made within

• rdinary business terms.

In the case of Meyer’s Bakeries, Inc. (“Meyer’s Bakeries”), filed in the United States Bankruptcy Court for the Western District of Arkansas, the debtor, Meyer’s Bakeries, made eight payments in the aggregate amount of $58,296.63 to Interstate Packaging Group, Inc. (“Interstate”) during the preference period. The court held that the alleged preferential transfers were subject to the

• bjective prong of the OCB defense based on the testimony of Interstate’s president that the

payments were not unusual in the packaging industry in which Interstate conducted business. The court also considered the testimony of the industry expert produced by Interstate, who had worked for approximately eight different packaging companies, and testified that customers in

the packaging industry rarely paid invoices within thirty days. Rather, according to this testimony, the practice in the industry was for customers to pay within a range of fifty to eighty days after receipt of invoices, and for sellers to base payment terms on the size of their customer, and permit larger customers to take longer to pay invoices and pay several invoices with one check. The cases involving the objective prong of the OCB defense have identified various forms of industry data that the courts will consider in this regard. This data can be found in publications by, among others, Credit Research Foundation, D&B, RMA and CapitalIQ. Debt Restructuring Agreements / Repayment Plans Case law is divided over whether alleged preferential payments made pursuant to debt restructuring agreements, even when the debt is in default, are subject to either the subjective or

• bjective prongs of the OCB defense. Generally, a creditor seeking to apply the OCB defense to

debt restructuring payments will be required to prove that (i) debt restructuring agreements are not unusual in the relevant industry, (ii) the terms of the debt restructuring agreement are not unusual, and (iii) the alleged preferential transfers were timely under the terms of the agreement,

• r consistent with the timing of payments made under prior debt restructuring agreements

between the parties. In Bender Shipbuilding and Repair Co., Inc. v. Oil Recovery Co., Inc. (In re Bender Shipbuilding and Repair Co., Inc.), the United States Bankruptcy Court for the Southern District of Alabama held that payments made during the preference period pursuant to a repayment plan entered prior to the preference period, were not subject to the subjective OCB defense. Over the course of the defendant’s over twenty year relationship with the debtor, the defendant’s invoices provided for payment within 30 days. When the balance owed by the debtor exceeded $290,000, the defendant threatened to cease doing business with the debtor. That resulted in the parties agreeing to a repayment plan that was entered prior to the preference period and required the debtor to make weekly payments of $20,000.00. Four such payments were made during the preference period, and were deemed beyond the scope of the subjective OCB defense, despite the defendant’s argument that the terms of the repayment plan represented the “new normal” business relations between it and the debtor. The court held that the alleged preferential transfers were made as a result of unusual debt collection practices because they were made pursuant to the terms of the repayment plan, which the debtor agreed to in response to the defendant’s threat to cease performing services for the

• debtor. The court also noted the absence of any evidence that the debtor had previously entered

into any similar repayment agreements with the defendant. However, the Eighth, Ninth and Second Circuits have held, in In re U.S.A. Inns, In re Kaypro, and In re Roblin, respectively, that payments made pursuant to restructuring or repayment plans are not automaticaly beyond the scope of the OCB defense. In this regard, the Second Circuit in In re Roblin explicitly “decline[d] to adopt a rule that payments made pursuant to debt restructing agreements, even when the debt is in default, can never be made according to

• rdinary business terms as a matter of law.” Rather, the Second Circuit held that such a

determination is a “question of fact that depends on the nature of the industry practice in each

particular case, a factual inquiry that is appropriately left to the bankruptcy courts.” The court also stated that “it is not difficult to imagine circumstances where frequent debt restructuring is

• rdinary and usual practice within an industry, and creditors operating in such an environment

should have the same opportunity to assert the ordinary course of business exception. Indeed, if the industry practice is to restructure defaulted debt, it would make little practical sense to require creditors to comply with any other standard in order to meet the requirement of §547(c)(2)(C).” As noted by the Ninth Circuit in In re Kaypro, application of the “ordinary business terms” standard where the alleged preferential transfer was made under a restructuring plan requires a showing that the applicable terms were also employed by similarly situated debtors and creditors facing the same or similar problems. Based on these decisions, a creditor that agrees to restructure a debt in a manner consistent with industry practice might not lose the protection of the OCB defense. The courts have distinguished between payments made under settlement agreements (which may not be a debt incurred in the ordinary course of business and, therefore, are not subject to the OCB defense) and payments made under debt restructuring agreements, provided that such debt-restructuring agreements are not unusual according to relevant industry practice. Factors considered by courts to determine whether an agreement is an non-OCB settlement agreement or an OCB debt restructuring agreement include, but are not limited to: (a) the creditor’s routine execution of debt-restructuring agreements with debtors that are unable to meet their obligations; (b) the terms of the creditor’s typical restructuring agreement, such as debt consolidation and execution of a promissory note; (c) the frequency of use of such restructuring agreements in the industry and by the particular creditor; and (d) whether the creditor typically requires security or guarantees from restructuring debtors.

Conclusion

As the foregoing demonstrates, the only prediction that can be made with any degree of reasonable certainty is the continued inconsistency of judicial application of the OCB defense. This inconsistency appears to derive from the various factors that can be considered in determining whether a transfer is “ordinary.” A factor that is considered significant by one court may be utterly disregarded by another. This plethora of potentially relevant factors also enables virtually every preference defendant to point to at least one factor in support of its claim that an alleged preferential transfer is ordinary. Consequently, the OCB defense appears likely to remain the most litigated of the affirmative defenses to the avoidance of preferential transfers. Bruce S. Nathan, Esq. bnathan@lowenstein.com David M. Banker, Esq. dbanker@lowenstein.com Terence D. Watson, Esq. tdwatson@lowenstein.com Lowenstein Sandler LLP; New York, NY