Defending Preferential Transfers: The Ordinary Business Terms Defense- Part II: Today's Ordinary Business Terms Defense

Under the pre-October 2005 version of Bankruptcy Code section 547(c)(2), a creditor wishing to shield a transfer from avoidance using an "ordinary course" defense had to prove, by a preponderance of the evidence, that the preferential 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 (the so-called "subjective test"); and (C) made according to ordinary business terms (the so-called "objective test"). The ordinary course defense is narrowly construed, and a creditor's failure to prove any one of these three elements doomed the entire defense.

As many of you know, the ordinary course of business defense is proven by demonstrating that the historical transactional relationship between a creditor and his (now bankrupt) customer is generally consistent with the transactional relationship of the parties in the 90 days immediately prior to the customer's bankruptcy filing (the "preference period").  That comparison is usually made by preparing spreadsheets that compare pre-preference period transactions (in terms of their timing, amount, manner and circumstances of payment) to transactions during the preference period.  Prior to October 2005, the ordinary business terms prong of the ordinary course defense was proven by demonstrating that the transactional history of the parties during the preference period was generally consistent with transactions in the relevant industry during the same time period.

In 2005, the Bankruptcy Code changed in a very small, but significant way.  A task force working on the 2005 changes to the Bankruptcy Code suggested that a separate "ordinary business terms" defense should be enacted by Congress, for use only when there was no significant prior course of dealing between the parties (i.e., no "ordinary course of business" defense was available).  However, when enacted by Congress, the ordinary business terms defense was given an equal footing with the ordinary course of business defense, and can be used even if the parties did have a prior course of dealing.

As a result of this change, beginning with bankruptcy cases filed after October 17, 2005, a transferee need only prove that the transfer was made either in the "ordinary course of business" of the debtor and transferee, or was made according to "ordinary business terms."  In other words, subsections (B) and (C) now stand on their own as separate, independent defenses, whereas they had previously been conjunctive elements of a single, ordinary course defense.

It was generally thought that the new, stand-alone ordinary business terms defense would significantly benefit creditors in their defense of preference actions.  However, that has not proven to be the case in actual application.  Prior to 2005, the focus of most courts when evaluating a creditor's ordinary course defense was on the subjective test, i.e., whether the amount, timing, manner and circumstances of the transfer were consistent with pre-preference period transfers between the creditor and the debtor.  Courts of the time would typically let the objective, "ordinary business terms" element of the ordinary course defense slide by, so long as such terms weren't particularly unusual in the relevant industry.

Today's ordinary business terms defense stands on its own, and must be proven on its own merits – not always a simple task.

Next Time:  Part III – How Courts Apply Today's Ordinary Business Terms Defense.

Bankruptcy Code section 547(c)(2), Ordinary Course Defense, insolvency-insights