Bankruptcy And The Ordinary Business Terms Preference Defense

23 Jan Bankruptcy And The Ordinary Business Terms Preference Defense

The 2005 amendments to the Bankruptcy Code modified the landscape for a key defense to bankruptcy preference actions. Preference actions are when a trustee or debtor in possession sue a creditor for the return of payments made in the 90 days before a bankruptcy.

The concept is that creditors that receive more than similarly situated creditors by extracting unusual pre-bankruptcy payments from the struggling debtor should have to give the money back so that it can be shared equally with their peers. This creates a disincentive to employ coercive collection techniques when a debtor is teetering on the edge of bankruptcy.

However, there is a defense to a preference case that allows the recipient of the money to keep it if the transfer was “ordinary”. There are several other defenses to preference actions (some of which I discuss here), but I will be highlighting the ordinary course of business defense, and more specifically, the “ordinary business terms” prong of that defense.

Section 547(c)(2) is where the general defense is found. It says:

(c) The Trustee may not avoid under this section a transfer —
(2) 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.

The “ordinary course of business” prong (subsection A) is known as the subjective test because it concerns the history of dealing between specific the debtor and creditor.

The “ordinary business terms” prong (subsection B) is known as the objective test because it concerns what is normal in the industry in which the debtor and creditor do business.

Prior to 2005, a preference defendant had the burden of proving both prongs of the defense, but now either one will suffice. This means that a preference defendant can win by proving that a suspect payment was normal for the industry even if it was not normal in the course of dealing with the debtor.

However, much of the case law on the topic is from pre-2005 bankruptcy cases. During that time, when it was necessary to prove both prongs, the objective component was often treated like an afterthought.

Now that “ordinary business terms” is its own defense, the question is how will the courts interpret it–and much is still uncertain because many preference cases coming to decision now are still in base cases filed before 2005. However, it is clear that in order to carry its burden on the “ordinary business terms” prong of the defense, a defendant will have to retain a trade expert to prepare a report and testify on the standard payment timing and behavior within the industry group during the preference period.

Courts will have wide discretion to assess dueling expert testimony, define what constitutes the relevant industry group, and define the range of what should be considered “ordinary” within that group. There are some obvious challenges in presenting this defense, like obtaining often proprietary trade information within an industry group.

Moreover, there is always wide discretion in defining a sample group, and thus much to fight over: Whether the group of businesses in the relevant industry group is defined broadly or narrowly will dictate much, and is within the discretion of the court.

An added factor to consider is the preference defendant’s right to demand a jury trial and transfer to the District Court. It has this right when it has not filed a proof of claim in the underlying bankruptcy case (the U.S. Supreme Court’s 2011 decision, Stern v. Marshall, does not change this).

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Nicholas Ortiz, Boston Bankruptcy Attorney

From Attorney Ortiz: We have been helping consumers and small businesses in Massachusetts successfully navigate through the bankruptcy process since 2002. We offer free initial consultations and payment plans. Call us at 617-716-0282 to discuss your debt relief options. Mention the Bankruptcy Law Network when you call!
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