Trustee Beware The Defenses to the Preferences Claim Part II

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Apr 2001

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Editor's Note:

The article is the second of a four-part series discussing four of
the seven affirmative defenses to preference action. The first, covering contemporaneous
exchange, appeared in the last month's issue. This article covers ordinary course of
business. The remaining two will appear in subsequent issues of the ABI Journal.
</blockquote>

The purpose of the ordinary course of business defense is to protect credit transactions
that are paid and received in the ordinary course of the business of the debtor and
the debtor's transferee. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Energy Co-op. Inc., 832 F.2d 997,
1004 (7th Cir. 1987)</a>. Such transactions do not detract from the general
policy of §547 of discouraging unusual action by either the debtor or creditors
during the debtor's slide into bankruptcy.

The affirmative defense of ordinary course of business has three elements:

<ol>

<li>The debt on which the payment was made must have been incurred in the
ordinary course of business or financial affairs of both the debtor and the
transferee §547(c)(2)(A).

</li><li>The transfer must have been made in the ordinary course of business or
financial affairs of the debtor and the transferee §547(c)(2)(B).

</li><li>The transfer must have been made according to ordinary business terms.
§547(c)(2)(C).
</li></ol>

See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re R.M. Taylor Inc., 245 B.R. 629, 637 (Bankr. W.D. Mo.
2000)</a>.

<h3>Ordinary Course of Business Between Debtor and Creditor: The Subjective Prong,
Subsections (c)(2), (A)-(B)</h3>

The courts have used the "baseline of dealings" between the parties in applying the
subjective test for determining if the debt and the transfer was made in the normal
course of business between the debtor and creditor. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Lan Yik-Foods Corp.,

185 B.R. 103, 113 (Bankr. E.D.N.Y. 1995)</a>. The
baseline-of-dealings approach is fairly simple: The court in applying the baseline of
dealings between the parties will examine the course of dealings between the debtor and
the creditor in the period before the 90-day preference period and compare that
"baseline" with the dealings between creditor and debtor during the 90-day period.
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Healthco Intern. Inc., 132 F.3d 104, 110 (1st Cir.
1997)</a>. If the debtor's payments made during the 90-day preference period were
in accordance with the baseline of dealings established by parties in the pre-90-day
period, they are protected by subsection (c)(2)(B) because they are recurring,
customary credit transactions. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re A.W. & Associates Inc., 136 F.3d
1439, 1441 (11th Cir. 1998)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re T.B. Home Sewing Enterprises
Inc., 173 B.R. 782, 789 (Bankr. N.D. Ga. 1993)</a>. Payments
made by the debtor during the preference period that are inconsistent with the debtor's
history of payment preceding the preference period were not made in the ordinary course
of business of the debtor and are avoidable preferences. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Healthco Intern.
Inc., 132 F.3d at 110</a>.

A late payment is considered "ordinary" within the meaning of subsection
(c)(2)(B) if the baseline of dealings between the parties shows that the creditor
accepted late payments from debtor. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Grand Chevrolet Inc., 25 F.3d
728, 733 (9th Cir. 1994)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of Tolona Pizza Products, 3 F.3d
1029, 1033 (7th Cir. 1993)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Fred Hawes Organization Inc.,
957 F.2d 239, 244 (6th Cir. 1992)</a>.

In <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Gateway Pacific Corp., 153 F.3d 915, 917-918 (8th
Cir. 1998)</a>, the debtor had consistently made tardy payments without penalty before
and during the preference period. The payments during the preference period, however,
were significantly later than the late payments made in the nine months preceding the
preference period. During the nine-month period preceding the preference period, the
median time that elapsed between the date of invoice and date of payment was 35
days. During the preference period, this median time increased to 54 days, or a
54 percent increase. Gateway Pacific at 918. Also, during the nine months
preceding the preference period, only nine of approximately 155 payments were 50
days old, while 24 of the 28 payments during the preference period were at least
50 or more days old. Gateway Pacific at 918. The Eighth Circuit affirmed the
bankruptcy court's holding that the late payments made during the preference period were
not exchanges protected by §547(c)(2). Gateway Pacific at 919.

If payments are made somewhat sooner during the preference period, they are not
preferential payments if they "were sufficiently consistent with the payment times during
the prior 12 months." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. St. Johnsbury Trucking, 931 F.2d 494,
498 (8th Cir. 1991)</a>.

<h3>"Ordinary Business Terms": The Objective Prong, Subsection (c)(2)(C)</h3>

The Seventh Circuit in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of Tolona Pizza Products Corp., 3 F.3d at
1031</a>, stated that it was easy to understand the first two requirements of the
ordinary course of business defense: The debt must have been incurred in the ordinary
course of debtor and creditor, and the payment on the debt must also have been made
and received in the ordinary course of their business. This "baseline" approach is
simple and easy to understand. The court stated that the third element, "ordinary
business terms," is more difficult to understand. Tolona Pizza at 1031. Does it
refer to what is "ordinary" between the debtor and the creditor, or does it refer
to what is ordinary in the market or industry in which they operate? The Seventh
Circuit stated that the circuits were divided on this point. The Seventh Circuit,
however, found that if §547(c)(2)(C) referred only to the dealings between
the creditor and debtor, then it added nothing to §547(c)(2)(B). Tolona Pizza

at 1032. After some additional analysis, the court concluded that a creditor "must
show that the payment he received was made in accordance with the ordinary business
terms in the industry (emphasis added)." Tolona Pizza at 1033. The court
formulated what has become the "objective" standard of §547(c)(2)(C) at page
1033 of the opinion:

<blockquote>
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.
</blockquote>

The above test for the third element of the ordinary course of business defense is
often referred to as the "objective" test. The Seventh Circuit revisited this issue
two years later in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of Midway Airlines Inc., 69 F.3d 792 (7th
Cir. 1995)</a>. The court stated that in order to sustain the ordinary course of
business exception, the creditor must prove by a preponderance of the evidence that
the transaction (1) was ordinary as between the parties (subsection
(c)(2)(A)-(B)), and (2) ordinary in the industry examined as a whole
(subsection (c)(2)(C)). Matter of Midway Airlines Inc. at 797.

In Tolona Pizza, the creditor-defendant introduced evidence of industry sales terms
through the testimony of its own executive vice president, a person with extensive
experience in the industry. The Seventh Circuit found this evidence sufficient. Tolona
Pizza at 1033. However, the court in Midway found that the creditor had tried
to satisfy subsection (c)(2)(C) indirectly by testimony on its own relationship
with the debtor and the creditor's other customers. The court found that the creditor
had not met its burden of proof. The creditor had failed to prove an industry
standard. The court stated at pages 797-798 of the opinion:

<blockquote>
Reliance solely on the experience of the creditor renders ineffectual the important
dichotomy between the subjective requirements of 11 U.S.C.
§547(c)(2)(A)-(B), which can be satisfied through the proof of the
parties' own dealings, and the objective requirement imposed by <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C.
§547(c)(2)(C)</a>, which requires reference to some external datum.
</blockquote>

See, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Weilert R.U. Inc., 245 B.R. 377 (Bankr. C.D.
Cal. 2000)</a>.

The U.S. Courts of Appeals that have considered this matter during the 1990s
have, after much effort, arrived at the same conclusion reached by the Seventh
Circuit in Tolona Pizza, but with some variations.

The Eighth Circuit in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re U.S.A. Inns of Eureka Springs, Arkansas, 9
F.3d 680, 684 (8th Cir. 1993)</a>, adopted the Tolona Pizza "objective"
test in applying §547(c)(2)(C). The Eighth Circuit in Eureka Springs stated
that subsection (c)(2)(C) "does not require a creditor to establish the existence
of some uniform set of business terms within the industry in order to satisfy its
burden. It requires evidence of a prevailing practice among similarly situated members
of the industry facing the same or similar problems." Eureka Springs at 685. The
Eighth Circuit went on to review the Tolona Pizza decision and adopted its "objective
test."

The Tenth Circuit in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Meredith Hoffman Partners, 12 F.3d 1549,
1553 (10th Cir. 1993)</a>, cited the Tolona Pizza decision and adopted a
variation of it. The court stated that "ordinary business terms" are "the kinds of
terms that creditors and debtors use in ordinary circumstances when debtors are healthy
(emphasis added)." Meredith Hoffman at 1553. This formulation raises a difficult
obstacle for defendants because it precludes them from using proof of how similar
businesses in the industry treat delinquent customers who are having financial problems.

The Third Circuit in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Molded Acoustical Products Inc., 18 F.3d 217
(3rd Cir. 1994)</a>, adopted a modified version of the Tolona Pizza objective test
for subsection (c)(2)(C) at page 225 of the opinion:

<blockquote>
[T]he more cemented (as measured by its duration) the pre-insolvency relationship
between the debtor and the creditor, the more the creditor will be allowed to
vary its credit terms from the industry norm yet remain within the safe harbor
of §547(c)(2).
</blockquote>

This Third Circuit approach, which adjusts the objective test based on the length
of the parties relationship, has been referred to as the "sliding scale standard" or
"sliding scale window." The "sliding scale standard" of the Third Circuit in Molded
Acoustical means that the longer the duration of the parties' pre-insolvency
relationship, the more the creditor will be allowed to vary its terms from the
industry norm by the customary terms between the parties if those terms did change
significantly during the pre-insolvency period. Molded Acoustical at 225. This
"sliding scale" variation on the Tolona Pizza test seems to inject a "subjective"
element into a supposedly "objective" test.

The Fourth Circuit in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Inc. v. Maxway Corp., 37 F.3d
1044, 1050 (4th Cir. 1994)</a>, adopted the Tolona Pizza rule "modified
by and embellished" by the Third Circuit's "sliding scale" of Molded Acoustical
Advo-System Inc.

The Sixth Circuit in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Carled Inc., 91 F.3d 811, 818 (6th
Cir. 1996)</a>, the Second Circuit in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Roblin Industries Inc., 78
F.3d 30, 41 (2nd Cir. 1996)</a> and the Eleventh Circuit in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re
A.W. & Associates, 136 F.3d 1439, 1442 (11th Cir. 1998)</a>,
adopted the Tolona Pizza interpretation of subsection (c)(2)(C) after reviewing
the decisions of the other circuits set out above. See, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Food Catering

& Housing Inc., 971 F.2d 396, 398 (9th Cir. 1992)</a>, which
required payment to be ordinary (1) in relation to past practices between the debtor
and the particular creditor, and (2) in relation to "prevailing business standards."

<h3>Enabling Loan Defense</h3>

Section 547(c)(3) of the Code exempts a transfer of a security interest in
property acquired by the debtor to the extent that the security interest secures new
value given by a secured party to enable the debtor to acquire property. The security
interest must be perfected on or before 20 days after the debtor received possession
of the property.<a href="#1" name="1a">1</a> The new value cannot be given prior to the execution of a security
agreement containing a description of the property as collateral. This provision of
§547 is referred to as the "enabling loan" defense. All of the circuit courts that
have considered the issue have agreed that a purchase-money security interest that is
not sheltered under the enabling loan defense of §547(c)(3) cannot have
alternative shelter under the contemporaneous exchange defense of subsection (c)(1).
See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of Locklin, 101 F.3d 435, 443 (5th Cir. 1996)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
re Holder, 892 F.2d 29, 31 (4th Cir. 1989)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Tressler,

771 F.2d 791, 794 (3rd Cir. 1985)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Davis, 734 F.2d
604, 607 (11th Cir. 1984)</a>; and <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Vance, 721 F.2d 259,
262 (9th Cir. 1983)</a>. The Fifth Circuit in Locklin at page 443 stated
that such a holding best accorded the legislative intent and policies underlying the
enactment of §547(c)(3). Hon. Emilio M. Garza, writing for the Fifth
Circuit in Locklin, summed up the court's position in Latin: Expressio unius est
exclusio alterius. Locklin at 444.

The courts, however, are divided in the application of §547(c) to
non-purchase-money security interests. The Ninth Circuit Bankruptcy Appellate Panel
(BAP) in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Marino, 193 B.R. 907 (9th BAP 1996)</a>, found that
the creditor had taken all the steps necessary to timely perfect its non-purchase
security interest, but the recording clerk failed to timely record the interest. The
court held that when the delay in recording the security interest can be explained,
the transfer can be protected as a contemporaneous exchange. Marino at 916. See,
also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Pine Top Ins. v. Bank of America Nat. Trust & Sav., 969
F.2d 321, 328-329 (7th Cir. 1992)</a>. However, the Sixth Circuit
in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Arnett, 731 F.2d 358, 363 (6th Cir. 1984)</a>, held that
a secured creditor that did not timely perfect its non-purchase security interest as
required by §547(c)(3) cannot use the affirmative defense of contemporaneous
exchange.

The grace period provided for in §547(c)(3) pre-empts any state law that
provides a different period. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Financial Services Inc. v. Fink, 522
U.S. 211, 118 S.Ct. 651 (1998)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of Hamilton, 892 F.2d
1230, 1234-1235 (5th Cir. 1990)</a>.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Prior to the 1994 amendments to the Bankruptcy Code, the period was 10 days. Congress expanded the period to 20 days to conform with most state law. <a href="#1a">Return to article</a>

Journal Authors

Keith M. Baker

Journal Date

Sunday, April 1, 2001 - 12:00

Bankruptcy Rule

2001