Infrequent but Ordinary: Bankruptcy Preference Claims Involving Infrequent Corporate Activities

Relations between one company and another do not always follow a consistent and steady course. As the economy, industry dynamics, material prices and politics change, the relationship between the customer and suppliers will also often change. This article discusses recent and long-standing opinions of various U.S. courts regarding these circumstances and provides guidelines for information that may be helpful in establishing that such arrangements and payments may indeed be “ordinary.”

Background
By definition, a preferential transfer in bankruptcy is any “transfer” to or for the benefit of the creditor during the 90-day period counting backwards from the bankruptcy filing date. [1] A “transfer” is anything of value, whether or not it is tangible, that the bankrupt customer gave any creditor or gave up for the benefit of a creditor for any reason. [2]

Creditor Approaches to Defending Preference Claims
A creditor has the burden of proving that the alleged transfers are not preferential and thus not recoverable by the debtor, and there are several approaches. One is the ordinary-course defense, where the creditor seeks to demonstrate that the transfers occurred consistent with the ordinary course in the industry or in the relationship between the parties. [3]

While the creditor may defend against preference actions through the ordinary-course defense as well as arguments for new value and contemporaneous exchange, this article will focus on issues pertaining to the ordinary-course defense. However, the arguments of new value and contemporaneous exchange are also important to consider as defenses to preference claims.

Ordinary Course Defense to Preference Claims
Ordinary Between the Parties
In establishing the ordinary-course defense relating to the relationship between parties, the timing and method of transfers between the parties is often of primary importance. Preference period transfers are typically analyzed to establish whether they were consistent with transfers made historically. If the timing and method of transfers from the debtor to the creditor during the preference period are similar to the timing and method of transfers in the historical period, the basis for an ordinary-course defense may be established. In general, issues commonly considered by courts in determining whether the alleged preferential transfers were ordinary include, but are not limited to:

• the length of time the parties were engaged in the transaction at issue;
• whether the amount or form of the transfer differed from past practices;
• whether the debtor or creditor engaged in any unusual collection or payment activity; and
• whether the creditor took advantage of the debtor’s deteriorating financial condition.

If any of these factors are present, then a court may find that the transfer does not qualify for an ordinary course of business defense. [4] The Eighth Circuit noted in Lovett v. St. Johnsbury Trucking [5] that when considering transactions between the parties, there is not a precise test that can be performed to determine whether it is ordinary. Rather, as noted in the Bridge Information Systems [6] bankruptcy, “the court should use a “peculiarly factual” analysis in its consideration of whether transactions are ordinary between the parties. The court went on to note that “[t]he central focus of the fact intensive analysis under Section 547(c)(2)(B) is to ensure that neither the creditor nor the debtor engaged in unusual activity during the debtor’s slide into bankruptcy to benefit the transferee creditor.” [7]

In this same opinion, the court referenced Central Hardware, [8] indicating “evidence that either party undertook some unusual activity to benefit the preferred creditor during the preference period will take the payments outside of the ordinary course of business.” Further, it cited Frank v. Volvo Pento of the Am. [9] in noting that “this is true even if the timing of the payments during the preference period was statistically consistent with the timing during the pre-preference period.”

As noted in these opinions, the courts are careful to apply the intent of the Bankruptcy Code in evaluating whether payments are ordinary. In addition, the courts are careful to evaluate the proofs when understanding whether transactions are ordinary, particularly when unique circumstances have altered the payment arrangements. However, as noted below, courts do appear willing to consider whether unique payment arrangements are ordinary in the industry, provided certain circumstances.

Ordinary in the Industry
Comparisons to industry standards are also often used to establish a reasonable basis for ordinary course. As stated by the Credit Research Foundation, when establishing the industry ordinary-course defense, “although the industry standard does not require a creditor to establish the existence of a uniform set of business terms, it does require evidence of a prevailing practice among similarly situated members of the industry facing the same or similar problems.” [10]

A 2010 opinion in Ghassan H. Kabbara [11] highlighted the consensus among the courts regarding what “ordinary-business terms” are. The court noted that in “Luper, the Sixth Circuit joined the ‘clear consensus’ among the other courts of appeals that the definition of “ordinary-business terms” [under § 547(c)(2)(C)] means that the transaction was not so unusual as to render it an aberration in the relevant industry.”
           
Many factors may impact the court’s ruling of whether the alleged preferential transfers occurred within industry “ordinary course.” In Smith Road Furniture, the court made the point that “the more established the trade relationship between the parties, the more that a creditor will be permitted to deviate from the industry standard and still qualify for the ordinary course of business exception. However, it is the creditor’s burden to establish the industry payment standard.” [12] This clearly pertains to both ordinary between the parties as well as within the industry, but underscores the importance of determining what is ordinary in the industry.
           
As noted in Bridge Information Systems [13] “although Section 547(c)(2)(C) does not require the creditor to establish the existence of a uniform set of business terms within the industry, it does require the creditor to demonstrate that the payments in question fit within the general range of terms prevailing among similarly situated firms.” [14] The Eighth Circuit also noted in U.S.A. Inns of Eureka Springs, Arkansas Inc. [15] that “[w]hat constitutes ‘ordinary business terms’ will vary widely from industry to industry.” It went on to note that “[s]ubsection (c)(2)(C) does not require a creditor to establish the existence of some 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.” [16]

In the recent bankruptcy of Erie County Plastics Corp., [17] the court was presented with the argument from creditor defendant Dow Chemical Co. that “it, as well as other suppliers in the industry, treat other customers similar to the Debtor, who have large balances that they are unable to pay on a current basis, similarly to its treatment of the Debtor in this case, i.e., continue to make shipment of product on a cash on delivery basis or cash in advance basis while requiring payments on the delinquent balance.” The court found support for Dow’s contention citing several cases, including the U.S.A. Inns of Eureka Springs case mentioned above. It also quoted In re Roblin Indus. Inc. [18]in noting that “[i]f the terms in question are ordinary for industry participants under financial distress, then that is ordinary for the industry.” [19] The court also described the “healthy debtor” perspective taken by certain courts in which industry norms should be considered when debtors are financially “healthy.”

In the bankruptcy of Energy Cooperative, [20] the court evaluated whether payments made related to a contract breach and settlement were ordinary in the industry. Creditor SOCAP International Ltd. argued that such payments were ordinary in the industry and would be expected to be made by a small supplier in its industry to maintain credibility in the industry. The court noted that “[a]lthough a transaction need not occur often to be in the ordinary course of business, a creditor asserting Section 547(c)(2) must show that the debtor incurred its debt and paid the creditor in ways similar to other transactions.” [21] Ultimately, the court found that “without more of a showing” the payments were “simply not in the ordinary course of business.”

The Energy Cooperative and Erie County opinions both support the notion that infrequent circumstances can still result in payments that are ordinary. However, the courts appear to be in agreement that the creditor must do more than simply assert this. Rather, there must be a showing of reasonable facts or opinions to support this.

Conclusion
Given the upheaval in the national and global economy over the last two years, many customer and supplier relationships have been strained and were strained prior to a customer bankruptcy. Such changes often resulted in modifications to the payment practices of the customer as its financial condition, products, or people changed.

Courts have suggested that they are willing to consider these unique circumstances as “ordinary” albeit infrequent. However, the creditor must carefully consider the burden it has in establishing what was ordinary between the parties, as well as what is ordinary in the industry.