News

Court Interprets 'Ordinary Course' Under New Bankruptcy Law

By: Myron A. Bloom 

Some of the most oft-discussed changes made by Congress in the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act are the seemingly small, but significant, changes made to §547(c)(2), often referred to as the "ordinary course of business" defense to the general provisions covering the avoidability of preferential transfers. Until now, most of the discussion concerning the changes made to this subsection have been academic; now we have a case opining on the changes.

In Hutson v. Branch Bank & Trust Co. (In re National Gas Distributors LLC), the Chapter 11 trustee sought to avoid transfers aggregating approximately $3.3 million made by the debtor to its bank in the 90-day period immediately preceding the filing of National's bankruptcy case. The bank defended on the basis that the payments were subject to the "ordinary course of business" defense.

More specifically, the bank contended that the payments were made "according to ordinary business terms" and could thus not be avoided by the trustee. In support, it referred to new §547(c)(2)(B), which now provides a defense so long as payments are made according to business terms, regardless of the prior dealings between the parties.

First, a bit of background. Prior to the passage of the BAPCPA, §547(c)(2)(B) and (C) contained what most courts viewed as a two-faceted component of a single defense. The "ordinary course of business" defense required that a party seeking to utilize the defense needed to prove that the transfer was in payment of a debt incurred in the ordinary course of business or financial affairs of the debtor and transferee. It also required a showing that the transfer was made in the ordinary course of business or financial affairs of the debtor and the transferee; and that the transfer was made according to ordinary business terms.

Uncertainty surrounded the implementation of this defense. Many creditors were concerned that the test was too subjective. Early decisions concentrated almost solely on the relationship between the debtor and the creditor in determining whether the transferee had satisfied its burden with respect to both subparagraphs the conditions mentioned above. It was only when there was no history of dealings between a debtor and a transferee that the courts looked to transactions involving third parties.

Later decisions began to examine more regularly the payment practices in the relevant industry. Courts struggled mightily to construe the two prongs of the defense so as to minimize an overlap, but at the same time give some meaning to the "ordinary business terms" provision, as doing otherwise would be to render superfluous the provisions of subsection (C). Thus, courts began to look beyond examining the relationship between the parties, a "subjective" test, and started to utilize additionally the so-called "objective" test, a test that focused on larger-scale industry standards.

Not content with this bifurcation, courts tended on top of the "objective/subjective" analysis to attempt to weigh the two analyses, giving more or less weight to the two standards depending on the length and nature of the relationship between the parties. The more the history, the more the importance of the subjective test. Some courts called it a "sliding scale."

As early as 1997, the American Bankruptcy Institute weighed in with a number of recommendations to clarify this troublesome issue, and the National Bankruptcy Review Commission, adopting the ABI recommendations, agreed that the conduct of the parties should prevail over the "industry standards" test so long as there was sufficient pre-petition conduct to establish a course of dealings. The objective test was to be used, stated the commission, only when there was insufficient pre-petition conduct between the parties to establish a course of dealing.

When enacted, however, things did not come out quite the way the commission intended. Under the amended subsection, the industry standards (objective) test now stands on equal footing with the pre-petition conduct of the parties (subjective) test. Thus, the courts are still left to determine what the "ordinary business terms" defense means, since it now stands as an independent test, and how much weight to give it. Should it be the equal of the relationship between the parties test? Apparently so, determined the court.

In this case, the bank argued that the "ordinary business terms" test required that the court, as many courts did under pre-BAPCPA law, look to the creditor's industry. In this case, the industry would be the banking industry, as opposed to the debtor's industry. A check on the debtor's conduct is unnecessary, according to the bank.

The bankruptcy court disagreed. "Now that 'ordinary business terms' is a separate defense, the court must consider the industry standards of both the debtor and its creditors. Furthermore, there are general business standards that are common to all business transactions in all industries that must be met."

In the case at bar, the bankruptcy court concluded that the bank could not prevail. At issue was the debtor's payment of a line of credit and a term loan down to zero, just before filing of a petition. Focusing specifically on the line of credit, the bank argued that in general, it was not unusual for a debtor to "zero out" a line periodically, and submitted evidence to that effect in the form of an affidavit. The court found that evidence to be too general to adequately characterize the industry norm. More importantly, stated the court, from the debtor's perspective the payment was not usual at all, given the fact that the debtor's principals had personally guaranteed the debt, and the fact that the debtor had not arranged for financing to continue in business after the pay-down.

It is apparent, stated the bankruptcy court, that under the new law, a creditor's burden has been lightened. It may now look either to the course of conduct between the parties or the standards. There is no particular weight to be given to either. But using either standard, the evidence cannot be presented in generalities. And here, the bank did just that. It did not attempt to utilize the specific debtor-creditor relationship, and did not present adequately the banking industry norm test. Moreover, it did not focus at all on the debtor's business dealings in general. For both of these reasons, its defense failed.

We now have at least one court dealing with the "ordinary course" defense after BAPCPA using real world facts. This court acknowledged in general terms the fact that the changes to §547(c)(2) may make it easier for the creditor to utilize the defense. However, the creditor's burden is still significant, and creditors should not, at least yet, look at this change as a major victory.

This article is reprinted with the permission from the September 1, 2006 issue of The Legal Intelligencer.  Copyright 2006 ALM Properties, Inc.  Further duplication without permission is prohibited.  All rights reserved.