Trade creditors dread the "p" word—by that, I mean "preferences." Under §547(b) of the Bankruptcy Code, a trustee or debtor-in-possession (DIP) may recover, as a preference, a debtor's payment or other transfer of assets to a creditor on account of antecedent indebtedness owing by the debtor to the creditor, made within 90 days of the debtor's bankruptcy filing (and within one year as to insider creditors) when the debtor was insolvent (insolvency is presumed within the 90-day preference period), and that enabled the creditor to receive more than it would have received in a chapter 7 liquidation of the debtor.

The drafters of §547 had intended to promote the fair treatment of similarly situated creditors. Section 547 is also designed to discourage creditors from racing to the courthouse to sue and obtain judgment against a financially distressed company, or take any other action to collect their claims, that would precipitate the company's filing for bankruptcy.

Section 547(c) sets forth various defenses to preference claims that limit or eliminate preference risk. These defenses are intended to encourage creditors to continue doing business with, and extend credit to, financially troubled companies.

One of the most frequently litigated preference defenses is the ordinary-course-of-business defense provided in §547(c)(2). A creditor seeking to invoke the ordinary-course-of-business defense must satisfy the following three requirements:

1. The transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and creditor—§547(c)(2)(A);
2. The transfer was made in the ordinary course of business or financial affairs of the debtor and creditor—§547(c)(2)(B); and
3. The transfer was made according to ordinary business terms—§547(c)(2)(C).

The ordinary-course-of-business defense is designed to protect from preference exposure a debtor's routine payments of recurring credit transactions. It is intended to encourage creditors to continue doing business with a financially distressed debtor. It also does not detract from the general policy of §547(b) to discourage unusual actions by either the debtor or its creditors.

Section 547(c)(2)(A)'s incurrence of debt in the ordinary course prong is usually satisfied and not subject to litigation. Most ordinary-course-of-business defense litigation concerns §547(c)(2)(B)'s requirement that the transfer was made "in the ordinary course of business or financial affairs of the debtor and the transferee," which is a "subjective test," and §547(c)(2)(C)'s requirement that the transfer was made according to "ordinary business terms," which is an "objective test."

This article focuses on §547(c)(2)(B). This element of the ordinary-course-of-business defense appears to assume that the debtor and creditor had engaged in transactions prior to the preference period from which the court could determine the ordinary course of their business affairs.

What happens where the debtor and creditor had not transacted any business prior to the preference period? Should a trade creditor that first conducted business with a financially distressed company shortly before the bankruptcy and received payment within the preference period avail itself of the §547(c)(2) ordinary-course-of-business defense? In two recent decisions, Bohm v. Golden Knitting Mills Inc. (In re Forman Enterprises Inc.), 293 B.R. 848 (Bankr. W.D. Pa. 2003), and Kleven v. Household Bank F.S.B., 334 F.3d.638 (7th Cir. Ind. 2003), the courts held that a payment, as part of the first transaction between the debtor and creditor, can be in the ordinary course of their business, and thereby satisfy §547(c)(2)(B).

In re Forman Enterprises Inc.

The debtor, Forman Enterprises Inc., was in the business of selling casual attire through retail outlets that it had operated. Golden Knitting was in the business of selling sweaters and other knitted apparel to retailers such as the debtor.

On Sept. 22, 1999, the debtor placed an order to purchase sweaters from Golden. This was the first transaction between Golden and the debtor. On Oct. 29, 1999, Golden shipped the sweaters to the debtor. That same day, Golden issued an invoice in the amount of $115,200 with payment terms of "net 30." That meant that the invoice was due and payable on Nov. 28, 1999. The debtor did not pay for the sweaters by the invoice due date.

On Dec. 2, 1999, four days after the invoice due date, the debtor placed a second order to purchase additional sweaters from Golden. The following day, an employee of Golden telephoned an employee of the debtor concerning payment of the Oct. 29 invoice. On Dec. 6, 1999, Golden sent a fax to the debtor stating that payment of the Oct. 29 invoice was "now due," enclosing another copy of the invoice and requesting immediate payment. Golden again telephoned the debtor and on Dec. 9, 1999, sent another fax to the debtor's chief financial officer stating that payment of the Oct. 29 invoice was past due and requesting payment.

On Dec. 10, 1999, the debtor's CFO spoke with Golden and promised to send payment of the Oct. 29 invoice by Federal Express. That same day, Golden shipped the second order of sweaters, on credit, to the debtor.

On Dec. 17, 1999, seven days after the debtor's CFO had promised to pay the Oct. 29 invoice, the debtor issued a check in the amount of $114,720.50 payable to Golden as payment in full of that invoice. Payment was made 19 days after the due date specified in the invoice and within the 90-day preference period.

On Jan. 26, 2000, the debtor filed a voluntary chapter 11 petition. Approximately one year later, the case was converted to a chapter 7 and a trustee was appointed. The trustee commenced an action against Golden for recovery of the payment as a preference. Golden asserted that the payment was subject to the §547(c)(2) ordinary-course-of-business defense.

The court considered whether an alleged preference that was paid as part of the very first transaction between a debtor and creditor can qualify as an ordinary-course transaction. The court followed the line of cases holding that a first-time transaction between a debtor and creditor can qualify as an ordinary-course transaction for purposes of §547(c)(2)(B). See In re Finn, 909 F.2d 903, 907 (6th Cir. Mich. 1990); Hovis v. Stambaugh Aviation Inc. (In re Air South Airlines Inc.), 247 B.R. 165, 171-172 (Bankr. D. S.C. 2000); Tomlins v. BRW Paper Co. (In re Tulsa Litho Co.), 229 B.R. 806, 808 (B.A.P. 10th Cir. Okla. 1999); Remes v. ASC Meat Imports Ltd. (In re Morren Meat and Poultry Co.), 92 B.R. 737, 740 (W.D. Mich. 1988).

The court rejected any per se rule that a first-time transaction between the debtor and creditor cannot, as a matter of law, qualify as an ordinary-course transaction for purposes of §547(c)(2)(B). See Miller v. Kibler (In re Winters), 182 B.R. 26, 28 (Bankr. E.D. Ky. 1995); Brizendine v. Barrett Oil Distributors Inc. (In re Brown Transport Truckload Inc.), 152 B.R. 690, 691 (Bankr. N.D. Ga. 1992), which follow such a per se rule. Any per se rule would discourage, rather than encourage, first-time creditors from doing business with a struggling debtor.

The court then examined the parties' conduct to determine whether either of them did anything unusual or extraordinary with respect to the payment of the underlying debt. If nothing unusual occurred, the payment was not out of the ordinary.

The court found nothing unusual in the debtor's and Golden's conduct between Oct. 29, 1999, and Dec. 17, 1999, to infer that the payment in question was out of the ordinary course of their business. The evidence did not support the inference that the parties considered the debtor in default of the Oct. 29 invoice or that Golden had acted extraordinarily in seeking the debtor's payment of that invoice. As a quid pro quo, the debtor had agreed to promptly pay the Oct. 29 invoice if Golden shipped the second order of sweaters to the debtor. Golden made the second shipment, and the debtor paid the Oct. 29 invoice seven days later. The court inferred that either the parties had not agreed to payment terms for the Oct. 29 delivery of sweaters or agreed to shift the due date of the Oct. 29 invoice to the date of Golden's second shipment of sweaters to the debtor. Therefore, the alleged preference was not made outside the ordinary course of the debtor's and Golden's business relationship, and Golden had met its burden of proof under §547(c)(2)(B).

Kleven v. Household Bank F.S.B.

This case dealt with tax refund anticipation loans (RALs). Numerous debtors had applied for loans from Household Bank within 90 days of their bankruptcy. The debtors submitted their loan application to Household and simultaneously established a bank account with Household for the sole purpose of electronically receiving the debtors' federal income tax refunds. The debtors also completed a form consenting to the Internal Revenue Service (IRS) depositing the tax refunds directly into the debtors' accounts at Household.

Within a day or so after the debtors had submitted their applications, Household advanced the RALs to the debtors in an amount equal to the debtors' anticipated tax refund, less Household's fee for the RALs. Sometime thereafter, the IRS deposited the debtors' tax refunds into the debtors' accounts at Household. Household then immediately applied the funds in the accounts toward payment of the RALs. These are the transfers that are subject to avoidance as preferences.

More than 100 bankruptcy trustees commenced adversary proceedings against Household to recover the tax refund payments Household had received from the IRS and applied them toward payment of the debtors' RALs. The trustees claimed the payments were inter alia avoidable preferences under §547 of the Bankruptcy Code. Fifteen of the actions involved first-time RALs.

Household argued that these transfers, including the payment of first-time RALs, were protected by the §547(c)(2) ordinary-course-of-business defense. The Seventh Circuit in Kleven v. Household Finance F.S.B., 334 F.3d 638 (7th Cir. Ind. 2003), held that the §547(c)(2) ordinary-course-of-business defense could apply to payments of first-time RALs. Since it was undisputed that the transactions were "ordinary" within the tax refund loan industry, if they were also ordinary between Household and the individual debtors, they would be subject to the §547(c)(2) ordinary-course-of-business defense.

The Seventh Circuit considered the following factors in determining whether a payment is ordinary as between a debtor and creditor:

1. the duration of the RAL arrangement between the debtors and Household,
2. whether the amount or form of tender differed from past practices,
3. whether the debtors or Household engaged in any unusual collection or payment activity and
4. whether Household took advantage of the debtors' deteriorating financial condition.

The Seventh Circuit held that a first-time transaction is not per se ineligible for protection from avoidance under §547(c)(2). A history of dealings between the parties is not absolutely necessary in every case to support a determination that a transaction between a debtor and alleged preference recipient is ordinary. The ordinary-course-of-business defense can be established by the terms of the parties' agreement until that agreement is somehow or other modified by actual performance. In the absence of modifying behavior, the court can look to the parties' agreement to determine their ordinary course of business.

The Seventh Circuit found that all RAL transactions, including the first-time RALs, were conducted in accordance with the terms of the parties' written agreements. That included the timing and manner in which Household had applied the funds from each debtor's account toward payment of that debtor's RAL loan balance. Accordingly, each transaction was ordinary as between the parties, satisfying §547(c)(2)(B).

Conclusion

The §547(c)(2) ordinary-course-of-business defense to preference claims has generated plenty of litigation to keep many bankruptcy practitioners quite busy. That particularly applies to the §547(c)(2)(B) prong that the payment or other transfer must be ordinary as between the debtor and creditor.

Thanks to recent court decisions, a creditor that starts doing business with a financially distressed company shortly before the latter's bankruptcy may still rely on the §547(c)(2) ordinary course of business defense to shield itself from preference exposure.