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The Ups and Downs of the New Ordinary-Course-of-Business Defense

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The recent decision in Hutson v. Branch Bank & Trust Co. (In re National Gas Distributors LLC), 346 B.R. 394 (Bankr. E.D.N.C. 2006), ventures into previously unmarked territory in the realm of preferences under the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). In National Gas, the corporate debtor (NGD) made two payments within the 90-day preference window to pay off certain debts owed to its bank lender, Branch Banking & Trust Co. (BB&T). BB&T asserted that the payments were made pursuant to ordinary business terms. The court rejected BB&T's "ordinary business terms defense," not on grounds that the terms of the debt were outside industry standards, but rather because the payments were "certainly not ordinary from the debtor's perspective and...not consistent with standard business practices in general. Id. at 405. With that backdrop, then, this article will examine whether or not the change made by BAPCPA to 11 U.S.C. §547(c)(2) "substantially lightens the creditor's burden of proof." Id.


Before the effective date of BAPCPA, §547(c) (2) required a creditor to affirmatively demonstrate that the transfer made within the preference period was: (A) in payment of a debt incurred in the ordinary-course-of-business or financial affairs of the debtor and creditor; (B) made in the ordinary course or financial affairs of the debtor and creditor; and (C) made according to ordinary business terms.

Essentially, these criteria were viewed as three prongs of a single defense. Moreover, the former §547(c)(2)(B) and (C) were treated respectively as subjective and objective components. Little dispute ever surrounded whether the debt itself was incurred in the ordinary course of business (§547(c)(2)(A)), so courts analyzed such payments in both the terms of the relationship between the debtor and creditor and the general practice of the industry. See Miller v. Florida Mining & Materials (In re A.W. & Assocs. Inc.), 136 F.3d 1439, 1442 (11th Cir. 1998). Some courts interpreted "ordinary business terms" as an ancillary device that largely depended on the extent of the parties' relationship, and adopted a "sliding scale" approach to the objective test. See In re Molded Acoustical Prods. Inc., 18 F.3d 217, 226 (3d Cir. 1994). In effect, a court might weigh the subjective and objective factors, giving more or less weight to the objective factors depending on the history of the parties' dealings.

As is true with many murky criteria, uncertainty permeated preference litigation involving the ordinary-course-of-business defense. In 1997, an ABI task force released a "Preference Survey Report," wherein it recommended that the ordinary-course-of-business defense should be "clarified by more 'objectification.'" National Gas 346 B.R. at 401. Indeed, the National Bankruptcy Review Commission (NBRC) adopted that recommendation and explained that the former §547(c)(2)(B) (the subjective component) "should be amended to provide a disjunctive test for whether a payment is made in the ordinary course of the debtor's business if it is made according to ordinary business terms." Nat'l Bankr.Rev. Comm'n, Bankruptcy: The Next Twenty Years, Final Report (1997). "The recommendation adopts the view that the conduct between the parties should prevail to the extent that there was sufficient pre-petition conduct to establish a course of dealing. A disjunctive test telescopes the ordinary-course inquiry on the course of conduct between the parties. In the event there is not sufficient pre-petition conduct to establish a course of dealing, then industry standards should supply the ordinary-course benchmark. Quite often, industry standards are extremely difficult to ascertain outside bankruptcy and difficult to prove in the context of preference litigation. Thus, it is more accurate to rely on the relationship between the parties." Id.

Congress included the recommended "disjunctive test" in the BAPCPA. Thus, the new §547(c)(2) reads:

[T]o 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 plain language of the retooled defense seems to indicate that the objective component—"ordinary business terms" in the industry—now receives as much deference as the subjective component. Even more important, the court reviews the transaction based on the "general business standards that are common to all business transactions in all industries." National Gas, 346 B.R. at 404. This outcome was not exactly what the NBRC envisioned. The NBRC sought to limit the objective test to "those rare cases" that lacked enough pre-petition conduct to establish a course of dealing. Id. at 401. The statute as passed does not contain any such restriction.

In National Gas, the debtor paid its lender more than $3 million to pay off a line of credit and a working capital loan right before it went out of business. At the same time of these payoffs, NGD transferred $850,000 to BB&T to collateralize NGD's obligations with respect to two letters of credit. As a result of that transfer, BB&T released property owned by the wife of NGD's principal that BB&T held as collateral to secure NGD's liability regarding the letters of credit. Although the trustee did not seek to recover the $850,000 transfers, the court considered those transactions "relevant to the course of dealing" between the parties. Id. at 397. The trustee did, however, seek to recover the payments made to satisfy the line-of-credit note and the working-capital note. Under the new §547(c)(2), BB&T relied only on ordinary business terms as a defense. BB&T either could not—or chose not to—plead the ordinary course of business between the parties themselves. This decision may well have been based on the fact that the payments were made to satisfy debts that were guaranteed by the debtor's owner and his wife. To add another layer to this already muddy situation, the wife's assets served as collateral for NGD's debts to BB&T. Consequently, "ordinary business terms" was probably the only available prong of §547(c) because a payoff of two loans would not be considered the norm in the course of the parties' usual business dealings.

To support its position that the payments were made according to ordinary business terms, BB&T submitted the affidavit of one of its loan officers, a 30-year banking industry veteran. The affidavit stated that: (1) the terms of the line of credit and working capital note were customary for the bank and the banking industry; (2) it was customary practice at the bank and in the industry to extend the maturity dates on loans, and that extensions were done on standard and ordinary terms; (3) when a loan becomes due, it is typical in the industry and for the bank for borrowers to pay the loans in full on or shortly before the maturity date; and (4) the payment of the line and loan were made within the terms of the notes, as modified. The trustee likewise submitted an affidavit, but as the court noted, it did "not address BB&T's 'ordinary business terms' defense." Id. at 399. The failure to rebut the defense, however, was not fatal to the trustee's case.

In siding with the trustee, the court found that the affidavit was simply "too general to establish industry norms, or to support the 'ordinary business terms' defense." Id. at 405. Citing Advo-System Inc. v. Maxaway Corp., 37 F.3d 1044, 1051 (4th Cir. 1994), the court admonished the bank for rendering §547(c)(2)(B) "virtually meaningless" by characterizing the industry norm "at too high a level of generality." Moreover, while the bank argued that its industry—banking—was the "relevant industry" under scrutiny, the court threw a triple punch, and held that the industries of both the creditor and debtor and business in general should be considered.

Perhaps more troubling to the court was that the bank maintained that it "did nothing out of the ordinary." According to the bank, the debtor left it in the dark as to its financial stress, the bank did not pursue collection activities, and the payments were simply received in payment of loans that had matured. The court perceived the facts as the final gasps of the debtor paying off the debts guaranteed by its principals on the eve of bankruptcy. Certainly the actions piqued the court's suspicions: "It is clear what was going on here: NGD was going out of business and was paying off those debts which Mr. and Mrs. Lawing guaranteed and for which Mrs. Lawing's assets stood as collateral." Id. This occurred as the debtor was paying off all of its financing without a commitment for replacement financing. "These payments were not made 'according to ordinary business terms' and are not the type of transfers that the 'ordinary business terms' defense is designed to protect." Id. So wrote the court.

There are lessons to be learned from National Gas. First, preference defendants cannot shelter payments made on a loan incurred in the ordinary course of their business, when those payments have the effect of reducing an insider's exposure. If National Gas is to be followed, the purported "lightened" load of the new §547(c)(2) now compels creditors in similar situations to become versed not only in a debtor's industry but also all the facts and circumstances surrounding business practices in general.

The bigger caution, however, is that notwithstanding a transfer made in the ordinary course of the creditor's business, if the facts and circumstances taken as a whole would be contrary to sound business practice by the debtor or sound business practice in general, the ordinary-course-of-business defense may fail. The either/or alternatives presented by the new §547(c)(2) are not a safety net. Instead, the ordinary-course-of-business defense now puts creditors on a seesaw. On the one hand, it relaxes a creditor's burden of proof in that a creditor can defend a preference payment as being within industry norms apart from demonstrating that it occurred in the actual ordinary course of business of the debtor and creditor. On the other hand, if a creditor chooses to (or is limited to) defend the transfer as being within ordinary business terms as permitted by §547(c)(2)(B), then the onus is on creditors to affirmatively and specifically demonstrate that the industry standards of the creditor and the debtor, and general business practices (whatever the court defines those to be) protect them against avoidance of the preference. Tolona Pizza recognized that the precise relevant industry of a debtor—or for that matter a creditor—may be multi-facted: "Not only is it difficult to identify the industry whose norm shall govern (is it, here, the sale of sausages to makers of pizza? The sale of sausages to anyone? The sale of anything to makers of pizza?), but there can be great variance in billing practices within an industry." Matter of Tolona Pizza Products Corp., 3 F.3d 1029, 1033 (7th Cir. 1993). This same conundrum will likely continue and result in greater cost in analyzing and litigating ordinary-course-of-business defenses to preference actions.

Congress intended the amendments to §547(c)(2) to provide preference defendants broader access to the ordinary-course-of-business defense. National Gas retracts from this congressional mandate and narrows the permissible "broad range" of dealings protected from avoidance.

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Wednesday, November 1, 2006

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