Trustee Beware The Defenses to the Preferences Claim Part II
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. In re Energy Co-op. Inc., 832 F.2d 997, 1004 (7th Cir. 1987). 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:
- 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).
- 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).
- The transfer must have been made according to ordinary business terms. §547(c)(2)(C).
Ordinary Course of Business Between Debtor and Creditor: The Subjective Prong, Subsections (c)(2), (A)-(B)
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. In re Lan Yik-Foods Corp., 185 B.R. 103, 113 (Bankr. E.D.N.Y. 1995). 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. In re Healthco Intern. Inc., 132 F.3d 104, 110 (1st Cir. 1997). 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. In re A.W. & Associates Inc., 136 F.3d 1439, 1441 (11th Cir. 1998); In re T.B. Home Sewing Enterprises Inc., 173 B.R. 782, 789 (Bankr. N.D. Ga. 1993). 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. In re Healthco Intern. Inc., 132 F.3d at 110.
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. In re Grand Chevrolet Inc., 25 F.3d 728, 733 (9th Cir. 1994); Matter of Tolona Pizza Products, 3 F.3d 1029, 1033 (7th Cir. 1993); In re Fred Hawes Organization Inc., 957 F.2d 239, 244 (6th Cir. 1992).
In In re Gateway Pacific Corp., 153 F.3d 915, 917-918 (8th Cir. 1998), 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." Lovett v. St. Johnsbury Trucking, 931 F.2d 494, 498 (8th Cir. 1991).
"Ordinary Business Terms": The Objective Prong, Subsection (c)(2)(C)
The Seventh Circuit in Matter of Tolona Pizza Products Corp., 3 F.3d at 1031, 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:
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.
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 Matter of Midway Airlines Inc., 69 F.3d 792 (7th Cir. 1995). 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:
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 11 U.S.C. §547(c)(2)(C), which requires reference to some external datum.See, also, In re Weilert R.U. Inc., 245 B.R. 377 (Bankr. C.D. Cal. 2000).
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 In re U.S.A. Inns of Eureka Springs, Arkansas, 9 F.3d 680, 684 (8th Cir. 1993), 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 In re Meredith Hoffman Partners, 12 F.3d 1549, 1553 (10th Cir. 1993), 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 In re Molded Acoustical Products Inc., 18 F.3d 217 (3rd Cir. 1994), adopted a modified version of the Tolona Pizza objective test for subsection (c)(2)(C) at page 225 of the opinion:
[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).
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 Advo-System Inc. v. Maxway Corp., 37 F.3d 1044, 1050 (4th Cir. 1994), 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 In re Carled Inc., 91 F.3d 811, 818 (6th Cir. 1996), the Second Circuit in In re Roblin Industries Inc., 78 F.3d 30, 41 (2nd Cir. 1996) and the Eleventh Circuit in In re A.W. & Associates, 136 F.3d 1439, 1442 (11th Cir. 1998), adopted the Tolona Pizza interpretation of subsection (c)(2)(C) after reviewing the decisions of the other circuits set out above. See, also, In re Food Catering & Housing Inc., 971 F.2d 396, 398 (9th Cir. 1992), 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."
Enabling Loan Defense
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.1 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 Matter of Locklin, 101 F.3d 435, 443 (5th Cir. 1996); In re Holder, 892 F.2d 29, 31 (4th Cir. 1989); In re Tressler, 771 F.2d 791, 794 (3rd Cir. 1985); In re Davis, 734 F.2d 604, 607 (11th Cir. 1984); and In re Vance, 721 F.2d 259, 262 (9th Cir. 1983). 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 In re Marino, 193 B.R. 907 (9th BAP 1996), 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, In re Pine Top Ins. v. Bank of America Nat. Trust & Sav., 969 F.2d 321, 328-329 (7th Cir. 1992). However, the Sixth Circuit in In re Arnett, 731 F.2d 358, 363 (6th Cir. 1984), 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. Fidelity Financial Services Inc. v. Fink, 522 U.S. 211, 118 S.Ct. 651 (1998); Matter of Hamilton, 892 F.2d 1230, 1234-1235 (5th Cir. 1990).