Fraud Not So Ordinary A Look into the Ordinary Course of Business Defense to Preference Actions

By: Samantha Aster
St. John's Law Student
American Bankruptcy Institute Law Review Staff

Recently, in In re Computer World Solution Inc.,[1] a bankruptcy court in Illinois held that the ordinary course of business defense to a preference claim does not apply to a debtor engaged in a fraudulent Ponzi scheme.[2] In 2006, an electronics distributor who was allegedly running a Ponzi scheme, obtained a $2.2 million loan from its lender.  The day before the loan was to mature, the loan was modified to extend the repayment period.[3] Shortly after the lender obtained a state-court judgment against the debtor it made the disputed payments. The estate sought to avoid these three payments made to the lender as preferences under section 547 of the Bankruptcy Code.[4] Even though the lender was unaware of the fraud, and thus not at fault, the court held that the ordinary course of business defense is inapplicable when the debtor engages in fraudulent conduct.[5] 

  In order to successfully invoke the ordinary course defense, a creditor “must prove that the debt was incurred in the ordinary course of business between the debtor and creditor and that either (1) the transfer was made in the ordinary course of business of the parties or (2) the transfer was made according to ordinary business terms in the creditor’s industry.”[6] First, the court found that the loan was not incurred in the ordinary course of business of the distributor and lender.[7] The court looked to how the debtor accounted for the loan on its books as an account receivable, rather than a loan, and concluded that the behavior was thus not ordinary.[8] Because the defense applies to “payments made by a legitimate business, not payments made by a fraudulent one,”[9] the debtor’s fraudulent actions here prevented the lender from asserting the defense. Second, the creditor could not establish that the transfers were made according to the ordinary course of business of the parties.[10] In reaching its decision, the court noted that (1) the lender engaged in unusual collection activities, including the state-court action, (2) the loan was modified, and (3) the transfers were late payments.[11] Finally, the court found that the transfers were not transfers made according to ordinary business terms in the creditor’s industry because the lender failed to present evidence of industry standards.[12]

The rationale behind the ordinary course of business defense is to encourage creditors to continue dealing with distressed debtors and to promote the equal treatment of distribution among creditors.[13] The affirmative defense attempts to “preserve normal financial relations,”[14] which does not include paying fictitious profits or defrauding lenders. For example, the Ninth Circuit held that payments made by a Ponzi scheme debtor are not in the ordinary course of business and fail to satisfy 547(c).[15] To apply section 547(c)(2) to immunize these activities “would lend judicial support to [fraudulent] schemes by rewarding investors at the expense of later victims.”[16]

In re Computer World Solution is consistent with the policy behind the ordinary course of business defense. Congress sought to encourage creditors to continue doing business with legitimate debtors on the eve of bankruptcy; not to prolong fraudulent businesses. Because some lenders may unknowingly engage in a transaction with a fraudulent debtor, Computer World highlights the need for lenders to investigate the borrower before lending the money.