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What is the “ordinary course of business” defense?

The answer is not as simple as it may seem. Creditors usually believe that nothing they have done falls outside of the ordinary course of business, and the necessary question is simply whether your business dealings with the debtor changed during the 90 days prior to the debtor’s bankruptcy filing. Not surprisingly, the U.S. Bankruptcy Code requires a more complicated analysis with respect to the applicability of the ordinary course of business defense.

What is needed for burden of proof?

The Bankruptcy Code provides that a transfer may not be avoided if it was:
  1. Payment for a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the recipient
  2. Made either in the ordinary course of business or financial affairs of the debtor and the recipient, or according to ordinary business terms

The creditor has the burden of proof with respect to the ordinary course of business defense so it is important to understand the basics of its application in case you or your business is faced with a preference demand.

A creditor needs to prove two elements to successfully utilize the ordinary course of business defense. First, the debt paid must have been incurred in the normal course of business or financial affairs of the debtor and the recipient. This element is generally satisfied if the creditor establishes that the transaction in question was similar to typical transactions between the parties. Second, the creditor must demonstrate that the transfer was made either in the ordinary course of business or financial affairs of both parties, or according to ordinary business terms. As a result of changes to the Bankruptcy Code in 2005, only one of these two elements of the ordinary course of business defense needs to be established.

In examining whether the alleged “preference” payment was made in the ordinary course of business or financial affairs of the debtor and the recipient, a creditor must undertake an analysis and comparison of the specific facts related to the transactions between the parties during the preference period (90 days prior to the bankruptcy filing) and before the preference period. This analysis typically looks at factors like:

  • The duration of the relationship
  • The number of transactions
  • The timing and method of payments
  • Whether there have been any collection efforts or pressure to pay

A historical analysis of timing of payment is important because it demonstrates how much time typically passes between the time that the debt is incurred and the time that the debt is paid. Conclusions about the timing of payment, however, are often disputed in court and during settlement discussions as it is highly unlikely that the parties doing business will have a totally consistent payment history. A change in the method of payment is also important, particularly during the preference period, because it could be considered a deviation from the ordinary course of business. Unusual collection activity may also lead to the conclusion that a payment was not made in the ordinary course of business.

If the recipient cannot establish that the “preference” payment was made in the ordinary course of business or financial affairs of the debtor and the recipient, then it must establish that the transfer was made according to ordinary business terms. This will require proof that the transfer in question was consistent with the typical standards and payments within the relevant industry. This analysis is more complicated and often requires the aid of an expert with knowledge of the business standards within the relevant industry.

Takeaways

In The other side of the coin: Why healthy companies need reliable bankruptcy counsel, I described the "preference" or "avoidance" action as a type of bankruptcy litigation commonly used to recover money for the benefit of creditors. The ordinary course of business defense is the most commonly used preference defense. It requires you to ask whether your business dealings with the debtor changed prior to the debtor’s bankruptcy filing.  When faced with an actual demand for return of payment, however, there is deeper analysis to be done and more questions to be answered: 

  • How much, if any, deviation from “ordinary” is considered acceptable?
  • What if there is relatively little history between the debtor and the recipient of the “preference” payment?
  • Which industry is the relevant industry when considering ordinary business terms?

These are just a few examples. This analysis can, and should be done with the help of knowledgeable counsel so you can successfully assert the appropriate defense or defenses to demands for return of payment that you or your company has received.

For more information on bankruptcy litigation, please contact:

Matthew A. Salerno
216.430.2051
msalerno@mcdonaldhopkins.com

The twists and turns of business restructuring are complex and demanding. Our attorneys approach every case with creativity and insight to ensure the solutions are cost-effective and practical. At every turn, you can be confident that our attorneys will guide you through the process, always providing practical and informed advice. We are positioned to respond to the special demands of a variety of matters in a wide range of industries, including health care, automotive, retail/distribution, franchise distribution and technology, real estate/construction, telecommunications, and mining/exploration.

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