In the case of a business drowning under a sea of red ink and contemplating bankruptcy, hard decisions need to be made about which vendors get paid and which are put off until a cash crunch eases.
When the business files for bankruptcy, the court’s going to start trying to undo all of those payments as preferences.
Under the bankruptcy laws, preferences can be recovered because they run contrary to the goal of equality of treatment among creditors.
Treating everyone fairly is a fundamental principle of the bankruptcy law, after all.
A vendor that receives a preference isn’t doing anything illegal, but when the requirements of the Code are satisfied, preferences must be returned to the bankruptcy estate unless there’s a defense. Once back safe and sound in the arms of the bankruptcy trustee, the funds are redistributed among all of the unsecured creditors.
In a preference action, the trustee or debtor that is looking to recover the preferential transfer has show that the transfer is avoidable. Once that’s done, the recipient of the funds is required to prove that there’s a defense under section 547(c) of the Code.
One of the defenses to a preference action is the “ordinary course” defense – what I lovingly call the, “taking care of business,” defense. The other concerns, “new value,” and we’ve chatted about that elsewhere in this series on preferences in bankruptcy.
In a nutshell, the ordinary course defense says that a transfer or payment can’t be avoided to the extent it 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 Rationale Behind The Ordinary Course Defense
The law recognizes that distressed companies need every possible opportunity to survive without bankruptcy. If there were no defense carved out for regular commercial dealings, however, no supplier would ever deal with a company on the verge of bankruptcy.
For that reason, this defense allows the embattled company to continue working with suppliers on a limited basis in the run-up to bankruptcy. If those dealings allow the company to right itself financially, so much the better. But if not, vendors and creditors don’t need to worry about difficulties down the road.
Incurred In The Ordinary Course?
In order to to properly defend against an avoidance action, the creditor needs to show that the debt was a debt which was incurred in the ordinary course of financial affairs between the parties. That’s usually fairly simple, as the creditor will show that the payment was related to the way the parties usually worked together.
For example, let’s say the company normally pays bills every 30 days. Therefore, any bills paid to the creditor during the preference period that were about 30 days old would satisfy this element.
Examine The Relationship Between The Creditor And Debtor
The next element of the defense is considered a subjective test because it looks to the course of dealing specific to the debtor and the creditor. We’re not looking only to the ordinary course of business, but specifically how this particular creditor has been working with this particular debtor over the lifetime of the relationship.
Are there normal terms used during the preference period that differ from those used before? Did something change in the relationship between the parties in the lead-up to bankruptcy? If so, the subjective test may cause problems for the creditor.
Looking At The Industry
The final prong of this defense to preference actions hinges on the industry as a whole, and how business is ordinarily transacted. We’re not looking at these particular parties anymore; rather, we’ve got to take a look at how companies of this sort deal with creditors of this sort industry-wide.
Here’s where the experts are going to come in. Industry standards need to be explained, and the “lay of the land” must be shown to the court in order to prove this up.
A Minefield For Creditors
If you’re hit with a preference action, your lawyer is going to look at all defenses – including one involving the ordinary course of business. It’s a defense used fairly often in the context of preference actions, but one that requires the use of outside experts as well as a deep dive into the overall relationship between the debtor and creditor.
Tread lightly, but realize that the defense is out there if you need it.
Image credit: Esthr