Death, Taxes & Preference Suits: At Least One May Be Escaped

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There is an old saying that only two things in life are certain: death and taxes. When it comes to bankruptcy cases, there is another certainty: creditors who got paid within the 90 days prior to their customer’s bankruptcy filing will get sued for a preference. In other words – and this is the hard part for creditors to understand – a creditor who got paid just prior to a bankruptcy for goods or services it actually provided may have to return the money.

Fundamentally, a “preference” is a payment on account of an antecedent debt that allows an unsecured creditor to receive more than it would have received if it had simply received its pro rata distribution in a Chapter 7 case. Unless the creditor received a prepayment (negating the antecedent debt requirement) or held collateral (negating the Chapter 7 distribution requirement), that’s not a hard standard for a plaintiff trustee to meet. Therefore, in the usual case, a preference defendant must turn to one of the enumerated defenses. The two most popular defenses are “subsequent new value” and “ordinary course.” The “subsequent new value” defense is one that, in theory, should be easily calculated: a creditor can offset its preference liability to the extent that, after the challenged payment, it extended unsecured credit for which it did not get paid (or, if it did get paid, has to return as itself a preference). The “ordinary course” defense is more subjective, and therefore is more subject to disagreement.

Since the amendments to the Bankruptcy Code in 2005, this defense applies when a transfer was (i) in payment of a debt incurred in the ordinary course of business or financial affairs of the debtor, and (ii) the transfer was made (A) in the ordinary course of business or financial affairs of the debtor and the transferee, or (B) according to ordinary business terms. In other words, a creditor only has to establish part (i) and either of A or B in part (ii).

Assuming that part (i) of the test is satisfied, as it usually is, most creditor/defendants first look to prong (ii)(A) of the test to determine whether they can establish a defense without looking to contract terms and industry standards as is required under prong (ii)(B). This is a subjective analysis. Provided there is a sufficient history of dealings between the parties, however, many courts have concluded that the ordinary course defense applies to protect a wide variety of payments. See, e.g., Kennedy v. 3M Corp. (In re Henberger Co.), 2005 WL 6960222, *4 (9th Cir. BAP Sept. 12, 2005) (“[T]he goal of the analysis [is] to determine whether payments made during the preference period are so inconsistent with the pre-preference transactions as to be outside the ordinary course of dealings between the parties.”); Lovett v. St. Johnsbury Trucking, 931 F.2d 494, 498 (8th Cir. 1991) (“Although it appears that payment generally was made [10 days] sooner in the 90-day period than during the preceding 12 months, the difference was not sufficiently significant to show that the payments during the 90-day period did not follow the ordinary course of business reflected in the prior 12 months.”); In re Molded Acoustical Products, Inc., 18 F.3d 217, 224 (3d Cir. 1994) (“Only dealings so idiosyncratic as to fall outside [the] broad range” established between the parties prior to the preference period “should be deemed extraordinary and therefore outside the scope of [Section 547(c)(2)].”); and In re Hechinger Investment Co. of Delaware, Inc., 320 B.R. 541, 549 (Bankr. D. Del. 2004) (only a “substantial departure from the normal and ordinary billing and payment procedures” that existed between the parties prior to the preference period falls outside the ordinary course of business defense).

Recently, yet another Bankruptcy Court added itself to the weight of authority finding that even late payments can satisfy the ordinary course of business defense under prong A – this time, in the landlord-tenant context.  In Baumgart v. Savani Props Ltd. (In re Murphy), Case No. 20-11873, Adv. Pro. No. 20-1070, 2021 WL 2524946 (Bankr. N.D. Ohio Apr. 19, 2021), the creditor/defendant owned an apartment complex where the debtor was the tenant. Under the lease, rent was due on the first of each month, and there was a late charge for any payments made after the fifth day of the month. About 20 months after entering into the lease, the tenant filed a bankruptcy case. During the 20 months of the tenancy, the debtor paid rent on time twice: once in November 2019, and once in October 2018, which was the first month of the lease. But the debtor’s rent payments were late – as much as 29 dates late – for each of the other 18 months of her tenancy. The trustee filed a preference action against the landlord to recover the payments made in the 90 days before the bankruptcy. The landlord defended, arguing that it was entitled to the ordinary course defense under prong (ii)(A).  The trustee, of course, disagreed.

The Bankruptcy Court agreed with the landlord. As the Bankruptcy Court explained, “In considering whether the payments were made in the ordinary course of business between the parties, courts consider the timing of the transfers, the amount and manner of the transfers, and the circumstances under which the transfers were made…. ‘[E]ven if the debtor’s business transactions were irregular, they may be considered ‘ordinary’ for purposes of 547(c)(2) if those transactions were consistent with the course of dealings between the particular parties.’ Therefore, even late payments may be considered the ordinary course of business if that is the usual course of dealing between the parties. Id.  (citations omitted). The Bankruptcy Court then found that “[a] 29-day range is not so extraordinary to make the rent payments fall outside the ordinary course of business between the parties.” Id. The Bankruptcy Court concluded: “The nature of the transfers also supports the conclusion that the rent payments were made in the ordinary course of business. ‘Paying rent due to a lessor, whether current or past due, is part of the ordinary course of business under any lease.’ This is especially true if ‘there were no unusual circumstances [ ], such as accelerating lease payments, that would make [a] situation seem to not be in the usual course.’ Although the debtor’s payments were virtually always late, they were in fact ordinary rent payments between tenant and landlord. There were no exceptional or unusual circumstances to indicate that the rent payments were not made in the ordinary course of business under the lease.” Id.

While this decision concerned a lease, its application is not limited to the landlord-tenant context. The decision should be equally applicable to any other contract.

Creditor-defendants should also remember that, where there is little pre-bankruptcy history between the two parties, or the history that exists is unhelpful to the creditor, the “objective prong” of (ii)(B) can still provide a defense. As the 9th Circuit has explained:

In this circuit, the rules attending § 547(c)(2)[(B)]  are also well-settled…. [T]he creditor must demonstrate that the relevant payments were “ordinary in relation to prevailing business terms.”  As before, this effectively breaks down into two components. First the creditor must establish the “broad range” of business terms employed by similarly situated debtors and creditors, including those in financial distress, during the relevant period.  Second, the creditor must show that the relevant payments were “ordinary in relation to [these] prevailing business terms.”  In general, § 547(c)(2)[(B)] should not pose a particularly high burden for creditors….

In re Healthcentral.com, 504 F.3d 775, 791 (9th Cir. 2007) (internal citations omitted) (emphasis added). And, there are many other courts following a similar approach. See e.g., In re Jan Weilert RV, Inc., 315 F.3d 1192, 1198 (9th Cir. 2003) (holding only payments which are so unusual as to be “aberration[s] in the relevant industry” do not satisfy the criteria); In re Ahaza Systems, Inc., 482 F.3d 1118, 1125 (9th Cir. 2007) (holding that first-time transactions are eligible for the exception); In re Gulf City Seafoods, Inc., 296 F.3d 363, 369 (5th Cir. 2002) (“Because ‘ordinary business terms’ sets an outer boundary to the parties’ practices, the ultimate question is simply whether a particular arrangement is so out of line with what others do that it fails to be ‘according to ordinary business terms.’”); In re Roblin Industries, Inc., 78 F.3d 30, 42 (2nd Cir. 1996) (“ ‘ordinary business terms’ refers to the general practices of similar industry members and that ‘only dealings so idiosyncratic as to fall outside that broad range should be deemed extraordinary …’”); and In re Strauss, 2015 WL 1221380, *3 (Bankr. D. Col. March 16, 2015) (explaining that the ordinary business terms inquiry “is a broad one, and a creditor is not required to prove ‘rigorous definitions of either the industry or the credit standards within that industry.’”) (citation omitted).

In sum, while death and taxes may be inevitable, having to return a payment that a creditor received in payment for a legitimate debt is not preordained.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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