United States: First-Instance Transaction May Qualify For "Ordinary Course Of Business" Preference Defense

Last Updated: February 26 2016
Article by Jonathan N. Edel

Section 547(c)(2) of the Bankruptcy Code excepts from the trustee's power to avoid preferential transfers any transaction in which the debtor transfers property to a creditor in the "ordinary course of business." Exactly what constitutes "ordinary course of business," however, is not a settled question of law. In Jubber v. SMC Electrical Products (In re C.W. Mining Co.), 798 F.3d 983 (10th Cir. 2015), the U.S. Court of Appeals for the Tenth Circuit considered whether a first-time transaction between a debtor and a creditor can satisfy the ordinary course exception. The Tenth Circuit held that a first-instance transaction can qualify if: (i) the debt was ordinary in accordance with the past practices of the debtor and the creditor when dealing with other, similarly situated parties; and (ii) the payment was made in the ordinary course of business of the debtor and the transferee. The court accordingly affirmed rulings below that a two-day-early installment payment on a first-instance equipment purchase could not be avoided by a bankruptcy trustee as a preference.

The Law

Section 547(b) of the Bankruptcy Code empowers a bankruptcy trustee to avoid transfers made by an insolvent debtor to creditors within 90 days of a bankruptcy filing if, as a consequence of the transfer, the creditor received a greater amount with respect to its claim than it would in a chapter 7 liquidation. Certain otherwise preferential transfers, however, are excepted from the trustee's avoidance powers. Among these—as specified in section 547(c)(2)—are transfers in payment of a debt incurred by the debtor in the ordinary course of business, which payments were "(A) made in the ordinary course of business . . . or (B) made according to ordinary business terms."

These exceptions enable a financially distressed company to continue operating its business in the ordinary course, prior to filing for bankruptcy, ultimately preserving the value of the assets of the estate as well as staving off the proverbial "race to the courthouse" by creditors. At the same time, by leaving undisturbed only the normal financial relations of debtors and creditors, this exception does not extend to unusual and risky behaviors, which could adversely affect the interests of creditors and the estate. See Union Bank v. Wolas, 502 U.S. 151 (1991).

Prior to 2005, many courts construed section 547(c)(2) to require that both subsections (A) and (B) must be satisfied to insulate a transfer from avoidance under the ordinary course of business exception—i.e., that a transfer was made in the ordinary course and that it was made according to ordinary business terms. See 5 Collier on Bankruptcy § 547.04[2] (16th ed. 2015). However, Congress amended the statute in 2005 to make clear that subparagraphs (A) and (B) are alternatives. Because the language of each alternative is unchanged, pre-2005 case law interpreting each continues to be relevant.

Under alternative (A) of section 547(c)(2), the debt must be incurred and the payment must be made in the ordinary course of business of both the debtor and the transferee. Some courts, however, have required the incurrence of the debt and the payment to be in the ordinary course of the business relations between the debtor and the transferee. See, e.g., Fitzpatrick v. Cent. Commc'ns & Elecs., Inc. (In re Tenn. Valley Steel Corp.), 203 B.R. 949 (Bankr. E.D. Tenn. 1996); Brizendine v. Barrett Oil Distribs., Inc. (In re Brown Transp. Truckload, Inc.), 152 B.R. 690 (Bankr. N.D. Ga. 1992). Under this approach, any first-time transaction would be ineligible for the exception because there is no prior course of dealing between the debtor and the transferee.

Because section 547(c)(2) expressly refers to the "ordinary course of business or financial affairs of the debtor and the transferee," rather than between the debtor and the transferee, the Sixth, Seventh, and Ninth Circuits have rejected this approach, ruling that a first-time transaction can qualify for the exception. See Gosch v. Burns (In re Finn), 909 F.2d 903 (6th Cir. 1990); Kleven v. Household Bank F.S.B., 334 F.3d 638 (7th Cir. 2003); Wood v. Stratos Prod. Dev., LLC (In re Ahaza Sys. Inc.), 482 F.3d 1118 (9th Cir. 2007). As the Ninth Circuit wrote in Ahaza:

With the "ordinary course of business" exception, Congress aimed not to protect well-established financial relations, but rather to "leave undisturbed normal financial relations, because [the exception] does not detract from the general policy of the preference section to discourage unusual action by either the debtor or his creditors during the debtor's slide into bankruptcy."

Ahaza, 482 F.3d at 1125 (quoting Union Bank, 502 U.S. at 160). The Tenth Circuit adopted this approach in C.W. Mining.

C.W. Mining

In mid-2007, Utah-based C.W. Mining Company ("C.W. Mining") decided to convert to a "longwall mining" operation in an attempt to reinvigorate its business. In furtherance of this strategy, C.W. Mining purchased certain equipment from SMC Electrical Products ("SMC") for approximately $1 million. SMC delivered an invoice to C.W. Mining setting forth deadlines for various installment payments, the first of which—a payment of $200,000—C.W. Mining made to SMC on October 16, 2007, which was two days earlier than the deadline specified in the invoice.

On January 8, 2008, certain C.W. Mining creditors filed an involuntary chapter 11 petition against the company in the District of Utah. After the case was converted to a chapter 7 liquidation, the chapter 7 trustee sued SMC, seeking avoidance of the $200,000 installment payment as a preference. SMC moved for summary judgment, asserting that the debt arose in the ordinary course of business and was therefore insulated from avoidance under section 547(c)(2).

The bankruptcy court granted the motion, holding that the first-instance transaction between C.W. Mining and SMC qualified as an ordinary course of business transaction. The trustee appealed the ruling to a Tenth Circuit bankruptcy appellate panel, which affirmed. The trustee then appealed to the Tenth Circuit.

The Tenth Circuit's Ruling

A three-judge panel of the Tenth Circuit affirmed. After examining the language and purpose of the ordinary course of business exception, the court noted that requiring a challenged transaction to be in the ordinary course of business between the parties—as required by some courts—would necessarily render first-instance transactions ineligible for the protections of section 547(c)(2). Any such per se rule, the court explained, would be inconsistent with the purpose of the provision (i.e., to leave normal business practices undisturbed, protect asset values, and curb the race to the courthouse).

"With the 'ordinary course of business' exception," the court wrote, "Congress aimed not to protect well-established financial relations, but rather to leave undisturbed normal financial relations" (quoting Ahaza, 482 F.3d at 1125). On the basis of this reasoning, as well as the rationale articulated by the Seventh Circuit in Kleven and the Sixth Circuit in Finn, the Tenth Circuit panel added that nothing would discourage the inception of new business relationships between a distressed entity and a potential creditor more than the knowledge that the ordinary course of business defense would be unavailable to combat a preference challenge in any subsequent bankruptcy.

According to the Tenth Circuit panel, its interpretation of the exception would not render superfluous section 547(c)(2)(B) (protecting transactions entered into according to "ordinary business terms"). The court explained that "we have defined ordinary business terms to mean 'those used in "normal financing relations": the kinds of terms that creditors and debtors use in ordinary circumstances, when debtors are healthy' " (quoting Clark v. Balcor Real Estate Fin., Inc. (In re Meridith Hoffman Partners), 12 F.3d 1549, 1553 (10th Cir. 1993)). The court concluded that the "ordinary business terms" defense in section 547(c)(2)(B) contemplates routine dealings within a particular industry, which is not necessarily the same as the ordinary business practices employed by a particular debtor or creditor.

The Tenth Circuit panel cautioned that this approach is not a license to authorize "unusual action by either the debtor or [its] creditors during the debtor's slide into bankruptcy" (quoting Ahaza, 482 F.3d at 1135). Courts should examine how the debtor and the creditor have dealt with similar transactions in the past; if the parties have a history of past practices with each other, compliance with those practices would satisfy this requirement. If, however, a first-time transaction is involved, the court should examine the past practices of the debtor and the creditor with other, similarly situated parties.

By way of example, the court analyzed Harrah's Tunica Corp. v. Meeks (In re Armstrong), 291 F.3d 517 (8th Cir. 2002). The debtor in Armstrong lost $48,800 over a two-day period while gambling at a casino he had visited for the first time in 1995 shortly before an involuntary chapter 7 case was filed against him. The chapter 7 trustee sued the casino to avoid the transfer as a preference. The Eighth Circuit ultimately ruled that, although the debt arose in the ordinary course of the casino's business, it did not arise in the ordinary course of the debtor's business, and therefore the transfer did not qualify for the section 547(c)(2) exception.

In C.W. Mining, the Tenth Circuit panel found Armstrong to be instructive, albeit unusual on its facts. Because every business effort is essentially a gamble, the court distinguished between a debtor's reasonable business risks, taken in a good-faith effort to reenergize the enterprise, and gambles made solely because the business is "playing with house money." According to the Tenth Circuit, "[A] debt incurred for an unduly risky project that can be justified only because the risk is borne solely by the company's creditors is not a debt incurred in the ordinary course of business."

The Tenth Circuit panel ruled that C.W. Mining incurred the debt and tendered the $200,000 payment to SMC in the ordinary course of business and that the transfer was therefore insulated from avoidance under section 547(c)(2). The court found, among other things, that the transaction's sole purpose was to assist in mining operations and that the parties had engaged in arm's-length negotiations in entering into the transaction. In addition, although C.W. Mining tendered its first installment payment to SMC two days prior to the due date, the tender was not unreasonable, according to the parties' past practices in similar situations with other entities.

The Tenth Circuit panel also noted that even though the trustee might have argued that C.W. Mining's new strategy was in fact a "gamble" sufficient to remove it from the ordinary course of business exception, he failed to do so. The court also wrote:

[I]n some instances a debt may be incurred in the ordinary course of business even though it was incurred only because the debtor was sliding into bankruptcy. For example, certain expenditures unique to struggling businesses—such as hiring a turnaround consultant, see Ciesla v. Harney Mgmt. Partners (In re KLN Steel Prods. Co., LLC), 506 B.R. 461, 470-72 (Bankr. W.D. Tex 2014)—are likely to qualify for the exception. The concern is only with what might be termed "gambling" by a failing business.

Outlook

With C.W. Mining, the Tenth Circuit joins the Sixth, Seventh, and Ninth Circuits in ruling that a first-instance transaction can satisfy the requirements for the ordinary course of business preference defense set forth in section 547(c)(2). Although this ruling broadens the scope of potential transfers that can be shielded from avoidance, it arguably comports with the purpose of, and the policy underpinning, the Bankruptcy Code's preferential transfer avoidance provisions. Under the Tenth Circuit's reasoning, provided that the debtor's decision to transfer property is reasonable and not a gamble by a failing business, a per se rule disqualifying first-instance transactions would discourage vendors or other third parties from providing goods or services which might enable the debtor to avoid a bankruptcy filing.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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