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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions