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Recent developments in the "ordinary course of business" defense.

The Bankruptcy Code vests the debtor (or trustee if one is appointed) with far-reaching powers to avoid transfers of assets and monetary transactions prior to a bankruptcy filing. The power to avoid preferential transfers is one of the best weapons of a trustee. The Bankruptcy Code defines a preference expansively to include nearly every transfer by an insolvent debtor 90 days prior to bankruptcy. The purpose of the preference provision is two-fold. First, Creditors are discouraged from racing to the courthouse to dismember a debtor, thereby hastening its slide into bankruptcy. Second, debtors are deterred from preferring certain creditors by requiring that any creditor that receives a greater payment than similarly situated creditors disgorge the preference so that like creditors receive an equal distribution of the debtor's assets.

Not all transfers made within the preference period are avoidable. To protect those transactions which replace value to the estate previously transferred, the Bankruptcy Code carves out seven exceptions to the trustee's recovery powers. The most commonly asserted exception by creditors is the ordinary course of business exception. That exception protects payments, in all or part, received by a creditor within 90 days of the bankruptcy from recovery where the creditor establishes certain elements detailed below. The policy supporting the ordinary course of business defense is two-fold: It protects customary transactions and encourages creditors to continue to extend credit to financially troubled debtors, helping the debtor avoid bankruptcy.

In the In re Grand Chevrolet opinion, the Ninth Circuit Court of Appeals (which covers California, Oregon, Washington, Idaho, Nevada, Montana, Arizona, Alaska, and Hawaii) recently rejected the "per se" rule adopted by certain courts that payments outside invoice terms made during the preference period can never be ordinary. The Grand Chevrolet court, joining holdings by the Sixth and Eighth Circuit Courts of Appeals, ruled that late payments can fall within the ordinary course of business exception so long as such late payments are consistent with the pre-preference business practices of the parties.

To qualify for the ordinary course of business exception, the Grand Chevrolet court stated that a creditor must establish that: The debt and payment are ordinary in relation to past practices between the debtor and the creditor; and the payment is ordinary in relation to prevailing business standards.

Regarding the first proposition, whether transfers are ordinary in relation to past practices, several factors are considered: The length of time the parties were engaged in the transactions at issue; whether the amount or form of payment differed from past practices; whether the debtor or creditor engaged in any unusual collection or payment activity; and whether the creditor took advantage of the debtor's deteriorating financial condition. With respect to the second proposition, the court determines a debtor's ordinariness of payments through comparison with prevailing business standards. Testimony by industry experts as to what is customary for payment by debtors usually will be offered on this issue.

The creditor in Grand Chevrolet sold new cars to the debtor who would resell them as used. The alleged preferential transfers involved automobile purchase drafts which acted like checks. The seller delivered the vehicle, and in exchange the buyer gave the seller an automobile purchase draft. The first transfer involved a 72-hour time draft which was exchanged for a purchase draft. The debtor's bank took approximately three weeks to honor the purchase draft.

In applying the ordinary course of business exception, the Grand Chevrolet court found that the debtor and creditor had engaged in comparable transactions for several years. It was also undisputed that the amount paid for the vehicles was not extraordinary and that the method of payment was often by automobile purchase drafts. Finally, the court found that the payment's being outside the stated terms did not, in itself, make the payment non-ordinary. The parties had engaged in nine prior transactions involving 72-hour drafts. However, on average, it took three weeks to honor the drafts. Thus, the creditor regularly received late payments. The alleged preference was paid within three weeks, and thus was ordinary in relation to past practices between the debtor and the creditor.

The Grand Chevrolet opinion is instructive for credit professionals on several fronts. First, it will make it more difficult for the debtor to recapture from a creditor a preference because a "bright line" rule, that payments outside invoice terms can never be ordinary, has been rejected in favor of a flexible rule, where such late payments are within the ordinary course exception so long as the creditor can establish such late payments are consistent with the business practice of the parties. Where payments are thus outside invoice terms and other aspects of the transaction between the parties are normal, the issue becomes how "late" may payments be yet still fall within the ordinary course of business exception. This becomes a point of negotiation between the creditor and the debtor or trustee. As the creditor has the burden of proof to establish the ordinary course of business exception, the creditor must maintain its business records as evidence of the prior dealings of the parties. In a majority of circuits, a chapter 11 debtor now has only two years from the date of the bankruptcy filing to commence a preference action and perhaps an additional two years should the case convert to chapter 7. This time span requires maintaining accurate files for several years to prevent the risk of losing the defense.

Scott E. Blakeley is an attorney in the Los Angeles office of Bronson, Bronson & McKinnon where he practices exclusively in the area of bankruptcy and creditors' rights law.
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Title Annotation:Business Law; 'ordinary course of business' exception to trustee recovery powers; implications of ruling of Ninth Circuit Court of Appeals
Author:Blakeley, Scott E.
Publication:Business Credit
Article Type:Column
Date:Feb 1, 1995
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