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Aug. 24, 2022

Ordinary course of business defense may protect creditors from preference liability

See more on Ordinary course of business defense may protect creditors from preference liability

Breck E. Milde

Of Counsel, Hopkins & Carley


Breck is of counsel in the firm's San Jose office and a member of the Financial Institutions & Creditors' Rights Practice Group. He has extensive experience with complex litigation matters in state and federal courts, and represents creditors in insolvency matters both outside and within the bankruptcy courts.

Bankruptcy practitioners, particularly those who represent creditors, are well aware of the potential exposure to liability under the preference statute provided in the United States Bankruptcy Code, 11 U.S.C. §547. Given the recent economic climate and increased chances of a recession, attorneys representing creditors should be aware of preference liability exposure, and the applicable defenses. Preference claims are typically brought by bankruptcy trustees who are assigned to represent the bankruptcy estate upon the filing of a bankruptcy case. Preference liability will often be asserted against a creditor who has received a payment on a pre-existing debt within 90 days before the date that a bankruptcy case was filed. The policies supporting the preference statute are (1) to discourage creditors from putting undue pressure on an economically challenged debtor and therefore hastening the debtor's bankruptcy filing, and (2) to equalize distribution of a debtor's assets among all creditors. In effect, preference liability penalizes the diligent creditor who manages to obtain payment from a debtor in preference to other, similarly situated creditors. One defense to preference liability, even though a payment is received during the 90-day preference window, is for payments made in the ordinary course of business or financial affairs of the debtor and creditor, and made in the ordinary course of business, or according to ordinary business terms. 11 U.S.C. §547(c)(2). This "ordinary course" defense recognizes that normal financial relations that do not reflect unusual action by the debtor or creditor prior to the bankruptcy should be left intact. A recent decision arising from a bankruptcy court in the Northern District of Texas, Faulkner v. Broadway Festivals, Inc. (In re Reagor-Dykes Motors, L.P), illustrates a more flexible approach to the ordinary course of business defense. The Texas Bankruptcy Court found in favor of a creditor who was sued by a bankruptcy trustee to avoid a $25,000 preference payment that was received from a debtor that produced a 4th of July festival in 2018. The creditor had provided publicity for the festival. The creditor had also provided the same services the prior year, and was paid long before the July 4 festival in 2017. In 2018, however, the debtor made its payment to the creditor 90 days after the July 4 event. The bankruptcy was filed within 90 days of that payment. The court ruled in favor of the creditor on the ordinary course defense even though there was only a history of two transactions between the parties. The court discussed the two tests for the ordinary course defense. One is the "objective" test, sometimes called the "horizontal" test, which considers what is ordinary in the industry. The other is the "subjective" test, sometimes called the "vertical" test, which focuses on what the past practices between the parties have been. The court rejected one line of cases that held there must be a number of prior transactions between the parties in order to establish an ordinary course "baseline." The court pointed out that the statute does not specifically require an ordinary course between the debtor and the creditor. Considering that the purpose of the preference law is to promote equality of distribution, the court focused on what is ordinary rather than unusual in the larger industry environment. The court noted that there was no unusual conduct between the parties. There was no evidence of pressure, threats or other factors that induced the payment. Further, the evidence showed that the creditor's customers paid over a wide variety of time, sometimes months after the services were performed. With no ordinary course evidence other than the timing of the debtor's 2018 payment differing from the 2017 payment in days and temporal relationship to the festival, the court concluded that the payment at issue was made in the ordinary course, and sustained the creditor's affirmative defense. This case, which is consistent with the approach taken by the Ninth Circuit Court of Appeals, highlights the scope of the ordinary course of business defense when it comes to resisting a trustee's preference claim. The ordinary course defense is one of several preference defenses available in a creditor's counsel's toolkit. When facing a preference claim, this defense, as well as the other statutory defenses, should be considered and asserted if applicable. Breck E. Milde is of counsel at Hopkins & Carley.


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