The "New and Improved" Ordinary Course Of Business Defense - The Most Common Defense to a Bankruptcy Preference Action

Bankruptcy is a topic that successful businesses normally do not need to discuss. That is, of course, unless the business is dragged into a bankruptcy case, as a creditor, after one of its clients or customers files for bankruptcy. This is a surprisingly frequent, and aggravating, situation where a bankruptcy trustee sues a business for "preferences" seeking to recapture those payments made by the debtor within the 90-day period prior to the debtor's bankruptcy petition.

However, the recently enacted Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the "Reform Act") has provided defendants with greater protection against a bankruptcy trustee's preference avoidance powers with one seemingly minor change - replacing the word "and" with the word "or" in the ordinary course of business defense. The bottom line - this affirmative defense should be easier and less expensive to prove as the Reform Act only requires 2 of the prior 3 elements to be established.

Under the prior law, Section 547(c)(2) of the Bankruptcy Code¹, a preference defendant could escape liability to the extent it could establish that a transfer was:

1. in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee;
2. made in the ordinary course of business or financial affairs of the debtor and the transferee; and
3. made according to ordinary business terms.

To a great extent, the courts construed this provision to require a defendant to establish not only that the debt and payment were made in the ordinary course of business between the parties, but also that the transfer was ordinary or typical in the related industry at large. Under the current law as amended by the Reform Act, a defendant is no longer required to establish that the transfer was ordinary in the industry. As amended, the ordinary course of business defense shields a defendant from preference liability to the extent that such transfer was:

1. in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and
2. made in the ordinary course of business or financial affairs of the debtor and the transferee, or
3. made according to ordinary business terms.

This "new and improved" defense will allow preference defendants more opportunities to assert it, as a defendant need only prove that the transfer was ordinary as between the parties. The revised defense should also reduce the cost of defending a preference action, since it is no longer necessary to produce expert testimony regarding ordinary industry standards. Moreover, the debate over whether expert testimony is even required to prove industry standards will not materialize so long as a defendant can show that the transfer was made in the ordinary course of business of the debtor and the transferee. While your business may not deal regularly with bankruptcy issues, you should not overlook Congress' "new and improved" ordinary course of business defense and you should be prepared to take advantage of it.