Restructuring

Contributed by Christopher Hopkins
The power to avoid preferential transfers under section 547 serves two broad purposes: (i) it prevents creditors from exerting undue pressure on struggling debtors, and (ii) it discourages a debtor from engaging in unusual acts that either favor certain creditors or otherwise hasten the debtor’s bankruptcy.  The threat of preference actions can be a double-edged sword, however, chilling creditors’ willingness to maintain normal financial relations with prospective debtors as the likelihood of bankruptcy increases.  To prevent this result, the Bankruptcy Code exempts certain transfers made within the ordinary course of the debtor’s and creditor’s business.
A creditor raising the “ordinary course of business defense” of section 547(c)(2)(A) must show that both the incurrence of the original debt and the allegedly preferential transfer occurred within the ordinary course of business of both the debtor and creditor.  The Bankruptcy Code never defines what the “ordinary course of business” means, leaving it to the courts to answer the question “how ordinary is ordinary?”  Although we previously discussed how courts go about answering this question where there is an established business relationship between the parties, a recent decision by the United States Bankruptcy Appellate Panel for the 10th Circuit in Rushton v. SMC Electrical Products, Inc. (In re C.W. Mining Co.) took up that question where the debtor and creditor engaged in a single purchase transaction and had no prior business relationship.
In C.W. Mining, the chapter 7 trustee brought a preference action against SMC Electrical Products seeking to avoid certain payments SMC received from the debtor, C.W. Mining Company.  Shortly before C.W. was forced into involuntary bankruptcy, it had entered into a purchase agreement with SMC for the purchase, installation, and service of a “longwall” mining system – a type of system C.W. had never used in its operations.  The contract called for C.W. to make “progress payments” at certain milestones, but the contract was otherwise silent as to payment terms except for a provision stating that additional charges could be applied to amounts paid more than 30 days after the invoice date.  After receiving an invoice from SMC, C.W. made five separate payments over a 28-day period.  Following C.W.’s descent into involuntary bankruptcy, the chapter 7 trustee sought to avoid those payments as preferences.
In response, SMC argued that although the payments were preferences, they could not be avoided because they fell within the ordinary course of business exception of section 547(c)(2)(A).  The bankruptcy court ultimately agreed with SMC, finding that both the purchase and the payments occurred within the ordinary course of C.W.’s and SMC’s business.  The trustee subsequently appealed the decision, arguing that the bankruptcy court had erred in its findings.
On appeal, the BAP applied a two-step approach to assessing whether the payments fell within the ordinary course of business defense.  First, the BAP analyzed whether the purchase transaction occurred in the ordinary course of C.W.’s business.  The trustee argued that the purchase was not ordinary because C.W. had never owned or operated a longwall mining system.  But the BAP found the trustee’s focus to be misplaced, stating that, in general, courts analyzing whether a debt was incurred in the ordinary course are concerned with whether the debt was incurred in a typical, arm’s-length transaction.  In other words, the transaction does not have to be common to the debtor or transferee, provided the transaction’s terms are similar to those ordinarily found in comparable transactions.  Because the trustee failed to focus on the relevant inquiry, the BAP upheld the bankruptcy court’s finding that C.W. incurred the debt in the ordinary course of its business.
Next, the BAP looked at whether the individual payments occurred within the ordinary course of business of both SMC and C.W.  As discussed in our earlier post on this issue, in cases where there is an established business relationship between the parties, courts generally look to contract terms and payment history to determine whether the payments were within the ordinary course.  In such cases, payments made early or late as compared to an established historical baseline may be found to be outside the ordinary course of business.  In C.W. Mining, the BAP had no such baseline to look to, so in addition to examining whether the payments complied with the terms of the purchase agreement, the BAP considered whether the manner of C.W.’s payments corresponded with those of SMC’s other customers.
The trustee argued that the payments were outside the ordinary course because C.W. made five separate payments from three different entities, none of which corresponded to either the invoice amount or the progress payment schedule.  In addition, the trustee claimed that because the payments were made on the heels of the entry of a substantial judgment against C.W., the totality of the circumstances surrounding the payments suggested that they were not made within the ordinary course.
The BAP rejected the trustee’s arguments and held that the bankruptcy court was correct in finding that the payments were within the ordinary course of business of C.W. and SMC because SMC’s evidence proved that the payments were made in accordance with both the terms of the purchase agreement and the past practices of SMC’s customers.  In its analysis, the BAP enumerated four factors it would look to when assessing whether payments were made in the ordinary course: (i) the length of time involved in the preference period, (ii) whether the amount or form of payment differed from past practices, (iii) whether there was any unusual or coercive collection activity, and (iv) the overall circumstances under which the transfer was made.  Two factors were particularly important to the BAP’s analysis: C.W.’s manner of payment and SMC’s lack of collection activity.
The BAP found that SMC’s undisputed evidence demonstrated that C.W.’s payments were substantially similar in manner and amount to those of SMC’s past customers.  Because the trustee did not refute SMC’s evidence, the BAP found that the bankruptcy court had not erred in finding that the payments occurred within the ordinary course.  Interestingly, although the court noted that the factors listed above should be measured from the perspective of both the debtor and the creditor, the BAP gave little attention to whether the payments were consistent with C.W.’s past practices.  Instead, the BAP seemed to assume that the payments were made within the ordinary course of C.W.’s business simply because other SMC customers made payments that way.
Further, the BAP placed considerable emphasis on the fact that SMC had not solicited the payments from C.W., noting in particular that SMC had not engaged in any coercive collection methods or provided C.W. with any particular payment instructions.  The BAP indicated that even where the circumstances surrounding a transfer are unusual, the court may nonetheless find the payment to be within the ordinary course if the transferee did nothing to solicit the payment.
The BAP’s holding in C.W. Mining seems to suggest that creditors seeking to prove the “ordinariness” of transfers arising out of a one-off transaction can meet their burden of proof by demonstrating that the transfers occurred in accordance with the typical business practices of similarly situated parties.  Still, given that the BAP applied a four-factor balancing test in reaching its decision, the answer to the question “how ordinary is ordinary?” may still be, “it depends.”