Restructuring

Contributed by Christopher Hopkins
Parties to a preference action must be aware of, and understand the differences between, the two approaches available to creditors raising a section 547(c)(2) ordinary course defense. The “subjective test” of section 547(c)(2)(A) provides that a preference may not be avoided if the creditor received the transfer in the ordinary course of the debtor’s business. The “objective test” of section 547(c)(2)(B), on the other hand, provides that a preference may not be avoided if the creditor received the transfer in accordance with “ordinary business terms.” Pre-BAPCPA, creditors did not have the luxury of proving either subjective or objective ordinariness under section 547(c)(2) of the Bankruptcy Code—they had to prove both. But in 2005, Congress amended section 547(c)(2) and rendered the test disjunctive, allowing a creditor to prevail under section 547(c)(2) if the transfer at issue met either the subjective test of subsection (A) or the objective test of subsection (B).
Providing creditors two separate measures of ordinariness when defending preference actions under section 547(c)(2) furthers the two-fold purpose of preference law: to promote equitable treatment of creditors and to discourage creditors from forcing distressed businesses into bankruptcy. In particular, the “objective test” provides creditors the flexibility and encouragement to continue to do business with a distressed entity. The disjunctive nature of section 547(c)(2) permits creditors to alter the parties’ past payment history—within industry norms—without risking avoidance under section 547(b). Absent this protection, a creditor would be locked into the parties’ past payment history and would be unable to adjust the distressed entity’s payment terms out of a fear that such accommodations would constitute an avoidable preference.
For all its benefits, the disjunctive character of section 547(c)(2) does contain traps for the unwary. If a party to a preference action mistakes or conflates the requirements of 547(c)(2)(A) and (B), the consequences can be severe. Both creditors and debtors must be aware of the differing methodologies employed by courts in determining whether an individual transaction meets the necessary “ordinariness” of either test. As noted by the Bankruptcy Court for the Southern District of New York’s recent decision in Pereira v. United Parcel Serv. of Am., Inc. (In re Waterford Wedgwood, Inc.), however, there is no “consensus in the case law” in the Second Circuit concerning the proper methodology for determining whether a particular transfer comports with industry practices under section 547(c)(2)(B).
In re Pereira
In Pereira, the chapter 7 trustee brought a preference action to recover certain payments made to UPS by the debtors. UPS conceded that the payments were preferences, but argued that the transfers could not be avoided because they were made in accordance with ordinary business terms pursuant to section 547(c)(2)(B). To support its claim, UPS presented evidence collected by credit monitoring services that showed the average payment collection times for forty similarly-situated domestic shippers. After rejecting the top and bottom five percent of the data set as outliers, UPS applied the “total range” method and concluded that the normal industry range for the periods in question was 14–70 days. UPS argued that because it received the transfers from the debtor on dates within this range, the transfers occurred in accordance with ordinary business terms and could not be avoided.
In response, the trustee contested section 547(c)(2)(B)’s applicability and scope. First, the trustee argued that section 547(c)(2)(B) could not apply to the transfers at issue because there were fluctuations in the parties’ payment history that showed that the debtors accelerated payments to UPS leading up to key prepetition events within the preference period. Second, the trustee took issue with UPS’s use of the “total range” method on the grounds that accepting 90% of the data set as being the “industry norm” was overly inclusive and outside the scope of section 547(c)(2)(B). The trustee argued that UPS should have used a single standard deviation from the mean to establish the acceptable range—which would have resulted in a more conservative range of 30 to 54 days.
Making the right argument
The court made short work of the trustee’s arguments concerning the applicability of section 547(c)(2)(B), finding that the trustee’s consideration of the parties’ payment history over time or the debtor’s stated policy was inapposite and improperly conflated the objective and subjective elements of section 547(c)(2). The question of whether the payments were received in accordance with ordinary business terms depends on whether the particular transfers in question comport with the standard conduct of the industry. Because the focus of this test is the industry standard, the historical experience between the debtors and UPS is of little or no import under the objective test. As the court noted, “if the court adopted the trustee’s reasoning, it would ensure that any late payment would be a transfer outside of ordinary business terms—rendering the defense useless.” By failing to understand the differences between the two prongs of section 547(c)(2)—or the effect of BAPCPA in making the test disjunctive—the trustee made arguments largely irrelevant to the applicability of section 547(c)(2)(B).
The scope of the objective test
After noting that there was no “consensus in the case law” concerning the appropriate methodology for a section 547(c)(2)(B) analysis, the court looked to the methods used in assessing ordinariness under section 547(c)(2)(A)’s subjective standard. The court explained that the settled methodology for subsection (A)’s subjective analysis is to compare the timing of the alleged preferences with the pattern of payments before the preference period to see whether the alleged preferences fit within this pattern. This framework, the court reasoned, should also apply to an objective analysis under section 547(c)(2)(B) because both the subjective and objective tests require a comparison of two data sets over time, and, therefore, it is appropriate to apply the same principles to both tests.
The court then addressed the appropriate scope of the section 547(c)(2)(B) defense. With respect to UPS’s “total range” method described above, the court noted that other courts had criticized the “total range” method as being overly inclusive by expanding the range of ordinary transactions to include industry outliers that skew the analysis of what is ordinary. Further, the court expressed skepticism concerning UPS’s inclusion of 90% of the range absent any justification as to why the 90% figure was reasonable.
Turning to the trustee’s proposal, the court found the standard deviation approach to be consistent with the approach generally utilized by courts applying the subjective test. The court was ultimately persuaded by the statistical soundness of the trustee’s approach, especially when compared to UPS’s reliance on “naked, unweighted averages.” As a result, the court held that the proper method for assessing whether a transfer is made in accordance with ordinary business terms is to determine whether the transfer occurred within one standard deviation of the industry average.
Conclusions
Creditors and debtors should learn from the mistakes the trustee and UPS made. As an initial matter, parties to a preference action must be sure they understand the different inquiries and methodologies involved in asserting a defense under section 547(c)(2)’s objective and subjective prongs. The trustee in Pereira discovered the hard way that missing the mark can have severe consequences. UPS erred in its own right by failing to provide supporting evidence justifying its “total range” analysis.