Understanding the Ordinary Course of Business
for the Bankruptcy Preference Laws:
What is the industry standard?
By Bradley D. Blakeley

Your company is paid by a customer according to history of the parties. The customer, however, files bankruptcy and the trustee seeks to recapture payments during the 90 days-the preference suit. If you present the payment history of the parties, do you prevail under the ordinary course of business defense? Perhaps not, reasoned the Fifth Circuit Court of Appeals in In re Gulf City Seafoods, Inc., 2002 WL 1362880 (C.A.5-Miss.).

The Bankruptcy Preference

The Bankruptcy Code vests the debtor (or trustee if one is appointed) with far-reaching powers to avoid payments prior to a bankruptcy filing. The power to avoid preferential transfers is one of the most powerful weapons a trustee has. 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, unsecured creditors are discouraged from racing to the courthouse to dismember a debtor, thereby hastening its slide into bankruptcy. Second, a debtor is deterred from preferring certain creditors by the requirement that a creditor that receives a greater payment than similarly situated unsecured creditors disgorge the payment 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 bankruptcy estate previously transferred, the Bankruptcy Code carves out seven exceptions or defenses to the trustee's recovery powers. The most commonly asserted exception by vendors is the ordinary course of business defense.

That defense protects payments, in all or part, received by an unsecured 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: (1) protect customary transactions, and (2) encourage creditors to continue to extend credit to financially troubled debtors, possibly helping the debtor avoid bankruptcy.

To qualify for the ordinary course of business defense, a creditor must establish that the payment is ordinary as between the parties and that the payment is ordinary in relation to prevailing business standards. The court determines a debtor's ordinariness of payments through comparison with prevailing business standards, which includes common terms used by other trade creditors in the same industry facing similar problems. Thus, only transactions between the parties so unusual as to fall outside the broad range of industry practice should be considered non-ordinary under this preference defense.

To establish the ordinary course of business defense, the vendor must not only establish the payments received from the customer during the preference were ordinary with payments prior to the preference period, the vendor may be required to show that the customer's practices are similar, though not necessarily identical, to others in the industry.

The Gulf City court wrestled with how to define the industry from which to compare the industry standard, but ruled:

[F]or an industry standard to be useful as a rough benchmark, the creditor should provide evidence of credit arrangements of other debtors and creditors in a similar market, preferably both geographic and product.

. . . In this case, [the vendor] might provide evidence, to the extent that it is reasonably available, of credit practices between suppliers to whom [debtor] might reasonably turn for its searfood supply and firms with whom [debtor] competes for consumers, from which a bankruptcy judge can determine whether there is some basis to find that the [vendor-debtor] arrangement is not a virtual stranger in the industry.

The Gulf City court considered a case involving a pizza parlor. Is the appropriate industry sellers of sausages to all businesses, just pizza parlors, or suppliers of all pizza supplies? The court reasoned that a vendor has the burden to show the trade practices between suppliers to whom a debtor might reasonably turn for its product for supply, and firms with whom the debtor competes for customers.

This evidence was missing from a vendor's defense in Gulf City, so the case was reversed and remanded to the bankruptcy court.

Reprinted by permission from The Trade Vendor Quarterly Blakeley & Blakeley LLP Fall 02