Bankruptcy Court Clarifies the Ordinary Course of Business
Preference Defense, and Vendor Prevails
By Bradley D. Blakeley

The recent flurry of chapter 11 filings in the State of Delaware has resulted in thousands of vendors finding themselves, like Armenia Coffee Corporation (Armenia), defending preference actions instituted in The First State. Thanks to Judge Judith K. Fitzgerald, vendors now have a brighter line to use in analyzing their ordinary course of business defense. Judge Fitzgerald ruled in favor of Armenia, finding that Armenia had an ordinary course of business defense to the preference action instituted by the debtor, Brothers Gourmet Coffees, Inc. Debtor).

In the preference action, the Debtor sought recovery of eight transfers to Armenia totaling more than $800,000 made in the 90 days prior to the petition date. In response, Armenia filed a motion for summary judgment asserting that seven transfers (one was made by wire transfer and not included in the motion) were made in the ordinary course of business.

The Preference Action and the Ordinary Course of Business Defense

The Bankruptcy Code vests the debtor (or trustee if one is appointed) with far-reaching powers to avoid transfers of assets and monetary transactions 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, vendors are discouraged from racing to the courthouse to dismember a debtor, thereby hastening its slide into bankruptcy. Second, debtors are deterred from preferring certain unsecured creditors by the requirement that any unsecured 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 trade creditors 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.

Ordinary Course Prevails

In its ruling, the Brothers Gourmet Coffee Court first examined whether the transfers were made within the ordinary course of business between the parties (the subjective analysis). The Debtor argued that Armenia stepped up its collection efforts during the preference period such that the payments were not made in the ordinary course of business. The record reflected that prior to the preference period, Armenia made calls to Debtor concerning payment related to 50 percent of its orders, but, during the preference period, called regarding five out of seven orders. However, the Court found that the change was not material.

Additionally, the Debtor admitted that the average time between invoice due date and payment date in the pre-preference period was approximately 32.69 days and the average time between invoice due date and payment date in the preference period was approximately 33.71 days. The Court found that the difference of one day was not material and the payments during the preference period were within the range of payments made in the pre-preference period. Accordingly, the Court found that Armenia met its burden on the issue of the subjective test.

The Court also found the transactions were made according to ordinary business terms (the objective analysis). The Debtor contended that Armenia had not provided any specific data regarding the ordinary business terms in the coffee industry. However, the Court disagreed. Instead, the Court found that Armenia's declarant was an expert whose opinion was offered as to the experience of payment for orders in the coffee industry, and that the transactions between the Debtor and Armenia were ordinary within the industry. The Court found that the Debtor produced no evidence to refute the expert's opinion, and summary judgment was granted on the section 547(c) issues.

As found in Brothers Gourmet Coffee, a small difference between prepreference period and preference period collection practices and timing of payments may not still allow you to prevail on the ordinary course of business defense. The Court provides ammunition for the vendor to negotiate the preference complaint.

Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley LLP Summer 02