In bankruptcies, a debtor or trustee may claw back legitimate payments the debtor made to its creditors within 90 days prior to filing of bankruptcy. In general terms, a preference claim is a transfer made (a) to or for the benefit of a creditor; (b) for or on account of antecedent debt owed by the debtor; (c) while the debtor was insolvent (liabilities exceed assets); (d) within 90 days before the bankruptcy petition was filed or one year if made to an insider; (e) such that it allows the creditor to receive more than it would have received if the debtor had not made the payment and the claim was paid through the bankruptcy process.
Subjective and Objective Prongs of the Ordinary Course of Business Defense
There are several defenses to a preference action, one of which is commonly referred to as the ordinary course of business defense. Essentially, the ordinary course of business defense protects a transfer if made in the ordinary course of business or financial affairs of the debtor and the transferee, known as the subjective prong of the ordinary course of business defense, or made according to ordinary business terms within the industry, known as the objective prong of the ordinary course of business defense. The transferee can try to prove one or the other.
Subjective Prong
As to the subjective prong, the transferee has the burden of showing that the pre-bankruptcy payment history was similar to the payment history of the preference payments made within 90 days of bankruptcy. As part of this analysis, courts will consider some or all of these factors: (i) the length of time the parties were engaged in the type of dealing at issue; (ii) whether the amounts of the alleged preferential transfers were larger than prior payments; (iii) whether the payments were tendered in a manner different from previous payments; (iv) whether there was any unusual action by either the debtor or the creditor to collect or pay the debt; and (v) whether the creditor did anything to gain an advantage in light of the debtor’s deteriorating financial condition.
Objective Prong
As to the objective prong, the transferee has the burden of showing that the payment or other transfer was made according to “ordinary business terms.” Though “ordinary business terms” is not defined in the Bankruptcy Code, courts generally require the transferee to show that the transfer was consistent with payments made in the creditor’s industry, the debtor’s industry, or some combination of both industries.
FI Liquidating Trust and Ordinary Course of Business Defense
In FI Liquidating Trust v. C.H. Robinson Co., (In re Fred’s Inc.), No. 21-51065, 2025 Bankr. LEXIS 63 (Bankr. D. Del. Jan. 15, 2025), the issue addressed by the bankruptcy court was whether the pressure the creditor applied on the debtor was consistent with the objective prong of ordinary course of business defense. There the creditor tightened credit terms imposing “credit pressure” and at one point, the creditor held up a shipment until the debtor wired $500,000.00.
First of all, the bankruptcy judge correctly noted the ordinary course of business defense “is intended to encourage creditors to continue to deal with distressed companies on ordinary terms.”
Even though the credit manager for the creditor testified that it is typical in the industry to put credit holds on delinquent or financially troubled creditors, the bankruptcy judge, relying on the Third Circuit Court of Appeals, In re Molded Acoustical Prods. Inc., 18 F.3d 217, 227 (3d Cir. 1994), noted that the ordinary course of business objective prong is not measured by dealings with financially troubled debtors but instead is determinative of dealings with financially healthy debtors.
Whether one wants to use the subjective prong of the ordinary course by undertaking a statistical analysis of the credit and payment history between the debtor and creditor, or the objective prong by establishing the industry practice, the placement of pressure on the debtor to pay its debts could be detrimental when and if the debtor files bankruptcy and then seeks to claw back payments made withing 90 days of bankruptcy.
The takeaway: placing pressure of any kind on a delinquent or financially troubled debtor may very well be determinative of whether an ordinary course of business defense is available to the creditor even though it’s common in the industry to place pressure when payments are not received or when the creditor is requested to provide additional goods or services to the debtor.
