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Defending Preferential Transfers: The Ordinary Business Terms Defense- Part IV: Proving up the Ordinary Business Terms Defense

Once a debtor or trustee establishes a transfer is a preferential transfer, the burden falls upon the creditor to establish one or more of the defenses to avoidance set forth in Bankruptcy Code section 547(c), such as the "ordinary business terms" defense set forth in Bankruptcy Code section 547(c)(2)(B).

Defining the Relevant Industry

Recent case authority confirms that today's ordinary business terms test focuses on whether preferential transfers are consistent with “industry norms” prevailing at the time the transfers were made.  However, courts approach the objective test from inconsistent perspectives, and a frequent point of controversy is "what is the relevant industry"?  Some courts require a transferee to demonstrate that transfers are consistent with the business terms prevailing within the debtor's industry, whereas other courts require the transferee to show that the transfers were consistent with terms prevailing in the creditor's industry.  At least one court appears to require that the transfers be consistent with three industry standards - namely the debtor’s industry, the creditor’s industry, and business generally.  Courts also differ on whether credit terms specifically tailored to companies in distress can be considered "ordinary business terms."  This lack of a clear direction on the applicable industry creates risk, and motivates parties to negotiate a settlement.

Generally speaking, courts will define the relevant industry by looking to (i) credit practices between suppliers to whom a debtor might reasonably turn for its inventory, and (ii) companies with whom the debtor competes (i.e., credit practices of a creditor's competitors, and credit practices of a debtor's competitors).  For an industry standard to be useful as a rough benchmark, the creditor should be able to provide proof of the credit arrangements of other debtors and creditors in a similar market, preferably in terms of both geography and product.

Establishing Industry Business Practices

Expert testimony is useful, but not necessary, in establishing the prevailing terms in an industry.  Lay testimony can also be acceptable.  Note that an "expert" is simply a person with specialized experience or knowledge in a particular industry.  Many of the people reading this article might be shown to be "experts."  Through either expert or lay testimony, a defendant must provide admissible, non-hearsay testimony related to industry credit, payment and general business terms in order to support the defendant's position.

Employees of a defendant-transferee may testify in an effort to show transfers were made according to "ordinary business terms.”  However, the witness must: 1) have specific knowledge of its competitors' practices during the preference period, and 2) have obtained the information objectively, i.e., outside his or her subjective experiences as an employee of the creditor/defendant.  Such information might also be obtained from credit industry trade sources, such as Dunn & Bradstreet, Credit Research Foundation, Risk Management Association, and others.  The creditor must then present evidence of its competitor's receivables and collection practices, and of the actual payment practices of the defendant's competitors' customers.

A creditor might also offer a mix of expert and lay testimony to prove the ordinary business terms defense.  For example, in In re American Home Mortgage Holdings, Inc., one Delaware bankruptcy case, the expert for a staffing agency preference defendant provided unrefuted testimony that he had at least two other clients that were the agency's direct competitors, and that the agency's invoices and the debtor's payments were not out of the ordinary for the industry.  The debtor's own chief executive officer then testified that the agency's receivable payment history with the debtor was representative of the industry.

Next time:  Part V – Failures using the Ordinary Business Terms Defense