Ohio Bankruptcy Court Offers Guidance on (the Amended) Ordinary Course Payment Preference Defense
To encourage vendors and other creditors to continue doing business with financially distressed entities, the Bankruptcy Code includes various defenses to litigation brought by a bankruptcy trustee or chapter 11 debtor-in-possession ("DIP") seeking to avoid pre-bankruptcy payments to such entities. One of these defenses shields from avoidance transfers made to pay debts incurred in the ordinary course of business of the debtor and the transferee. Until lawmakers amended the Bankruptcy Code in 2005 as part of the Bankruptcy Abuse Prevention and Consumer Protection Act ("BAPCPA"), transferees seeking to invoke the ordinary course payment defense bore a heavier evidentiary burden because the statutory provision—section 547(c)(2)—required that the transferee prove both that the payment was made in the ordinary course of business of the debtor and the transferee (the "subjective test"), and that the payment was made according to ordinary business terms (the "objective test").
The U.S. Bankruptcy Court for the Southern District of Ohio addressed a preference defendant's burden of proof under amended section 547(c)(2) in In re ASPC Corp., 658 B.R. 455 (Bankr. S.D. Ohio 2024). The court granted summary judgment to a creditor in avoidance litigation, ruling that the defendant need only demonstrate that the payment satisfied one—but not both—of the tests stated in section 547(c)(2). According to the bankruptcy court, "[t]his case illustrates the importance of [the 2005 amendment's] replacement of the conjunctive 'and' with the disjunctive 'or' between the subjective and objective tests for the ordinary course of business defense."
The Ordinary Course of Business Payment Defense to Preferential Transfer Avoidance
Section 547(b) of the Bankruptcy Code provides that a trustee or DIP, "based on reasonable due diligence in the circumstances of the case and taking into account a party's known or reasonably knowable affirmative defenses under subsection (c)," may avoid any transfer made by an insolvent debtor within 90 days of a bankruptcy petition filing (or up to one year, if the transferee is an insider) "to or for the benefit of a creditor … for or on account of an antecedent debt," if the creditor, by reason of the transfer, receives more than it would have received in a chapter 7 liquidation and the transfer had not been made. 11 U.S.C. § 547(b).
Section 547(c) sets forth nine defenses or exceptions to preference avoidance. One of those is the "ordinary course payment" defense in section 547(c)(2), which provides as follows:
The trustee may not avoid under this section a transfer … to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was—(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or (B) made according to ordinary business terms….
11 U.S.C. § 547(c)(2).
The ordinary course payment defense was intended to "leave undisturbed normal commercial and financial relationships and protect recurring, customary credit transactions which are incurred and paid in the ordinary course of business of both the debtor and the debtor's transferee." Comm. of Unsecured Creditors of Gregg Appliances v. Curtis Int'l Ltd. (In re hhgregg, Inc.), 636 B.R. 545, 549 (Bankr. S.D. Ind. 2022) (quoting Kleven v. Household Bank, F.S.B., 334 F.3d 638, 642 (7th Cir. 2003)); accord Desmond v. Northern Ocean Liquidating Corp. (In re Nat'l Fish and Seafood, Inc.), 2024 WL 1422665 (Bankr. D. Mass. Apr. 1, 2024); In re Liquidating Est. of H&P, Inc., 648 B.R. 767 (Bankr. W.D. Pa. 2023).
The defense "is formulated to induce creditors to continue dealing with a distressed debtor so as to kindle its chances of survival without a costly detour through, or a humbling ending in, the sticky web of bankruptcy." Fiber Lite Corp. v. Molded Acoustical Prods. (In re Molded Acoustical Prods.), 18 F.3d 217, 219–220 (3d Cir. 1994) (citations omitted); accord Auriga Polymers Inc. v. PMCM2, LLC as Tr. for Beaulieu Liquidating Tr., 40 F.4th 1273, 1288 (11th Cir. 2022) (citing In re BFW Liquidation, LLC, 899 F.3d 1178, 1193 (11th Cir. 2018)). Section 547(c)(2)'s legislative history indicates that its purpose is "to leave undisturbed normal financial relations." H.R. Rep. No. 95-595, at 373 (1977)); see generally Collier on Bankruptcy ("Collier") ¶ 547.04 [2] (16th ed. 2024) ("This section is intended to protect recurring, customary credit transactions that are incurred and paid in the ordinary course of business of the debtor and the debtor's transferee.").
Section 547(c)(2) is an affirmative defense, meaning that the preference defendant bears the burden of proof. See 11 U.S.C. § 547(g); Gulf City Seafoods, Inc. v. Ludwig Shrimp Co., Inc. (In re Gulf City Seafoods, Inc.), 296 F.3d 363, 367 (5th Cir. 2002); In re Liquidating Est. of H&P, Inc., 648 B.R. 767, 790 (Bankr. W.D. Pa. 2023).
Section 547(c)(2) was amended in 2005 as part of BAPCPA. It previously provided as follows:
The trustee may not avoid under this section a transfer … to the extent that such transfer was—(A) in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee; (B) made in the ordinary course of business or financial affairs of the debtor and the transferee; and (C) made according to ordinary business terms.
11 U.S.C. § 547(c)(2) (amended in 2005) (emphasis added).
The 2005 amendments made successful invocation of the ordinary course payment defense considerably easier. A transferee still must demonstrate that a challenged transfer was "in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee." However, under amended section 547(c)(2), a transferee's additional evidentiary burden is limited to proving either: (i) that the transfer was made "in the ordinary course of business or financial affairs of the debtor and the transferee"; or (ii) that the transfer was made according to "ordinary business terms." See Baumgart v. Savani Props. (In re Murphy), 2021 WL 2524946 at *2 (Bankr. N.D. Ohio Apr. 19, 2021).
Prior to the 2005 amendments, a preference defendant was required to prove both (i) and (ii) to successfully invoke the defense. Because the language of those alternatives remains unchanged, pre-2005 amendment case law interpreting the meaning of the provisions is still relevant. See generally Collier at ¶ 547.04 [2] (citing cases); see Pirinate Consulting Group. v. Maryland Dep't of Env't (In re Newpage Corp.), 555 B.R. 444, 452 (Bankr. D. Del. 2016); Pereira v. United Parcel Serv. Of Am., Inc. (In re Waterford Wedgewood USA, Inc.), 508 B.R, 821, 827 (Bankr. S.D.N.Y. 2014).
The initial element of the ordinary course payment defense requires that the transfer be made to pay a debt incurred by the debtor in the ordinary course of business or financial affairs of both the debtor and the transferee. There is relatively little case law addressing this element of section 547(c)(2), and it is frequently undisputed. See PMC Mktg. Corp., 543 B.R. 345, 357 (B.A.P. 1st Cir. 2016) ("There is no precise legal test to determine whether a preferential transfer was made in the ordinary course of business between the debtor and the creditor.") (citations and internal quotation marks omitted); Collier at ¶ 547.04 [2][i] (noting that "[m]ost courts assume this requirement is met by inferring from the evidence that there was nothing 'unusual' about the transactions underlying the preferential payment").
Section 547(c)(2)(A) creates a "subjective test," whereas section 547(c)(2)(B) establishes an "objective test." The former is an "inherently fact-intensive inquiry, aimed at determining whether the transfer at issue conformed with the 'normal payment practice between the parties.'" In re Diversified Mercury Commc'ns, LLC, 646 B.R. 403, 412 (Bankr. D. Del. 2022) (citing In re Am. Home Mortg. Holdings, Inc., 476 B.R. 124, 135 (Bankr. D. Del. 2012); Stanziale v. Superior Tech. Res., Inc. (In re Powerwave Techs., Inc.), 2017 WL 1373252, at *4 (Bankr. D. Del. Apr. 13, 2017)); accord Faulkner v. Broadway Festivals, Inc. (In re Reagor-Dykes Motors, LP), 2022 WL 120199, at *5 (Bankr. N.D. Tex. Jan. 12, 2022).
In applying the subjective test, some courts consider the following factors:
(1) the length of time the parties engaged in the type of dealings at issue; (2) whether the subject transfers were in an amount more than usually paid; (3) whether payments at issue were tendered in a manner different from previous payments; (4) whether there appears to have been an unusual action by the debtor or creditor to collect on or pay the debt; and (5) whether the creditor did anything to gain an advantage (such as additional security) in light of the debtor's deteriorating condition.
Diversified Mercury, 646 B.R. at 412 (citing FBI Wind Down, Inc. v. Careers USA, Inc. (In re FBI Wind Down, Inc.), 614 B.R. 460, 487 (Bankr. D. Del. 2020); accord Hechinger Inv. Co. v. Universal Forest Prods., Inc. (In re Hechinger Inv. Co.), 489 F.3d 568, 578 (3d Cir. 2007); In re Gaines, 502 B.R. 633, 641 (Bankr. N.D. Ga. 2013).
By contrast, the objective test examines whether a challenged transfer was "ordinary in the industry." Reagor-Dykes, 2022 WL 2046144, at *14; accord H&P, 648 B.R. at 790; In re Whistler Energy II, LLC, 608 B.R. 655, 662 (Bankr. E.D. La. 2019). For example, the U.S. Court of Appeals for the Sixth Circuit has held that, for purposes of the objective test, "'ordinary business terms' means that the transaction was not so unusual as to render it an aberration in the relevant industry." Luper v. Columbia Gas of Ohio, Inc. (In re Carled, Inc.), 91 F.3d 811. 818 (6th Cir. 1996).
In applying the objective test, every federal circuit court that has addressed the issue has concluded that the phrase "ordinary business terms" in section 547(c)(2)(B) refers to the practices in the preference defendant's industry. See Miller v. Fla. Mining & Materials (In re A.W. & Associates, Inc.), 136 F.3d 1439, 1443 (11th Cir. 1998); Fiber Lite Corp. v. Molded Acoustical Prods., Inc. (In re Molded Acoustical Prods., Inc.), 18 F.3d 217, 220 (3d Cir. 1994); In re Tolona Pizza Prods. Corp., 3 F.3d 1029, 1033 (7th Cir. 1993).
ASPC
Before it filed for chapter 11 protection on May 1, 2018, in the Southern District of Ohio, ASPC Corp., formerly known as AcuSport Corp. ("AcuSport"), was an authorized distributer of firearms manufactured by Sturm Ruger & Co., Inc. ("Ruger"). During the 90-day period preceding its bankruptcy filing, AcuSport made several wire transfers to Ruger totaling more than $3 million for firearms shipped to AcuSport under distribution agreements.
In 2020, the trustee of a creditor trust established under AcuSport's liquidating chapter 11 plan sued Ruger seeking, among other things, to avoid the payments as preferential transfers.
Ruger moved for summary judgment in the avoidance litigation, arguing that AcuSport made the payments according to ordinary business terms and that the challenged transfers were shielded from avoidance under section 547(c)(2). Both parties agreed that the transfers were made in the ordinary course of business. Ruger's motion for summary judgment relied only on the objective test, contending that the transfers were "made according to ordinary business terms."
To support its affirmative defense, Ruger presented expert testimony regarding payment practices from both retailers and wholesalers like AcuSport to manufacturers in Ruger's small firearms manufacturing industry. It also claimed that the bankruptcy court should determine whether the challenged transfers were made according to ordinary business terms based on the number of days AcuSport's invoices remained unpaid compared to a range of days that invoices were typically outstanding in the relevant industry.
According to Ruger, with one exception, AcuSport paid Ruger's invoices within 42–56 days after their issuance, which was well within ordinary payment ranges in the small firearms manufacturing industry. AcuSport made only one payment outside the range—approximately $3,500—which AcuSport paid 74 days after its receipt of the invoice.
In opposing summary judgment, the trustee did not produce his own expert, but instead countered that Ruger should also have presented evidence of payments made by companies in AcuSport's durable goods wholesalers industry. He also argued that the court should focus on evidence other than the duration of outstanding invoices, including how other firearms manufacturers adjust credit limits, as compared to how Ruger adjusted AcuSport's credit limit during the 90-day preference period.
The Bankruptcy Court's Ruling
The bankruptcy court awarded summary judgment in favor of Ruger.
At the outset of his analysis, Chief U.S. Bankruptcy Judge John E. Hoffman, Jr. examined the history and purpose of section 547(c)(2), explaining that "[the 2005 amendment] did not change the subjective or objective tests themselves, but made it so a preference defendant need only prove that a transfer satisfies either of the two tests—not both." ASPC, 658 B.R. at 465.
Judge Hoffman emphasized that the Sixth Circuit gives preference defendants "considerable latitude" in defining the relevant industry for purposes of section 547(c)(2), and agreed with Ruger that its industry, as the recipient of the allegedly preferential transfer, was the relevant industry. He characterized the trustee's contention to the contrary as "a non-starter" because, among other things, the cases relied on by the trustee—two Sixth Circuit (and therefore precedential) rulings—did not support using the debtor-transferor's industry to assess ordinariness. Id. (citing Logan v. Basic Distrib. Corp. (In re Fred Hawes Org., Inc.), 957 F.2d 239 (6th Cir. 1992); First Fed. of Mich. v. Barrow, 878 F.2d 912 (6th Cir. 1989)).
Moreover, Judge Hoffman noted, the one decision relied on by the trustee that did hold that the debtor's industry is the touchstone of ordinariness under section 547(c)(2)—Shodeen v. Airline Software, Inc. (In re Access Air, Inc.), 314 B.R. 386 (B.A.P. 8th Cir. 2004)—had already been rejected by a bankruptcy court in a neighboring circuit and would not be followed by his court. Id. (citing US Bank Nat'l Ass'n (In re Interstate Bakeries Corp.), 499 B.R. 376, 388 n.7 (Bankr. W.D. Mo. 2013) (disagreeing with Access Air).
Instead, Judge Hoffman explained, "Sixth Circuit law is consistent with selecting Ruger's (i.e., the defendant/transferee's) industry as the relevant industry for assessing whether the Transfers satisfy the objective test for the ordinary course of business defense." Id. at 466. Specifically, he noted, the Sixth Circuit in Fred Hawes stated that the transferor's "payment practices were in accordance with those of the [the defendant's] overall customer base," indicating that ordinariness should be determined by reference to the preference defendant's industry. Id. (citing Fred Hawes, 957 F.2d at 246) (internal quotation marks omitted). He further noted that every other circuit to consider the question has reached the same conclusion. Id. (citing Tolona Pizza, 3 F.3d at 1033; A.W. & Associates, 136 F.3d 1441; Molded Acoustical, 18 F.3d at 220).
Judge Hoffman found no fault with Ruger's analysis concerning the timing of payments in assessing the ordinariness of the transfers made by AcuSport. He also noted that the information regarding whether changes to AcuSport's credit limits by Ruger during the preference period were ordinary course (and clearly relevant to the subjective test) was not readily available and "would saddle Ruger (and any other creditor defending a preference action) with the burden of producing 'information that the competitors oft will be reluctant to yield and that frequently the creditor will find difficult to obtain.'" Id. at 468 (quoting Molded Acoustical, 18 F.3d at 224).
The bankruptcy court accordingly ruled that the trustee failed to raise any genuine issues of material fact that would preclude summary judgment in favor of Ruger on its preference defense claim under section 547(c)(2)(B) with respect to all transfers other than the $3,500 paid by AcuSport 74 days after its receipt of an invoice from Ruger. Most of the trustee's evidence, he explained, was directed to the subjective test for ordinariness under section 547(c)((2)(A) rather than the objective test under section 547(c)(2)(B)—only one of which Ruger needed to satisfy to escape preference liability.
According to Judge Hoffman, "[t]his case illustrates the importance of [the 2005 amendment's] replacement of the conjunctive 'and' with the disjunctive 'or' between the subjective and objective tests for the ordinary course of business defense." Id. at 470. He also noted in dicta that, because there appeared to have been a change in the way that Ruger dealt with AcuSport before and during the preference period regarding credit limits, Ruger likely would not have been able to satisfy the pre-2005 version of section 547(c)(2).
Outlook
Congress eased preference transferees' evidentiary burden considerably under the ordinary course payment defense when it amended section 547(c)(2) in 2005. As illustrated by ASPC, a transferee now need satisfy only one of the alternative tests stated in the provision to shield payments made during the preference period from avoidance. To be sure, because section 547(c)(2) is an affirmative defense, it is still incumbent on a preference defendant to introduce evidence sufficient to establish that either the subjective test or the objective defense has been satisfied. In addition, the trustee or DIP should be prepared to counter the transferee's evidence concerning the course of dealing between the parties and ordinary industry standards with its own evidence and expert testimony—a deficiency that was highlighted repeatedly by the bankruptcy court in ASPC. Another key takeaway from the ruling is that, at least in the Sixth Circuit, preference defendants are given considerable latitude in defining the "relevant industry" for purposes of the ordinary course payment defense.
