Payments made by a debtor within 90 days of a bankruptcy petition are generally avoidable as preferences under section 547 of the Bankruptcy Code.  Many exceptions and defenses exist, however, to ensure that creditors are not discouraged from conducting business with companies that may be at risk of filing for bankruptcy.  Section 547(c)(2) creates one such exception, exempting transfers made in the ordinary course of business from avoidance.  In the recent case of Jubber v. SMC Electrical Products Inc. (In re C.W. Mining Co.), the United States Court of Appeals for the Tenth Circuit weighed in on an open question regarding the exception: can a first-time transaction between a debtor and a transferee fall within the ordinary course of business exception?  The court held that it could, relying both on the language of the statute and the policy underlying exceptions to the avoidance power. 

Background

In C.W. Mining, the debtor entered into a purchase agreement with SMC Electrical Products, Inc., a company with which it had never previously contracted, months before certain of its creditors filed an involuntary petition.  The chapter 7 trustee sought to avoid the debtor’s first payment under the agreement, which occurred less than 90 days before the petition date, as a preference.  The United States Bankruptcy Court for the District of Utah rejected the trustee’s claim, and the Tenth Circuit Bankruptcy Appellate Panel affirmed, both on the basis that the debtor incurred the debt and made the payment in the ordinary course of business.  The trustee appealed to the Tenth Circuit.

The Ordinary Course of Business Exception

The court first outlined the purpose of section 547 of the Bankruptcy Code and the exceptions thereto, explaining that under section 547(c)(2), a trustee may not avoid a transfer made to pay a debt incurred in the ordinary course of business or financial affairs of the debtor and the transferee when “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.”  Although this exception may clash with the Bankruptcy Code’s policy of equal treatment of creditors by favoring transferees, the court noted that allowing a company facing bankruptcy to continue its normal financial relations “may benefit all creditors by deterring the ‘race to the courthouse’ and enabling the struggling debtor to continue operating its business.”

Around the Circuits

The court next examined different interpretations of the exception.  Acknowledging a split in authority, the court explained that some bankruptcy courts have held that the incurrence of the debt in question must be in the ordinary course of business between the debtor and the transferee, which would make any first-time transaction ineligible for the exception because no prior course of dealing could exist.  The Tenth Circuit instead agreed with the approach of the SixthSeventh, and Ninth Circuits, which have held that first-time transfers can qualify under the ordinary course of business exception because the statute refers explicitly to the affairs of the debtor and transferee, not between the debtor and transferee.

In addition to the statutory language, the Tenth Circuit relied on the purpose of the ordinary course of business exception to support its holding.  The court cited the Ninth Circuit’s statement that Congress intended to protect normal financial relations – not just well-established financial relations – because doing so “does not detract from the general policy of the preference section to discourage unusual action by either the debtors or his creditors during the debtor’s slide into bankruptcy.”  The court also agreed with the Seventh Circuit’s statement that potential creditors would be discouraged from providing funds to companies facing bankruptcy if they were prohibited from even raising the ordinary course of business defense in the event of an avoidance action.  Finally, the court considered the argument that 547(c)(2)(B) – which exempts transfers made “according to ordinary business terms” – is superfluous if section 547(c)(2)(A) can be satisfied by looking at the ordinary course of business of each party independently.  The court distinguished the two subsections by noting that subsection (A) examines “what is ordinary in each party’s respective practices,” while subsection (B) accounts for “what is ordinary in the relevant industry.”

With respect to whether a payment is made in the ordinary course of business, the opinion notes that courts usually consider a variety of factors pertaining to the circumstances under which the payment was made.  In the event of a first-time transaction, however, the Tenth Circuit held that the court may refer solely to the written terms of the transaction and that a payment made shortly before or at the due date is generally in the ordinary course of business.

Upholding the Transfer

In this case, the court held that C.W. Mining’s debt was incurred in the ordinary course of business because the undisputed purpose of the purchase was to assist in the debtor’s business operations.  The court also held that the debt was paid in the ordinary course of business because the payment was made two days before its due date, from C.W. Mining’s bank account, and with no evidence of collection activity by SMC.

Conclusion: Limits on the Rule

Although the Tenth Circuit joins a growing number of courts allowing first-time exceptions to qualify for the ordinary course of business exception, the court noted that the exception has “real teeth.”  For example, incurring debt for a risky project – such as a last-resort effort to save a company – that will only harm creditors if it fails is not the type of transaction that will be protected by the ordinary course of business exception.  A debtor’s motivation for entering into the transaction is thus a determinative factor in the application of the exception.  It will be interesting to see how courts that agree with the Tenth Circuit’s approach make the ordinary course determination in first time transactions.