In theory, Bankruptcy Code Section 547 promotes the most noble of interests, ensuring equality among creditors by permitting the "avoidance" of those pre-bankruptcy transfers uniquely preferring one claimant to the detriment of others. The Code accomplishes this egalitarian goal first by allowing an insolvent debtor to avoid those pre-bankruptcy transfers to creditors which were made on account of pre-existing debt, to the extent that those transfers allowed the creditor to receive more than it would if the debtor were liquidated under Chapter 7 of the Code. By virtue of this broad proscription, nearly any payment tendered by an insolvent debtor within 90 days of filing may potentially be avoided by the debtor, if it resulted in the creditor advancing his position.
In order to restrict the wide reach of preference law's application, the Bankruptcy Code then sets forth an array of affirmative defenses that, if successfully established, will insulate the transferee from avoidance liability. As one might expect, each of these various defenses finds anchoring in its own set of policy initiatives, just as each is subject to its own unique criteria.
From a theoretical standpoint, the most compelling of these defenses seems to lie within Code Section 547(c)(2), which deems non-avoidable any transfer: (i) made in payment of a debt incurred in the ordinary course of affairs for the debtor and the transferee; (ii) made in the ordinary course of business or financial affairs of both the debtor and the transferee; and (iii) made according to ordinary business terms. Commonly known as the "ordinary course" defense, this exception ensures that the license granted under Section 547 will stay true to its mission -- recovering only those transfers that reflect a deviation from the norm, and, as a result, an inequitable preference.
Of Section 547(c)(2)'s three requirements, case law applying the second standard of "payment in the ordinary course" furnishes the most insight into the defense itself. It has, for example, become widely accepted that placing the debtor on a C.O.D. basis just prior to bankruptcy, or changing the billing cycle of the subject account, will prevent a creditor from obtaining the benefits of a Section 547(c)(2) defense. As these cases instruct, no creditor may be said to have continued its "ordinary course of business" in light of such affirmative action.
But what if the creditor maintains the status quo? Given the fundamental policy of Section 547(c), and the examples discussed above, a creditor that in no way changes its manner of dealing with the debtor before bankruptcy surely must be permitted to cloak itself in the protections of the "ordinary course of business" defense. Right?
Not necessarily. Consider the Eighth Circuit's recent holding in Central Hardware Co., Inc. v. Sherwin-Williams Co. (In re Spirit Holding Co., Inc.), No. 97-4353 (8th Cir. Aug. 28, 1998). In Central Hardware, the subsidiary company had an established pattern of buying its paint from the supplier and paying by check upon receipt of an invoice. In keeping with that custom, the subsidiary mailed the supplier a check in payment of its then-outstanding invoices. One day later, the subsidiary's parent filed a bankruptcy petition. On the next day, the subsidiary called the supplier to inquire if the check had arrived, only to discover that it had not. After again contacting the supplier, the subsidiary announced that it would make payment by alternate means, and then wired funds in substitute for the original check. Four days later, the subsidiary commenced its own bankruptcy case.
In the wake of the subsidiary's filing, the bankruptcy trustee commenced an action against the supplier to recover the previously wired funds. Under Section 547(c)(2)'s "ordinary course" defense, the bankruptcy court granted summary judgment in the supplier's favor. The district court reversed, and the case was appealed to the United States Court of Appeals for the Eighth Circuit. Disposition of the appeal hinged upon whether the supplier could satisfy Section 547(c)(2)(B), namely, whether the transfer received by it had come in the "ordinary course of business."
Acknowledging that the supplier had not deviated from its standard mode of dealing with the debtor, the Eighth Circuit cautioned that this fact only meant that the supplier's collection efforts were not extraordinary. Looking to the subsidiary's pattern of conduct, however, the Court found nothing to suggest an ordinary practice of issuing checks to the supplier and then sending wire transfers in their stead. Indeed, the fact that this substitution had taken place between the parent's and the subsidiary's bankruptcy filings led the Court to only one conclusion -- the wire transfer represented a sufficient enough deviation from past dealings that it could not qualify as a payment made in the "ordinary course of business." The mere fact that no unusual collection efforts had been employed by the supplier did nothing to ensure the ordinariness of the transfer.
Central Hardware undoubtedly adds another dimension to preference analysis in bankruptcy, and it likewise has dramatic implications for pre-bankruptcy planning to be exercised by companies in distress.