What Is the ‘Ordinary Course of Business’ Defense in a Preference Action?

Concept

The Systemic Stabilizer in Financial Distress

Within the intricate architecture of bankruptcy law, the preference action under Section 547 of the U.S. Bankruptcy Code functions as a powerful corrective mechanism. Its primary objective is to enforce the principle of equitable distribution among creditors by permitting a bankruptcy trustee or debtor-in-possession to reclaim certain payments made to creditors within the 90 days preceding a bankruptcy filing (or one year for insiders). This “clawback” provision is designed to dismantle last-minute payment arrangements that favor one creditor over others, ensuring the bankruptcy estate is not unfairly depleted just before the formal proceedings begin. Yet, this corrective power, if applied without nuance, would create a chilling effect on commerce.

Creditors, fearing that any payment received from a struggling company could be later reclaimed, would have a powerful incentive to cease all dealings at the first sign of distress, thereby accelerating the very collapse the system seeks to manage. This is the critical juncture where the ordinary course of business defense intervenes, acting as a systemic stabilizer. It is a legislative acknowledgment that the continuation of normal commercial relationships is vital for economic stability and provides a potential pathway for a distressed company to recover.

The defense, codified in Section 547(c)(2), provides a sanctuary for routine payments, shielding them from avoidance. It operates on a core principle ▴ to protect transactions that are consistent with the established financial relationship between the debtor and creditor, or with the norms of their industry. By doing so, it encourages creditors to continue extending trade credit and providing services to companies navigating financial turbulence, preserving the possibility of a workout or an orderly reorganization. The defense allows a creditor to retain a payment received during the preference period if it can demonstrate that the transaction was part of the normal, ongoing commercial relationship.

Proving this requires a rigorous, evidence-based approach, transforming a history of invoices and payments into a coherent narrative of operational consistency. The creditor carries the full burden of proof, needing to meticulously document and present the case that the disputed payments were, in fact, business as usual.

The ordinary course of business defense is a crucial exception within bankruptcy law that protects routine payments to creditors from being reversed, thereby encouraging continued commerce with financially distressed companies.

The Dual Pathways of Validation

To establish the defense, the Bankruptcy Code provides two distinct analytical pathways. A creditor needs to successfully navigate only one of these paths to shield the payment from being classified as a preference. This structure was a significant change introduced by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which made the defense more accessible by allowing creditors to satisfy either the subjective or the objective test, not both as was previously required.

The first path is the “subjective test,” which examines the specific history between the creditor and the debtor. This analysis is intensely fact-specific and inwardly focused, scrutinizing the pattern of dealings that the two parties established over time. The core question is whether the timing, amount, and manner of the disputed payments are consistent with the parties’ prior course of dealing. It is a historical baseline analysis.

The court looks for a consistent rhythm in the financial relationship, and any deviation from that established pattern during the preference period can weaken the defense. For instance, a sudden shift from net 60 to net 30 payments, or a flurry of payments to clear a large overdue balance after unusual collection efforts, might be viewed as falling outside the subjective ordinary course.

The second path is the “objective test,” which broadens the lens to an industry-wide perspective. This test assesses whether the payment was made according to “ordinary business terms.” Here, the specific history between the debtor and creditor is less important than the prevailing standards and practices within their relevant industry. The inquiry is whether the terms of the transaction, including payment timing and method, conform to the norms of the marketplace. This path is particularly valuable for creditors who may have a short or inconsistent history with the debtor, or even for a first-time transaction.

Successfully mounting a defense under the objective test often requires the testimony of an industry expert who can provide evidence on what constitutes standard practice for companies of similar size and in similar sectors. This expert analysis provides the court with an external benchmark against which the disputed transaction can be measured, determining if it aligns with the broader commercial ecosystem.

Strategy

Constructing a Preemptive Defense Framework

For a creditor, the most effective strategy for leveraging the ordinary course of business defense begins long before a customer files for bankruptcy. It involves architecting a system of record-keeping and accounts receivable management that is inherently designed to produce the evidence needed to satisfy the defense’s stringent requirements. This proactive stance transforms routine business operations into a continuous process of building a potential legal defense. The core of this strategy is consistency.

Every aspect of the credit and collections cycle ▴ from the terms on the initial invoice to the methods used for follow-up on late payments ▴ should be standardized and meticulously documented. This creates a predictable, verifiable pattern that can be later presented to a court as the “ordinary course” of the relationship.

A primary strategic component is the systematic analysis of payment history. Creditors should implement systems to track key metrics for all major customers, such as the average time to payment, the frequency of partial payments, and the typical communication preceding payment. This data provides the baseline for the subjective test. When a customer begins to show signs of financial distress, the creditor’s actions must remain consistent with this established baseline.

For example, if the historical data shows that reminder calls are typically made 15 days after an invoice is past due, this procedure should be maintained. Deviating by making aggressive, daily calls could be interpreted as unusual collection activity, potentially invalidating the defense for any payments received thereafter. The goal is to demonstrate that the creditor’s behavior did not change in response to the debtor’s deteriorating financial condition, but rather followed a pre-existing, uniform protocol.

A creditor’s strategy for the ordinary course defense is built on maintaining and documenting consistent payment practices and communication protocols with a customer, even as that customer approaches financial distress.

Evidence Architecture for the Subjective Test

The subjective test is won or lost on the quality and clarity of the historical data presented. A creditor’s strategy must focus on assembling a comprehensive evidentiary package that paints a clear picture of the business relationship over time. This involves more than just a list of payments. It requires a multi-layered presentation of data that contextualizes the transactions made during the 90-day preference period.

The following elements are central to this strategy:

• Longitudinal Payment Analysis ▴ The creditor must analyze the payment history over a significant period before the preference period, often 1-2 years, to establish a reliable baseline. This analysis should calculate the average payment latency (the time between the invoice date and the payment date) and the range of typical payment times. This historical data is then compared to the payments made during the preference period to demonstrate consistency.
• Consistency in Transaction Size and Frequency ▴ The analysis should show that the amount and frequency of payments during the preference period are comparable to the historical baseline. A sudden shift to smaller, more frequent payments or a single large payment to cover multiple old invoices could be viewed as unusual.
• Documentation of Collection Activities ▴ All communications with the debtor regarding payments must be logged and preserved. This includes emails, call logs, and formal letters. The strategy is to demonstrate that the collection efforts during the preference period were no different in tone, method, or frequency than those employed historically for that customer. Any evidence of escalating pressure or threats can undermine the defense.
• Contractual Terms versus Actual Practice ▴ It is common for the actual payment practices between parties to differ from the formal terms stated on invoices (e.g. invoices state “Net 30” but payments are consistently made in 45-60 days). The strategy is to prove that this deviation was itself the ordinary course. By showing a long history of accepting payments outside the formal terms without taking adverse action, the creditor can argue that this informal arrangement became the de facto ordinary course of business.

Navigating the Objective Industry Standard

When a creditor cannot rely on a long and stable history with the debtor, the strategic focus shifts to the objective test. This is common in cases involving new customers, one-off transactions, or relationships with erratic payment histories. The core strategy here is to define the relevant “industry” as favorably as possible and procure expert testimony to validate the payment terms as standard within that industry.

The first step is to carefully define the market. Is the industry defined by the debtor’s business, the creditor’s business, or a specific niche they both occupy? A creditor will strategically argue for the definition that best aligns with the payment practices in question. For example, if a small software provider was paid in 90 days by a large manufacturing debtor, it might argue that the relevant industry standard is “large manufacturing procurement practices,” where longer payment terms are common, rather than “software sales,” where terms might be shorter.

The selection of an expert witness is the most critical part of this strategy. The expert must have deep, verifiable experience in the chosen industry and be able to provide a robust analysis of common business terms. Their testimony will typically involve:

• Defining Industry Norms ▴ The expert will establish a range of common payment terms and practices for similar transactions in the industry.
• Comparative Analysis ▴ The expert will compare the disputed payment to these industry norms, explaining why it falls within the acceptable range.
• Supporting Data ▴ The expert’s opinion must be backed by data, such as industry surveys, trade publications, or their own professional experience managing transactions in the sector.

The table below outlines the strategic focus and key evidence for each of the two defense pathways.

Execution

Executing the Data-Driven Defense

The execution of an ordinary course of business defense is a forensic exercise in data analysis and narrative construction. Upon receiving a preference demand from a bankruptcy trustee, the creditor’s legal team must immediately move to dissect the financial history between the parties. The objective is to transform raw transactional data into a compelling legal argument.

This process begins with the meticulous compilation of all relevant documents, including every invoice, purchase order, payment record, check image, and piece of correspondence exchanged between the parties, ideally for a period of at least two years prior to the bankruptcy filing. This period, known as the “historical period,” serves as the control against which the “preference period” (the 90 days before filing) is compared.

The core of the execution is a detailed quantitative analysis of payment patterns. This is where the defense becomes a matter of statistical proof. The legal team, often working with financial analysts, will construct a master spreadsheet or database that maps the entire transactional history. For each invoice, key data points are logged ▴ invoice date, invoice amount, invoice due date, and the date the payment was received.

From these inputs, the most critical metric is calculated ▴ payment latency, or the number of days from the invoice date to the payment date. This data is then analyzed to establish the normal operating rhythm of the commercial relationship.

Executing the defense requires a forensic analysis of historical payment data to build a statistical case proving the consistency of transactions during the preference period.

A Procedural Playbook for Defense Assembly

Successfully executing the defense requires a disciplined, sequential approach. The following steps provide a framework for a creditor’s counsel to systematically build the case from the ground up.

1. Data Aggregation and Validation ▴ The first step is to gather all transactional documents. This includes not just invoices and payment records, but also the master services agreement or any other contracts governing the relationship. The data must be cross-validated to ensure accuracy. For instance, the date a check was received by the creditor is the legally relevant date, not the date it was mailed by the debtor or the date it cleared the bank.
2. Establishment of the Historical Baseline ▴ Using the validated data, a detailed statistical profile of the pre-preference relationship is created. This involves calculating key metrics for the historical period:
   • Mean and Median Payment Latency ▴ The average and median number of days to pay. The median is often more useful as it is less skewed by outliers.
   • Range of Payments ▴ The shortest and longest payment times that were common during the historical period.
   • Weighted Average Days to Pay ▴ An analysis that gives more weight to larger invoices, providing a more accurate picture of how significant dollar amounts were handled.
3. Comparative Analysis of the Preference Period ▴ Each payment received during the 90-day preference period is then subjected to a rigorous comparison against the historical baseline. The key question for each payment is ▴ does it fall within the established ordinary range? For example, if the historical baseline shows payments were consistently made between 45 and 75 days, a preference period payment made in 60 days has a strong argument for being ordinary. A payment made in 120 days, or one made before the invoice was even issued, would be a significant red flag.
4. Qualitative Review of Circumstances ▴ Alongside the quantitative analysis, a qualitative review is essential. This involves examining all communications and surrounding events. Were there any unusual collection efforts? Did the debtor suddenly change its payment method (e.g. from company check to cashier’s check)? Was a payment plan instituted? Any action by the creditor or debtor that deviates from past practice can be used by the trustee to argue the payments were not ordinary.
5. Selection of Defense Pathway ▴ Based on the strength of the comparative analysis, the legal team makes a strategic decision on whether to primarily pursue the subjective test, the objective test, or both. If the historical data shows a highly consistent payment pattern that continued into the preference period, the subjective test is the most direct path. If the history is erratic, the focus must shift to gathering evidence for the objective industry-standard test.

Quantitative Modeling for Courtroom Presentation

Presenting the data in a clear and persuasive format is critical. Simple averages are often insufficient. Courts are more receptive to visual and comprehensive data presentations that clearly illustrate the consistency of payments.

The following table is an example of a detailed payment analysis that would be prepared to defend against a preference claim. It separates the historical period from the preference period and calculates the essential metrics needed to build the argument for the subjective test.

In this simplified example, the creditor would argue that the average latency during the preference period (63.3 days) is substantially similar to the historical average (58.7 days). The defense would present this data to show that the payments, while slightly slower, remained well within the established pattern of the business relationship, thus satisfying the subjective test for the ordinary course of business defense.

Reflection

Beyond the Legal Test

Mastering the mechanics of the ordinary course of business defense provides a lens into a deeper operational principle. The legal framework does not merely offer a reactive shield in litigation; it provides a proactive blueprint for financial discipline and relationship management. The rigorous documentation and consistency demanded by the statute are the very same practices that define robust and resilient commercial enterprises. By embedding the principles of this defense into daily accounts receivable and communication protocols, a company does more than prepare for a potential bankruptcy of a counterparty.

It builds a system of predictable, transparent, and defensible operations. This transforms a legal requirement into a strategic asset, where the ability to withstand judicial scrutiny is a direct byproduct of operational excellence. The ultimate inquiry, then, is how the architecture of your own commercial practices would appear under the exacting light of a preference action.