Introduction

Judge Kevin J. Carey, Chief Judge of the United States Bankruptcy Court for the District of Delaware, recently issued a decision in the Pillowtex bankruptcy addressing the ordinary course of business (“OCB”) defense.  Given the large number of preference actions that are filed it Delaware every year, there is a fair amount of case law in Delaware on this commonly relied upon defense to avoidance actions.  Judge Carey’s decision in Pillowtex highlights those decisions the Court finds relevant when considering the OCB defense. Better still, because Pillowtex filed for bankruptcy before the 2005 amendments to the Bankruptcy Code, the decision looks at both the “subjective” and “objective” prongs of the OCB defense.

Background

Pillowtex filed for bankruptcy in Delaware in 2003.  In 2005, Pillowtex filed an adversary action against Classic Packaging Company seeking the recovery of approximately $60,000 in transfers.  Pillowtex alleged the transfers constituted both preferential transfers under section 547 of the Bankruptcy Code, and fraudulent transfers under section 548 of the Code.  Classic filed a motion for summary judgment on the preferential transfers portion of the complaint, arguing that the payments it received from Pillowtex were sheltered from avoidance under the OCB defense.  Classic also sought dismissal of the fraudulent transfers, arguing the Plaintiff (the Liquidating Trustee of Pillowtex) failed to satisfy the pleading requirements under Federal Rule of Civil Procedure 9(b).

Analysis

After discussing the facts underlying the case and the standard for summary judgment, the Court turned to the elements and policy behind the OCB defense.  The Court began by noting the two reasons behind the OCB defense:  encourage creditors to continue dealing with distressed debtors and promote the equal treatment of distribution among creditors.  Fiber Lite Corp. v Molded Acoustical Products, Inc. (In re Molded Acoustical Products, Inc.), 18 F.3d 217, 219 (3d Cir. 1994).  Because Pillowtex filed for bankruptcy prior to the amendments to section 547(c)(2),  Classic was required to prove all three elements of the defense.  Section 547(c)(2) protects from avoidance those transfers that are:

(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 transferee; and,

(C)  made according to ordinary business terms.

The Plaintiff argued that Classic could not show there were no material factual issues regarding section 547(c)(2)(B) and (C).  The Court first looked at the OCB defense under section 547(c)(2)(B), commonly referred to the “subjective test.”  The question for the Court under the subjective test is to “determine the consistency of transactions between the parties before and during the preference period.”  Opinion at *9, citing SEC v. First Jersey Sec., Inc. (In re First Jersey Sec., Inc.), 180 F.3d 504, 512 (3d Cir. 1999).  To determine whether transactions between the creditor and debtor are consistent before and during the 90 day preference period, courts consider the following:

  1. the length of time the parties have engaged in the type of dealing at issue;
  2. whether the subject transfer was in an amount more than usually paid;
  3. whether the payments were tendered in a manner different from the previous payments;
  4. whether there appears any unusual action by either the debtor or the creditor to collect or pay on the debt; and
  5. whether the creditor did anything to gain an advantage (such as gain additional security) in light of the debtor’s deteriorating financial condition.

Opinion at *9, citing HLI Creditor Trust v. Metal Tech. Woodstock Corp (In re Hayes Lemmerz, Int’l, Inc.), 339 B.R. 97, 106 (Bankr.D.Del. 2006).  The defendant, Classic, argued that the Debtors always paid Classic in a timely manner, with some exceptions, and that the payments made during the preference period continued in a timely manner.  Opinion at *11.  Plaintiff, on the other hand, argued that Debtors started paying Classic more quickly during the preference period, with some payments as early as two days after invoice.  Opinion at *12.  After considering the parties’ arguments, the Court found that Classic failed to prove that no genuine issues of material fact exist.  Id.

Having considered Classic’s “subjective” prong of the ordinary course defense, the Court next turned to the “objective” prong of the test under section 547(c)(2)(C).  The objective test requires the Court to determine whether “the business terms between the Debtors and Classic were ordinary in the industry …”  Opinion at *13.  Classic argued, and the Court agreed, that in proving the objective prong (aka the “industry standard”) of the ordinary course of business defense,  Classic can rely on the testimony from employees of the parties involved in a preference payment dispute.  Id.  citing Troiso v. E.B. Eddy Forest Products (In re Global Tissue LLC), 106 Fed. Appx. 99, 103 (3d Cir. 2004).

Because the Court found that there was a factual dispute under the subjective prong of the ordinary course of business defense, the Court declined to decide whether terms that existed between the Debtors and Classic were ordinary in the industry.  Opinion at * 14.  Further, because summary judgment was not appropriate, the Court declined to decide whether Classic’s witnesses were qualified to testify.  Id.

Conclusion

With the high volume of preference actions filed in the Delaware Bankruptcy Court each year, decisions addressing the ordinary course of business decision always provide value.  In Pillowtex, the Court makes an interesting point in footnote *9.  Classic argued that the facts presented through its motion for summary judgment were similar to those in Montgomery Ward LLC v. OTC Int’l, Ltd. (In re Montgomery Ward, LLC), 348 B.R. 662 (Bankr.D.Del. 2006).  In Montgomery Ward, the court found that the ordinary course of business defense applied even though there was a change in payment terms before and during the preference period.  Montgomery Ward, 348 B.R. at 679.  The distinction between Classic’s defense in Pillowtex and that of the defendant in Montgomery Ward was that Montgomery Ward was decided after a trial that included “detailed findings of fact by the Judge regarding the parties’ business relationship.”  Opinion at *13.

The Court’s comments in footnote *9 make an interesting point regarding preference litigation – these cases often involve factual disputes that are not able to be resolved through summary judgment.  As the Court observed in Pillowtex, when the court is deciding a motion for summary judgment, “it is not the role of the judge to weigh the evidence or to evaluate its credibility, but to determine ‘whether there exists a genuine issue for trial.'”  Opinion at *7, citing Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248, 106 S.Ct. 2505, 91 L.Ed. 2d 202 (1986).  By its very nature, the ordinary course of business defense requires the Court to weigh evidence – whether payments made before and during the preference period were similar as to the parties and as to the relevant industry.