Delaware Bankruptcy Court: Applying Credit Pressure on Financially Distressed Debtor Scuttles Ordinary Course Payment Preference Defense
The power of a bankruptcy trustee or chapter 11 debtor-in-possession ("DIP") to avoid pre-bankruptcy preferential transfers is an important tool designed to promote the bankruptcy policy of equality of distribution and to generate value for the bankruptcy estate that can be used to pay creditors and/or fund a plan. However, the Bankruptcy Code contains certain defenses to avoidance, including the "ordinary course payment" defense, which incentivizes vendors and other creditors to continue doing business with financially distressed entities.
Courts disagree on the scope of the defense and, in particular, whether its requirement (in some cases) that payments be made according to "ordinary business terms" means business terms applied when a debtor is in good financial health, as distinguished from terms imposed when the debtor is in financial distress. The U.S. Bankruptcy Court for the District of Delaware weighed in on this debate in In re Fred's Inc., No. 19-11984 (CTG), 2025 WL 208536 (Bankr. D. Del. Jan. 15, 2025). The court granted partial summary judgment to a liquidating trustee in preference litigation, ruling that "ordinary business terms" within the meaning of section 547(c)(2)(B) of the Bankruptcy Code should be assessed in accordance with the "healthy debtor" standard rather than based upon customary industry practice tightening credit terms for financially distressed entities. Because the creditor/transferee applied "credit pressure" to the debtor once it became financially distressed, the court ruled that the creditor could not rely on the ordinary course payment 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. 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); accord In re ASPC Corp., 658 B.R. 455 (Bankr. S.D. Ohio 2024) (ruling that the defendant in preference litigation need only demonstrate that the payment satisfied one—but not both—of the tests stated in section 547(c)(2), and noting that "[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").
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, e.g., 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); see also Collier at ¶ 547.04 [2] (citing cases).
The initial element of the ordinary course payment defense requires that the transfer have been 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. This element of section 547(c)(2) is frequently undisputed, and there is relatively little case law addressing it. 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 (7thCir. 1993).
Fred's
Fred's Inc. (the "debtor") operated a chain of general merchandise retail stores located in the southeastern United States. In 2019, the debtor contracted with C.H. Robinson ("CHR") to provide transportation brokerage services. Under the agreement, the debtor was obligated to pay CHR for its services within 30 days of the debtor's receipt of an invoice. The agreement initially set a credit limit of $3 million as part of an anticipated $45 million relationship.
After the debtor began to experience financial distress and announced store closings, CHR tightened its credit terms by reducing the debtor's credit limit from $3 million to $1.75 million in June 2019, and then to $1 million the following month. Correspondence between the parties indicated that CHR was imposing credit restrictions to extract payment from the debtor and thereby reduce CHR's exposure. On July 11, 2019, in response to a threat that CHR would stop delivering the debtor's goods, the debtor transferred $800,000 to CHR. Less than a week later, CHR reduced the credit terms under its agreement with the debtor from 30 to 14 days.
In September 2019, the debtor filed for chapter 11 protection in the District of Delaware. Nine months later, the bankruptcy court confirmed a liquidating chapter 11 plan for the debtor. The plan established a liquidating trust that was assigned all of the estate's causes of action, including avoidance claims.
The liquidating trustee (the "trustee") sued CHR to avoid nearly $3.5 million in payments made by the debtor in 15 separate transfers to CHR during the 90 days preceding the bankruptcy petition date. The trustee moved for summary judgment. In his motion, the trustee acknowledged that CHR provided new value to the debtor following the transfers in the amount of approximately $1.93 million, and that CHR was entitled to a defense in that amount under section 547(c)(4) of the Bankruptcy Code, which provides that a bankruptcy trustee may not avoid a preferential transfer to the extent that the transferee subsequently provided new value to or for the benefit of the debtor, with certain exceptions.
In opposing the motion for summary judgment, CHR: (i) disputed the amount of the trustee's preference claim, which CHR asserted was overstated by approximately $330,000; (ii) disputed the amount of its new value defense under section 547(c)(4), which CHR claimed was understated by approximately $43,000; and (iii) acknowledged that its "standard practice" was to adjust a customer's credit limit according to the customer's "credit profile, including its existing financial status and projections of future financial performance," which practice CHR characterized as "standard within the transportation and logistics industry." CHR accordingly invoked the ordinary course payment preference defense in section 547(c)(2)(B).
The Bankruptcy Court's Ruling
The bankruptcy court granted the trustee's motion for summary judgment in part.
After concluding that the trustee had satisfied his burden of establishing a prima facie case for avoidance as preferential of approximately $3.125 million in transfers under section 547(b) of the Bankruptcy Code, U.S. Bankruptcy Judge Craig T. Goldblatt ruled that CHR could not rely on the ordinary course payment preference defense under section 547(c)(2)(B). CHR argued that the payments it received from the debtor were made according to "ordinary business terms" within the meaning of section 547(c)(2)(B) because it is common in the transportation and logistics industry for a supplier to tighten credit terms once a customer begins to face financial difficulty. According to Judge Goldblatt, the "fundamental disagreement between the parties is over whether 'ordinary course' means terms that are ordinary when dealing with a healthy company, or whether the defense is still available when the defendant was imposing credit pressure on the debtor, so long as the defendant can show that it was customary in the relevant industry to impose such credit pressure on customers in financial distress." Fred's, 2025 WL 208536, at *7.
Guided by the bankruptcy court's ruling in In re Erie County Plastics Corp., 438 B.R. 89 (Bankr. W.D. Pa. 2010), and the position staked out by the Third and Tenth circuits in In re Molded Acoustical Prods., Inc., 18 F.3d 2017 (3d Cir. 1994), and In re Meredith Hoffman Partners, 12 F.3d 1549 (10th Cir. 1994), respectively, Judge Goldblatt concluded that the "healthy debtor" standard should apply. Under that standard, he explained, "[o]ne's dealings with companies facing financial distress is not the measure of ordinariness [,but instead,] ordinary terms are those which prevail in healthy, not moribund, creditor-debtor relationships." Fred's, 2025 WL 208536, at *7 (citations and internal quotation marks omitted).
Judge Goldblatt acknowledged that a circuit split apparently exists on this issue. The Second, Eighth, and Ninth Circuits have endorsed the view that the scope of the meaning of "ordinary business terms" extends beyond average transactions to include the "broad range of terms that encompasses the practices employed" by "similarly situated debtors and creditors facing the same or similar problems," including a debtor's financial distress. See In re Roblin Indus., Inc., 78 F.3d 30, 42 (2d Cir. 1996); In re U.S.A. Inns of Eureka Springs, Arkansas, Inc., 9 F.3d 680, 685 (8th Cir. 1993); In re Jan Weilert RV, Inc., 315 F.3d 1192, 1199 (9th Cir.), as amended, 326 F.3d 1028 (9th Cir. 2003). However, Judge Goldblatt reasoned that the Third Circuit's approach in Molded Acoustical Prods., in addition to being binding precedent, "better accords with the underlying congressional purpose in adopting the ordinary course defense, which was to keep distressed companies out of bankruptcy by creating an incentive for vendors to continue extending credit." Fred's, 2025 WL 208536, at *8.
The bankruptcy court accordingly concluded that CHR could not rely on section 547(c)(2)(B) as a defense to preference liability:
[T]he summary judgment record makes clear that throughout the preference period [CHR] was applying credit pressure to the debtor, including threatening to discontinue providing services if the debtor failed to make payment. There is nothing in the record to suggest that this is the way a vendor in the shipping and logistics industry would treat a financially healthy customer. Based on the summary judgment record before the Court, the trustee is thus entitled to partial summary judgment that the ordinary course of business defense is unavailable.
Id. at *9.
Finally, the bankruptcy court denied summary judgment regarding the new value defense under section 547(c)(4) due to the existence of a genuine dispute regarding the amount of the new value provided by CHR, but awarded summary judgment to the trustee on his request for prejudgment interest on any avoidance recovery at the federal judgment rate.
Outlook
The principal takeaway from the bankruptcy court's ruling in Fred's is that, in assessing potential preference litigation exposure, creditors doing business with financially distressed debtors should be aware of the approach endorsed in any likely venue for the debtor's bankruptcy filing. If a bankruptcy court—like the court in Fred's—embraces the "healthy debtor" approach, pre-bankruptcy transfers made by a debtor during the preference period may not be shielded from avoidance under the ordinary course payment defense if the payments were "extracted" by means of credit terms deviating from those applied when the debtor was not in financial distress. If not, creditors that have demanded restricted credit terms due to the debtor's financial distress may still be able to invoke the defense successfully.
Given the important purpose of section 547(c)(2) in encouraging vendors to continue doing business with financially distressed debtors, the uncertainty caused by the circuit split on this issue may be an invitation to Supreme Court resolution of the dispute.
