Ordinary course of business

What Is Ordinary Course of Business?

"Ordinary course of business" refers to the regular, usual, and customary activities and transactions that a company undertakes in its day-to-day business operations. It encompasses the actions that would logically be expected in the normal functioning of an enterprise, as opposed to infrequent or extraordinary transactions. This concept is fundamental in various aspects of business law and finance, including contracts, financial reporting, and legal compliance. It helps to differentiate routine activities from those that might signal a significant change in the company's status or strategy.

History and Origin

The concept of "ordinary course of business" has evolved largely through common law and legislative interpretations, particularly in areas like bankruptcy and taxation. Early legal systems recognized the need to distinguish between routine commercial dealings and unusual transactions that might indicate an attempt to defraud creditors or avoid obligations. For instance, in bankruptcy law, transactions made in the ordinary course of business are often protected from being clawed back, meaning a payment received by a creditor for a routine invoice may be considered legitimate even if the debtor subsequently files for bankruptcy. Courts have historically considered factors such as the frequency and past conduct of the company, whether a transaction is a "stray or casual act" or a "habit system" with continuity to satisfy the test of regular or ordinary course of business.²¹ The Internal Revenue Service (IRS) further solidified this distinction in tax law with the concept of "ordinary and necessary" business expenses, which are deductible. An expense is "ordinary" if it is common and accepted in a specific industry, and "necessary" if it is helpful and appropriate, though not indispensable.²⁰ This distinction ensures that only legitimate costs of running a business qualify for tax deductions.

Key Takeaways

• "Ordinary course of business" describes a company's routine, normal, and customary transactions and activities.
• It is a crucial concept in contract law, tax law, bankruptcy proceedings, and mergers and acquisitions.
• Actions deemed in the ordinary course of business are consistent with past practices and industry standards.
• The determination often involves assessing factors like consistency, regularity, and typicality of transactions.
• Deviations from the ordinary course of business can trigger specific contractual clauses or legal scrutiny.

Interpreting the Ordinary Course of Business

Interpreting what constitutes the "ordinary course of business" is often a subjective and fact-specific determination, heavily dependent on the context of the business and its industry.¹⁹ Generally, actions fall within this definition if they align with the historical practices of the entity and are part of its normal day-to-day operations.¹⁸ This includes routine activities such as ordering inventory, processing customer payments, managing financial statements, and handling general administrative tasks.¹⁷ Conversely, activities that are highly unusual for a business, given its history and typical operations, are less likely to be considered "ordinary."¹⁶ For example, a court might analyze the purpose of an expense or the frequency of similar transactions to determine if it meets the criteria.¹⁵

Hypothetical Example

Consider "Tech Solutions Inc.," a software development company. Its ordinary course of business involves developing and selling software licenses, providing customer support, paying employee salaries, and covering monthly office rent and utility bills. These are recurring activities central to its mission.

One month, Tech Solutions Inc. decides to sell its main office building and lease a smaller space in a different city. This transaction, involving the disposition of a significant asset like real estate, would likely not be considered in the ordinary course of business. Such a sale is not a frequent or typical activity for a software company whose primary revenue comes from software sales. It represents a significant strategic shift and would typically require special approvals, unlike routine payroll or software development expenses. This distinction is critical in various contexts, such as during a due diligence phase before an acquisition.

Practical Applications

The concept of "ordinary course of business" is widely applied across several financial and legal domains:

• Contractual Agreements: In mergers and acquisitions (M&A) agreements, sellers often covenant to operate the target company in the ordinary course of business between the signing of the deal and its closing. This clause protects the buyer by ensuring the target's value and operational integrity are maintained and that no significant, unforeseen changes occur before the acquisition is complete.¹⁴ This covenant prevents sellers from undertaking unusual actions—like selling off key assets or incurring substantial new debt—that could negatively impact the acquired entity. Reu¹³ters provides further analysis on how this term is interpreted in M&A transactions.
• Taxation: As defined by the IRS, business expenses must be "ordinary and necessary" to be tax-deductible. This means they must be common and accepted in the industry and helpful and appropriate for the business. Thi¹²s principle underpins many accounting principles and helps businesses accurately calculate their taxable income. More detailed guidance on this can be found through official IRS guidance on ordinary and necessary expenses.
• Bankruptcy Law: Payments made or obligations incurred by a debtor in the ordinary course of business are often shielded from being recovered by a bankruptcy trustee. This defense protects routine transactions and ensures that businesses can continue their normal operations without undue fear of future repayment demands if a trading partner becomes insolvent.
• ¹¹ Auditing and Financial Reporting: Auditors scrutinize transactions to determine if they fall within the ordinary course of business when evaluating a company's ability to continue as a going concern. Sig¹⁰nificant unusual transactions not in the ordinary course of business must be communicated to the audit committee. Add⁹itionally, certain related-party transactions, unless they occur in the ordinary course of business, may require specific disclosures in financial statements under Generally Accepted Accounting Principles.

##⁸ Limitations and Criticisms

Defining "ordinary course of business" can be challenging due to its subjective nature and dependence on specific facts and circumstances. Courts and regulators often grapple with ambiguous cases, leading to extensive litigation and varying interpretations. For⁷ instance, while a past practice can inform what is considered "ordinary," a company might argue that extraordinary circumstances (e.g., a global pandemic or a sudden market shift) necessitate "ordinary responses to extraordinary events" that deviate from historical norms. How⁶ever, some legal interpretations have held that "consistent with past practice" effectively "froze" a target to its past practice, even in the face of such events.

An⁵other criticism arises in the context of security interests. The Uniform Commercial Code (UCC) protects a "buyer in the ordinary course of business," meaning a person who buys goods in good faith without knowing the sale violates another person's rights in the goods. How⁴ever, determining what constitutes a sale "in the ordinary course" can be complex, especially if the seller's business practices are not clearly established or if the transaction involves atypical items. This can create uncertainty for both buyers and those holding security interests. The³ legal community often refers to the Cornell Law School Legal Information Institute for common definitions and usage of this term in US law.

Ordinary Course of Business vs. Extraordinary Transactions

The primary distinction between "ordinary course of business" and extraordinary transactions lies in their nature, frequency, and impact on a company. Activities in the ordinary course of business are routine, recurring, and essential for the daily functioning and primary revenue generation of the enterprise. They reflect the normal operations and typical commercial customs and practices. Examples include sales to customers, purchasing supplies, paying salaries, and covering operational expenses.

Conversely, extraordinary transactions are infrequent, non-recurring, and often involve significant strategic or financial implications that fall outside the typical daily flow of commerce. These might include selling a major subsidiary, acquiring another company, incurring a large, unusual debt, or settling a major lawsuit. Such transactions are not part of the company's regular trade and often require special approvals from the board of directors or shareholders. While ordinary course activities maintain the status quo, extraordinary transactions often change the company's structure, financial position, or future direction.

FAQs

What does "in the ordinary course of business" mean for a small business?

For a small business, "in the ordinary course of business" means performing the regular activities necessary to operate and generate revenue. This includes tasks like buying inventory, selling products or services, managing payroll, paying rent, and marketing. It encompasses the routine, expected actions that keep the business running day-to-day.

Why is "ordinary course of business" important in legal agreements?

It is crucial in legal agreements, particularly in contracts for mergers and acquisitions, because it sets an expectation for how a company should operate during a transitional period. It prevents one party from taking unusual actions that could significantly alter the company's value or financial standing without the other party's consent. This protects the buyer's investment and ensures the acquired business is substantially as expected.

How is "ordinary course of business" determined if there's no clear past practice?

If a company is new or a transaction is a "first-time" event, determining "ordinary course of business" becomes more complex. In such cases, courts and analysts may look to industry standards, common practices among similar businesses, the transaction's purpose, and whether it serves a legitimate business goal. It'²s about what is generally accepted and helpful within that particular trade or business, even if the specific company hasn't done it before.

Does "ordinary course of business" apply to personal finances?

While the direct legal and financial definitions of "ordinary course of business" are typically applied to companies and commercial entities, the underlying concept of "ordinary and necessary" expenses can somewhat align with personal tax deductions. Individuals can deduct "ordinary and necessary" expenses related to their trade or business, such as professional uniforms or business-related software. However, the scope and legal implications are far broader and more formalized for businesses than for individuals.

Can an activity be "ordinary" even if it doesn't happen frequently?

Yes, an activity can be considered "ordinary" even if it doesn't happen very frequently, as long as it's a normal and accepted part of that particular industry or business type. For example, for a real estate developer, the sale of a completed property is "ordinary" even if it only happens a few times a year, because it is central to their business operations and revenue model. The key is whether it aligns with the business's core purpose and established practices, rather than simply its recurrence.¹