Bankruptcy and Restructuring

The Supreme Court Hands Down a New Standard for Bankruptcy Discharge Violations

The Supreme Court Hands Down a New Standard for Bankruptcy Discharge Violations

On June 3, 2019, Justice Breyer delivered a unanimous opinion of the Supreme Court conclusively establishing the standard courts must apply to hold a creditor in civil contempt for violation of a bankruptcy discharge order. In reaching its decision, the Supreme Court rejected both a subjective standard and a standard “akin to strict liability.” Henceforth, “[a] court may hold a creditor in civil contempt for violating a discharge order where there is not a ‘fair ground of doubt’ as to whether the creditor’s conduct might be lawful under the discharge.”

Background and Opinions Below

The case, Taggart v. Lorenzen, involved a debtor who transferred his interest in a closely held corporation in violation of the company’s operating agreement and the other shareholders’ rights of first refusal. The company and its shareholders sued the debtor in state court but, prior to trial, the debtor petitioned the bankruptcy court for Chapter 7 relief and ultimately obtained a bankruptcy discharge order of all debts arising before the petition. When the state court subsequently entered judgment against the debtor, the shareholders filed a petition in the state court seeking attorney’s fees incurred after the debtor filed his bankruptcy petition. In response, the debtor reopened his bankruptcy case and sued the company and its shareholders for violation of the bankruptcy discharge order, requesting that the bankruptcy court hold them in civil contempt for the violation. While the parties initially disputed whether the post-petition fees were discharged, the bankruptcy court ultimately concluded that they were and that petitioning for the fees violated the post-discharge injunction. Thus, the only issue that remained before the court was whether the violation warranted civil contempt sanctions.

The bankruptcy court held the shareholders in civil contempt, applying a standard that it likened to “strict liability.” Under the standard the bankruptcy court applied, civil contempt sanctions are appropriate where a creditor (here, the company and shareholders) (1) is aware of the discharge and (2) intended the actions which violated the discharge injunction. Because the shareholders were aware of the discharge and intended to file a petition for fees, the bankruptcy court held them in civil contempt and awarded the debtor $112,000 for attorney’s fees, court costs, emotional distress, and punitive damages. The Bankruptcy Appellate Panel disagreed and vacated the sanctions. When the Ninth Circuit affirmed the BAP’s decision, it applied a subjective standard, holding that a creditor’s “good faith belief” that the discharge order does not apply precludes an award of sanctions for discharge injunction violations – even if the creditor’s belief is unreasonable. The debtor appealed and the Supreme Court granted certiorari.

The Supreme Court Hands Down a New Standard

The Supreme Court rejected both of these standards and looked instead to the language of the Bankruptcy Code and the “longstanding interpretive principle” that, “When a statutory term is ‘obviously transplanted from another legal source,’ it ‘brings the old soil with it.’” The court reasoned that, because the Bankruptcy Code says a discharge order “operates as an injunction,” and further permits a bankruptcy court to enter any order or judgment “necessary or appropriate” to carry out the Code’s provisions, this language brings with it the “old soil” that governs the law of injunctions. And because that “old soil” includes the “potent weapon” of civil contempt, traditional standards of equity practice must be observed to determine whether a party may be held in civil contempt for violating an injunction.

Outside the bankruptcy context, the Court has recognized that civil contempt “should not be resorted to where there is a fair ground of doubt as to the wrongfulness of the defendant’s conduct.” The Court rejected the Ninth Circuit’s subjective standard because it relies too heavily on difficult-to-prove states of mind and is inconsistent with traditional contempt principles, which cannot insulate a party from the consequences of unreasonable beliefs. The bankruptcy court’s standard “akin to strict liability” also proved unworkable as it would ignore the reasonable beliefs of creditors and risk additional federal litigation, costs, and delays that are inconsistent with the chief purposes of the bankruptcy code. Thus, the Court concluded, traditional standards of equity apply so that a creditor may be held in civil contempt for violating discharge injunctions only where there is no fair ground of doubt as to whether the creditors’ conduct was lawful under the discharge order.

The Eleventh Circuit Since Taggart

This decision overrules Eleventh Circuit case law, which has applied the strict standard used by the bankruptcy court in Taggart. In a pair of cases in 1996, the Eleventh Circuit adopted a two part test for determining whether violations of the automatic stay and the discharge injunction are willful, and therefore warrant civil contempt sanctions. In both contexts, the Eleventh Circuit found that violations are willful where a creditor (1) is aware of the automatic stay or discharge injunction and (2) intends the actions that violate the stay or injunction. The bankruptcy court in Taggart relied upon the Eleventh Circuit’s decision in Hardy v. United States (In re Hardy) when it awarded sanctions. Because the Supreme Court expressly overruled this standard, the Eleventh Circuit’s test is no longer viable for violations of discharge orders.

The Eleventh Circuit recently recognized the overruling of In re Hardy, and became the first appellate court to weigh in on post discharge injunction violations since Taggart. In Roth v. Nationstar Mortage, LLC (In re Roth), a debtor indicated on her bankruptcy schedules that she planned to surrender her non-homestead property to the bank in her chapter 13 plan. The debtor obtained a discharge; however, rather than foreclose on the property, the bank started mailing monthly “informational” statements to the debtor indicating the amount due, due dates, and instructions for how to make payment with a disclaimer that the statements were “not intended as an attempt to collect” her discharged debt.

When the debtor filed for sanctions under § 524, the bankruptcy court dismissed the case, finding that the bank statements were not intended to collect a debt and, therefore, did not violated the discharge injunction. The Eleventh Circuit affirmed this decision. While the bankruptcy court’s decision was limited to whether a discharge violation had occurred, the Eleventh Circuit went a step further. “The Taggart standard is a rigorous one,” wrote Judge Branch, and there must be “daylight” between an unlawful attempt to collect a debt and a legitimate attempt to informa debtor how they can regain property. Thus, “even if we reached a different conclusion . . . and found that the issue of the § 524 violation presented a close call, we would nonetheless find that sanctions under § 105 are unavailable under the Supreme Court’s recent decision in Taggart.”

Bankruptcy Sanctions Going Forward

After Taggart and In re Roth, it is clear in the Eleventh Circuit that a post-discharge injunction action must (1) actually violate the discharge order, and (2) leave no fair ground of doubt that the creditor’s intended action would violate the discharge order.

Less clear is what standard will apply to awarding sanctions for violations of the automatic stay. The Court in Taggart recognized in dicta that both the purpose and the language of the Bankruptcy Code’s automatic stay provisions differ from the discharge provisions. Specifically, the Court noted that the word “willful” appears in the automatic stay provision, but declined to address whether this inclusion would support a standard akin to strict liability. For now, the Eleventh Circuit’s standard must yield to Taggart in the discharge injunction context, but the stricter standard may still be argued for violations of the automatic stay.