SCOTUS Adopts ‘Objectively Reasonable’ Standard for Violations of Bankruptcy Discharge Orders

In determining the legal standard for holding a creditor in civil contempt for attempting to collect a debt in violation of a bankruptcy discharge order, the Supreme Court of the United States adopted an “objectively reasonable” standard, and held that a court may hold a creditor in civil contempt if there is “no fair ground of doubt” as to whether the order barred the creditor’s conduct.

Accordingly, the Supreme Court reversed the Ninth Circuit’s ruling, which had applied a subjective standard for civil contempt.

A copy of the opinion in Taggart v. Lorenzen is available at:  Link to Opinion.

The bankruptcy debtor formerly owned an interest in an Oregon company.  The company brought a lawsuit in Oregon state court claiming that the debtor had breached its operating agreement.

Before trial, the debtor filed for bankruptcy under Chapter 7 of the Bankruptcy Code.  Thereafter, the bankruptcy court issued a discharge order stating that the debtor “shall be granted a discharge under § 727.”

As you will recall, Section 727 provides that a discharge relieves a debtor “from all debts that arose before the date of the order for relief,” “[e]xcept as provided in section 523.”  Section 523 then lists in detail the debts that are exempt from discharge.

After the discharge order was issued, the Oregon state court proceeded to enter judgment against the debtor.  The company then filed a petition in state court seeking attorney’s fees that were incurred after the debtor filed his bankruptcy petition.

All parties agreed that under the Ninth Circuit’s decision in In re Ybarra, 424 F.3d 1018 (2005), a discharge order would normally discharge postpetition attorney’s fees stemming from prepetition litigation unless the discharged debtor “returned to the fray” after filing bankruptcy.

The company argued that the debtor had “returned to the fray” postpetition and was therefore liable for the postpetition attorney’s fees that the company sought to collect.  The state court agreed and awarded the company its postpetition attorney’s fees.

The debtor then returned to the bankruptcy court and argued that he had not returned to the “fray” under Ybarra, and that the discharge order therefore barred the company from collecting postpetition attorney’s fees.  The debtor requested that the court hold the company in civil contempt for violating the discharge order.

However, finding no violation of the discharge order, the bankruptcy court refused to hold the company in civil contempt.

The debtor appealed to the district court, which held that he had not returned to the fray, and therefore concluded that the company had violated the discharge order by trying to collect attorney’s fees.  The district court then remanded the matter back to the bankruptcy court.

On remand, the bankruptcy court held the company in civil contempt.  In doing so, it applied a standard likened to strict liability.  Specifically, the bankruptcy court determined that civil contempt sanctions were appropriate because the company had been “aware of the discharge” order and “intended the action which violate[d]” it.  The court awarded the debtor approximately $105,000 in attorney’s fees and costs, $5,000 in damages for emotional distress, and $2,000 in punitive damages.

The company appealed, and the Bankruptcy Appellate Panel vacated the sanctions, and the Ninth Circuit affirmed the panel’s decision.  In reaching its decision, the Ninth Circuit applied a different standard from the bankruptcy court, concluding that a “creditor’s good faith belief” that the discharge order “does not apply to the creditor’s claim precludes a finding of contempt, even if the creditor’s belief is unreasonable.”

Because the company had a “good faith belief” that the discharge order did not apply to its claims, the Ninth Circuit held that the civil contempt sanctions were improper.

The debtor then filed a petition for certiorari, which was granted.

Initially, the Supreme Court noted that “[t]he question before us concerns the legal standard for holding a creditor in civil contempt when the creditor attempts to collect a debt in violation of a bankruptcy discharge order.”

In determining the answer to the question, the Court analyzed two bankruptcy code provisions.  First, section 524, which provides that a discharge order “operates as an injunction against the commencement or continuation of an action, the employment of process, or an act, to collect, recover or offset” a discharged debt.  Second, section 105, which authorizes a court to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.”

After reviewing these provisions, the Court determined that they “authorize a court to impose civil contempt sanctions when there is no objectively reasonable basis for concluding that the creditor’s conduct might be lawful under the discharge order.”

The Court further observed that in cases outside the bankruptcy context, it has said 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.”

Moreover, this standard reflects that civil contempt is a “severe remedy,” and that principles of “basic fairness requir[e] that those enjoined receive explicit notice” of “what conduct is outlawed” before being held in civil contempt.

Thus, “[t]his standard is generally an objective one.”  However, subject intent is not always irrelevant, and “civil contempt sanctions may be warranted when a party acts in bad faith.”

After analyzing these traditional civil contempt principles, the Court noted they “apply straightforwardly to the bankruptcy discharge context.”  Thus, “[u]nder the fair ground of doubt standard, civil contempt . . . may be appropriate when the creditor violates a discharge order based on an objectively unreasonable understanding of the discharge order or the statute that govern its scope.”

The Court therefore held: “[A] court may hold a creditor in civil contempt for violating a discharge order if there is no fair ground of doubt as to whether the order barred the creditor’s conduct.  In other words, civil contempt may be appropriate if there is no objectively reasonable basis for concluding that the creditor’s conduct might be lawful.”

Because the Ninth Circuit erred in applying a subjective standard for civil contempt, its judgment was vacated and the matter was remanded.

About Maurice Wutscher

Maurice Wutscher is a national financial services defense and compliance law firm providing superlative defense and unmatched dedication to clients in key cities nationwide. Maurice Wutscher specializes in appellate matters, business formation and transactions, class action litigation, commercial litigation, construction litigation, consumer credit litigation, contested bankruptcies, contested foreclosures, employment litigation, insurance recovery and advisory services, intellectual property litigation, regulatory compliance, and trials and evidentiary hearings. Maurice Wutscher’s attorneys are leaders and influencers in the area of consumer financial services law, serving in leadership positions in industry groups and regularly publishing and speaking before national audiences. Bold leadership, strategic guidance and sound insight are the hallmarks of the Maurice Wutscher professional. The firm is committed to providing unparalleled client service, efficiency, and thought leadership.

This article courtesy of Maurice Wutscher’s Consumer Financial Services Blog and was written by Jeffrey Karek.