It is well settled that the purpose of filing a bankruptcy petition is to “give the honest but unfortunate debtor . . . a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of pre-existing debt.” Local Loan Co. v. Hunt, 292 U.S. 234, (1934). A debtor’s discharge in bankruptcy, and the corresponding injunction provisions of the Bankruptcy Code, are the two primary elements that effectuate this financial fresh start. Chapman v. Bituminous Ins. Co. (In re Coho Res., Inc.), 345 F.3d 338, 342 (5th Cir. 2003). More specifically, a discharge granted under the Bankruptcy Code “operates as an injunction against the commencement or continuation of an action, the employment of process, or an act, to collect, recover, or offset any such debt as a personal liability of the debtor, whether or not discharge of such debt is waived.” 11 U.S.C. § 524(a)(2). Like other court orders, the legal force of the discharge injunction is the threat of contempt: A bankruptcy court can hold a creditor in contempt if the creditor attempts to collect a discharged debt.
In an opinion issued on June 3, the Supreme Court in Taggart v. Lorenzen wrestled with how to decide whether a court should sanction a creditor for collection activities that violate the discharge injunction. In this case, the creditors (a business named Sherwood, its owners, and their former attorney, represented by the executor of his estate, respondent Shelley Lorenzen) were involved in post-bankruptcy litigation with the debtor (Bradley Taggart) over ownership of a business in which Taggart had invested before the bankruptcy.
In 2007, on the eve of a state court trial in a suit brought by his former partners in a real estate development, Taggert filed for Chapter 7. Taggert ultimately received a discharge of debts, including from damages stemming from the civil litigation. When the automatic stay was lifted and the state court case resumed, the parties agreed they would not pursue a monetary judgment against Taggert.
But after winning at trial, the plaintiffs sought attorneys’ fees from Taggart, alleging that his post-bankruptcy participation in the case fell outside the discharge. After litigation and appeals in state and bankruptcy courts, it was settled that the judgment against Taggart violated the discharge and that Taggert could not be forced to pay the attorneys’ fees. The business partners were found to have willfully violated the discharge injunction and were ordered to pay more than $110,000 in compensation and punitive damages.
That contempt ruling was subsequently overturned by the bankruptcy appellate panel and, on an appeal by Taggert, the Ninth Circuit affirmed the vacatur of the sanctions award, determining Sherwood could not be held in contempt so long as it had held a subjective belief, however unreasonable, that it was entitled to collect the attorneys’ fees award from Taggart.
Justice Stephen Breyer’s opinion for a unanimous court squarely rejects the Ninth Circuit’s “subjective belief” standard, but declined to adopt the debtor’s call for a strict liability standard. The debtor had argued that actions which violate the discharge injunction should be sanctioned unless the creditor precleared them with the bankruptcy court.
The Court noted that courts faced with injunctions have understood that “basic fairness” requires that sanctions do not apply in the face of a “fair ground of doubt” about the propriety of activity.
Justice Breyer emphasized that the “standard is generally an objective one,” which means “that a party’s subjective belief that [the party] was complying with an order ordinarily will not insulate [the party] from civil contempt if that belief was objectively unreasonable.” The Court held sanctions are appropriate “when the creditor violates a discharge order based on an objectively unreasonable understanding of the discharge order or the statutes that govern its scope.”
Applying the “objectively unreasonable” standard, Justice Breyer summarily rejected the Ninth Circuit’s view that even an unreasonable understanding of the discharge protects a creditor from contempt: “[T]his standard is inconsistent with traditional civil contempt principles, under which parties cannot be insulated from a finding of civil contempt based on their subjective good faith.”
The Court reinforced its “objectionably unreasonable” standard with policy considerations. With respect to the subjective test adopted below, the Court found it “relies too heavily on difficult-to-prove states of mind” and “may too often lead creditors who stand on shaky legal ground to collect discharged debts, forcing debtors back into litigation … to protect the discharge that it was the very purpose of the bankruptcy proceeding to provide.”
Conversely, the Court rejected the “strict-liability” standard that the debtor had proposed, under which actions that violate the discharge would be sanctioned unless the creditor precleared them with the bankruptcy court. The Court did not believe a strict liability standard would “provide a workable solution to the creditor’s potential dilemma.” Noting “there will often be at least some doubt as to the scope of such orders,” a preclearance requirement would “lead to frequent use of the advance determination procedure” and “widespread use of this procedure” would “mov[e]” a substantial body of “litigation out of state courts, who have concurrent jurisdiction over such questions, and into federal courts.” Such additional litigation, cost, and delay warranted a rejection of this approach.
Claims against creditors alleging violations of the bankruptcy discharge injunction are frequent, and until the Taggart decision, their outcome could depend on which court they were filed in. The Taggert decision clarifies the standard that courts will have to apply to resolving such claims, and that a creditor will face sanctions if its belief that it was not violating the injunction was objectively unreasonable.