In a unanimous opinion issued June 3, 2019, the U.S. Supreme Court held that a creditor’s “good faith belief” that a discharge order was inapplicable to that creditor’s claim was insufficient to preclude a finding of contempt for violation of the order. The ruling in Taggart v. Lorenzen, 587 U.S. __ (2019) reversed the decision of the U.S. Court of Appeals for the Ninth Circuit, which held that even an unreasonable belief by a creditor that its actions would not violate a discharge order could shield the creditor from sanctions, if that belief was held in good faith. The Supreme Court rejected this subjective standard as well as a strict liability standard and instead established that a court may sanction a creditor for violation of the discharge order if there is “no fair ground of doubt” as to whether the order prohibited the creditor’s conduct. This standard aims to strike a balance between overly strict and purely subjective analyses and offers increased predictability.
In Lorenzen, the Petitioner (Taggart) was initially sued in Oregon state court for breaching his former company’s operating agreement. During the suit but before trial, Taggart filed for Chapter 7 bankruptcy. When that proceeding concluded, the Bankruptcy Court for the District of Oregon (the “bankruptcy court”) issued a discharge order stating that the debtor “shall be granted a discharge under §727.” That section provides that debtors granted a discharge are relieved from “all debts that arose before the date of the order for relief,” except for those listed in 11 U.S.C. §523. After the bankruptcy court issued the discharge order, the state court entered judgment against Taggart. The prevailing plaintiff, Sherwood, filed a petition seeking attorney’s fees incurred after Taggart filed his bankruptcy petition. Citing In re Ybarra, 424 F.3d 1018 (9th Cir. 2005), Sherwood argued that while discharge orders normally cover postpetition attorney’s fees stemming from prepetition litigation, that principle does not apply where a discharged debtor “returned to the fray” of litigation after filing for bankruptcy. The state court agreed with Sherwood and ordered Taggart to pay the fee request of approximately $45,000.
In filings with the bankruptcy court, Taggart disputed the finding that he had “returned to the fray” and argued that the discharge order barred Sherwood from collecting postpetition attorney’s fees and that Sherwood should be held in civil contempt for violating the discharge order granted to Taggart. The bankruptcy court found no violation, agreeing with the state court that Taggart had “returned to the fray” within the meaning of Ybarra. Taggart appealed to the U.S. District Court for the District of Oregon (the “district court”), which reversed and remanded the case to the bankruptcy court. Adhering to the district court’s ruling, the bankruptcy court held Sherwood in contempt. The bankruptcy court stated that its finding was supported by a standard akin to strict liability: Sherwood was aware of the discharge order and intended the actions that violated the order, so contempt and monetary sanctions were appropriate.
Sherwood then appealed to the Bankruptcy Appellate Panel, which vacated the sanctions, and the Ninth Circuit affirmed. In doing so, the Ninth Circuit applied a much more creditor-friendly standard than the bankruptcy court. The Ninth Circuit held that a creditor’s “good faith belief” that a discharge order does not apply to the creditor’s claim precludes any finding of contempt, even where that belief is unreasonable. The appeals court stated that because Sherwood had a “good faith belief” that the discharge order did not apply to its claims, civil contempt sanctions were inappropriate. Taggart filed a petition for certiorari, which the Supreme Court granted.
In its decision, the Supreme Court rejected both the bankruptcy court’s and the Ninth Circuit’s analyses. The justices found that a strict liability standard would likely increase litigation because risk-averse creditors would seek advance determination regarding the scope of discharge orders to avoid the harsh penalties associated with misunderstanding them. The Court further determined that the “good faith belief” standard, among other flaws, relied too heavily on difficult-to-prove states of mind and might lead creditors to be overzealous in collecting potentially discharged debts, forcing debtors back into costly litigation to protect their discharges.
In reaching a more objective standard, the Court looked to the history of civil contempt sanctions for injunction violations, including the “traditional standards in equity practice” the bankruptcy statutes incorporate. The Court found California Artificial Stone Paving Co. v. Molitor, 113 U.S. 609 (1885) to be instructive; that case held that civil contempt “should not be resorted to where there is [a] fair ground of doubt as to the wrongfulness” of the conduct. Such a standard reflects the severity of the remedy of contempt by requiring that those enjoined have “explicit notice” of prohibited conduct before they are held in contempt. Thus, where a creditor violates a discharge order based on “an objectively unreasonable understanding of the discharge order or the statutes that govern its scope,” contempt may be appropriate. According to the Court, such a standard strikes the “careful balance between the interest of creditors and debtors” that the Bankruptcy Code aims to achieve.
By offering an objective standard, the Lorenzen decision should, in theory, improve predictability with respect to the applicability of sanctions. However, the determination of what constitutes a “fair ground of doubt” may vary from creditor to creditor and from court to court. In addition, some creditors may be frustrated that their good faith will not be sufficient to avoid sanctions. The Court did provide some solace for such creditors, however, noting that subjective intent is not always irrelevant. For example, a finding of good faith may have a tempering effect on the severity of sanctions. So while a creditor’s intent may not be enough to avoid contempt, good faith may still provide some relief. Ultimately, the establishment of the “no fair ground of doubt” standard will likely cause creditors to take a closer look at the content of any discharge orders as well as the exceptions enumerated in 11 U.S.C. §523 to determine if their conduct is covered.
Client Alert 2019-159
