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US SUPREME COURT FINDS BANK NOT SUBJECT TO CIVIL CONTEMPT IF THERE IS A “FAIR GROUND OF DOUBT” AS TO WHETHER BANK’S CONDUCT WAS LAWFUL UNDER BANKRUPTCY DISCHARGE ORDER

On June 3, 2019, the United States Supreme Court (“USSC”) granted certiorari relief and weighed in on “the criteria for determining when a court may hold a creditor in civil contempt for attempting to collect a debt that a discharge order has immunized from collection.” Taggart v. Lorenzen. Taggart involved a debtor, Bradley Taggart, and Taggart’s former business partners who together co-owned Sherwood Park Business Center (“Sherwood”). Sherwood sued Taggart for breach of their operating agreement. Prior to trial on the breach of contract claim, Taggart filed a Chapter 7 bankruptcy petition ostensibly seeking to discharge his debts and other obligations to Sherwood. The Oregon state court stayed Sherwood’s action against Taggart pending relief from the bankruptcy stay or resolution of the bankruptcy petition.

Taggart obtained a discharge order from the bankruptcy court. The USSC explained the significance of the order: “[A] discharge relieves the debtor from all debts that arose before the date of the order for relief…” and “typically” releases the debtor from liability for prebankruptcy debts and prohibits a creditor from attempting to collect debts covered by the order. The Court elaborated: “The words of the discharge order, though simple, have an important effect: A discharge order “operates as an injunction” that bars creditors from collecting any debt that has been discharged. § 524(a)(2).”

Upon resolution of Taggart’s bankruptcy, “the Oregon state court proceeded to enter judgment against Taggart in the prebankruptcy suit involving Sherwood. Sherwood then filed a petition in state court seeking attorney’s fees that were incurred after Taggart filed his bankruptcy petition.” The USSC explained that the discharge order “would normally cover and thereby discharge post-petition attorney’s fees stemming from prepetition litigation (such as the Oregon litigation)” however, Sherwood argued that Taggart had “returned to the fray” post-petition and therefore was liable for the post-petition attorney’s fees that Sherwood sought to collect.

The term “returned to fray” has become a term of art in the bankruptcy context. A party is deemed to have “returned to fray” if, after being discharged in bankruptcy and freed from an obligation such as a contract, that party voluntarily decides to enforce rights under that same contract post-discharge. Siegel v. Fed. Home Loan Mortg. Corp. In Siegel, the Ninth Circuit provided an insightful example of when a party was deemed to have “returned to the fray”:

This is a case where the debtor, Siegel, had been freed from the untoward effects of [Freddie Mac’s mortgage] contracts he had entered into. Freddie Mac could not pursue him further, nor could anyone else. He, however, chose to return to the fray and to use the contract as a weapon. It is perfectly just, and within the purposes of bankruptcy, to allow the same weapon to be used against him….

In Siegel, after his post-petition discharge, Siegel initiated litigation against Freddie Mac for breach of contract and tort violations. The court in Siegel explained:

Siegel’s decision to pursue a whole new course of litigation made him subject to the strictures of the attorney’s fee provision. In other words, while his bankruptcy did protect him from the results of his past acts, including attorney’s fees associated with those acts, it did not give him carte blanche to go out and commence new litigation about the contract without consequences.

Ostensibly finding that Taggart had “returned to the fray” like the debtor in Siegel, the Oregon court awarded “roughly $45,000” in post-petition attorney’s fees to Sherwood. Taggart returned to bankruptcy court and argued the discharge order “barred Sherwood from collecting post-petition attorney’s fees” and asked the bankruptcy court to enter a civil contempt order against Sherwood for violating the discharge order. The bankruptcy court refused to do so agreeing with Sherwood that Taggart had returned to the fray. Taggart successfully appealed that finding and the matter was remanded to the bankruptcy court to address the violation of the discharge order. In so doing, the bankruptcy court applied a “strict liability” standard and held Sherwood in civil contempt explaining such a sanction was appropriate “because Sherwood had been aware of the discharge order and intended the actions which violate[d] it.” Sherwood appealed and the “Bankruptcy Appellate Panel (“BAP”) vacated [the] sanctions and the Ninth Circuit affirmed the panel’s decision.” Id.

Instead of applying a strict liability standard, the Ninth Circuit “concluded 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…” The Ninth Circuit went on to explain: “Because Sherwood had a ‘good faith belief’ that the discharge order ‘did not apply’ to Sherwood’s claims…civil contempt sanctions were improper.” Taggart petitioned the USSC for certiorari relief.

In granting certiorari relief, the USSC rejected both the strict liability standard used by the bankruptcy court and the subjective “good faith belief” standard relied upon by the Ninth Circuit. The USSC, relying on section 524 of the bankruptcy code, explained that a discharge order “operates as an injunction” so it was necessary to look at the standard employed when a party violated an injunction to determine the appropriateness of a contempt sanction in the context of a discharge order violation. The Court explained:

When a statutory term is obviously transplanted from another legal source, it brings the old soil with it…Here, the statutes specifying that a discharge order ‘operates as an injunction,’ § 524(a)(2), and that a court may issue any order or judgment that is necessary or appropriate to carry out other bankruptcy provisions, § 105(a), bring with them the old soil that has long governed how courts enforce injunctions. That ‘old soil’ includes the potent weapon of civil contempt.

The USSC analyzed injunction cases addressing civil contempt and concluded that civil contempt was a “severe remedy” that required “explicit notice of what conduct is outlawed before being held in civil contempt.” The Court concluded this was an objective standard and that civil contempt “may be 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.”

The Court explained the Ninth Circuit’s “good faith belief” standard was “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 elaborated a party’s subjective good faith is a “difficult-to-prove” state of mind which may “lead creditors who stand on shaky legal ground to collect discharged debts, forcing debtors back into litigation.”

Likewise, the Court rejected the bankruptcy court’s strict liability standard finding “it would authorize civil contempt sanctions for a violation of a discharge order regardless of the creditor’s subjective beliefs about the scope of the discharge order, and regardless of whether there was a reasonable basis for concluding that the creditor’s conduct did not violate the order.” This, the Court concluded, would “risk additional federal litigation, additional costs, and additional delays” which “would interfere with a chief purpose of the bankruptcy laws.”

Based on these findings, the USSC ultimately concluded the Ninth Circuit “erred in applying a subjective standard for civil contempt” and remanded the case for further proceedings. It 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, the standard is established, and civil contempt should not apply if there is an objectively reasonable basis for concluding that the creditor’s conduct might be lawful.”