Justices Setting New Standard For Discharged Debt Collection

12 June 2019 Law360 Publication
Author(s): Tamar N. Dolcourt

This article originally appeared on Law360, and is republished here with permission.

In a unanimous decision, the U.S. Supreme Court recently clarified the appropriate standard to be applied in determining whether civil contempt sanctions are appropriate where a creditor seeks to collect a debt that has been discharged in a bankruptcy proceeding.

In Taggart v. Lorenzen, et al.[1], the court adopted an objective standard, finding that civil contempt sanctions against a creditor would be appropriate where “there is no fair ground of doubt” as to whether the discharge order barred collection of a particular debt.[2] This new standard is likely to change some behavior at the margins, but likely will not have a large impact on the collection of potentially discharged debts in the short term until courts have applied it in a number of cases and a consensus emerges as to how the standard should be applied.

Bradley Taggart was part-owner of a business located in Oregon, the Sherwood Business Center. There was a dispute regarding the business and the other Sherwood owners sued Taggart for breaching the operating agreement. Before trial, Taggart filed a Chapter 7 bankruptcy. He was granted a discharge in the bankruptcy. The discharge order barred the collection of any debt that had been discharged in the bankruptcy proceeding.

After the discharge was entered, the state court entered a judgment against Taggart. After judgment (and after discharge), the prevailing parties sought postpetition attorneys’ fees and costs from Taggart. The parties agreed that under binding U.S. Court of Appeals for the Ninth Circuit precedent, those postpetition fees would be discharged because they arose from a prepetition action unless Taggart had “returned to the fray.”[3] The state court found that Taggart had indeed returned to the fray, and therefore was liable for the fees.

Taggart brought an action in the bankruptcy court, seeking an order that the postpetition fees had been discharged under Ybarra, and seeking civil contempt sanctions against the Sherwood owners. The bankruptcy court found that the state court’s determination that Taggart had returned to the fray in the state court litigation was correct and denied his motion.

However, the district court reversed, finding that the attempt to collect the postpetition fees was a violation of the discharge order. The district court remanded to the bankruptcy court to determine if contempt sanctions were appropriate.

The bankruptcy court applied a standard similar to strict liability, finding that because the Sherwood owners were aware of the discharge order and had intended the actions that violated it, they were liable for the violation. Taggart was awarded damages, including $105,000 in attorneys’ fees, $5,000 for emotional distress and $2,000 in punitive damages. The Sherwood owners appealed to the bankruptcy appellate panel, which vacated the sanctions.

The Ninth Circuit affirmed, applying a subjective standard to the sanctions determination. This standard meant that a creditor’s good faith belief that the discharge order did not bar an action would preclude a finding of contempt, even if the belief was unreasonable.

The Supreme Court granted certiorari to determine the applicable standard for a contempt finding when a creditor violates a discharge order. The court evaluated both the bankruptcy court’s strict liability standard and the Ninth Circuit’s fully subjective standard and determined that neither was correct.

It found that the correct standard was an objective one, one that requires an objectively reasonable belief that a creditor’s actions do not violate the discharge injunction.[4] This holding was based on the court’s prior holdings regarding civil contempt.[5] The court found that outside of the bankruptcy context, civil contempt is a severe consequence and requires that a court find that the party against whom sanctions are sought needs to have “explicit notice” of “what conduct is outlawed.”[6]

By analyzing the standards of civil contempt in other contexts, the court found that the subjective standard adopted by the Ninth Circuit went too far, because in other circumstances parties are not relieved from a civil contempt finding based on their subjective good faith.[7] There would also be difficulties in proving a party’s subjective good faith, and the adoption of such a standard would likely force debtors back to court to litigate such issues, which would prevent them from obtaining the fresh start a bankruptcy discharge permits.[8]

However, the court found that Taggart’s proposed “strict liability” standard went too far in the other direction. While Taggart argued that creditors could go to the bankruptcy court for an advance determination as to whether their debt was discharged under Bankruptcy Rule 4007(a), the court found that such an approach would likely lead to an increase in litigation, which would impede timely and efficient resolution of bankruptcy cases.[9]

The court ultimately determined that an objective standard in which a creditor is liable for civil contempt where there “is not a fair ground of doubt” that its actions are lawful would strike the right balance between the interests of debtors and creditors.[10] However, this standard will require creditors to take a serious look at the actions they wish to bring against discharged debtors. For example, in the Taggart case, the Sherwood owners would have been required to do a comprehensive analysis of the Ybarra decision to determine whether Taggart had indeed “returned to the fray” in order to seek the postpetition attorneys’ fees.

Practitioners will need to be very cognizant of the applicable standards in their own jurisdictions in order to properly advise creditor clients as to whether actions to collect debts that may be subject to the discharge order are prudent and whether there are proper grounds to withstand a motion for contempt if a court ultimately finds the debt was discharged.

As courts throughout the country begin to apply the objective standard, new issues will likely emerge and new tests will be created. The objective standard is likely to have an impact in cases where the creditor is aware that there is not really a fair reason to believe that a debt is not discharged. In those circumstances, which are hopefully rare, if such creditor cannot rely on its own subjective good faith, and where significant contempt sanctions may be awarded (including attorneys’ fees and punitive damages), the court’s new standard may decrease those actions.

It is also possible that the most risk-averse creditors will refrain from bringing potentially meritorious cases. However, as always, it is the tougher cases that will be litigated. It is possible that the new standard may do exactly what the court feared and push creditors toward increased advance litigation over dischargeability in order to avoid a finding of contempt. If this is the case, the bankruptcy process is likely to become more protracted and difficult for debtors and more expensive for creditors.

[1] Taggart v. Lorenzen , No. 18-489, 2019 U.S. LEXIS 3890 (June 3, 2019).

[2] Id. at *5.

[3] In re Ybarra, 424 F.3d 1018 (9th Cir. 2005)

[4] Taggart, supra at 1799.

[5] Id. at 1801.

[6] Id. at 1802 (quoting Schmidt v. Lessard , 414 U.S. 473, 476 (1974) (per curiam)).

[7] Id. at 1802-03.

[8] Id. at 1803.

[9] Id.

[10] Id. at 1804.


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