Opinion analysis: Justices reject subjective standard on sanctions for violating the bankruptcy discharge

Yesterday’s decision in Taggart v. Lorenzen will not go down as one of the major decisions of the term, but it should provide some useful guidance in an area as to which the Supreme Court has not previously spoken: the standards for punishing creditors that violate the discharge that bankruptcy provides to debtors.

A central feature of the bankruptcy process for consumers is a “discharge” that excuses a debtor that completes a bankruptcy proceeding from paying debts incurred before the bankruptcy filing. The legal force of the discharge is the threat of contempt: A bankruptcy court will hold a creditor in contempt if the creditor attempts to collect a discharged debt.

One problem with that process arises when it is not clear that a creditor’s post-discharge interactions with a debtor violate the discharge. In some cases, for example, it may not be clear that the debt in question has been discharged. The Bankruptcy Code includes a large number of detailed exceptions that allow certain debts to survive the bankruptcy discharge.  For example, the discharge does not extend to most student-loan debts, to fraudulently incurred debts, and to domestic-support obligations. In cases in which application of the discharge is ambiguous, creditors might be unsure about whether particular activities violate the discharge.

The question before the Supreme Court in Taggart is how to decide whether a court should sanction a creditor for collection activities that turn out to violate the discharge. In this case, the creditors in question (a business named Sherwood, its owners, and their former attorney, who is 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. Because the litigation involved ownership of the business, the litigation itself did not violate the discharge. At the end of the litigation, though, the state court ordered Taggart to pay Sherwood’s attorney’s fees. That monetary judgment ordinarily would violate the discharge, but the state court concluded that it was permissible under a lower-court doctrine holding that the discharge no longer applies when a debtor “returns to the fray” of litigation against the creditor.

By the end of the litigation in the lower courts, it was settled that the judgment against Taggart violated the discharge, and that he could not be forced to pay the attorney’s fees. The U.S. Court of Appeals for the 9th Circuit concluded, however, that Sherwood could not be held in contempt so long as it had held a subjective belief, however unreasonable, that it was entitled to press Taggart to pay those fees. Justice Stephen Breyer’s opinion for a unanimous court squarely rejects that holding.

Breyer starts with Section 524 of the Bankruptcy Code, which provides that the bankruptcy court’s order of discharge “operates as an injunction against” post-bankruptcy collection of debts. Because that statute gives the discharge force by treating it as an injunction, Breyer reasons, enforcement of the discharge should follow traditional rules for enforcing injunctions. Quoting a law-review article by Justice Felix Frankfurter, Breyer explains: “When a statutory term is ‘obviously transplanted from another legal source,’ it ‘brings the old soil with it.’” In this case, the “old soil” is the “potent weapon” of sanctions for contempt. Traditionally, Breyer notes, courts faced with injunctions have understood that “basic fairness” requires that those sanctions do not apply in the face of a “fair ground of doubt” about the propriety of activity.

Coming closer to the dispute at hand, Breyer emphasizes 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.” Breyer offers one qualification of that statement, noting that “subjective intent is [not] always irrelevant,” both because “sanctions may be warranted when a party acts in bad faith” and because “a party’s good faith, even where it does not bar civil contempt, may help to determine an appropriate sanction.” Breyer closes that discussion by offering a summary statement of a rule of decision: 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.”

With that “objectively unreasonable” standard in hand, Breyer readily disposes of the 9th 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.” For Breyer the lower-court standard “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.”

Finally, Breyer turns to the standard that Taggart proposes, a “strict-liability” standard under which actions that violate the discharge would be sanctioned unless the creditor precleared them with the bankruptcy court. For Breyer, that standard does not “provide a workable solution to the creditor’s potential dilemma.” From his perspective, because “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.” The statute suggests, though, that such a “procedure would be needed in only a small number of cases.” In contrast, Breyer explains, “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.” The “additional federal litigation, additional costs, and additional delays” of that proposal are enough to persuade Breyer to reject it.

Taggart is not an earth-shaking decision. It does, though, provide the first Supreme Court discussion of a topic that comes up with considerable frequency in the bankruptcy courts, so we can expect it to be widely used to provide the organizing principle for the trial-court opinions that resolve litigation in the area.