“I have a great deal of trouble with this business model,” Justice Sonia Sotomayor said today near the outset of oral argument in the Supreme Court on Midland Funding LLC v. Johnson, the case to decide whether debt collectors violate the federal Fair Debt Collection Practices Act by purchasing stale claims for pennies and then filing proofs of claim when the underlying debt is barred by the statute of limitations.

The observation by Justice Sotomayor was the high point for debtors, because the justices seemed divided along the usual ideological lines. The Court will not likely be split 4/4, because Justice Stephen G. Breyer, who is often allied with the liberal wing on bankruptcy cases, repeatedly seemed concerned that ruling for debtors would transfer disputes into federal district courts that should be in bankruptcy courts.

The Issues

The Supreme Court granted certiorari to resolve splits among the circuits and decide whether the Bankruptcy Code impliedly repealed the FDCPA and whether the filing of a knowingly time-barred proof of claim violates the FDCPA.

The case involves an industry created when debt collectors began paying small amounts to buy debts where statutes of limitations would preclude recovery were they to file suit. The debt purchasers’ computer systems automatically notify them when their debtors file bankruptcy and allow them to file proofs of claim at little cost. The purchasers’ claim forms typically disclose all required information that should alert trustees and debtors to the fact that collection of the debts would be time-barred.

The business model is based on the reality in bankruptcy that there will be no objections to time-barred claims in some cases, either through inadvertence or because objecting is not economically justifiable or not covered by counsels’ flat-fee arrangements. By paying so little to buy the claims, debt collectors can turn a profit even if only just a few of the claims are allowed to slip through.

Outside of bankruptcy, five circuit courts have held that filing suit to collect on a stale claim violates the FDCPA because an unsophisticated consumer may not realize there is an iron-clad defense. For the Supreme Court, the question is whether the same rule should apply to bankruptcy. The outcome is important, because a violation of the FDCPA automatically entitles the consumer to recover attorneys’ fees and up to $1,000 in statutory damages.

The Eleventh Circuit, from which the appeal was taken, was intent on stamping out this business practice. In addition to adding costs to bankruptcy cases by forcing trustees or debtors to object to patently time-barred claims, the Atlanta-based appeals court said that creditors with legitimate claims suffer from the dilution of their recoveries when trustees or debtors fail to object.

The Eleventh Circuit therefore held in May that filing a stale claim violated the FDCPA. In a prior case called Crawford, the Eleventh Circuit had held that the later-adopted Bankruptcy Code did not impliedly repeal the FDCPA with regard to claims filed in bankruptcy court.

Affirming the Eleventh Circuit and finding a violation of the FDCPA will mean the end of the business of buying time-barred claims. Reversing will give the industry a shot in the arm. On the other hand, victory by debt collectors could be short lived if the Bankruptcy Rules are amended in a fashion that effectively bars the filing of stale claims.

Splits Among the Circuits

In Nelson v. Midland Credit Management Inc., the Eighth Circuit disagreed with the Eleventh when it held in July that filing a stale proof of claim does not violate the FDCPA. In August, the Fourth Circuit similarly ruled, 2-1, that filing a time-barred claim does not violate the FDCPA, on the theory that the Bankruptcy Code and Rules invite creditors to file proofs of claim based on stale debts.

The Seventh, Eighth and Second Circuits have already held that the FDCPA is not violated when a creditor files a claim based on a debt where collection is precluded by the statute of limitations.

The circuit courts had previously split on whether the Bankruptcy Code impliedly repealed the FDCPA. The Second and Ninth Circuits found implied repeal, while the Third, Seventh and Eleventh Circuits held there is no implied repeal because the FDCPA and the Bankruptcy Code may coexist, since creditors can comply with both simultaneously.

Courts that have found no irreconcilable conflict between the two statutes usually say that the Bankruptcy Code does not compel creditors to file proofs of claim, thus enabling them to avoid an FDCPA violation.

The Justices’ Questions and Comments

Justices Sotomayor and Elena Kagan seemed firmly in the debtor’s camp. On the question of whether the Bankruptcy Code invites creditors to file stale claims and thus creates an exception to the FDCPA, Justice Kagan said it was hard to believe that Congress wanted claims to be filed that are unenforceable under statutes of limitations.

Justice Ruth Bader Ginsburg also had problems with the bona fides of the business model when she observed how there was no point to filing a time-barred claim apart from the chance it might slip through the cracks.

Even if the Bankruptcy Code invites creditors generally to file stale claims, Justice Kagan intimated it could be an FDCPA violation because that law applies only to sophisticated debt collectors taking advantage of shortcomings in the bankruptcy system.

Even to have a 4/4 split, which would affirm the Eleventh Circuit without setting a precedent, Justice Breyer would need to vote with the three women justices. Justice Breyer is often the most knowledgeable among the justices when it comes to bankruptcy.

However, Justice Breyer was fixated on the notion that the FDCPA could bring a flood of lawsuits into district court when the whole point of the Bankruptcy Code is to concentrate all disputes over claims in the bankruptcy court. If the debt collection industry is engaged in a nefarious business, he suggested that the Federal Trade Commission should step in to ban the practice of filing stale claims rather than find the solution in the FDCPA.

Possibly in the debt collector’s camp, Chief Justice John G. Roberts Jr. was troubled by the notion that applying the FDCPA to bankruptcy claims would effectively shift the burdens from what they are under the Bankruptcy Code. Under the Code, he said, the debtor has the burden of objecting when a filed claim is invalid. Applying the FDCPA would put the burden initially on the debt collector to withhold a claim in the first instance.

Justice Anthony M. Kennedy, often the swing vote, observed that only two states’ laws extinguish stale claims entirely, insinuating that creditors have the right to file proofs of claim because the statute of limitations is an affirmative defense. He also said that the FDCPA could become a “trap for the unwary.”

Although he said he found it a “difficult case,” Justice Samuel A. Alito, Jr. asked why it wouldn’t be cheap and easy to file objections to stale claims. He was also troubled by Justice Roberts’ point that applying the FDCPA would shift the burden of proof.

Given a division among the justices, don’t expect a decision quickly. The outcome may indicate whether the Court is inclined to interpret federal consumer protection laws broadly, in favor of consumers, or narrowly, to protect the financial industry from lawsuits.