A creditor’s subjective, good faith belief that its action does not violate the discharge injunction precludes finding the creditor in contempt, even if the discharge injunction did apply and the creditor’s belief was “unreasonable,” the Ninth Circuit ruled in an April 23 opinion.
The opinion appears to mean that a creditor can act in good faith even if the creditor’s belief is unreasonable. In other words, litigation in the Ninth Circuit over contempt of the discharge injunction will focus on the creditor’s subjective good faith, without regard to whether the creditor’s belief was right or wrong, reasonable or unreasonable.
The facts were horribly complex. With apologies for oversimplification, we summarize the facts as follows:
Before bankruptcy, the debtor transferred his interest in a closely held corporation. After the debtor received his chapter 7 discharge, two other shareholders sued the debtor in state court for transferring his interest without honoring their contractual right of first refusal. They also sued the transferee of the stock.
After the debtor raised his discharge as a defense in state court, the parties agreed he would not be liable for a monetary judgment. The state court eventually ruled in favor of the creditors and unwound the transfer.
The creditors then sought attorneys’ fees as the prevailing parties, invoking a fee-shifting provision in the shareholders’ agreement. The state court ruled that the debtor “returned to the fray” and thereby made himself liable for post-discharge attorneys’ fees.
Meanwhile, the debtor reopened his bankruptcy case, seeking to hold the creditors in contempt for violating the discharge injunction. The bankruptcy judge sided with the debtor and imposed sanctions. The Bankruptcy Appellate Panel reversed the finding of contempt, ruling that the creditors’ good faith belief that their actions did not violate the injunction absolved them of contempt.
Meanwhile, the state appellate court and a federal district court in related litigation both ruled that the debtor’s participation in the litigation did not constitute returning to the fray, thus taking away the grounds for imposing attorneys’ fees and lending credence to the notion that the creditors did technically violate the injunction.
In sum, judges disagreed over whether the discharge injunction applied to the litigation to recover attorneys’ fees.
The debtor appealed the BAP’s opinion to the Ninth Circuit, where Circuit Judge Carlos T. Bea upheld the BAP and found no contempt. In the process, he expanded the defenses available to someone charged with contempt of a discharge injunction.
To impose sanctions, existing Ninth Circuit precedent requires the debtor to show that the creditor knew the discharge injunction was applicable and prove that the creditor intended the actions that violated the injunction. In the case at hand, knowledge of the applicability of the injunction was the only issue.
Based on In re Zilog Inc., 450 F.3d 996 (9th Cir. 2006), Judge Bea said that knowledge of the injunction cannot be proven by merely showing that the creditor was aware of the bankruptcy. Citing a footnote in Zilog, he went on to hold that “the creditor’s good faith belief that the discharge injunction does not apply to the creditor’s claim precludes a finding of contempt, even if the creditor’s belief is unreasonable.”
Judge Bea acknowledged that his interpretation of Zilog is “somewhat at tension” with two other Ninth Circuit precedents. Although Judge Bea said that Zilog was binding, it is arguable that the footnote in Zilog was dicta and therefore was not binding. Regardless of whether Zilog was binding or not, Judge Bea’s opinion is now law in the Ninth Circuit, although it is unclear whether it was necessary for him to rule that an unreasonable belief is not actionable.
Based on his reading of Zilog, Judge Bea concluded, like the BAP, that the creditor had a good faith belief that the discharge injunction was inapplicable on the theory that the debtor had “returned to the fray.” The creditor’s belief in that regard was strengthened because the state trial court agreed.
Recall, however, that the state appellate court and the district court took the opposite view by concluding that the debtor had not “returned to the fray” but had been compelled to litigate. In other words, judges disagreed about the applicability of the injunction.
Although the creditors’ belief in the inapplicability of the injunction ultimately was proven wrong, Judge Bea said that “their good faith belief, even if unreasonable, insulated them from a finding of contempt.”
Judge Bea’s opinion applies a subjective test with respect to belief in the inapplicability of the injunction. Moreover, there is no contempt even if the creditor’s subjective belief is unreasonable. Consequently, it seems that reliance on counsel’s advice would always absolve a client from contempt liability in the Ninth Circuit.
Judge Bea’s opinion also seems to stand for the proposition that there is no contempt if reasonable minds could differ on the applicability of the injunction. Since it’s often debatable whether the discharge injunction applies, contempt henceforth may be difficult to prove in the Ninth Circuit.
Because an unreasonable belief is not grounds for a finding of contempt, an argument evidently must be at least frivolous before there is contempt.
We submit that the appeals court could have reached the same result on more narrow grounds by finding good faith since the trial judge in state court supported the creditors’ belief by ruling that the injunction did not apply. By ruling more narrowly, the appeals court could have avoided pronouncing a rule that gives creditors license to disregard discharge injunctions by making pretextual arguments.
It is not clear from the opinion whether the same contempt standard applies to violation of the automatic stay. If it does, the automatic stay will have lost its teeth in the Ninth Circuit.