Supreme Court Hears Argument on Good Faith as Defense to Discharge Violation

The Supreme Court heard oral argument yesterday in Taggart v. Lorenzen, 18-489 (Sup. Ct.), to decide whether a good faith belief that a debt was not discharged precludes holding the creditor in civil contempt.

The Court will choose among three tests, one proposed by the debtor, one by the U.S. Solicitor General and another by the creditor. Not surprisingly, the debtor argued for strict liability where the creditor’s good faith is no defense. The Solicitor General proposed a purely objective test but said the government would go along with the creditor’s objective test that also considers good faith.

As usual, it’s impossible to guess how the opinion will come down, based on questions from the justices. It’s likely the Court will pick from Column A or Column B.

Column A is the debtor’s strict liability rule, based on the notion that a creditor in doubt should ask the bankruptcy court to rule on whether a debt was discharged. Column B would be some combination of standards proposed by the creditor and Solicitor General, who believe there should be no contempt if the creditor has an objectively reasonable or good faith belief that the debt was not discharged.

The Facts

The facts were exceptionally complex. In summary, the debtor had transferred his interest in a closely held corporation before bankruptcy. 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.

The debtor had 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 had technically violated the discharge injunction.

In sum, the judges disagreed over whether the discharge injunction applied to the litigation to recover attorneys’ fees.

The Ninth Circuit Opinion

The debtor appealed the BAP’s opinion to the Ninth Circuit, where Circuit Judge Carlos T. Bea upheld the BAP and found no contempt. The circuit court held that subjective good faith that a debt was not discharged is a defense to a stay violation, even if the belief is “unreasonable.” Lorenzen v. Taggart (In re Taggart), 888 F.3d 438 (9th Cir. April 23, 2018, rehearing denied Sept. 7, 2018).

There was a circuit split a mere five weeks later, when the First Circuit held in IRS v. Murphy, 892 F.3d 29 (1st Cir. June 7, 2018), that good faith is not a defense to contempt of the discharge injunction.

The Court granted certiorari on January 4 to resolve the circuit split.

Oral Argument

The justices heard one hour of argument yesterday from the debtor, the Solicitor General and the creditor. Technically speaking, the government was taking neither side but was largely supporting the creditor.

Right off the bat, no one supported the Ninth Circuit’s position that a subjective belief is a defense to contempt. The government and the creditor both argued that the belief in the inapplicability of the injunction must be objectively reasonable. Likewise, none of the justices seemed enamored with the Ninth Circuit’s formulation.

Conceivably, the decision may come down to the current Court’s interpretation of Supreme Court authority from the 1800s on the contours of civil contempt. The Solicitor General, for instance, argued that the ancient, ordinary rules regarding civil contempt should apply in the bankruptcy context.

There should be no contempt, the government said, “where as an objective matter there’s a fair ground of doubt about whether the injunction prohibits the challenged conduct.”

The government’s formulation garnered seemingly favorable comments from Justices Sonia Sotomayor, Stephen G. Breyer, Brett M. Kavanaugh and Neil M. Gorsuch. For instance, Justice Kavanaugh said that “the traditional rules of contempt for injunctions suggest that a reasonable, good faith belief that you weren’t violating the order is sufficient.”

The debtor is surely hoping that Chief Justice John G. Roberts, Jr. writes the opinion for the Court, because he seemed squarely in the debtor’s corner. Several times, he came back to the idea that a creditor in doubt can seek a declaration from the bankruptcy court to say whether the debt was discharged.

With regard to the applicability of ordinary rules dealing with civil contempt, the Chief Justice said there is a “deep policy in the Bankruptcy Code to grant relief to the honest debtor.” If there is any doubt about the discharge injunction, he said, the creditor can seek a declaration from the bankruptcy court. Given the availability of a safe harbor, he suggested there should be a “pretty rigorous standard before you can get out of contempt.”

However, the Chief Justice said “it doesn’t have to be strict liability.” Still, he said that the “existence of the safe harbor . . . makes the rigorous standard more acceptable.”

Near the end of the creditor’s argument, the Chief Justice agreed that a rigorous standard would have a “chilling effect” on creditors who want to collect debts they believe were not discharged. But since the debt may or may not have been discharged, he said, “it seems to me perfectly reasonable to have them bear the risk [and] have them make a careful choice.”

Justice Elena Kagan offered an analogy favorable to the debtor based on Section 362(k), which allows an individual to collect actual damages, costs and attorneys’ fees for a “willful violation” of the automatic stay. The statute permits punitive damages “in appropriate circumstances.”

Since Section 362(k) allows the imposition of sanctions regardless of the “reasonableness” of the debtor’s “beliefs,” she asked, “why shouldn’t we have the exact same rule in the two contexts?”

Daniel L. Geyser of Dallas argued for the debtor; Assistant Solicitor General Sopan Joshi appeared for the government, and Nicole A. Sharsky of Washington, D.C., argued for the creditor.

Articles by the American Bankruptcy Institute were cited twice in the debtor’s opening brief.