Supreme Court Rejects Strict Liability for Discharge Violations

Today, the Supreme Court rejected a strict-liability standard for the imposition of contempt for violating the discharge injunction. Instead, the justices held unanimously that the bankruptcy court “may impose civil contempt sanctions when there is no objectively reasonable basis for concluding that the creditor’s conduct might be lawful under the discharge order.”

The opinion for the Court by Justice Stephen G. Breyer also rejected the Ninth Circuit’s idea that a subjective, good faith belief about the inapplicability of the discharge injunction is a defense to contempt. It is unclear from the opinion whether the Court’s standard for a discharge violation also applies to violations of the automatic stay under Section 362.

A Discharge Violation Was Unclear

The procedural history of the case in the lower courts was exceptionally complex. Suffice it to say that the debtor had transferred his interest in a closely held corporation. After the debtor received his chapter 7 discharge, two other shareholders sued him 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 in April 2018 and found no contempt. However, he expanded the defense available to someone charged with contempt of a discharge injunction. The appeals court held 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.”

The debtor filed a petition for certiorari, which the Supreme Court granted in January. Oral argument was held on April 24.

The Standard Borrowed from Equity

In his 11-page opinion, Justice Breyer said the outcome was informed by Section 524(a)(2), the statutory discharge injunction, and by Section 105(a), the bankruptcy version of the All Writs Act.

Those two sections, according to Justice Breyer, “bring with them the ‘old soil’ that has long governed how courts enforce injunctions.” The “old soil,” he said, includes “the traditional standards in equity practice for determining when a party may be held in civil contempt for violating an injunction.”

Justice Breyer cited Supreme Court precedent from 1885 holding that civil contempt should not be found “where there is [a] fair ground of doubt as to the wrongfulness of the defendant’s conduct.” California Artificial Stone Paving Co. v. Molitor, 113 U.S. 609, 618 (1885) (emphasis added by Justice Breyer).

Justice Breyer then cited Schmidt v. Lessard, 414 U.S. 473, 476 (1974) (per curiam), for the notion that “principles of ‘basic fairness requir[e] that those enjoined receive explicit notice’ of ‘what conduct is outlawed’ before being held in civil contempt.”

Although subjective intent is not “always irrelevant,” Justice Breyer said, “This standard is generally an objective one.” [Emphasis in original.] Again citing high court precedent, he said that “a party’s good faith, even where it does not bar civil contempt, may help determine an appropriate sanction.”

Given that the “typical discharge order entered by a bankruptcy court is not detailed,” Justice Breyer held that civil contempt “therefore may be 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.”

The Rejected Standards

Justice Breyer rejected the Ninth Circuit’s “good faith belief” standard. Recognizing the realities of life for debtors, he said that the rule proposed by the circuit court “may too often lead creditors who stand on shaky legal ground to collect discharged debts, forcing debtors back into litigation (with its accompanying costs) to protect the discharge that it was the very purpose of the bankruptcy proceeding to provide.”

On the other hand, he also rejected a strict-liability standard that would authorize a contempt finding “regardless of the creditors’ subjective beliefs about the scope of the discharge order, and regardless of whether there was a reasonable basis for concluding that the creditor’s conduct did not violate the order.”

In support of strict liability, the debtor argued that a creditor can turn to the bankruptcy court for a so-called comfort order declaring that a proposed action would not violate the discharge injunction. To that, Justice Breyer said that a “risk averse” creditor would seek a comfort order “even when there is only a slight doubt” about a violation of discharge. Often, he said, there will “be at least some doubt as to the scope of” the discharge.

Frequent use of comfort orders, Justice Breyer said, would run contrary to Section 523(c)(1), where only three categories of debts require advance determinations of dischargeability.

Frequent resort to comfort orders, according to Justice Breyer, would “alter who decides whether a debt has been discharged, moving litigation out of state courts, which have concurrent jurisdiction over such questions, and into federal courts.”

Because the Ninth Circuit had not employed the proper standard, the Justice Breyer vacated the judgment of the appeals court and remanded “the case for further proceedings consistent with this opinion.”

What About the Automatic Stay?

Does the Supreme Court’s standard for contempt of the discharge injunction also apply to violations of the automatic stay under Section 362(a)?

Justice Breyer said that the language in Section 362(k)(1) “differs from the more general language in Section 105(a).” Section 362(k)(1) allows an individual to recover actual damages, costs, attorneys’ fees and even punitive damages (in “appropriate circumstances”) for “any willful violation” of the automatic stay.

The debtor argued that lower courts have often imposed strict liability for violating the automatic stay. Coupled with the different purpose of the automatic stay, the absence of the word “willful” in the discharge context prompted Justice Breyer to reject the idea of importing lower courts’ standards for violation of the automatic stay to contempt of the discharge injunction.

Parenthetically, Justice Breyer noted that the use of “willful” in Section 362(k)(1) is “a word the law typically does not associate with strict liability.” However, he ducked the question, saying that “[w]e need not, and do not, decide whether the word ‘willful’ supports a standard akin to strict liability.”

Although the Court made no holding about automatic stay violations, Justice Breyer’s parenthetical observation can lay the foundation for contending there is also no strict liability for stay violations.

So, the question remains: Is the contempt standard different for automatic stay violations?

Craig Goldblatt of Wilmer Cutler Pickering Hale & Dorr LLP in Washington, D.C., observed that “the Code sets out a standard for the stay but not the discharge injunction. Bankruptcy lawyers think they serve a similar role and so read them to be parallel. But there is no textual basis for that.”

“In the absence of text,” Goldblatt said in a message to ABI, “the Court says you read the discharge injunction just like you would any injunction outside of bankruptcy. That is all that he needed to say to resolve this case. Because it is not a case about the automatic stay, it presented no basis to opine on how the automatic stay works.”

Goldblatt therefore concluded, “Taggart has nothing at all to do with the automatic stay.” He has argued three bankruptcy cases in the Supreme Court.

Assuming the Court said nothing about automatic stay violations with respect to individuals, what about violations of the stay protecting corporate debtors where there is no statutory standard like 362(k)(1)? Does the absence of a statutory standard for corporate debtors throw the issue back to common law regarding injunctions?

However, the standards may be different, because, as Justice Breyer observed, the automatic stay has a shorter duration and a different purpose in preventing disruptions in the administration of bankruptcy cases.

The high court’s ruling on discharge violations may touch off decades of litigation over the standard for deciding whether someone violated the automatic stay.