The applicability of contempt penalties in bankruptcy

Editor’s Note: This feature originally appeared in the January issue of DS News

A bankruptcy discharge order acts as an injunction against any action to recover, recover or set off a discharged debt. This includes commencing or continuing a lawsuit for the same. Sections 524 and 105 of the United States Code authorize a court to impose civil contempt penalties for breaches of a release order and, as we know, for the most part this has been strictly enforced.

The majority of courts treat breach of a discharge order as strict liability. As long as a creditor acted deliberately, with knowledge of the bankruptcy case, civil penalties may be appropriate. A subjective belief that an action was compliant, or otherwise exempt from bankruptcy discharge, would not protect a creditor from civil contempt.

A minority of circuits followed a more lenient subjective standard that a creditor would not be held in civil contempt merely by establishing that it had a good faith belief that the release order did not apply to his request, even though that belief was unreasonable.

The Supreme Court handed down a unanimous decision last June, setting a new standard for holding a creditor in contempt for breaching a discharge order. [In re Taggart, 139 S Ct 1795 (2019)]. The court created a standard based on “objective reasonableness”. In other words, the court should not impose contempt penalties where there is just cause for doubt as to the wrongfulness of the defendant’s conduct.

In Taggart pre-injunctive litigation resumed after the debtor’s Chapter 7 bankruptcy discharge became effective. The plaintiff was successful in the lawsuit and sued to recover his attorney’s fees after the motion. The state court ruled that the discharge injunction did not apply to this debt and awarded the plaintiff’s attorney fees after the petition. The defendant reopened the bankruptcy action and filed a motion for contempt for breach of the discharge order. The bankruptcy court issued a contempt order and penalties for violation of the release despite the state court’s finding that the release did not apply to this debt. After several appeals, the Ninth Circuit, applying a subjective standard of review, ultimately reversed the contempt and penalties ruling against the plaintiff. The defendant, Taggart, appealed to the Supreme Court and was granted certiorari.

Taggart argued that the plaintiff breached the release injunction because he was “aware of the release” and “intended to act.” This is the strict liability standard applied in the majority of circuits. The Ninth Circuit disagreed because the plaintiff was told by the state court that the release did not apply to the collection of such attorney’s fees after the petition and therefore had a “belief of good faith” that the discharge injunction did not apply to his action. The Ninth Circuit relied on a subjective standard used in a minority of circuits.

Both standards were problematic in that the strict liability standard could lead to sanctions in cases even with a prudent creditor who had reasonable grounds to believe that the discharge was not applicable (i.e. notice of a lower court). Alternatively, the subjective standard would rely too much on “hard-to-prove states of mind”, resulting in costly litigation for both creditors and debtors. In an attempt to create something between the majority’s strict liability standard and the less common subjective standard, the Supreme Court has created what may be called an “objective reasonability” standard. According to this standard, a bankruptcy court cannot impose civil contempt penalties for breaching the discharge “if there is no just cause for doubt as to whether the order prevented the conduct of the creditor … where there is no objectively reasonable basis for concluding that the creditor’s conduct might be lawful under the discharge order.

The Supreme Court has created an objective standard that takes into account reasonableness and good faith. This allows creditors to be a little less willing to take risks in servicing mortgages after a bankruptcy discharge. A less stringent penalty standard is not only beneficial for creditors, but could also be beneficial for debtors seeking information about their loans or post-bankruptcy loss mitigation options. It also minimizes some of the conflicts creditors face when complying with financial protection rules requiring disclosure, such as the FDCPA and FCRA, with less threat of penalties if they conflict with bankruptcy regulations.

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