The Restructuring Report

As commonly understood amongst bankruptcy professionals, when a creditor violates the discharge injunction in a bankruptcy case, courts have the authority to levy civil contempt violations against the violating creditor. However, a more difficult question for those professionals, and one that presiding courts have occasionally struggled to answer, is under which circumstances a creditor’s abusive action actually rises to the level of civil contempt.

Multiple courts, such as the Eighth Circuit in First State Bank of Roscoe v. Stabler, have found sanctions to be available for a willful violation of the discharge injunction where a creditor violated the injunction without a good faith basis for believing its debt was excepted from discharge or had knowledge of the injunction’s existence. Similarly, In re Ritchey found no defense from a violation of the discharge injunction for failure to understand the effect of the discharge injunction, citing McCool v. Beneficial (In re McCool). In re Nassoko decided that “[a]ctual or constructive knowledge of the discharged debt will suffice to find a party in violation of the discharge injunction.” However, with its recent decision In re Taggart, the Ninth Circuit has departed from the standard recognized by these other courts and in the process generated more complex questions than its opinion actually answered.

In re Taggart began with the bankruptcy proceedings of Bradley Taggart, a real estate developer with an interest in the Sherwood Park Business Center, LLC. Terry Emmert and Keith Jehnke, also interest holders in Sherwood, sued Taggart in state court for transferring his interest in Sherwood to his attorney in an alleged breach of Sherwood’s operating agreement. Taggart then filed a voluntary Chapter 7 bankruptcy case shortly before trial, staying the state court trial.

After the bankruptcy court eventually granted Taggart a discharge, Emmert and Jehnke resumed their state court action against Taggart. The state court later denied Taggart’s motions to dismiss the lawsuit as a violation of the discharge injunction and ultimately unwound Taggart’s Sherwood transfer and allowed the parties to petition the court for attorney’s fees. While Emmert and Jehnke’s petitions for fees remained pending in state court, Taggart reopened his bankruptcy case and filed a motion seeking to hold Emmert, Jehnke, Sherwood and their attorney in contempt for violating the discharge injunction.

After the bankruptcy court found Emmert and Jehnke in violation of the discharge injunction and awarded sanctions against them, the Bankruptcy Appellate Court reversed by holding that Emmert and Jehnke had relied in good faith on the state court’s finding that the discharge injunction did not apply to their claims for attorney’s fees and Taggart’s continued participation in the state court action post-discharge.

On appeal, the Ninth Circuit recognized that sanctions for the violation of the discharge injunction are only justified when a creditor:

(i) knew the discharge injunction was applicable and
(ii) intended the violating actions.

Focusing on the first element, the Ninth Circuit recognized that Emmert and Jehnke’s reliance on the state court’s finding and Taggart’s continued participation — instead of relying on a bankruptcy court order — may have been unreasonable; nonetheless, the Ninth Circuit concluded that Emmert and Jehnke’s reliance was still in good faith. Thus, as the Ninth Circuit had previously held in In re Zilog, Inc. Emmert and Jehnke’s unreasonable belief that the discharge injunction did not apply to them insulated them from sanctions.

While the Taggart decision attempted to clarify the Ninth Circuit’s standard for determining when a creditor may be held in civil contempt for a violation of the discharge injunction, the ruling still leaves open the question of just how far a creditor really can go before it will be held in civil contempt within the Ninth Circuit. Does any conduct short of blatant bad faith escape civil punishment? Could a party who remains purposefully ignorant of the discharge’s application to its claim be insulated from sanctions because that party did not “know” that the injunction specifically applied to that claim? Subsequent cases in the Ninth Circuit show that the answer to that question may be “yes.” For example, In re Torres found creditor not in contempt where he was not explicitly told that his continued prosecution of a state court action violated the discharge injunction pursuant to In re Taggart.

Yet, with the U.S. Supreme Court recently granting certiorari and holding oral arguments in In re Taggart on this issue, it remains to be seen if this precedent will ultimately influence other courts that have previously found that good faith or lack of actual knowledge alone may not be enough to shield a violating creditor from civil sanctions to instead adopt the Ninth Circuit’s unreasonable yet good faith standard.