On April 23, 2018, the Ninth Circuit held in In re Taggart (the “Opinion”) that a creditor will not be held in contempt for violating the bankruptcy discharge injunction if it has a good-faith belief, even if unreasonable, that the discharge injunction does not apply to it.  A copy of the Opinion is available here.  This is one of very few instances where mistake of law may be an effective defense.

Background

The Debtor, Bradley Taggart, was a property developer who co-owned a business center organized as a limited liability company (the “LLC”) with Terry Emmert and Keith Jehnke.  Prior to his bankruptcy filing, Taggart transferred his membership interests in the LLC to his attorney, John Berman, in violation of Emmert and Jehnke’s right of first refusal.  Emmert and Jehnke sued Taggart and Berman in state court (the “State Litigation”) for failing to allow them to exercise their right of first refusal.  Just before the trial in the State Litigation began, Taggart filed for bankruptcy under chapter 7. The filing of Taggart’s bankruptcy petition triggered the “automatic stay,” staying the State Litigation.

On February 23, 2010, Taggart received his bankruptcy discharge, at which point the State Litigation resumed.  Despite his bankruptcy discharge, the state court held that Taggart was a necessary party and did not dismiss him from the State Litigation.  However, in light of his bankruptcy discharge, the parties agreed that no monetary judgment could be awarded against him.  After trial, the state court held that the Debtor violated Emmert and Jehnke’s right of first refusal and it unwound Taggart’s prepetition transfer of his membership interests in the LLC and expelled him from the LLC.  Emmert and Jehnke’s attorney, Stuart Brown (together with Emmert and Jehnke, the “Creditors”), filed a petition for attorneys’ fees, limiting the request for fees against Taggart to those fees incurred after his bankruptcy discharge, alleging that Taggart had “returned to the fray” – or willingly resumed litigation by participating in the State Litigation after obtaining his discharge.  Taggart opposed the Creditors’ petition.  He also filed a motion in the bankruptcy court to reopen his bankruptcy case, seeking to hold the Creditors in contempt for violating his discharge.

The state court ruled that Taggart could be held liable for attorneys’ fees that were incurred after his bankruptcy discharge because he had returned to the fray.  Subsequent to the state court’s ruling, the bankruptcy court denied Taggart’s motion for contempt, finding that the state court had correctly decided that he had voluntarily resumed litigation.  Taggart appealed the state court’s decision to the Oregon Court of Appeals and appealed the bankruptcy court’s decision to the district court.  The district court reversed, holding that Taggart did not “return to the fray.”  It then remanded the case to the bankruptcy court for a determination of whether the Creditors knowingly violated the discharge injunction in seeking attorneys’ fees. 

On remand, the bankruptcy court found the Creditors had knowingly violated the discharge injunction by seeking attorneys’ fees in the State Litigation, holding them in contempt and awarding sanctions against all three Creditors.  The Creditors appealed the bankruptcy court’s contempt ruling to the Bankruptcy Appellate Panel (the “BAP”).  On appeal, the BAP reversed the bankruptcy court,  holding that the attorneys’ fee petition violated the discharge injunction, but ruled that the Creditors could not be held in contempt unless they “knowingly” violated the discharge injunction. After finding that the Creditors had a good-faith belief that the discharge injunction did not apply to their attorneys’ fee petition, the BAP concluded that they had not “knowingly” violated the discharge injunction.  At this time, the Oregon Court of Appeals issued its opinion reversing the state court’s ruling, holding that Taggart’s actions were neither sufficiently affirmative nor voluntary to constitute a “return to the fray.”

Ultimately, the Creditors were barred from pursuing attorneys’ fees against Taggart by the rulings of both the district court and the Oregon Court of Appeals but, pursuant to the BAP’s ruling, were not liable for sanctions for knowingly violating the discharge injunction. Taggart appealed the BAP’s decision denying sanctions and the Creditors appealed the district court’s decision that Taggart did not return to the fray.

The Ninth Circuit’s Holding

The Ninth Circuit affirmed the BAP’s decision and held that it did not need to address the Creditors’ appeal of the district court’s ruling.

In 2002, the Ninth Circuit adopted a two-part test for issuing a contempt sanction for the violation of a discharge injunction, providing that: “[T]o justify sanctions, the movant must prove that the creditor (1) knew the discharge injunction was applicable and (2) intended the actions which violated the injunction.”  In re Bennett, 298 F.3d 1059, 1069 (9th Cir. 2002).  In the Opinion, the Ninth Circuit ruled that a “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.”  Opinion at 13 (citing In re Zilog, Inc., 450 F.3d 996, 1009 n.14 (9th Cir. 2006)).  In Zilog, the Ninth Circuit held that because the Debtor failed to prove that the alleged violators of the discharge injunction knew of the injunction and its applicability to them, it failed to meet its burden of proof and a contempt award was not warranted.

After considering the Creditors’ argument that their belief was based, in part, on the Debtor’s return to the fray, the Ninth Circuit concluded the Opinion by holding that “the Creditors possessed a good faith belief that the discharge injunction did not apply to their claims,” and accordingly, “[e]ven if the Creditors did violate the discharge injunction … they cannot be held in contempt for that alleged violation.”  Opinion at 14, 15.  The Opinion strengthens the law in the Ninth Circuit that actual knowledge that a discharge injunction applies is required in order for a party to be held in contempt for its violation.  It both reminds debtors of their burden of proof and serves as a warning to creditors of the risks associated with “returning to the fray” of litigation with a debtor post-discharge.