OK to Seek Attorneys' Fees in State Court After Bankruptcy

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April 25 — A bankruptcy court applied an incorrect legal standard to determine whether parties had actual knowledge that they violated an order granting the bankrupt debtor a discharge from his debts when they applied for their attorneys' fees in state court, the U.S. Bankruptcy Appellate Panel for the Ninth Circuit held April 12.

Judge Meredith A. Jury reversed the bankruptcy court's finding of contempt and vacated its judgment awarding sanctions against the appellants. The bankruptcy court's factual findings were erroneous and not supported by the record, the BAP said.

Violation of Discharge Injunction?

In a Chapter 7 case in which nonexempt assets are liquidated and the proceeds are distributed to creditors, the bankruptcy court grants the debtor a discharge under Bankruptcy Code Section 727(a). That order “discharges the debtor from all debts that arose before the date of the bankruptcy filing.”

Under Section 524(a)(2), a discharge “operates as an injunction against the commencement or continuation of an action, the employment of process, or an act, to collect, recover or offset any such debt as a personal liability of the debtor, whether or not discharge of such debt is waived,” the BAP said. A party who knowingly violates this discharge order can be held in contempt under Section 105(a), the BAP said.

It is undisputed, the BAP said, that the appellants had actual knowledge that the debtor's discharge had been entered at the time they sought post-discharge attorneys' fees in state court. They couldn't have been aware that the discharge injunction applied to their fee request until the question was adjudicated, the BAP said.

When a discharge in bankruptcy relieves a debtor from all prepetition debts, the Ninth Circuit has adopted a different standard for determining for discharge purposes when an attorneys' fee claim arises, the BAP said. Even if the underlying claim arose prepetition, “the claim for fees incurred postpetition on account of that underlying claim is deemed to have arisen postpetition if the debtor ‘returned to the fray' postpetition by voluntarily and affirmatively acting to commence or resume the litigation with the creditor,” the BAP said, citing Boeing North American, Inc. v. Ybarra (In re Ybarra), 424 F.3d 1018 (9th Cir. 2005).

This isn't a case in which the appellants “knew of the discharge injunction and continued to press their attorneys' fees claim in state court under the assumption that the discharge injunction” didn't apply to them, the BAP said. Although the discharge order was in place at the time the appellants made their fee request in the state court, the order didn't advise the appellants of the scope of the injunction under the Ybarra rule, the BAP said.

State Court Suit

Sherwood Park Business Center, LLC (SPBC) sued debtor Bradley Weston Taggart, BT of Sherwood, LLC, and the debtor's attorney John M. Berman in state court before the debtor filed for Chapter 7 bankruptcy. The litigation was based on the debtor's transfer of his membership interest in SPBC to another LLC entity. Ultimately, the membership was purchased by Berman, in violation of SPBC's operating agreement.

The debtor filed his bankruptcy petition on the eve of the state court trial and then received a discharge. Postpetition, Terry W. Emmert and Keith Jehnke resumed the state court litigation. The state court ruled in SPBC's favor by unwinding the debtor's transfer of his membership interest.

Attorneys' Fees, Costs?

Later, Emmert and Jehnke's attorney sought attorneys' fees and costs in state court for the period after the debtor's discharge. They also asked for a ruling on whether the discharge injunction applied to the post-discharge fee request.

The state court ruled that the debtor “had returned to the fray” and, thus, the discharge injunction didn't apply to the post-discharge request for attorneys' fees and costs under the Ybarra rule. The state court awarded SPBC attorneys' fees and costs.

Meanwhile, the debtor reopened his bankruptcy case and filed a motion to hold the appellants in contempt for violating the discharge injunction under Section 524(a)(2).

The bankruptcy court found no error with the state court's ruling on the applicability of the discharge injunction.

The district court reversed and remanded the case.

On remand, the bankruptcy court found that the debtor proved by clear and convincing evidence that the appellants had willfully violated the discharge injunction since they were aware of the discharge injunction and intended the actions that violated it. The court entered an order for contempt and ordered sanctions in favor of the debtor.

Incorrect Legal Standard Applied

Emmert, Jehnke, and SPBC appealed to the BAP, which reversed the bankruptcy court's finding of contempt and vacated the sanctions judgment.

The bankruptcy court applied an incorrect legal standard to determine whether the appellants had actual knowledge that the discharge injunction applied to their fee request in the state court, the BAP said, citing Zilog, Inc. v. Corning (In re Zilog, Inc.), 450 F.3d 996 (9th Cir. 2006). Under Zilog, the movant must prove that the creditor “(1) knew the discharge injunction was applicable and (2) intended the actions which violated the injunction,” the BAP said.

Although the bankruptcy court cited the correct test for a finding of willfulness, it mistakenly used the test from Hardy v. United States (In re Hardy), 97 F.3d 1384 (11th Cir. 1996), which is whether the defendant in the contempt action “knew that the discharge injunction was invoked,” the BAP said.

Judges Ralph B. Kirscher and Robert J. Faris joined the opinion.

Hollis K. McMilan represented appellants Terry W. Emmert, Keith Jehnke, and Sherwood Park Business Center, LLC; James Ray Streinz, McEwen Gisvold LLP, represented appellant Shelley A. Lorenzen; John M. Berman represented appellee/debtor Bradley Weston Taggart.

To contact the reporter on this story: Diane Davis in Washington at ddavis@bna.com

To contact the editor responsible for this story: Jay Horowitz at jhorowitz@bna.com