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Eleventh Circuit Holds Filing Proof of Claim on Previously Discharged Debt Violates Discharge Injunction

Picture2The U.S. Court of Appeals for the Eleventh Circuit recently held, in a case of first impression, that a creditor violates the bankruptcy discharge injunction by filing a proof of claim on a debt that was previously discharged in another bankruptcy proceeding.

A copy of the opinion is available at: Link to Opinion.

Husband and wife debtors filed a Chapter 13 bankruptcy petition in 2006. The case was converted to a Chapter 7 liquidation, and the subject debt, a deficiency of approximately $11,000 on a sales contract for a mobile home, was discharged in 2009.

In 2012, the debtors filed a second Chapter 13 case, in which the creditor and its servicer filed a proof of claim for the discharged debt.  The debtors objected to the claim and filed an adversary proceeding, alleging that the creditor and its servicer violated 11 U.S.C. § 524(a)(2) of the Bankruptcy Code, which provides that a discharge order operates as an injunction against further collection efforts.

The bankruptcy court sustained the debtors’ objection to the claim and, after a trial in the adversary proceeding, found that the discharge injunction was violated, awarding compensatory sanctions for the debtors’ emotional distress and punitive sanctions designed to persuade the creditor and servicer to fix any defects in their automated systems in order to avoid future violations.

The creditor and servicer appealed to the district court.

The district court, sitting in its appellate bankruptcy capacity, affirmed the bankruptcy court’s judgment, reasoning that even though the creditor withdrew its proof of claim, the punitive sanctions were proper because the creditor acted with reckless disregard of the risk of violating the discharge injunction. The creditor appealed to the Eleventh Circuit.

On appeal, as a threshold issue, the Eleventh Circuit was concerned with and addressed sua sponte whether the bankruptcy court in the second bankruptcy case had jurisdiction to enforce the discharge injunction issued in the first bankruptcy case. The Appellate Court concluded that the bankruptcy court in the second action did have jurisdiction, even over a case with a different case number, because the bankruptcy court has inherent authority to punish contempt “as a means to protecting itself as an institution,” not just to enforce a ruling in particular cases.

The Eleventh Circuit also pointed out that the bankruptcy court has statutory contempt power under 11 U.S.C. § 1105(a) to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of” the Bankruptcy Code.

Because the bankruptcy court had the power to enforce the discharge injunction in the first case, the Appellate Court held it also had jurisdiction to hear the motion for contempt in the debtors’ second case for violating the injunction in the first case.  Thus, the Eleventh Circuit concluded it had jurisdiction to hear the appeal.

Turning to the merits, the Appellate Court addressed whether the discharge injunction under 11 U.S.C. § 524(a)(2) is violated where a creditor files a proof of claim on a debt that was discharged in an earlier bankruptcy proceeding.

Finding the statutory text ambiguous, the Eleventh Circuit analyzed the legislative history and, joining other Circuits that had considered the issue, concluded that because § 524(a)(2) was designed to broadly prevent any form of harassment of a debtor, and that an action by a creditor violates the discharge injunction if “the objective effect of the creditor’s action is to pressure a debtor to repay a discharged debt, regardless of the legal entity against which the creditor files its claim.”

The Appellate Court rejected the creditor’s argument that the discharge injunction was not violated because the filing of the proof of claim was not an attempt to collect the debt personally against the debtors, but rather from the bankruptcy estate.  The creditor also argued that, by analogy to the automatic stay in 11 U.S.C. § 362(a), although that section prohibits debt collection outside of bankruptcy, it does not prohibit the filing of a proof of claim to collect an unenforceable debt within the bankruptcy process.

Relying on its prior rulings about the broad scope of the discharge injunction and “persuasive authorities,” the Eleventh Circuit concluded the creditor violated the discharge injunction, holding that “the test for whether a creditor violates the discharge injunction under 11 U.S.C. § 524(a)(2) is whether the objective effect of the creditor’s action is to pressure a debtor to repay a discharged debt, regardless of the legal entity against which the creditor files its claim.”

Importantly, the Appellate Court reasoned that the filing of the proof of claim was clearly an “act to collect, recover or offset [the discharged] debt as a personal liability” of the debtors because (a) the Eleventh Circuit had previously held that the filing of a proof of claim constitutes the first step in collecting a debt in bankruptcy, at least indirectly; and (b) the filing of the proof of claim triggered an increase in the debtors’ Chapter 13 plan payments, which imposed the kind of pressure on the debtors that § 524(a)(2) was designed to prevent.

Although the Eleventh Circuit concluded the creditor and servicer violated the discharge injunction, it found the sanctions were punitive rather than coercive, and the creditor was not afforded sufficient due process.  Accordingly, the Eleventh Circuit reversed and vacated the sanctions awards, and remanded to the district court with instructions to vacate and remand the case to the bankruptcy court for further proceedings.

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The attorneys of Maurice Wutscher are seasoned business lawyers with substantial experience in business law, financial services litigation and regulatory compliance. They represent consumer and commercial financial services companies, including depository and non-depository mortgage lenders and servicers, as well as mortgage loan investors, financial asset buyers and sellers, loss mitigation companies, third-party debt collectors, and other financial services providers. They have defended scores of putative class actions, have substantial experience in federal appellate court litigation and bring substantial trial and complex bankruptcy experience. They are leaders and influencers in their highly specialized area of law. They serve in leadership positions in industry associations and regularly publish and speak before national audiences.

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