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8th Cir. Holds State Court Judgment Did Not Preclude Bankruptcy Court from Enforcing Its Own Orders

The U.S. Court of Appeals for the Eighth Circuit recently affirmed a trial court judgment holding a bank and its principal in contempt and sanctioning them for violating a bankruptcy discharge injunction, based on the findings in a parallel state court proceeding.

In so ruling, the Eighth Circuit held that the state court judgment did not preclude the bankruptcy court’s ability to enforce its own orders.

A copy of the opinion in First State Bank of Roscoe v. Stabler is available at:  Link to Opinion.

A bank issued a loan to husband and wife borrowers for their business. After the business failed, a principal at the bank counseled them to obtain bankruptcy protection.  The principal also recommended the borrowers retain a particular bankruptcy attorney to assist them.

The borrowers filed bankruptcy and eventually received a discharge.  After the discharge, the bank still held security interests on the borrowers’ property and on the property of the husband borrower’s parents, but the bank would have realized a substantial loss if it foreclosed on its security.  Therefore, instead of foreclosing, the bank sought and received commitments from the borrowers and the parents to pay new notes that were “substantially in excess of the security interests that had survived bankruptcy.”

The borrowers and the parents defaulted on their post-bankruptcy obligation. Faced with collection efforts by the bank, the borrowers initiated a state court case in South Dakota to determine the amount they owed.  They alleged their post-bankruptcy obligations were not enforceable because they were based on an improper attempt to reaffirm discharged debt.  The bank and the principal asserted various counterclaims in response, alleging that they could enforce the post-bankruptcy commitments.

The borrowers then filed an adversary action in bankruptcy court against the bank and the principal alleging a violation of the discharge injunction and seeking contempt sanctions.  While the adversary action was pending, the state court initially entered summary judgment in favor of the bank and the principal on several counterclaims.

In turn, the bankruptcy court found “that the state court possessed jurisdiction and authority to make discharge determinations.”  The bankruptcy court therefore declined to rule on a motion to dismiss and indicated that the borrowers could return to the bankruptcy court if the state court ultimately determined that the bank or the principal had wrongly “attempted to collect discharged debt.”  Although the bankruptcy court expressed doubt that it would ever re-open the adversary proceeding and in doing so seemed to grant the motion to dismiss, it expressly reserved its right to preside over proceedings in the future.

The state court later granted summary judgment in favor of the borrowers on the remaining counterclaims and reversed its prior summary judgment order on several counterclaims against the borrowers.  After a bench trial the court determined that the bank and the principal coerced the borrowers into reaffirming their debt and wrongly attempted to collect on discharged debt.  Separately, a jury found the bank and the principal obtained some of the post-discharge commitments through fraud. The South Dakota Supreme Court eventually affirmed the judgment.

Once the state court action concluded, the borrowers returned to bankruptcy court seeking attorneys’ fees and a contempt sanction for violation of the discharge injunction. The bankruptcy court found that the bank and the principal violated the discharge injunction, held them in contempt, and found them liable for attorneys’ fees.

The bank and the principal appealed to the Bankruptcy Appellate Panel and then to the trial court.  Both affirmed and this appeal followed.

The bank and the principal argued that the bankruptcy court’s initial abstention and the subsequent state court judgment precluded the bankruptcy court from later issuing its sanctions order.  The Eighth Circuit applied state law to examine the preclusive effect of the bankruptcy court’s abstention ruling and the state court judgment. Like the Eighth Circuit, South Dakota uses a practical analysis that examines “the parties’ roles and actions in the underlying proceeding.”

The Eighth Circuit noted that the bankruptcy court did not permanently abstain from presiding over the adversary proceeding.  Further, the Eighth Circuit also held that the bankruptcy court correctly determined that “the state court possessed the authority to make discharge determinations and to assess the true scope of what Appellants were actually seeking through their counterclaims.”

Significantly, the borrowers always expressed their intention to return to the bankruptcy court when the state action concluded.  The bank and the principal never objected to this plan.  Faced with this silence in response to the borrowers’ plan, the Eighth Circuit declined to thwart the borrowers’ “clearly expressed intentions.”

The Eighth Circuit also rejected the argument that Apex Oil Company, Inc. v. Sparks, 406 F. 3d 538 (8th Cir. 2005) should have prevented the bankruptcy court from re-opening the adversary proceeding.  Apex only held that “a bankruptcy court did not abuse its discretion in refusing to reopen a case.”  It did not strip a bankruptcy court’s “jurisdiction to enforce its own orders.”

Thus, because the bankruptcy court invited the borrowers to return if the state court ruled in their favor and later accepted the case again, the bankruptcy court did not abuse its discretion when it re-opened the adversary proceeding.

The Eighth Circuit also rejected the argument that the law of the case prevented the bankruptcy court from later entering its sanction order.  Because the bankruptcy court initially abstained from hearing the dispute, its comments on the merits at that time had no effect.  Thus, the Eighth Circuit held that the bankruptcy court’s initial skepticism and election to allow the state court to examine the merits did not “establish the law of the case or preclude a later ruling on the merits.”

Finally, the Eighth Circuit also rejected the argument that the bank and the principal acted in good faith because when they alleged their state court counterclaims “the law was unclear regarding the permissibility of obtaining a new commitment from a bankrupt debtor after discharge based upon a secured lender’s forbearance in foreclosing on a security interest.”  The Eighth Circuit found no authority allowing a lienholder to “leverage a security interest to obtain a larger repayment commitment” on a “discharged personal debt.”

Although the bank and the principal argued that they only sought to collected non-discharged debt, the state court found that they “clearly knew no unsecured debt had survived bankruptcy.”  As such, given that the principal steered the borrowers into bankruptcy in the first place and then later sought to collect on the discharged debt, the bank and the principal “demonstrated a lack of good faith.”

Thus, the Eighth Circuit affirmed the judgment of the trial court affirming the judgment of the bankruptcy court.

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