Sixth Circuit Shows Why the Supreme Court Must Reverse Taggart

February 26, 2019

The Sixth Circuit refused to allow an ambiguously written state statute to provide insulation from liability for violating the automatic stay. The case shows the damage that will be done to debtors and trustees if the Supreme Court sides with the Ninth Circuit in Taggart v. Lorenzen, 18-489 (Sup. Ct.), and rules that good faith is a defense to violating the stay.

The February 22 opinion by the Sixth Circuit describes the simple process for avoiding contempt liability: When in doubt, ask the bankruptcy court to say whether a contemplated action would violate the stay.

The Facts

A man was the sole owner of a corporation producing natural gas. The company ended up in bankruptcy. Before bankruptcy, the owner began complaining that competitors and a gas pipeline company conspired to destroy the business.

In bankruptcy, the trustee followed up on the allegations by negotiating a settlement where the pipeline and the competitors would have paid the estate $250,000 in return for releases.

The owner believed the trustee was settling for peanuts. Without notifying the trustee, the owner hired lawyers and filed suit in state court against the pipeline and the competitors under the Ohio Corrupt Practices Act, a state-law counterpart to the federal Racketeer Influenced and Corrupt Organizations statute. The suit sought damages of $34 million.

Eventually, the trustee learned about the suit and filed a motion for contempt in bankruptcy court. The trustee alleged that the suit violated the automatic stay under Section 362(a)(3) as an attempt to exercise control over estate property, namely the claims against the pipeline and the competitors.

The suit in state court came to a halt.

The Decisions Below

The owner and his lawyers contended there was no stay violation because the owner had independent claims under the Ohio statute. The OCPA allows “any person directly or indirectly injured” to recover treble damages for an act that violates the statute.

Finding a willful violation of the automatic stay, the bankruptcy judge rejected the defense and assessed about $91,000 in damages, representing the trustee’s attorneys’ fees.

On appeal, the Sixth Circuit Bankruptcy Appellate Panel initially certified a question to the Ohio Supreme Court because there was no precedent saying whether an injured shareholder has individual standing under the state statute. The state’s highest court declined to answer the question.

The BAP then proceeded to affirm the bankruptcy court, ruling that the claims belonged entirely to the bankrupt estate.

The Circuit’s Opinion

Circuit Judge Gilbert S. Merritt, Jr. upheld the lower courts on February 22. On several occasions in his opinion, he lauded the decisions by Bankruptcy Judge John E. Hoffman and the BAP panelists, Bankruptcy Judges Paulette J. Delk, Marian F. Harrison and Daniel S. Opperman.

The owner and his lawyers may have been undone by allegations in their own complaint in state court. The owner alleged no damages against himself personally. He only claimed to have been harmed by his indirect ownership of the debtor corporation.

As Judge Merritt said, the complaint sounded like a derivative suit prosecuting claims belonging to the corporation because the owner only sought damages sustained by the corporation “in multiple paragraphs.” However, he did not rule based only on the complaint in state court.

Instead, Judge Merritt said the “most important question” turned on state law, because there was no statute or case explicitly saying whether the OCPA conferred standing on individual shareholders.

As for the statute by itself, Judge Merritt said it was ambiguous, thus requiring him to consult other principles of statutory interpretation. First, he said, the court could assume the Ohio legislature adopted the OCPA “with knowledge of the existing common law of derivative suits.”

Citing Ohio law, Judge Merritt said that a shareholder cannot claim that injuries sustained by the corporation “have lowered the value of his or her interest in that corporation.” In that regard, he said the complaint in state court “did not allege any injuries specific to [the owner] outside his role as owner.”

Judge Merritt went on to say that a shareholder may bring a direct action for injuries that were separate and distinct from injury to the corporation. Therefore, he said, a derivative action is a shareholder’s “single path” to recover losses suffered by the corporation.

Examining the OCPA, Judge Merritt found “no clear indication that, by using the term ‘indirect,’ the [state legislature] supplanted an entire area of the common law.” He went on to say that the “legislature’s presumed omniscience does not mean that the enactors . . . intended to destroy a whole area of corporate law without so much as mentioning it.”

Judge Merritt thus upheld the lower courts’ rulings that the owner and his lawyers violated the automatic stay because they attempted to prosecute a claim belonging to the debtor corporation. In the process, he noted how courts in Oregon and Michigan similarly found that shareholders may not bring derivative claims under those states’ RICO statutes.

Finally, Judge Merritt dealt with damages. The owner and the attorneys contended that Baker Botts LLP v. ASARCO LLC, 135 S. Ct. 2158 (2015), precluded the court from awarding attorneys’ fees.

Judge Merritt said that “Baker Botts does not apply to the Bankruptcy Court’s fee award here, which was a contempt citation” under Section 105(a).

Judge Merritt affirmed for the reasons stated in his opinion “and for the reasons articulated by the Bankruptcy Court and the Bankruptcy Appellate Panel below.”

Observations

In Lorenzen v. Taggart (In re Taggart), 888 F.3d 438 (9th Cir. April 23, 2018, rehearing den.Sept. 7, 2018), the Ninth Circuit held that a subjective, good faith belief that an action does not violate the discharge injunction absolves the creditor of contempt, even if the belief is “unreasonable.”

The Supreme Court granted certiorari and scheduled oral argument to take place on April 24.

If the case before Judge Merritt had arisen in the Ninth Circuit, the owner and his counsel would not have been held in contempt because the ambiguous state statute provided them with a good faith belief that they were not violating the automatic stay. As a consequence, the bankrupt estate would have borne the $91,000 cost of halting an action that indeed violated the stay.

In a similar case, the trustee might be forced to forfeit an estate asset if the estate lacked funds to defend the automatic stay. The effect of Taggart would be even worse for consumers.

First, a Taggart rule would embolden creditors to violate the stay. Furthermore, bankrupt consumers (usually) lack the resources to enforce the automatic stay or the discharge injunction. Without funds to engage a lawyer, a consumer might pay a discharged debt rather than fight, and especially so because Taggart would disincline lawyers to represent debtors on a contingency.

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