7th Cir. Holds Creditor Liable for Its Counsel’s Bankruptcy Discharge Violation

Editor's Note: This article was originally published on the Maurice Wutscher blog and is republished here with permission.

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The U.S. Court of Appeals for the Seventh Circuit recently affirmed in part and reversed in part a trial court’s judgment against a debtor who filed an adversary proceeding alleging that a creditor and its counsel violated the bankruptcy discharge by trying to collect a discharged debt, holding that the attorney could not be held in contempt because he lacked knowledge of the discharge, but the creditor could be held liable for the actions of its counsel under agency law.

A copy of the opinion in Jacqueline M. Sterling v. Southlake Nautilus Health is available here.

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The plaintiff failed to pay her membership fees to a health club, and in July 2001, the law firm representing the club filed a collection action in state court. In February 2002, a default judgment was entered against the plaintiff.

The law firm engaged in post-judgment collection efforts and the judgment debtor failed to show up at several hearings to show cause, resulting in the entry of a writ of bodily attachment or bench warrant against her in April 2010. Almost a year later, she was arrested by a police officer who stopped to help her with a flat tire and discovered the outstanding warrant.

Unbeknownst to the law firm, the judgment debtor had filed for bankruptcy in 2009 and listed the health club as a creditor, receiving a discharge in January 2010. The notice of discharge was mailed to the club, but its manager failed to notify the law firm. The debtor also failed to notify both the state court and the law firm that the debt had been discharged, despite a local bankruptcy court rule requiring her to do so.

The debtor sued the creditor and its law firm in state court, but that suit was dismissed for lack of subject matter jurisdiction.

The debtor then filed an adversary complaint in bankruptcy court seeking to hold the defendants in civil contempt for violating 11 U.S.C. § 524 by trying to collect a discharged debt.

After a bench trial, the bankruptcy court ruled in favor of the defendants, reasoning that the individual lawyer for the creditor involved in the case lacked knowledge of the discharge, had no duty to inquire, and the debtor failed to notify him of the discharge. As to the creditor, the bankruptcy court found that although the creditor received notice of the discharge, it did not willfully violate the discharge order because after referring the case for collection in 2001, “there was no evidence that [the creditor] was aware of the status of its case against [the debtor] or that it directed [the lawyer] to take any particular action in the case.”

The trial court affirmed the bankruptcy court’s judgment and the debtor appealed.

On appeal, the Seventh Circuit explained that “[w]hen a party violates a bankruptcy court’s order by pursuing a discharged debt, the debtor can ask that the court hold that party in contempt. … But the debtor can do so only for willful violations. … A willful violation … require[s] that the offending party both violated the court’s order and had ‘actual knowledge that a bankruptcy is under way or has ended in a discharge.” The debtor has “the burden of proving the defendants’ contempt by clear and convincing evidence.”

The Court first addressed whether the creditor had actual knowledge of the discharge, agreeing with the bankruptcy court’s finding that the creditor knew the debt had been discharged because the notice was mailed by the bankruptcy court, and the creditor offered no evidence that the notice had not been received, entitling the plaintiff to the presumption that it was received.

Turning to the second prong of the test — “violative action” — the Court disagreed with the bankruptcy and trial courts because while the creditor “had itself taken no action that violated the discharge order,” the lower courts’ finding reflected “an error in legal reasoning,” namely that the creditor was “responsible for only its own actions and not those of [its counsel].”

The Court explained that it has “repeatedly stated that clients are bound by their counsel’s conduct[,][which] … makes perfect sense when viewed through the lens of agency law:  the clients are principals, the attorney is an agent, and under the law of agency the principal is bound by his chosen agent’s deeds.’”

Applying agency law, the Seventh Circuit concluded that the creditor’s counsel was acting within the scope of his authority when he continued the state court collection case against the debtor in violation of the discharge order and that the attorney’s “actions, imputed to [the creditor], were taken despite [the creditor’s] knowledge of the discharge order, meeting the requirements for civil contempt. The bankruptcy court erred as a legal matter by concluding otherwise. … Our conclusion here is not only consistent with our circuit precedent, it is sensible. Holding otherwise would create a loophole in the law through which creditors could avoid liability simply by remaining ignorant of their agents’ actions or by failing to notify their agents of debtors’ bankruptcy proceedings. We decline to incentivize such careless behavior.”

Turning to the attorney’s knowledge, the Appellate Court found that “[t]he bankruptcy court’s finding that [the attorney] did not have the requisite knowledge was reasonable and was supported by the evidence. We see no clear error in it.”

Thus, the attorney/agent was “in the inverse position” of its client/principal. However, “[u]nlike with the [creditor/principal], we do not impute the principal’s knowledge to the agent.”

Because the attorney did not have knowledge of the discharge order and the principal’s knowledge is not imputed to the agent, the attorney “cannot have willfully violated the discharge order and cannot be held in contempt. Both the district court and the bankruptcy court correctly concluded as much, and we affirm their rulings.”

Finally, the Court gave a “final word of caution[,]” explaining that although it concluded that the creditor “acted in contempt, we note that this regrettable event could have been avoided had” the debtor complied with the local bankruptcy rule requiring her to give notice of the discharge and left it “to the bankruptcy court’s discretion whether to factor this into the damages calculation.”

Accordingly, the Seventh Circuit affirmed in part and reversed in part the trial court’s judgment and remanded the case to the bankruptcy court for further proceedings.