The Supreme Court Says, “No Need to Spare the Rod, but Don’t Spoil the Fraudulent Debtor’s Exemptions Either”

Contributed by Charles Persons
While bankruptcy practitioners eagerly await the Supreme Court’s ruling in Executive Benefits Insurance Agency v. Arkison, the Supreme Court made a quick foray into the world of bankruptcy this week to partake in one of its favorite pastimes—overturning the Ninth Circuit Court of Appeals.  Reviewing that circuit’s decision in Law v. Siegel, 571 U.S. ____ (2014), the Court held that a bankruptcy court may not use section 105(a) of the Bankruptcy Code or its inherent power to sanction abusive litigation practices by “surcharging” a debtor’s homestead exemption in order to defray a chapter 7 trustee’s fees.  More broadly, the Court held that federal law “provides no authority for bankruptcy courts to deny an exemption on a ground not specified in the Code.”
Exemptions under 11 U.S.C. § 522
The filing of a bankruptcy petition creates the bankruptcy “estate,” which is generally comprised of all of the debtor’s property under section 541(a)(1) of the Bankruptcy Code.  The Bankruptcy Code, however, permits a debtor to “exempt” certain property from the bankruptcy estate.  This exempt property “is not liable” for the payment of prepetition debt or administrative debt.
Under section 522(d), which applies to individual debtors, the Bankruptcy Code creates a rather extensive list of exemptions, unless such exemption is prohibited by state law.  Among the listed exemptions is the “homestead exemption” in section 522(d)(1), which protects up to $22,975 in equity in the debtor’s residence.  The debtor may elect to forego the exemptions provided by the Bankruptcy Code in favor of exemptions under applicable state or local law, and would be expected to do so in situations where the state law exemption exceeds the $22,975 allowed under the Bankruptcy Code.  One jurisdiction with a particularly generous homestead exemption, California, was the jurisdiction in play in Law v. Siegel.
The ironically-named debtor, Stephen Law, filed for chapter 7 relief in the Bankruptcy Court for the Central District of California in 2004.  The estate’s only listed asset was a house, which the Debtor valued at $363,348.  Law reported the house was subject to two liens, one for $147,156.52 to Washington Mutual, and the second for $156,929.04 in favor of “Lin’s Mortgage & Associates.”  Combined with the $75,000 exemption the Debtor claimed under California’s generous homestead exemption, the filings represented that no equity remained in the house for other creditors.
Had Law’s representations been accurate, he would have presumably retained the house subject to the two liens, but the chapter 7 trustee, Alfred Siegel, apparently became suspicious of “Lin’s Mortgage & Associates” and filed an adversary proceeding alleging that the lien was fraudulent.  Over the next five years, “Lili Lin” managed to engage in extensive and costly litigation, including several appeals, to contest the avoidance of the deed and sale of the house, all “despite supposedly living in China and speaking no English.”  Finally in 2009, the bankruptcy court entered an order concluding that “no person named Lili Lin ever made a loan” to the debtor, that “the most plausible conclusion was that Law himself had authored, signed, and filed some or all of [the pleadings],” and that the loan was a “fiction, meant to preserve [Law’s] equity in his residence beyond what he was entitled to exempt by perpetuating a fraud on his creditors and on the court.”
Meanwhile, the trustee had incurred more than $500,000 in attorney’s fees fighting the fraudulent misrepresentations over the course of five years.  In an effort to defray some of these fees, the bankruptcy court ordered the entirety of Law’s $75,000 homestead extension turned over the trustee as a “surcharge” under the penumbra of section 105(a) of the Bankruptcy Code.
The Ninth Circuit Bankruptcy Appellate Panel upheld the decision.  In support, it cited the Ninth Circuit case Latman v. Burdette, 366 F.3d 774 (9th Cir. 2004) to conclude that the bankruptcy court had the power to “equitably surcharge a debtor’s statutory exemptions in exceptional circumstances, such as when a debtor engages in inequitable or fraudulent conduct.”  The Ninth Circuit affirmed, holding the surcharge was “calculated to compensate the estate for the actual monetary costs imposed by the debtor’s misconduct, and was warranted to protect the integrity of the bankruptcy process.”
The Supreme Court Reverses Course
The Supreme Court overturned the Ninth Circuit’s decision.  Noting that section 105(a) is not without limitations, namely that it “does not allow the bankruptcy court to override explicit mandates of other sections of the Bankruptcy Code,” the Supreme Court held that the “surcharge” contravened a specific code provision—section 522.  In fact, Justice Scalia, delivering the opinion for a unanimous Court, stated that the “surcharge” contravened section 522 twice.  First, by not permitting Law to take his homestead exemption, the order violated section 522(b)(3)(A).  Second, by using the exempt funds to pay the Trustee’s fees, the order violated section 522(k), which says that property exempted by section 522 is not liable for payment of any administrative expense.
The Court went further, however, concluding with a broader ruling that is more widely applicable to other bankruptcy cases.  Looking to the language of section 522, the Court concluded that section 522 “does not give courts discretion to grant or withhold exemptions based on whatever considerations they deem appropriate.”  The Court further held that federal courts may apply state law to disallow state-created exemptions, but federal law itself “provides no authority for bankruptcy courts to deny an exemption on a ground not specified in the Code.”
Despite being an apparent blow for trustees fighting debtors acting badly, the ruling in Law v. Siegel should not be construed as license for debtors to commit fraud without consequence.  There are a wide range of weapons available to a bankruptcy court that finds itself in need of meting out discipline.  As the Supreme Court noted, the bankruptcy court may use other authority to address debtor misconduct, including denial of discharge, as well as sanctions for bad faith litigation conduct under the Bankruptcy Rule 9011, section 105(a) or its inherent powers.  Unfortunately, it can’t carve those remedies out of the Congressionally-granted protections afforded to debtors.