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Bankruptcy Judge Can’t Deny Exemptions Because Debtor Lied

By Columbia – Lexington Bankruptcy Lawyer Lex Rogerson

High Court rules bankruptcy courts’ equitable powers don’t trump exemption statutes.umbrella over home - optimized

In a case that limits the ways bankruptcy courts can punish debtor misconduct, the US Supreme Court has held that a debtor who acts badly cannot be denied the benefit of an exemption to which the law entitles him.  Bankruptcy laws provide several ways to punish bad faith or dishonesty, including denial of a discharge and even criminal prosecution, but depriving the debtor of asset protection is not one of those ways.  Law v. Siegel, No. 12-5196, slip op. (U.S. Sup. Ct. filed March 4, 2014).

The facts in the Law case

Stephen Law of Hacienda Heights, California, filed a chapter 7 bankruptcy case in 2004.  He disclosed that he owned a home worth $360,000 that he claimed was subject to two mortgages totaling just over $300,000.  According to his schedules, then, his equity in the home was about $60,000.

In chapter 7, a bankruptcy trustee is appointed to liquidate whatever property the debtor owns that he cannot protect through his available exemptions.  Law claimed the maximum California homestead exemption of $75,000.  To all appearances, the exemption covered Law’s equity in the property, leaving nothing for the trustee to liquidate.  So Law could retain his home — or so it appeared.

Alfred Siegel, the chapter 7 trustee, became suspicious of the second mortgage, allegedly held by “Lin’s Mortgage & Associates” to secure a debt to one Lili Lin.  He brought an adversary proceeding in bankruptcy court to establish that the mortgage was fictitious and did not encumber the home.  Someone purporting to be Ms. Lin, supposedly a citizen of China, contested the litigation at great length.  Ultimately the court found that Lili Lin was a fiction, that there was no debt underlying the supposed mortgage, and that Law had fabricated both the mortgage and its supposed holder.   This enabled Sigel to sell the home.

In the process of the litigation, however, the trustee incurred legal fees and costs of over $500,000.  To recover some of this expense, Siegel asked the court to “surcharge,” or deny, Law’s homestead exemption.  Many lower courts had permitted this extraordinary step.  This would mean that Law would not get his $75,000 from the proceeds of the home sale.  Instead, those funds would go to reimburse Siegel.

Acting under its general powers under section 105 to carry out the Bankruptcy Code, the bankruptcy court granted Siegel’s request, effectively denying the exemption Law claimed.  Two intermediate appellate courts affirmed.  The Supreme Court then agreed to consider Law’s appeal.

The Law opinion

In a unanimous decision, the high court reversed.  It first observed that the exemption section of the Code specifically provides that exempt property is not liable for administrative expenses such as the trustee’s fees and costs.  And that section also expressly allowed Law to exercise the $75,000 California homestead exemption in his home.  Exemption laws can limit the situations in which they apply, and the Code in fact provides specific limitations for specific kinds of misconduct.  For example, if the debtor has been convicted of bankruptcy crimes, his homestead exemption is limited to about $156,000.  But the exemption laws are not subject to a blanket exception making them disappear when the debtor acts badly.

Siegel argued that the court’s general powers to carry out the bankruptcy laws gave it the authority to limit or deny exemptions based on the debtor’s misconduct.  He submitted that, without power to surcharge exemptions, the court is powerless to penalize misconduct that causes trustees unnecessary expense.   The Supreme Court disagreed.  It held that the power to carry out the Bankruptcy Code could not be converted into a power to nullify specific provisions of the Code.  It also stated the Code prescribes other consequences for debtor misconduct — Stephen Law, for example, was denied a discharge because of his dishonesty — but those consequences do not include taking away specific rights Congress has granted.

What the ruling means

The Law decision has ramifications on three different levels.  At the first and most concrete level, it abolishes the practice of surcharging exemptions, at least under current law.  But that holding has effect in only a limited range of cases.

Next, the ruling means that courts must apply exemption laws as they are written.  Courts may not add restrictions that the enacting legislative bodies did not impose.  The opinion effectively reverses rulings in several bankruptcy courts, including the District of South Carolina, that would prevent a debtor from amending his exemption claim to cover property the trustee uncovers but the debtor did not initially disclose.  The facts in this case make this point emphatically.  Law’s misconduct was especially egregious and costly.  If his exemptions cannot be taken away, then no one’s exemptions can be.

At the broadest level, the ruling cuts back on bankruptcy courts’ “105 powers” — that is, the power to order outcomes not expressly authorized by the Code based on the court’s views of justice and equity.  After Law, it is clear that a court cannot use section 105 to defeat the statutory rights of debtors or creditors.  It will take many years and much litigation to determine exactly how this changes our prior understanding of what a bankruptcy court can and cannot do.

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