In Law v. Siegel, 571 U.S. ___ (2014) (slip opinion), the Supreme Court of the United States invalidated a bankruptcy court’s use of its inherent authority to tax (surcharge) a debtor’s exempt property with legal expenses incurred by a chapter 7 trustee during a bankruptcy case. In doing so, the Supreme Court reminded us that a bankruptcy court cannot use its inherent authority to circumvent specific provisions the legislature imbedded into the Bankruptcy Code.
The Debtor Stephen Law (“Debtor”) filed for chapter 7 bankruptcy relief in 2004. Upon filing, a chapter 7 trustee was appointed (“Trustee”). Chapter 7 of the Bankruptcy Code generally allows an insolvent debtor the opportunity to discharge his or her debts by liquidating assets to pay the debtor’s creditors. 11 U. S. C. §§ 704(a)(1), 726, 727. The filing of a bankruptcy petition under chapter 7 creates a bankruptcy “estate” comprising all of the debtor’s property. See 11 U.S.C. § 541(a)(1). The estate is placed under the control of a trustee, who is responsible for managing liquidation of the estate’s assets and distribution of liquidation proceeds to the debtor’s creditors. See 11 U.S.C. § 704(a)(1).
The Bankruptcy Code authorizes a debtor to “exempt,” however, certain kinds of property from the estate, enabling the debtor to retain those assets post-bankruptcy. See 11 U.S.C. § 522(b)(1). Except in particular situations under the Bankruptcy Code, exempt property is not liable for the payment of any pre-bankruptcy debt or any “administrative expense” incurred during the bankruptcy case. See 11 U.S.C. § 522(c), (k).
Section 522(d) of the Bankruptcy Code provides a number of exemptions unless they are specifically prohibited by state law. See 11 U.S.C. § 522(b)(2), (d). One exemption, commonly known as the “homestead exemption,” protects up to $22,975 in equity in the debtor’s residence. See 11 U.S.C § 522(d)(1) and note following §522; see also Owen v. Owen, 500 U. S. 305, 310 (1991). The debtor may elect, however, to forgo the Bankruptcy Code’s exemptions and instead claim whatever exemptions are available under applicable state or local law. See 11 U.S.C. § 522(b)(3)(A). Some States provide homestead exemptions that are more generous than the federal exemption; some provide less generous versions; but nearly every State provides some type of homestead exemption.
In this case, the bankruptcy estate’s only significant asset was the Debtor’s house in which the Debtor claimed equity of $75,000 that was exempt under California law. See Cal. Civ. Proc. Code Ann. § 704.730(a)(1) (West Supp.2014). The Debtor also represented that, due to two pre-bankruptcy liens on the house, there was no non-exempt equity in the house that could be recovered for the benefit of his other creditors.
The Alleged Sham
A few months after the Debtor filed bankruptcy, the Trustee initiated an adversary proceeding, alleging that one of the liens on the Debtor’s homestead was fraudulent and therefore should be avoided or extinguished. If the Trustee was successful in his claim, this would theoretically leave approximately $160,000 in non-exempt equity in the homestead available to satisfy creditor claims.
In 2009, the bankruptcy court agreed with the Trustee and found that the second lien on the homestead was created fraudulently, in order to disguise the Debtor’s equity in the homestead and perpetrate a fraud on creditors. But, from a legal standpoint, fraud is expensive to discover. The Trustee had incurred more than $500,000 in attorney’s fees to discover the fraud and prove it to the bankruptcy court’s satisfaction. Appreciative of the Trustee’s efforts, the bankruptcy court allowed the Trustee to “surcharge” the entirety of the Debtor’s $75,000 homestead exemption, making those assets available to defray the Trustee’s legal fees.
The Debtor appealed the bankruptcy court’s surcharge, but, based on precedent from the Ninth Circuit Court of Appeals (see Latman v. Burdette, 366 F. 3d 774 (9th Cir. 2004)), the Bankruptcy Appellate Panel (“BAP”) upheld the bankruptcy court’s power to “equitably surcharge a debtor’s statutory exemptions” in exceptional circumstances such as “when a debtor engages in inequitable or fraudulent conduct.” Also believing the Trustee’s actions were necessary to preserve the “integrity of the bankruptcy process,” the Ninth Circuit Court of Appeals affirmed the BAP decision, leading to an appeal to the Supreme Court.
The Supreme Court acknowledged, as it had in the past, that a bankruptcy court has statutory authority to “issue any order, process, or judgment that is necessary or appropriate to carry out the provision of the Bankruptcy Code,” pursuant to section 105 of the Bankruptcy Code. See 11 U.S.C. § 105(a); Marrama v. Citizens Bank of Mass., 549 U. S. 365, 375– 376 (2007). But the Supreme Court reiterated that, in exercising those statutory and inherent powers, a bankruptcy court may not contravene specific statutory provisions of the Code. Indeed, the Supreme Court historically maintained that “whatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of ” the Bankruptcy Code. See Norwest Bank Worthington v. Ahlers, 485 U. S. 197, 206 (1988); see, e.g., Raleigh v. Illinois Dept. of Revenue, 530 U. S. 15, 24–25 (2000);United States v. Noland, 517 U. S. 535, 543 (1996); SEC v. United States Realty & Improvement Co., 310 U. S. 434, 455 (1940).
In this case, the “surcharge” of the Debtor’s exempt property violated a specific provision of the Bankruptcy Code. The Bankruptcy Code provides that exempt property is “not liable for any administrative expense” incurred during a bankruptcy case. 11 U.S.C. § 522(b)(3)(A). And since the Trustee’s legal expenses incurred in avoiding the second lien on the Debtor’s homestead were indubitably “administrative expenses,” they could not be surcharged against the Debtor’s exempt property per section 522(b)(3)(A). The Supreme Court concluded therefore that the bankruptcy court’s ruling otherwise “exceeded the limits of its authority under section 105 and its inherent powers.”
State Law Exceptions Still Exist
While the Supreme Court found that the Bankruptcy Code could not circumvent California state law exemptions in this instance, it nonetheless recognized that any state law exemption’s scope is determined by state law and state law could otherwise provide that debtor misconduct could warrant denial of such exemption. However, the Supreme Court found that a bankruptcy court has no authority to deny an exemption on grounds not existing under state law or specifically provided in the Code.
Categories: Recent Case Law