US Supreme Court Decision in In re Law Limits Courts’ Discretion to Paint Debtors with the “Bad Faith” Brush

Court Can't Surcharge Chapter 7 Bankruptcy ExemptionsNearly a year ago, The Supreme Court held in Law v. Siegel (In re Law), No. 12-5196, 571 U.S. ___ (March 4, 2014), that despite a debtor’s misdeeds, the Bankruptcy Court still has to follow the Bankruptcy Code and can’t just dispense its own sense of justice ad hoc. This same reasoning was recently applied in a bankruptcy court case in California, In re Arellano, 517 B.R. 228 (Bankr. S.D. Cal. 2014), the bankruptcy court there followed the Supreme Court’s logic in affirming that a bankruptcy trustee can’t object to a debtor’s amended claim of exemption based merely on a claim of “bad faith,” just because the debtor failed to disclose the asset in his original filing. Following the Law case, the bankruptcy court reasoned, any exception to a debtor’s claimed exemption must be based in law, not simply the bankruptcy court’s own sense of equitable considerations. This case prompted me to go back and cover the Law case.

In the Law case, the Supreme Court held that just because a Chapter 7 Bankruptcy debtor has committed some pretty serious misdeeds, that does not give the Bankruptcy Court the authority to “surcharge” his homestead exemption. Seriously, though, folks, don’t try this at home. Sometimes it takes really bad facts to get good law. The Chapter 7 bankruptcy debtor in this case—on appeal to the Supreme Court from the Ninth Circuit—was about as unsympathetic a character as one might imagine. The debtor, whose name was actually Law (no kidding) filed Chapter 7 bankruptcy in 2004. The only significant asset was debtor’s home in Hacienda Heights, California, valued at $363,348. The debtor claimed his California homestead exemption, protecting $75,000 of any equity in the property. The property was also encumbered by a valid note and first deed of trust in favor of Washington Mutual in the amount of $147,156.52. Debtor also claimed a second note and deed of trust (recorded in 1999) in favor of a “Lin’s Mortgage & Associates” in the amount of $156,929.04.

However, the bankruptcy court found that this second deed of trust was a fiction, manufactured by the debtor. The Chapter 7 trustee brought an adversary proceeding to invalidate the second deed of trust as fraudulent. Proving that truth is often stranger than fiction, two—count ’em, two—separate individuals claiming to be “Lily Lin,” (the named beneficiary of the fraudulent deed of trust) answered the bankruptcy trustee’s complaint. The first was an acquaintance of the debtor who denied ever lending the debtor the money that was supposedly secured by the deed of trust. This first Lily Lin cooperated with the bankruptcy trustee detailing how the debtor had attempted to involve her in the fraudulent deed of trust years before. Take this as a lesson: the debtor evidently planned his bankruptcy fraud for a long time, having recorded the fraudulent deed of trust in 1999—five years before he filed his Chapter 7 bankruptcy. It didn’t matter. Never, and I mean never, try to pull one over on the bankruptcy trustee or the Bankruptcy Court.

The second “Lily Lin” who answered the bankruptcy trustee’s complaint was purportedly a resident of China who spoke no English, but who nevertheless litigated the adversary proceeding for five years until, in 2009, the Bankruptcy Court found that no such person had ever lent the debtor any money for the fraudulent deed of trust. The court further found that it was in fact the debtor who likely “authored, signed, and filed” the pleadings on behalf of this purported second “Lily Lin.” The five years of bankruptcy litigation cost the Chapter 7 bankruptcy trustee over $500,000 in attorneys’ fees.

When the debtor’s fictitious straw person finally lost at trial, the Bankruptcy Court then imposed a “surcharge” against the debtor’s $75,000 homestead exemption in its entirety to defray the Chapter 7 trustee’s legal expenses. On appeal, the Ninth Circuit upheld this surcharge citing Latman v. Burdette, 366 F. 3d. 774 (2004), which had recognized the court’s authority to surcharge a statutory exemption among the court’s equitable powers where the debtor had engaged in fraudulent conduct.

Now, everyone can readily agree that this case presents a dishonest bankruptcy debtor for whom we can muster little sympathy. But the particularly unsavory debtor and his actions aren’t what make this case important and good for bankruptcy debtors generally. Like I said at the outset, sometimes it takes bad facts to result in good law. The technical issue before the Supreme Court was whether the bankruptcy court has the authority to take away a Chapter 7 bankruptcy debtor’s statutory exemptions, such as the California homestead exemption. The Ninth Circuit had held that bankruptcy courts do have such authority under either 11 U.S.C. §105(a), which grants the court the authority to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of” the Code, or the “inherent power” recognized in another Supreme Court case, Marrama v. Citizens Bank of Mass, 549 U.S. 365, 375-376 (2007), to “sanction ‘abusive litigation practices.’” The question before the Supreme Court was whether either of these gave the Bankruptcy Court the authority to ignore the debtor’s rightful statutory exemptions and “surcharge” the debtor’s homestead exemption.

The Ninth Circuit Court of Appeals ruled that the Bankruptcy Code plainly makes a debtor’s exemptions “not liable for payment of any administrative expense” 11 USC §522(k). Neither Bankruptcy Code §105(a) nor the “inherent power” to sanction recognized previously by the Supreme Court may contravene a specific provision of the Code. “The Bankruptcy Court thus violated §522’s express terms when it ordered that the $75,000 protected by [debtor’s] homestead exemption be made available to pay [the Trustee’s] attorney’s fees, an administrative expense.” Section 522(k) “does not give courts discretion to grant or withhold exemptions based on whatever considerations they deem appropriate.” The trustee could have timely objected to the claimed exemption but failed to do so. The debtor could also be denied a discharge under §727 or sanctioned under Rule 9011 or even prosecuted criminally, but the Bankruptcy Court has no authority to impose a “surcharge” on a claimed exemption.

The Law case has far reaching implications. At its core, it stands for the proposition that the bankruptcy court does not have the discretion to ignore the Bankruptcy Code or state law statutory exemptions available to every debtor, even unsavory ones.

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