Robbin Itkin’s e-Bulletin re Law v. Siegel

Dear constituency list members of the Insolvency Law Committee, the following is a case update on a recent decision of interest:

SUMMARY

The Supreme Court of the United States held that a bankruptcy court exceeded the limits of its authority by imposing a surcharge on a debtor’s homestead exemption to pay for a chapter 7 trustee’s litigation fees and costs incurred in avoiding a fraudulent lien against estate property created by the debtor.  In a unanimous opinion written by Justice Scalia, the Court held that a bankruptcy court cannot exercise its authority under 11 U.S.C. § 105(a) or its inherent equitable powers in contravention to a specific statutory provision, in this case 11 U.S.C. § 522.  Law v. Siegel, Chapter 7 Trustee, __ U.S. __, 134 S.Ct. 1188, 2014 WL 813702 (March 4, 2014).  To read the decision, click here: http://www.supremecourt.gov/opinions/13pdf/12-5196_8mjp.pdf.

FACTUAL BACKGROUND

Debtor Stephen Law (“Debtor”) filed for chapter 7 bankruptcy relief in 2004.  On his schedules of assets and liabilities filed with the bankruptcy court, the Debtor listed his personal residence located in Hacienda Heights, California (the “Property”), stated the value of the Property to be $363,348, and claimed a homestead exemption in the Property of $75,000 under section 704.730(a)(1) of California Code of Civil Procedure.  The Debtor further listed two creditors holding claims secured by deeds of trust against the Property.  The first deed of trust was held by Washington Mutual Bank and secured a note in the amount of $147,156.52.  The second deed of trust, securing a note in the amount of $156,929.04, named “Lin’s Mortgage & Associates” (“Lin”), as beneficiary, and reflected a debt owed to someone named “Lili Lin” (the “Lin Deed of Trust”). Because the two stated liens against the Property exceeded the nonexempt value of the Property, it appeared that there was no value in the Property that would be available to pay the estate’s creditors.

Alfred H. Siegel, the duly-appointed chapter 7 trustee (the “Trustee”), commenced an adversary proceeding to challenge the validity of the lien purportedly held by Lin.  During the course of the litigation, two different individuals appeared claiming to be Lili Lin.  The first Lili Lin, of Artesia, California, claimed to be a former acquaintance of the Debtor and described the Debtor’s numerous attempts to involve her in sham transactions involving the Property and Lin Deed of Trust.  Ms. Lin of Artesia denied ever loaning money to the Debtor and quickly entered into a stipulated judgment with the Trustee in which she disclaimed any interest in the Property.  At some point, however, a second Lili Lin, who supposedly lived in China and spoke no English, appeared in the matter and claimed to be the true beneficiary under the Lin Deed of Trust.  This second Ms. Lin engaged in extensive and costly litigation with the Trustee, including several appeals, over the avoidance of the Lin Deed of Trust and subsequent sale of the Property.

After five years of litigation, the bankruptcy court concluded that no person named Lili Lin made a loan to the Debtor and that the alleged loan was a fiction created by the Debtor to preserve the Debtor’s equity in the Property beyond his homestead exemption.  The bankruptcy court was unpersuaded that Lili Lin of China signed or approved any of the declarations or pleadings filed in her name, finding it more likely that the Debtor himself drafted, signed and filed such papers.  The bankruptcy court further found that the Debtor submitted false evidence purporting to show that Lili Lin of China, and not Lili Lin of Artesia, was the beneficiary under the Lin Deed of Trust. 

In the end, the Trustee had incurred over $500,000 in fees and costs in litigating the dispute and overcoming the Debtor’s fraudulent misrepresentations.  Based on the Debtor’s misconduct, the Trustee moved to “surcharge” the entire $75,000 homestead exemption to defray the Trustee’s attorney’s fees.  The bankruptcy court granted the Trustee’s motion.  The Ninth Circuit Bankruptcy Appellate Panel affirmed the bankruptcy court’s decision.  Citing Latman v. Burdette, 366 F.3d 774 (9th Cir. 2004), the BAP recognized a bankruptcy court’s power to equitably surcharge a debtor’s statutory exemption in exceptional circumstances, including where the debtor engages in inequitable or fraudulent conduct.  The Ninth Circuit Court of Appeals also affirmed, holding that the surcharge was proper because it 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 Debtor appealed.

HOLDING AND ANALYSIS

The Supreme Court found that the bankruptcy court exceeded the limits of its authority by surcharging the Debtor’s homestead exemption and ultimately reversed and remanded the Ninth Circuit’s decision.

The Court’s opinion began by recognizing the bankruptcy court’s statutory authority under Bankruptcy Code section 105(a) to issue any order, process, or judgment necessary to carry out the provisions of the Bankruptcy Code, along with the bankruptcy court’s inherent power to sanction parties engaging in abusive litigation conduct.  The Court, however, held that the bankruptcy court may not exercise either its statutory power under section 105(a) or its inherent equitable powers in contravention to any specific statutory provisions.  In this case, the Court found that the bankruptcy court’s surcharge of the Debtor’s homestead exemption contravened Bankruptcy Code section 522, which: (1) allowed the Debtor to claim a California homestead exemption (sub-section 522(b)(3)(A)) and (2) provided that such exemption could not be liable for the payment of any administrative expenses of the estate (section 522(k)).

The Court was not persuaded by the Trustee’s argument that section 522 merely establishes the procedure for a debtor to claim an exemption in property, and does not require the bankruptcy court to allow such exemption regardless of the circumstances.  This argument was supported by the United States, which filed an amicus brief asserting that section 522 “neither gives debtors an absolute right to retain exempt property nor limits a court’s authority to impose an equitable surcharge on such property.”  The Court read these arguments as equating a bankruptcy court’s right to surcharge an exemption with the bankruptcy court’s right to deny or limit the Debtor’s homestead exemption under section 522.  In this case, the Court held that such arguments fail for two reasons. 

First, the Court held that the Trustee did not timely object to the Debtor’s claimed homestead exemption, and, therefore, the exemption became final prior to the imposition of the surcharge.  The Court noted that it previously held that a trustee’s failure to object timely to a claimed exemption prevents him from later challenging the exemption, citing Taylor v. Freeland & Kronz, 503 U.S. 638, 643-644 (1992).

Second, the Court reasoned that, even if the bankruptcy court could reconsider the Debtor’s ability to claim the exemption, section 522 does not give the bankruptcy court discretion to grant or withhold exemptions based on any factors the bankruptcy court deems appropriate.  The statute specifies the criteria that will allow the debtor to claim an exemption, and it is the debtor’s discretion whether to elect to take the exemption.  If the debtor chooses to do so, the Court reasoned, a bankruptcy court may not refuse to honor such exemption without a valid statutory basis.  The Court explained that section 522 sets forth a number of specific exceptions and limitations to exemptions, some of which relate to a debtor’s misconduct, and stated that section 522’s “meticulous…enumeration of exemptions and exceptions to those exemptions confirms that courts are not authorized to create additional exceptions.”  While the Court acknowledged that there may be circumstances where state law may be applied to disallow a state-created exemption based on the debtor’s misconduct, the Court held that “federal law provides no authority for bankruptcy courts to deny an exemption on a ground not specified in the Code.” (emphasis in original).

The Court concluded by recognizing that its ruling will leave the Trustee with a great financial burden as a result of the Debtor’s egregious misconduct, and may also result in inequitable outcomes in future cases as well.  Ultimately, however, the Court determined that Congress already balanced the interests of debtors and creditors in section 522, and the courts cannot alter the statute’s balance.  The Court also reassured the bankruptcy courts that this decision does not strip or otherwise alter the bankruptcy court’s authority to impose other authorized means of discipline on a dishonest debtor, such as sanctions, a denial of discharge, and, in cases of fraudulent conduct in a bankruptcy case, criminal prosecution.

AUTHOR’S COMMENTARY

Although the bankruptcy court in this case admirably tried to achieve an equitable result and to lessen the substantial financial burden to be borne by the Trustee as a result of outrageous and egregious conduct on the part of the Debtor, all in the best interests of the creditors, the Supreme Court’s decision appropriately requires that any actions taken by the bankruptcy court be consistent with specific provisions of the Bankruptcy Code.  To the extent any trustees have relied on Ninth Circuit law allowing for surcharging of a debtor’s exemption in certain circumstances, this decision may impact the strategic considerations of litigating contested property disputes because the trustees would not be able to reach any property subject to a debtor’s exemption.  In this particular case, the fees incurred by the Trustee in fighting over the Debtor’s exemption exceeded the value of the Property—so certainly Trustees need to keep this decision in mind when commencing litigation and in evaluating the costs and benefits of extensive litigation. 

These materials were written by Robbin Itkin and Monsi Morales of Steptoe & Johnson LLP, in Los Angeles, California (ritkin@steptoe.com and mmorales@steptoe.com), with editorial contributions were provided by ILC member Haeji Hong in San Diego, California.  Ms. Itkin is a member of the Insolvency Law Committee. 

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee