Law v. Siegel:  Chapter 7 Trustees and Bankruptcy Courts Lose, While Debtor’s Fraudulent Behavior Goes Unpunished

03.05.2014

On March 4, 2014, the Supreme Court decided Law v. Siegel, holding that the bankruptcy court lacked authority to surcharge the debtor’s exempt property for payment of the Chapter 7 trustee’s attorney’s fees caused by the debtor’s fraudulent conduct.  In that case, the debtor’s only significant asset was his home.  The debtor claimed $75,000 of his home’s value as exempt under California’s homestead exemption and the remainder of his home’s value subject to two mortgages.  After extensive litigation and multiple appeals to the Ninth Circuit Bankruptcy Appellate Panel and the Ninth Circuit, the bankruptcy court determined that the second mortgage was fake, fictionalized to remove the debtor’s equity in his home from the reach of his creditors.  The bankruptcy court further provided that, due to the debtor’s fraudulent conduct causing the protracted litigation, the debtor’s $75,000 exemption in his home would be surcharged to defray the Chapter 7 trustee’s attorney’s fees.

In a unanimous decision authored by Justice Scalia, the Supreme Court determined the imposition of the surcharge exceeded the bankruptcy court’s equitable powers.  Under section 105 of the Bankruptcy Code, bankruptcy courts are authorized to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions” of the Bankruptcy Code.  However, the Supreme Court determined that the bankruptcy courts’ general equitable powers are subject to the specific limitations contained in the Bankruptcy Code.  Namely, section 522 of the Bankruptcy Code allows a debtor to exempt certain property under either the federal exemptions or the state exemptions.  To the extent that property is properly exempted, section 522(k) prevents the payment of administrative expenses, subject to certain inapplicable exceptions, from exempt property.  Attorney’s fees incurred by a Chapter 7 trustee constitute administrative expenses.  11 U.S.C. §§ 503(b)(2), 330(a)(1), 327.

Although the Supreme Court acknowledged that this decision “may produce inequitable results for trustee and creditors in other cases,” the decision does not preclude all possible avenues for recovery by a Chapter 7 trustee.  First, the decision emphasized the fact that the Chapter 7 trustee had not timely objected to the debtor’s claimed homestead exemption.  Thus, perhaps if a Chapter 7 trustee were to successfully object to a claimed homestead exemption, the bankruptcy court would have the equitable power to surcharge the no longer exempt property.  Second, the Supreme Court indicated in dicta that its decision neither impacts the bankruptcy courts’ ability to deny a debtor a discharge for bad faith nor the ability to impose sanctions for bad-faith conduct in litigation.

Perhaps more importantly, this decision comes in the wake of Stern v. Marshall as yet another limitation on the bankruptcy courts’ inherent authority.  The ability of bankruptcy courts to fashion equitable relief and remedies pursuant to section 105 of the Bankruptcy Code is a basic premise in bankruptcy law.  Under Law v. Siegel, bankruptcy courts will be limited in their exercise of 105(a) equitable powers to instances where there are no express applicable Bankruptcy Code provisions, regardless of the equities.  Although the exact ramifications are unclear, it is clear that bankruptcy courts have yet again lost flexibility and discretion, necessary to the proper functioning of the system.