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Supreme Court Issues Decision in Law v. Siegel, Eliminating Ability to Impose Surcharge on Exempt Property Unless Explicitly Authorized by Bankruptcy Code

On March 4, 2014, the Supreme Court issued a unanimous opinion in Law v. Seigel, Case No. 12-5196, 571 U.S. ___ (2014) holding that the bankruptcy court used its equitable powers in contravention of Bankruptcy Code section 522 by ordering the $75,000 protected by the debtor’s homestead exemption to be made available to pay the chapter 7 trustee’s attorney’s fees in light of the egregious misconduct of the debtor. 

The Debtor’s Fraud and Prolonged Litigation With Trustee

Stephen Law filed his chapter 7 bankruptcy petition in Los Angeles, California over 10 years ago, on January 5, 2004.  The case was assigned to the Honorable Thomas B. Donovan, United States Bankruptcy Judge.  The estate’s only significant asset was Law’s house in California, which Law valued at $363,348.  Law claimed a $75,000 homestead exemption in his bankruptcy schedules, and he listed two mortgages, totaling approximately $304,000, that exceeded the non-exempt value of the house.

Alfred H. Siegel, the chapter 7 Trustee, contended that one of the mortgages was a sham.  As detailed in the Supreme Court’s decision, the Trustee then spent almost five years proving that Law fabricated the second mortgage and deed of trust on the house – allegedly in favor of “Lili Lin” of China – to defraud his creditors and keep his equity in the house.  Ultimately, the Bankruptcy Court entered an order concluding that “no person named Lili Lin ever made a loan to [Law] in exchange for the disputed deed of trust,” and that the loan was a fiction meant to preserve [Law’s] equity in his residence beyond what he was entitled to exempt” by perpetrating “a fraud on his creditors and the court.”  In re Law, 401 B.R. 447, 453 (Bankr. C.D. Cal. 2009).  The Trustee apparently incurred more than $500,000 in attorney’s fees in the course of uncovering and litigating Law’s fraudulent misrepresentations.

After the conclusion of the litigation, the Bankruptcy Court granted the Trustee’s motion to “surcharge” the entirety of Law’s homestead exemption based on its inherent power, as well as section 105(a) of the Bankruptcy Code, so that those funds would be available to satisfy a portion of the Trustee’s attorneys’ fees.  The Ninth Circuit Bankruptcy Appellate Panel and the Ninth Circuit Court of Appeals both affirmed.  In particular, the Ninth Circuit found 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.”  In re Law, 435 Fed. Appx. 697 (9th Cir. 2011) (per curiam).

Strict Construction Favored

The Supreme Court reversed the ruling of the Ninth Circuit, stating “whatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of the Bankruptcy Code.”  The unanimous opinion, written by Justice Scalia, found that the “surcharge” imposed by the bankruptcy court contravenes Bankruptcy Code section 522, which makes the homestead exemption “not liable for payment of any administrative expense,” including, in this case, the Trustee’s legal fees incurred uncovering the Debtor’s misconduct.

The Supreme Court applied a strict construction of section 522, and emphasized that equitable considerations do not “permit a bankruptcy court to contravene express provisions of the Code.”   The Trustee and the United States, which filed a brief in support of the Trustee, did not dispute this principle but advanced the argument that the power of the bankruptcy court to deny a debtor’s homestead exemption necessarily includes the power to surcharge the exemption.  The Supreme Court rejected this argument, finding that the “general rule that exempt assets are not liable for administrative expenses,” is subject only to the two narrow exceptions enumerated in section 522(k) for “the use of exempt assets to pay expenses associated with the avoidance of certain voidable transfers of exempt property.”

The Supreme Court acknowledged that it's ruling “forces Siegel to shoulder a heavy financial burden resulting from Law’s egregious misconduct and that it may produce inequitable results for trustees and creditors in other cases.”  On the other hand, the Supreme Court also noted the availability of other “meaningful sanctions” such as: (1) the denial of a discharge for a dishonest debtor, (2) the imposition of sanctions, including attorneys’ fees, for bad faith litigation conduct under Bankruptcy Rule 9011, (3) other sanctions imposed under Bankruptcy Code section 105 or the bankruptcy court’s inherent powers, and/or (4) criminal prosecution under 18 U.S.C. § 152.

Time Is of the Essence Where Exemptions Are Concerned

One issue highlighted in the Law v. Siegelopinion was the lack of a timely objection to the debtor’s homestead exemption, which allowed the exemption to “become final” before the bankruptcy court found that there were grounds to impose the surcharge.  Objections are normally claimed with a debtor’s original Schedules of Assets and Liabilities, often filed at the very outset of a chapter 7 case.  The deadline to object to exemptions can, therefore, arise soon after the commencement of the case.  After Law v. Siegel, it will be critical for chapter 7 trustees, their counsel, as well as any interested creditors, to evaluate claimed exemptions and timely file any necessary objections within the deadlines specified in Bankruptcy Rule 4003, in circumstances where a debtor’s malfeasance could deplete funds available to the estate.

Categories: Chapter 7, Supreme Court