The Supreme Court Rules To Protect Bankruptcy Exemptions

Bankruptcy is a complex set of laws that balance the interests of debtors against the rights of creditors to receive payments. The central feature of the bankruptcy law is the Bankruptcy Code, authorized by the U.S. Constitution and written by Congress. The Bankruptcy Code is generally the supreme law in a bankruptcy case and debtors, trustees, creditors, and even bankruptcy judges are obligated to follow its dictates.

The recent U.S. Supreme Court case of Law v. Siegel examines the extent of how obligated a bankruptcy judge is to follow the Bankruptcy Code. In this case, the Chapter 7 debtor, Law, claimed that his home had two liens against it and also applied a California state homestead exemption of $75,000 to protect any remaining equity. If his assertions were true, there was no equity for payment to creditors. However, the trustee smelled a rat and objected to the second mortgage lien.

After lengthy and costly litigation, the bankruptcy judge concluded that the second lien “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.” The trustee took and sold Law’s home, and then applied to recover some of his litigation costs from Law (which totaled over $500,000).

The bankruptcy court used its equitable powers (ostensibly granted by Section 105 of the Bankruptcy Code) to “surcharge” Law’s homestead exemption. The case was appealed and both the Ninth Circuit Bankruptcy Appellate Panel and the Ninth Circuit Court of Appeals affirmed the bankruptcy court’s decision.

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In a rare move, the U.S. Supreme Court agreed to hear this case to resolve a split between the appellate circuits. The Ninth and First circuits agreed that bankruptcy courts have the power under Section 105 to impose an “equitable surcharge” for debtor misconduct on otherwise exempted property. The Tenth Circuit disagreed stating that the Bankruptcy Code confers no power to surcharge exempt property.

The unanimous Supreme Court reversed the Ninth Circuit Court of Appeals saying that the bankruptcy court had no authority to surcharge the debtor’s exempt assets. Justice Scalia delivered the opinion of the Court and stated that bankruptcy courts have the inherent power to sanction “abusive litigation practices.”

He also acknowledged that through Section 105 Congress gave bankruptcy judges authority to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of ” the Bankruptcy Code. However, a bankruptcy court’s orders may not override a specific mandate of the Bankruptcy Code itself.

Scalia wrote that the surcharge against Law “contravened a specific provision of the” Bankruptcy Code found in Section 522. Essentially, Law was entitled to claim a homestead exemption in his bankruptcy case. The Bankruptcy Code only permits a court to charge an administrative expense, such as the trustee’s litigation expenses, under two very narrow conditions. Neither was present in Law’s case, so the bankruptcy court exceeded its authority.

The bankruptcy trustee also argued that the bankruptcy court could deny Law’s homestead exemption, but the Supreme Court disagreed. Justice Scalia wrote that “A debtor need not invoke an exemption to which the statute entitles him; but if he does, the court may not refuse to honor the exemption absent a valid statutory basis for doing so.” There was simply no statutory justification to withhold Law’s homestead exemption.

The end result of this case is that the Chapter 7 trustee must pay the debtor $75,000 from the proceeds from the sale of the home. But Scalia also points out that the Court is not without power to sanction debtor misconduct. The court may deny a bankruptcy discharge to a dishonest debtor, and can sanction bad faith litigation, including directing Law to pay the Chapter 7 trustee’s litigation costs. Debts from post-bankruptcy misconduct are non-dischargeable. Finally, a dishonest debtor may be subject to criminal prosecution, which could result in a penalty of up to five years in federal prison.

Like every bankruptcy case decided by the Supreme Court, there are many lessons to learn. One of the most beneficial to the debtor is that bankruptcy exemptions belong to the debtor, and are not subject to the whimsical discretion of an individual bankruptcy judge. A bankruptcy court may not deny or surcharge a debtor’s exemption absent statutory authority. This strengthens every debtor’s exemption rights and aids debtors in the financial recovery process.

Protecting a debtor’s property during bankruptcy is always challenging. No two bankruptcy cases are identical, and each case needs the careful attention of an experienced bankruptcy attorney. If you are struggling with debts you cannot pay, seek the consultation of a seasoned attorney and learn how the federal bankruptcy laws can help you.