If a debtor in bankruptcy commits misconduct during bankruptcy proceedings, can statutory exemptions previously granted to him be revoked as punishment for his misbehavior?
Stephen Law filed for Chapter 7 bankruptcy, and Alfred Siegel was appointed as his bankruptcy trustee. Law filed for and was granted an exemption for a value of $75,000 in equity for his home under § 522 of the Bankruptcy Code. Throughout the bankruptcy proceedings, however, Law was uncooperative, and ultimately defrauded the court and Siegel. After Law fraudulently claimed a second mortgage on his home, the court granted Siegel’s request to revoke the previously granted exemption in order to pay administrative expenses for the proceedings. Law argues that by granting the revocation, the court frustrated Congress’s intent to give debtors sufficient funds to support themselves when they emerge from bankruptcy. Siegel responds that courts have the power to protect the judicial process through equitable revocation of exemptions when dishonest and misbehaving debtors act to damage the judicial process. The Supreme Court will decide whether bankruptcy courts have the power to revoke congressionally granted exemptions for debtors’ assets as punishment for debtor misconduct. The decision will impact debtors in bankruptcy and the security of the minimal assets they might retain after proceedings.
Questions as Framed for the Court by the Parties
- Whether § 105 empowers a bankruptcy court to eliminate an exemption that § 522 guarantees to the debtor?
- Whether a bankruptcy court may—under § 105(a) or its inherent sanctioning powers—order the equitable forfeiture of a claim to an exemption based on the debtor’s egregious misconduct in seeking to wrongly withhold non-exempt assets from the estate?
In January 2004, Stephen Law filed a Chapter 7 petition for bankruptcy. Alfred H. Siegel acted as the Chapter 7 trustee. Such a trustee is responsible for taking possession of all the debtor’s assets, liquidating them, and distributing the proceeds to the debtor’s creditors.
When Law filed, his primary asset was his home, which he valued at just over $360,000. Under the California Code of Civil Procedure, a debtor filing for bankruptcy can file a “homestead exemption” for up to a particular amount. As such, Law claimed an exemption from the bankruptcy estate for $75,000 of equity in his home, the maximum he could claim given his status. The trustee of the estate, Siegel, did not object to this exemption.
Additionally, Law claimed that his home was subject to two mortgages. The first mortgage was owned by Washington Mutual Bank, and supposedly, Lin’s Mortgage & Associates held the second. Siegel sold the house at auction for $680,000.
Only one creditor, Cau-Min Li, filed a claim for payment out of the bankruptcy proceedings. Although the claim was for just over $130,000, Li and Siegel reached a settlement agreement to pay Li $120,000. Law vigorously opposed this agreement.
During these various transactions, Siegel submitted two motions to “surcharge” (i.e., forfeit) Law’s homestead exemption because of Law’s behavior throughout the bankruptcy process. Although the first motion was dismissed because the court found no misconduct beyond litigiousness, the court granted the second motion to surcharge the exemption. As a result, the $75,000 exemption was used to satisfy some of the remaining claims against the estate. These claims included, in large part, the expenses and fees for the Trustee and his team.
The bankruptcy court found that (1) the Lin mortgage was a fiction created by Law to preserve his equity in the property and to defraud his creditors and the court, and (2) the harm to the estate because of this misconduct exceeded the $75,000 exemption. In addition to these facts, the court also relied on case precedent establishing equitable authority to surcharge an exemption when a debtor’s misconduct results in fraud on the court or creditors. Following the same reasoning, the Bankruptcy Appellate Panel of the Ninth Circuit affirmed the order.
The Ninth Circuit Court of Appeals affirmed the surcharge order for the exemption. The court agreed with the reasoning in the lower courts regarding equitable surcharge and asserted that such measures are necessary to protect the integrity of the bankruptcy process. Law’s petition for a hearing en banc was denied. Law filed a petition for a writ of certiorari with the Supreme Court, which granted the petition on June 17, 2013.
Law argues that § 522 of the Bankruptcy Code (“Code”) expresses congressional intent to exempt certain assets from bankruptcy collection in order to provide debtors in bankruptcy a chance at a “fresh start.” Siegel responds that when a debtor acts in bad faith, bankruptcy courts have equitable power to revoke such exemptions in order to prevent abuses of the judicial process. The Supreme Court’s resolution of this case will determine whether congressionally-defined exemptions for assets can be revoked as punishment for a debtor’s bad-faith behavior in bankruptcy proceedings. This case will impact debtors in bankruptcy and whether they can depend on exemptions even after committing misconduct.
Law argues that § 522 of the Code expressly prohibits using exemptions to pay debts or administrative expenses unless certain circumstances are met. Law and supporting amici note that Congress has made it clear that only in extreme circumstances can a person be denied exemptions previously granted to them. In their brief, bankruptcy law scholars (“scholars”) argue that where Congress clearly expresses exceptions to exemptions and provides penalties for wrongful conduct, the Court should not circumvent these provisions. Indeed, the scholars argue that the strict requirements of the Code would be undermined if courts could nullify exemptions. Eric Brundstad and the National Association of Consumer Bankruptcy Attorneys (“NACBA”) add that a bankruptcy court should not be able to exercise its equitable powers to create rights or remedies that are outside the statutory regime. Finally, Law and the NACBA argue that other procedures such as civil contempt, denial of discharge, and sanctions are more appropriate punishments for bad behavior and are within the statutory scheme established by Congress.
Siegel and supporting amici counter that courts have an inherent power in equity to create appropriate sanctions for abuses of the judicial process. Siegel argues that such equitable forfeiture does not violate the Code. In support of this argument, the National Association of Bankruptcy Trustees (“NABT”) adds that when a debtor acts dishonestly and frustrates the purpose of the Code, provisions therein give the court meaningful equitable power to prevent the debtor from profiting from his misbehavior. The National Association of Chapter Thirteen Trustees (“NACTT”) argues that such equitable power does not override congressional intent; rather, this authority allows courts to further Congress’ legislative choices. The NABT argues that the other remedies suggested by Law do not provide effective redress and that equitable remedies are necessary and appropriate to prevent debtors from abusing the bankruptcy system.
PURPOSE OF EXEMPTIONS
Law and supporting amici argue that the purpose of the exemptions is to give debtors a “fresh start” out of bankruptcy. According to Law, this means that debtors should emerge from bankruptcy with enough property that the public will not need to support them. Law notes that Congress intended to provide this fresh start even if it meant that creditors’ claims are sometimes unsatisfied and the trustee is left responsible for the costs of administering the estate. NACBA adds that exemptions to protect debtor livelihood are fundamental to the bankruptcy process and that taking away these exemptions would contravene bankruptcy’s purpose to provide a fresh start.
Siegel and supporting amici counter that a debtor can only receive the benefits of exemptions if he comes into the process with “clean hands” and does not abuse the bankruptcy process. Siegel argues that the fresh-start policy is understood to apply only to an “honest but unfortunate debtor.” The United States asserts the same argument and adds that the bankruptcy process depends on honest and full disclosure of the debtor’s assets. Siegel and supporting amici note that debtors who do not act honestly in bankruptcy abuse the process. As such, the NABT argues that a court should have the power to revoke an exemption when it is necessary to curtail the debtor’s abuse and preserve the integrity of the bankruptcy system.
The issue before the Court is whether a bankruptcy court may use its equitable powers under § 105 of the Bankruptcy Code to deprive a debtor of a homestead exemption. Law argues that it is contrary to the text of the Code as well as Congress’ clearly expressed intent to use the court’s equity authority to deprive a creditor of a homestead exemption. Siegel responds that it was appropriate in this case under both the court’s express and implied equitable powers to deny Law’s homestead exemption.
CAN A BANKRUPTCY COURT DEPRIVE A DEBTOR OF A HOMESTEAD EXCEPTION?
Law argues principally that the text of the Code clearly establishes that a court may not deprive a debtor of a homestead exemption. Section 105 of the Code, which grants general equitable powers to bankruptcy courts, reads in relevant part: A “court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.” According to Law, denying a homestead exemption to a debtor does not “carry out” the provisions of the Code; rather, it directly contravenes them. Under § 522 of the Code, once it is determined that a debtor is entitled to a homestead exemption, those funds are precluded from being used to pay the debtor’s creditors, including any administrative expenses incurred by the trustee in administering the estate. Law notes that the § 522 exemptions reflect Congress’s rationale that debtors should have a “fresh start” after leaving bankruptcy, even if it means that certain of their debts go unpaid. In light of this expressed legislative intent and the central feature that § 522 plays in the Code overall, Law argues that depriving a debtor of a homestead exemption directly contravenes the clear mandate of § 522 that whatever property is exempted cannot be used to pay any of the debtor’s debts or any administrative expenses.
Law further argues that where Congress intended to create exceptions to a § 522 exemption, it expressly said so. According to Law, there are at least twenty such exceptions outlined in the Code, under which a debtor’s otherwise exempt property may be used to pay its debts. Law contends that none of those exceptions applies here, and that allowing the lower court to create its own would render the specifically enumerated exceptions superfluous. According to Law, where a statute specifically lists exceptions to a general prohibition, then additional exceptions cannot be implied without evidence of such legislative intent—evidence of which is lacking here. Law further argues that when Congress drafted its exceptions to § 522, it specifically addressed debtor misconduct, but consciously chose not to create a general exception for bad conduct. Rather, Congress chose to rely on more targeted instances of misconduct—for example, where a debtor has been convicted of a felony. In further support of this argument, Law notes that even where a debtor has non-dischargeable debts caused by the debtor’s fraud or bad faith, the Code still allows those debtors a homestead exemption. If changes should be made to allow a court to deny a debtor a homestead exemption, then they should be made by Congress, not the courts, according to Law.
Siegel, on the other hand, argues that by denying Law his homestead exemption, the bankruptcy court acted within its authority under § 105 of the Code. Siegel emphasizes that the statute authorizes a court to take action which is necessary or appropriate to carry out the Code, and argues that the use of “or” indicates that Congress intended to give bankruptcy courts very broad authority. According to Siegel, the equitable forfeiture ordered in this case filled the gap left by the Code’s inability to properly punish Law for his fraudulent conduct. Thus, Siegel argues that the remedies expressly provided for in the Code, such as denial of discharge and criminal sanctions, would have done nothing to offset the effect of Law’s fraud, which was to deprive creditors and the estate of some of the non-exempt equity in his homestead. The extraordinary circumstances of this case thus warranted the court’s denial of Law’s homestead exemption, an action which was directly within the purview of § 105.
Siegel contends that, even if there is no statutory authority for the court’s equitable remedy in this case, it was nevertheless within its “inherent sanctioning powers,” which is a separate source of authority. According to Siegel, every federal court possesses the authority to sanction abusive litigation practices. What is more, according to Siegel, there is no unqualified right to a homestead exemption; rather, the “fresh start” intended by the exemptions carved out in § 522 of the Code is limited to “honest but unfortunate” debtors. In support of this claim, Siegel points out that the Code states that a debtor “may” be entitled to an exemption, not that he “shall” be granted one, thus leaving it within a court’s equitable powers to deny a debtor an exemption. Furthermore, Siegel claims that Congress earlier expressly rejected a draft version of the Code which would have made exemptions mandatory rather than discretionary. With respect to the provisions of the Code that cap, rather than entirely eliminate, a debtor’s exemptions, Siegel argues that they are inapplicable in this case because they were enacted by Congress after the proceeding was initiated.
Thirdly, Law challenges the lower court’s reasoning that it denied the homestead exemption in order to prevent an abuse of process. Under the second sentence of § 105, no provision of the Code which allows a party to raise an issue is to be interpreted to prevent the court on its own motion from taking any action which is necessary to prevent an abuse of process. According to Law, this part of § 105 does not allow a court to override substantive provisions of the Code in the name of preventing an abuse of process; rather, it merely clarifies the power of bankruptcy courts to make their own motions with respect to issues which the parties are also allowed to raise. Law contends that the relevant language was inserted into § 105 to expressly overrule a Court of Appeals decision, which held that a court could not act in an area where the Code expressly granted such power to the parties. That, according to Law, is the full extent of the language in § 105. It does not grant a bankruptcy court any more authority than is already granted to courts in the first sentence of § 105, which entitles them to “issue any order, process, or judgment that is necessary or appropriate to carry out” the Code.
Siegel challenges Law’s reading of the second sentence of the statute. According to Siegel, the second sentence of § 105 enhances the first sentence. Thus, the second sentence of the statute means, under Siegel’s reading, that part of a bankruptcy court’s discretion in carrying out the provisions of the Code—as authorized in the first sentence—is to take action necessary or appropriate to prevent an abuse of process. Under this reading, the second sentence of § 105 is an example of what the first sentence refers to when it speaks of courts taking action necessary or appropriate to carry out the provisions of the Code.
Finally, Law contends that other provisions of the Code are sufficient to deter the kind of conduct that the court sought to punish here. For instance, Law points out that the Code authorizes a court to deny the discharge of a debtor’s debts and further to impose criminal penalties in order to deter fraudulent conduct. Siegel, however, argues that the existence of these remedies does not preclude others which may be appropriate. Specifically, Siegel contends that denial of discharge or the imposition of criminal penalties does nothing to make the victims of the fraud whole or protect the integrity of the bankruptcy proceedings. Because these remedies are so inadequate to punish Law’s egregious behavior, Siegel contends that it was within the scope of the court’s power to deny him a homestead exemption.
In this case, the Supreme Court will decide whether a bankruptcy court may revoke a homestead exemption using its equitable powers under § 105 of the Bankruptcy Code. Law contends that the homestead exemption is integral to allowing debtors—even debtors who perpetrate fraud—to obtain a “fresh start.” Accordingly, a court cannot deny that exemption without a clearly expressed intention from Congress. Siegel, on the other hand, argues that it is well within a court’s express and implied equitable powers to deny a homestead exemption when doing so is necessary to carry out the provisions of the Code. In deciding this case the Court will be asked to interpret § 105 of the Code and to determine how far a bankruptcy court’s equitable powers reach with respect to homestead exemptions for debtors who act in bad faith.
- James Cordrey, U.S. Supreme Court Will Hear Bankruptcy Case Involving Charge on Debtor’s Property, LexisNexis Legal Newsroom, (June 17, 2013)