Laying Down the Law – US Supreme Court Determined Bankruptcy Court Exceeded Its Power By Applying Surcharge to Debtor’s Exempt Property

March 7, 2014

A man’s home is his castle and he will not be dethroned, at least not now or through some back door process. Justice Antonin Scalia of the US Supreme Court concluded in Law v. Siegel that the bankruptcy court exceeded its authority when it ordered that a surcharge be applied to the debtor’s exempt property to resolve the Chapter 7 Trustee’s legal fees. I consciously used the nondescript phrase of “exempt property” in lieu of stating “homestead exemption” because the type of property exemption is immaterial. The generic phrasing prevents us from being sidetracked by discussions of the value of home ownership or the necessity to protect the home, which really have no import in this case. This case is truly about the bankruptcy court’s powers, a matter that has been the topic of legal discourse for years and will continue to be at issue, especially as practitioners await further clarification on an attempted clarification (sorry, a sidebar). 


Stephen Law filed for Chapter 7 bankruptcy protection in 2004, but he defrauded the court by listing a fictitious second mortgage to protect his home equity. Law valued his California home at $363,348. He listed two mortgages on his schedules – one in the amount of $147,156.52 for Washington Mutual Bank and the other for $156,929.04 in favor of Lin’s Mortgage and Associates. Law also claimed the $75,000 homestead exemption under California law. Consequently, no assets remained for distrubution to his creditors.  But Alfred H. Siegel, the Chapter 7 Trustee, questioned the legitimacy of the second mortgage. His investigation revealed two possible beneficiaries of the second mortgage – a Lili Lin in California who was formerly associated with Law and another Lili Lin in China who did not speak English. Obviously, Lin in California was the intended party, especially after she admitted that Law solicited her to participate in his devious plan. However, Lin in China represented, at great time and expense, that she was the actual Lin. Well, at least we know who the Law is.


After finding that the second mortgage was a sham, the bankruptcy court, on Siegel’s motion, ordered that a surcharge be applied to Law’s $75,000 exemption to defray the $500,000 in legal fees reasonably incurred by the trustee in uncovering his fraud. But the time to object to a debtor’s exemptions had passed. So how could the bankruptcy court essentially disallow a previously allowed exemption? And this question demonstrates why the case is about the court's power, not the exemption.  

The Bankruptcy Code grants the court authority to issue any order or judgment necessary to enforce the Code’s provisions. But it does not allow the court to override explicit mandates stated elsewhere in the Code. Section 522 of the Code permits a debtor to claim a homestead exemption afforded under state law. The Code further states that exempt property cannot be liable for administrative expenses, which is the characterization of the trustee’s legal fees. By ordering that the $75,000 protected by the homestead exemption be made available to pay the trustee’s legal fees, the bankruptcy court violated § 522 of the Code. While it seems that the debate should end there, the Law’s opponents did not concede defeat.  (Of course, the pun is intended).


The United States (through amicus brief) challenged the absolution of the homestead exemption, and the trustee further contended that the Code states that a debtor may take an exemption but it was not a statutory requirement.  Justice Scalia noted that the exemption could be challenged, but it must be done so timely.  And here, it was not. Scalia also acknowledged the permissive nature of the right to the homestead exemption but stated the option to take the exemption is exercised by the debtor, not the court. It is baffling how the bankruptcy court can be cited for erring in preventing a debtor from benefitting from his misconduct. Law committed fraud to shield his equity from creditors, which was against the law, but he retained the exemption after the fraud was uncovered, leaving the trustee without compensation. The law is unfair. Well, at least the debtor Law.


Justice Scalia reminded the parties that the bankruptcy court, while erroneous in its chosen path, is not powerless. The law enables the court to deny a dishonest debtor a discharge, which would adversely affect the debtor’s credit without the benefit of eliminating his debts. The court also can seek monetary sanctions against the wrongful debtor and direct him to pay the attorney’s fees. Because these sanctions arose post-petition, they would not be subject to discharge through the bankruptcy process. So he would still have to pay the trustee's fees by way of some other resource.  And the most serious of penalties for a dishonest debtor is criminal prosecution, which could subject the debtor to a maximum of five years imprisonment. Clearly, the debtor attempted to circumvent the law through fraud and deception, but when presented with the options that the bankruptcy court has remaining, it might not be so difficult for Law to abide.

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