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Supreme Court Rules Bankruptcy Trustee Cannot Use Exempt Assets to Pay Expenses, Even If Caused by Debtor Misconduct

FarmerT from morguefile.comThe U.S. Supreme Court ruled against the trustee in a Chapter 7 case who had obtained a bankruptcy court’s leave to pay attorney’s fees, incurred as a result of fraud by the debtor, from the debtor’s exempt assets. Law v. Siegel, No. 12-5196, slip op. (Sup. Ct., Mar. 4, 2014). While a court may impose other sanctions on a debtor for fraud and other misconduct, the court held that use of exempt assets in such a situation exceeds a bankruptcy court’s discretionary authority under 11 U.S.C. § 105(a).

The debtor filed a Chapter 7 bankruptcy petition in 2004. He listed a house with a value of $363,348 as his only asset, and claimed the $75,000 of that value was exempt under California law. Cal. Civ. Proc. Code § 704.730(a)(1). He also identified two liens encumbering the house held by Washington Mutual Bank for $147,156.52 and Lin’s Mortgage and Associates for $156,929.04. Since the sum of the two liens exceeded the claimed value of the house, the debtor alleged that the house had no equity.

The trustee filed an adversary proceeding several months later, claiming that the second lien was fraudulent. An individual named Lili Lin, who claimed to be the beneficiary of the deed of trust to Lin’s Mortgage and Associates, tied the case up in litigation for about five years. The bankruptcy court ruled in 2009 that the loan from Lin was a “fiction” meant to enable the debtor to keep the house. Law, slip op. at 3. It further found that the trustee had incurred over $500,000 in attorney’s fees, and it granted the trustee’s motion to “surcharge” the debtor’s $75,000 exemption to put towards those fees. Id. at 4.

The Bankruptcy Appellate Panel (BAP) and the Ninth Circuit Court of Appeals affirmed the bankruptcy court’s ruling. The BAP cited Latman v. Burdette, 366 F.3d 774 (9th Cir. 2004), which held that a bankruptcy court is permitted in certain situations, including fraud by the debtor, to “equitably surcharge a debtor’s statutory exemptions.” Law, slip op. at 4, quoting Latman, 366 F.3d at 786. The BAP also noted that other circuits held differing views. The Tenth Circuit, for example, held in In re Scrivner, 535 F.3d 1258, 1263-64 (10th Cir. 2008), that allowing a trustee to surcharge exempt assets was inconsistent with other provisions of the Bankruptcy Code. The Supreme Court granted certiorari.

Justice Scalia, writing for the court, noted that “hornbook law” holds that a bankruptcy court’s discretion under § 105(a) is subordinate to “specific mandates” found elsewhere in the Bankruptcy Code. Law, slip op. at 5. The court held that the bankruptcy court went against § 522 of the Code, which allowed the debtor, applying California law, to exempt $75,000 of equity in his home, and which specifically stated in § 522(k) that the exempt property may not be used to pay “administrative expense” except in circumstances not applicable to this case. The court reversed the judgment and remanded the case to the bankruptcy court.

Bankruptcy attorney Devin Sawdayi has represented individuals and families in the Los Angeles area since 1997, helping them repair their finances through Chapter 7 or Chapter 13 bankruptcies with dignity and respect. To schedule a free and confidential consultation to see how we may can assist you, please contact us today online or at (310) 475-9399.

More Blog Posts:

Court Converts Bankruptcy Case from Chapter 13 to Chapter 7 Based on Finding that Debtor Withheld Information, Los Angeles Bankruptcy Lawyer Blawg, January 27, 2014

Bankruptcy Court Denies Chapter 13 Debtor’s Request for Turnover of Garnished Wages, Los Angeles Bankruptcy Lawyer Blawg, October 15, 2013

More than Just a Sweet Ride: A Car May Be Exempt from Bankruptcy Estate Under California’s “Wildcard” Exemption, Appellate Court Holds, Los Angeles Bankruptcy Lawyer Blawg, June 11, 2013

Photo credit: Photo credit: FarmerT from morguefile.com.