US Supreme CourtIn a recent case, Law v. Siegel, the U.S. Supreme Court said that a bankruptcy trustee cannot “surcharge” (redirect funds from) a bankruptcy debtor’s exempt property to pay for the trustee’s attorney’s fees — even if the debtor defrauded the court. The decision was a blow to bankruptcy trustees. But it certainly doesn’t mean that debtors who lie and cheat will get off without penalty.

The Facts of Law v. Siegel

In 2004 Mr. Law filed for Chapter 7 bankruptcy in California.  His home was worth $363,348 and he claimed the full $75,000 of California’s homestead exemption. He also listed two liens against his home that, taken together, exceeded the value of his home. Because these three liens meant that he had no equity in his home, there was nothing left for creditors and he proposed to keep his home in the bankruptcy.

The bankruptcy trustee, Mr. Siegel, questioned the existence of one of the junior liens – that of Lin’s Mortgage and Associates. Long story short: After five years of litigation, the bankruptcy court ruled that the Lin’s Mortgage loan was fictitious. Law had made it up just so he could keep his home. The bankruptcy court ruled that Mr. Law defrauded his creditors and the court.

At this point, Mr. Siegel was in the hole for attorney’s fees to the tune of a whopping $500,000. Bankruptcy law allowed Mr. Siegel to take his fees out of the proceeds of the home sale, after paying off Mr. Law’s first mortgage. But that amount didn’t make a dent in Mr. Siegel’s fees. So, Mr. Siegel asked the court to “surcharge” Mr. Law’s $75,000 homestead exemption. Essentially, he asked the court deny the exemption, and allow Mr. Siegel to use the $75,000 to defray his attorney’s fees.

Needless to say, Mr. Law was not a sympathetic character and the bankruptcy court did not have a problem giving the $75,000 to Mr. Siegel. When Mr. Siegel appealed to the Bankruptcy Appellate Panel of the Ninth Circuit, those judges agreed with the bankruptcy court. He then appealed to the Ninth Circuit, which also agreed with the bankruptcy court.

Split in the Circuit Courts Over Surcharging

Although the bankruptcy court’s ruling seems like a no-brainer, there has been a split between the circuit courts over surcharging – and for good reason. The federal bankruptcy law (§522) which allowed Mr. Law to exempt $75,000 in his home specifically states that the exempted amount “is not liable for” administrative expenses, including attorney’s fees.  And that’s exactly what Mr. Siegel proposed – to use the $75,000 to pay his attorney’s fees.

But here’s the rub. The Ninth Circuit and a few others have ruled over the years that surcharging is allowed because:

  • §105(a) of the bankruptcy code gives the bankruptcy court the authority to do what is necessary to carry out the provisions of the bankruptcy code, and
  • the bankruptcy court has “inherent power”  to sanction litigation practices.

Enter the Supreme Court

The bankruptcy bar awaited the result with baited breath. On the one hand was the group of lawyers who serve as bankruptcy trustees. They were hoping the U.S. Supreme Court would allow the surcharge.

On the other side was the group of lawyers who regularly represent debtors. Those lawyers didn’t want a decision which gave bankruptcy courts more power to take away debtors’ exemptions. And this case was worrisome because “bad facts often make bad law.”

The Supreme Court Says No to the Surcharge

In the end, the Supreme Court held its nose and ruled for Mr. Law.

Its reasoning was fairly simple: A bankruptcy court cannot take an action that is specifically prohibited by another section of the bankruptcy code.

The Supreme Court said that while the bankruptcy court does have inherent power to sanction fraudulent debtors, and §105(a) does give it power to make orders to carry out the code, nonetheless, the bankruptcy court cannot do so if it contravenes another provision of the code. Here, the bankruptcy court’s actions overrode §522, which allows a debtor to exempt certain property. To be sure, §522 does allow a bankruptcy court to deny an exemption, but only for a reason specifically outlined in that section. To that end, §522 lists quite an array of exceptions and limitations to a debtor’s use of exemptions. In what has quickly become a popular quote among bankruptcy attorneys, the Supremes said:

“The Code’s meticulous – not to say mind-numbingly detailed – enumeration of exemptions and exceptions to those exemptions confirms that courts are not authorized to created additional exceptions.”

(Anyone who has dealt with bankruptcy exemptions, both attorneys and debtors alike, will agree that they are mind-numbing. It was nice to have that fact recognized by the highest court in the country.)

What Does This Mean for Bankruptcy Trustees?

The decision is not a good one for bankruptcy trustees. Mr. Siegel labored for five years to prove that Mr. Law had defrauded the court and his creditors. And now he can’t even touch the $75,000 exemption. Yes, there are consequences for Mr. Law (see below), but they don’t necessarily help Mr. Siegel recover his attorney’s fees.

What Does This Mean for Debtors?

This decision certainly doesn’t give free reign to debtors to play fast and loose with the bankruptcy code, or worse, to defraud the court.

The U.S. Supreme Court was very careful to point out the many sanctions that are available to deal with debtors like Mr. Law.

  • The bankruptcy court can deny Mr. Law’s discharge, so that he’d still be on the hook for his debts. (The Court recognized that in this case, because of a settlement, Mr. Law didn’t have any debts to discharge. In most bankruptcy cases, however, this would be a big stick.)
  • The bankruptcy court can impose sanctions on a debtor for bad faith litigation tactics. It won’t take much to put Mr. Law in this category.
  • A debtor who commits fraud can be subject to criminal prosecution, and possibly go to jail for up to five years.