Surcharge of Exemption Violated § 522(k)

By William Houston Brown, Adviser/Editor, Academy for Consumer Bankruptcy Education

On March 4, in Justice Scalia’s unanimous opinion, Law v. Siegel,1 the Supreme Court held that the bankruptcy court exceeded its authority when it surcharged the Chapter 7 debtor’s homestead exemption for the payment of a portion of the trustee’s administrative expense. Although a Chapter 7 case, the holding and reasoning of the Court is important for Chapter 13 cases, its trustees and creditors. The opinion contains significant reminders about the limits of the bankruptcy court’s authority, as well as lessons about how the bad result might be avoided in future cases.

First, a reminder of what is at play, with the understanding that this brief article restricts itself to the exemption issues addressed in Law.2 In all bankruptcy cases, the individual debtor is entitled to claim exemptions,3 and generally objections to claimed exemptions must be timely,4 with failure to timely object leading to allowance of the claimed exemptions.5 If allowed, the exemptions, subject to specific statutory exceptions, are protected from pre-bankruptcy claims of creditors; that is, the exemptions survive discharge.6 Moreover, the Code specifically protects allowed exemptions from administrative expense claims in the case, again subject to certain exceptions.7 As will be seen, this last Code provision was critical to the Law decision.

With that background, an overview of the facts in Law, as stated in the Supreme Court’s decision: The debtor’s only significant asset was his California home, which he valued at $363,348, and the debtor claimed the California homestead of $75,000. The debtor had a first mortgage, apparently valid, for approximately $147,000, but he asserted that there was a second mortgage held by an individual. After much expensive litigation, the bankruptcy court determined that the second mortgage did not exist. The asserted second mortgage, which would have consumed all equity in the home, was intended to prevent the trustee’s sale of the home. In the course of prolonged litigation, including avoidance of the fraudulent deed of trust, the trustee incurred $500,000 in attorney fees. No big surprise, under these facts, that the bankruptcy court, affirmed by the Ninth Circuit, approved a surcharge of the $75,000 exemption, permitting the trustee to capture that in partial reimbursement of incurred fees. There was appellate authority in that Circuit approving surcharge as an equitable remedy in appropriate cases.8

Some were surprised at the Supreme Court’s grant of certiorari in a case with such bad facts, but there was a split in Circuit authority on at least portions of the surcharge issue. The First Circuit had followed the Ninth, holding that the bankruptcy court had authority to surcharge when the Chapter 7 debtor had willfully concealed nonexempt funds.9 The Tenth Circuit had earlier concluded that there was no statutory authority to surcharge.10

The Law opinion’s results are terrible for the trustee, who diligently pursued a deceitful debtor, but the reasoning of the Court should not be a surprise. The crux of the opinion is that specific Code provisions prevail over equitable remedies, and we have seen this reasoning before.11 As the Court said, “Section 105(a) confers authority to ‘carry out’ the provisions of the Code, but it is quite impossible to do that by taking action that the Code prohibits.”12 The Law Court observed that the claimed homestead exemption had been allowed, becoming final before the surcharge was imposed, since no one objected to it, applying Taylor v. Freeland & Kronz.13 The Court then stated that the surcharge contravened § 522(k), which prevented the allowed exemption from being liable for administrative expenses, finding that the trustee’s attorney fees were clearly an administrative expense.

Bottom line—the imposition of a surcharge is not authorized in the Code, and the bankruptcy court exceeded both § 105(a) and its inherent authority when it created a non-Code remedy. The Court concluded that Congress had created “meticulous—not to say mind-numbingly detailed—enumeration of exemptions and exceptions [which] confirms that courts are not authorized to create additional exceptions.”14

Where does this leave trustees, creditors and the bankruptcy courts? First, it is a reminder to object to all suspect exemptions, and do it timely. Of course, within the brief time for normal objections, the trustee or creditors may not yet know that the debtor’s claimed exemption is improper, but remember that Rule 4003(b)(1) permits extension of the objection time, provided such a motion is itself timely.

Look at the basis for the debtor’s exemption claim if made under State law, since there may be state-law remedies for an improper claim. The Law Court noted that state-law remedies for debtor misconduct may exist when there is no Bankruptcy Code remedy, but such state-law remedies will not often be available. There is no indication that such remedies were available in Law. Of course, the Court alluded to the potential of criminal prosecution, which doesn’t compensate the trustee.

Are there effective remedies under these types of facts, when the opportunity for objection to allowance has passed? The Law opinion points to the potential of denial of discharge as a remedy, one that does the trustee little good in a typical case. More importantly, the opinion makes a point at closing to say that the bankruptcy court does have § 105(a), Rule 9011(c)(2), and inherent authority to “impose sanctions for bad-faith litigation conduct,” with such sanctions including reasonable attorney fees and expenses.15 “And because it arises postpetition, a bankruptcy court’s monetary sanction survives the bankruptcy case and is thereafter enforceable through the normal procedures for collecting monetary judgments. See § 727(b).”16

It is not as simple as saying that whether the trustee and/or creditors prevail depends on what they call the remedy, but the concluding portion of Law v. Siegel does send a message: The bankruptcy court lacks authority to create an exemption-surcharge remedy, but the court does have authority to award fees as a sanction, including for litigation misconduct. Fabricating a mortgage to defeat the trustee’s sale of property for the benefit of creditors, or to defeat the trustee’s avoidance of the fraudulent mortgage is surely litigation misconduct. When and how to raise the issue of sanctions for such conduct may be the real issue in future cases.

______________________

[1] 571 U.S. ____, 2014 WL 813702 (Mar. 4, 2014).

[2] See Brown, Ahern & MacLean, Bankruptcy Exemption Manual, for in-depth discussion of exemption issues.

[3] 11 U.S.C. § 522 (“An individual debtor may exempt from property of the estate the property listed” under § 522(d) or applicable state law. Often, the choice will be driven by whether the applicable state law has opted out of the § 522(d) exemptions.)

[4] Fed. R. Bankr. P. 4003(b).

[5] There are, of course, exceptions to the general rule of timely objection, as seen in Schwab v. Reilly, 130 S.Ct. 2652 (2010), but the Schwab rationale was not an issue in the Law opinion.

[6] 11 U.S.C. § 522(c).

[7] 11 U.S.C. § 522(k).

[8] Latman v. Burdette, 366 F.3d 774 (9th Cir. 2004).

[9] Malley v. Agin, 693 F.3d 28 (1st Cir. 2012).

[10] In re Scrivner, 535 F.3d 1258 (10th Cir. 2009), cert. denied, 129 S.Ct. 1613 (2009).

[11] See Norwest Bank Worthington v. Ahlers, 485 U.S. 197 (1988).

[12] Law v. Siegel, 2014 WL 813702, at * 5.

[13] 503 U.S. 638 (1992).

[14] Law v. Siegel, 2014 WL 813702, at * 6.

[15] Law v. Siegel, 2014 WL 813702, at * 8.

[16] Law v. Siegel, 2014 WL 813702, at * 8. Of course, the reference to § 727(b) is of no direct help in Chapter 13 cases, but is unlikely that an appropriate post-petition monetary sanction would be “provided for” in the plan in order to be dischargeable under § 1328(a).

_______________________________

Bill-Brown-colorThe Honorable William Houston Brown retired in 2006 as a United States Bankruptcy Judge for the Western District of Tennessee, and he had been designated to sit also in the Middle District of Tennessee, Southern District of Florida, Eastern District of Michigan and Western District of Kentucky. Judge Brown served a four-year term on the Bankruptcy Appellate Panel for the Sixth Circuit from 1999 through 2002. He received his law degree from the University of Tennessee College of Law, where he was Order of the Coif. Judge Brown is a member of the American Bankruptcy Institute, having served on its Board and Executive Committee, and he is a Fellow in the American College of Bankruptcy. He is the author or co-author of several texts, including Bankruptcy Exemption Manual, 2005 Bankruptcy Reform Legislation with Analysis 1st and 2d editions, Bankruptcy and Domestic Relations Manual, The Law of Debtors and Creditors, as well as bankruptcy form books, all published by Thomson West. He is also a principal contributing editor for Norton Bankruptcy Law and Practice 3rd, published by Thomson West. Judge Brown prepares a quarterly update of consumer cases for the Federal Judicial Center, which distributes those materials to all bankruptcy judges, and he is a speaker at the Federal Judicial Center’s annual seminars for bankruptcy judges. He also speaks regularly at seminars throughout the United States, on consumer bankruptcy topics. Judge Brown co-authors Chapter 13 Bankruptcy 4th ed., a digital publication, available at ch13online.com. Judge Brown also acts as a mediator in bankruptcy-related disputes, has conducted mock trials, and has testified as an expert witness in bankruptcy court proceedings.

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