The Bottom Line:

In Law v. Siegel, No. 12-5195 (U.S. Mar. 4, 2014), the United States Supreme Court ruled that the bankruptcy court cannot use its general “equitable powers” under section 105 in a way which contravenes another specific section of the Bankruptcy Code. In Law, an individual debtor engaged in misconduct that led to hundreds of thousands of dollars in litigation costs being incurred by the Chapter 7 trustee. Despite this behavior, the Supreme Court ruled that it was erroneous to effectively surcharge the individual debtor for these costs by using section 105 to charge those administrative costs against the debtor’s homestead exemption, which exemption is specially protected by the Bankruptcy Code. Although the case involves a narrow issue – an individual debtor’s homestead exemption – the Supreme Court’s admonishment on the broad use of section 105’s equitable powers could be expanded to Chapter 11 cases. 

What Happened:

The petitioner, Stephen Law, filed for Chapter 7 bankruptcy in California in 2004. He valued his home at $363,348 and claimed that there was a $147,156.52 first lien on the house in favor of Washington Mutual as well as a second lien for $156,929.04 on the house in favor of “Lin’s Mortgage & Associates.” Law also claimed that $75,000 of the value of the home was exempt from the bankruptcy estate by virtue of California’s homestead exemption, pursuant to section 522 of the Bankruptcy Code and California State law. The two liens combined with the homestead exemption meant that there was no reason for the trustee to sell the home given that Law’s other creditors would not receive any value from the sale.

The chapter 7 trustee, Alfred Siegel, initiated an adversary proceeding alleging that the second lien in favor of Lin’s Mortgage & Associates (reflecting a debt owed to someone named “Lili Lin”) was fraudulent. Two individuals claiming to be Lili Lin came forward and responded to the trustee’s complaint. The first “Lili Lin” was a former acquaintance of Law and denied ever having loaned any money to him. She entered into a stipulated judgment disclaiming any interest in the house. A second “Lili Lin” claimed to be the true beneficiary of the disputed deed of trust. Despite living in China and speaking no English, the second Lili Lin engaged in costly and expensive litigation with the trustee over Siegel’s attempt to avoid the deed of trust and sell the house. Siegel incurred more than $500,000 on the related adversary proceeding. 

In 2009, the Bankruptcy Court concluded that the lien in favor of (the second) Lili Lin had been executed in order to avoid any sale of Law’s home and, therefore, perpetuate a fraud on Law’s creditors. The Bankruptcy Court concluded that the most plausible situation was that Law himself had written, signed, and filed the declarations and pleadings purporting to come from Lili Lin in China. The Bankruptcy Court granted Siegel’s motion to surcharge all of the $75,000 Law had retained through the homestead exemption in order to defray some of the fees and expenses incurred by the Chapter 7 trustee in prosecuting the adversary proceeding. Both the Ninth Circuit Bankruptcy Appellate Panel and the Ninth Circuit affirmed the Bankruptcy Court’s decision to surcharge the homestead exemption amount.

The Supreme Court granted certiorari to determine whether a bankruptcy court may contravene specific statutory provisions of the Bankruptcy Code – here, the homestead exemption – in exercising its section 105(a) powers to carry out provisions of the Bankruptcy Code. The Supreme Court reversed the lower courts and held that the court’s equitable powers under section 105(a) could not be used overcome the explicit homestead exemption in section 522 and, as such, the debtor had the right to receive and retain his $75,000 exemption amount. Surcharging the exemption for the payment of some of the trustee’s legal fees was improper. The Court stated: “[i]t is hornbook law that section 105(a) does not allow the bankruptcy court to override explicit mandates of other sections of the Bankruptcy Code." Section 522(k) specifically prevents exempt assets from being used to pay administrative expenses (other than with regard to specifically enumerated exceptions).

The Court also rejected Siegel’s (and the United States as amicus curiae) argument that the Bankruptcy Court was in fact using its equitable power to deny an exemption in the first place, not contravene the Bankruptcy Code. However, the procedural history was inconsistent with this argument as the homestead exemption became final before the bankruptcy court entered the surcharge order. The Court ruled that even if the exemption had been timely objected to, bankruptcy courts do not have “discretion to grant or withhold exemptions based on whatever considerations they deem appropriate.” Section 522 lays out very specific exceptions to the exemptions and in doing prevents courts from creating additional exceptions through their equitable powers.

The Court acknowledged that while the decision in the case may produce inequitable results as Siegel has to bear a heavy financial burden, courts and trustees are not without recourse for dealing with outrageous conduct by debtors. Courts can impose sanctions for bad faith litigation conduct, as well as deny a debtor a discharge (although this course of action was not available in this particular case because of a settlement which occurred). The case was remanded for further proceedings consistent with the Court’s opinion.

Why the Case is Interesting: 

The facts of the case were very specific to improper conduct by an individual debtor. In Law, the court addressed a direct conflict between the application and interpretation of two provisions – section 105 and section 552. However, the impact of the decision remains to be seen in expanding the scope of the prohibition on the use of section 105 to another not-quite-conflicting context. Bankruptcy courts are routinely asked to use section 105 to permit payments or take actions as part of a Chapter 11 case. For example, payments of prepetition amounts under the so-called “Doctrine of Necessity” are based upon the use of section 105 in conjunction with section 363. Stay tuned for if/how the principle of Law is expanded.