A bankruptcy court ordered that a debtor’s homestead exemption be surcharged to pay the attorney’s fees of a Chapter 7 incurred in overcoming the debtor’s fraud. The order was affirmed on appeal until it reached the Supreme Court.
The debtor’s primary asset was his home, which he valued at ~$363,000. He claimed a state homestead exemption of $75,000, and contended that the home was subject to a deed of trust in favor of a bank for ~$147,000 and a second deed of trust for ~$157,000. If that was true, there would not be any equity in the property for other creditors.
The trustee initiated an adversary proceeding to avoid the second lien in favor of “Lili Lin,” alleging that it was fraudulent. Unfortunately for the trustee, establishing the fraud was easier said than done. Two Lili Lin’s surfaced – one from California and one from China. The California Lili Lin claimed that the debtor repeatedly tried to involve her in sham transactions, while the Chinese Lili Lin (who supposedly lived in China and spoke no English) managed to drag out the avoidance litigation for five years. In the process, the trustee incurred over $500,000 in attorney fees.
After the bankruptcy court found that the second deed of trust was fictitious and that the debtor was attempting to perpetuate a fraud on his creditors and the court, the court granted the trustee’s motion to surcharge the $75,000 homestead exemption to help pay the attorney fees.
The bankruptcy appellate panel for the 9th Circuit affirmed based on a court’s power to equitably surcharge statutory exemptions in cases where a debtor engages in inequitable or fraudulent conduct. The 9th Circuit also affirmed, finding that the surcharge was appropriate to protect the integrity of the bankruptcy process.
The Supreme Court acknowledged that under Section 105(a) of the Bankruptcy Code a bankruptcy court has the power to issue “any order … that is necessary or appropriate to carry out the provisions of” the Bankruptcy Code, and that it has the “inherent power … to sanction ‘abusive litigation practices.’” However, the court concluded that this did not authorize surcharging a statutory exemption. It marshalled various rules of statutory construction to support its conclusion:
- “It is hornbook law that § 105 ‘does not allow the bankruptcy court to override explicit mandates of other sections of the Bankruptcy Code.’”
- “That is simply an application of the axiom that a statute’s general permission to take actions on a certain type must yield to a specific prohibition found elsewhere.”
- “Courts’ inherent sanctioning powers are likewise subordinate to valid statutory directives and prohibitions.”
- “We have long held that ‘whatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of’ the Bankruptcy Code.”
In this case, the court concluded that a surcharge would contravene Section 522 of the Bankruptcy Code:
- Under Section 522 the debtor was entitled to exempt $75,000 of equity in his home from the bankruptcy estate, which meant that the $75,000 was “not liable for payment of any administrative expense.”
- The trustee attorney fees were an administrative expense:
o Under Section 503(b)(2) compensation awarded under Section 330(a) is an administrative expense;
o Section 330(a)(1) authorizes compensation for services provided by professionals employed under Section 327; and
o Section 327(a) authorizes the trustee to employ attorneys.
Thus the surcharge order violated Section 522 when it made the $75,000 available to pay the trustee’s attorney fees.
The court commented that Section 522 includes “a number of carefully calibrated exemptions and limitations,” including some that relate to misconduct:
- Section 522(c) makes exempt property available for debts arising from tax fraud, student loan fraud, and certain other types of wrongdoing.
- Section 522(o) prevents the homestead exemption to the extent that it was acquired with non-exempt property within ten years before a bankruptcy “with the intent to hinder, delay, or defraud a creditor.”
- Section 522(q) caps the homestead exemption if the debtor is convicted of a felony that “demonstrates the filing of the case was an abuse of the provisions” of the Bankruptcy Code or if there is a debt arising from specified acts such as securities fraud, RICO violations, or “any criminal act, intentional tort, or wilful or reckless misconduct that caused serious physical injury or death to another individual in the preceding 5 years.”
In conclusion, the court found that the “meticulous – not to say mind-numbingly detailed – enumeration of exemptions and exceptions to those exemptions confirm that courts are not authorized to create additional exceptions.”
The court went on to distinguish a couple of additional cases, and closed by noting some options for holding a debtor responsible for its misconduct:
- A court can deny a discharge for a dishonest debtor. (Not effective in this case since the debtor settled his only debts.)
- Under the bankruptcy equivalent of Rule 11, a court can impose sanctions for litigation misconduct, including directing payment of attorney fees. The court further commented that since the monetary sanctions arise post-petition, they will survive bankruptcy and can be collected post-bankruptcy through normal collection procedures.
- Fraudulent conduct in the bankruptcy case may also be criminal, exposing the debtor to up to 5 years imprisonment.
It is interesting that Congress chose to include only very specific exceptions to the right to claim exemptions, so that many categories of misconduct will fall through the cracks and not be penalized – at least not in the context of being able to obtain exemptions. It is also interesting that after the Supreme Court declined to allow the surcharge, it went out of its way to suggest alternative ways to sanction a debtor for misconduct.