United States: Restructuring Alert - March 2014

U.S. Supreme Court Eliminates Equitable Surcharge on Exemption

A Chapter 7 debtor creates a fraudulent mortgage on his residence to cheat creditors and his Chapter 7 trustee.  One would expect that the courts would penalize the debtor for such flagrant misconduct.  But in a recent decision, Law v. Siegel,1 the Supreme Court reversed lower court rulings that had imposed the judge-made remedy of "equitable surcharge" against the debtor's statutory exemptions, and held that the Bankruptcy Code does not give bankruptcy courts the power to sanction debtors unless the Bankruptcy Code expressly authorizes such a remedy.  While the result is unexpected, the decision fits squarely within the Supreme Court's "plain meaning" doctrine and its clear intent to restrict the equitable discretion of the bankruptcy courts.2

Background

On March 4, 2014 the U.S. Supreme Court held in Law v. Siegel that the plain meaning of the Bankruptcy Code deprives the bankruptcy court of any equitable power to allow a trustee to surcharge a debtor's statutory exemptions. While used infrequently, the remedy of "equitable surcharge" had been utilized by bankruptcy courts for years, typically in cases where, as here, the debtor had engaged in serious misconduct for the purpose of frustrating creditors.3 When employed, the equitable surcharge reduced the value of a debtor's statutorily exempt property dollar for dollar.  For example, New York has a household exemption of $150,000 for a single individual. If an equitable surcharge of $50,000 were imposed, that exemption would be reduced to $100,000.  But under the Supreme Court's ruling, the power to surcharge is restricted to specific provisions of Federal or state law.

Facts

When debtor Steven Law filed his chapter 7 petition, his only significant asset was his residence, which was encumbered by two deeds of trust and three judgment liens. The first deed of trust was issued to an institutional lender.  Mr. Law alleged that a second deed of trust secured a $168,000 loan from a woman named Lili Lin. His Chapter 7 trustee contested the authenticity of this loan and the deed of trust, and the bankruptcy court found that the loan was fabricated by the debtor.  Tthe bankruptcy court then imposed an equitable surcharge on the debtor's homestead exemption.4  That ruling was affirmed by the Bankruptcy Appellate Panel 5 and the Ninth Circuit.6

The Bankruptcy Code Penalizes Debtor Misconduct

The Bankruptcy Code sets forth several bases on which exempt property can be subject to pre-petition or administration claims, but provides no authority for surcharging the debtor's property because of inequitable or fraudulent conduct.  Section 523 of the Bankruptcy Code provides that certain debts are excepted from discharge,  such as debts incurred on the basis of fraud, debts for willful or malicious injury, or for embezzlement or defalcation in a fiduciary capacity. In these cases the creditor has to move before the bankruptcy court to except the debt from discharge.  Section 727 of the Bankruptcy Code provides that other misconduct, where the bankruptcy estate as a whole is victimized, gives rise to the right for a trustee or creditor to seek a denial of discharge.  Trustees, however, rarely seek to bar a debtor's discharge because the litigation with the debtor rarely yields funds to pay the trustee or creditors.  This leaves surcharge of the debtor's exempt property as a seemingly attractive option. If the trustee were able to reduce these exemptions, the newly available non-exempt property could create a source of payment for creditors and the trustee. Bankruptcy judges' desire to punish cases of significant misconduct led them to impose such surcharges.

The Supreme Court Reverses Rules That Bankruptcy Court May Not Create Non-Statutory Remedies

For more than twenty years the Supreme Court's construction of the Bankruptcy Code has been guided by the "plain meaning" of the statute.7  In Law v. Siegel, the Supreme Court held that the "Bankruptcy Court's 'surcharge' was unauthorized if it contravened a specific provision of the Code," adding that the "§ 522 does not give courts discretion to grant or withhold exemptions based on whatever considerations they deem appropriate. .... A debtor need not invoke an exemption to which the statute entitles him; but if he does, the court may not refuse to honor the exemption absent a valid statutory basis for doing so." 8 While the decision appears to reward misconduct, the Court's unanimous ruling is meant to make a point: that its insistence on the primacy of the plain meaning doctrine is more important than the consequences of a single case. The lesson of this ruling is clear: if a controversy in bankruptcy court is governed by a specific statute, the Supreme Court does not want bankruptcy courts to exercise equitable discretion to fashion an extra-statutory remedy, no matter how distorted the result appears.  In that regard, this decision is as much directed to bankruptcy judges as it is to individual litigants.

Footnotes

1. Law v. Siegel, 134 S. Ct. 1188 (2014).

2. United States v. Ron Pair Enterprises, Inc., 489 U.S. 235, 242, 109 S. Ct. 1026, 1031, 103 L. Ed. 2d 290 (1989); Connecticut Nat. Bank v. Germain, 503 U.S. 249, 253-54, 112 S. Ct. 1146, 1149, 117 L. Ed. 2d 391 (1992) ("We have stated time and again that courts must presume that a legislature says in a statute what it means and means in a statute what it says there. See, e.g., United States v. Ron Pair Enterprises, Inc., 489 U.S. 235, 241–242, 109 S.Ct. 1026, 1030–1031, 103 L.Ed.2d 290 (1989)"); In re Caldor Corp., 303 F.3d 161, 167-68 (2d Cir. 2002)  "[A]s long as the statutory scheme is coherent and consistent, there generally is no need for a court to inquire beyond the plain language of the statute."

3. See, e.g. In re Seres, 437 B.R. 775, 779 (Bankr. W.D.N.Y. 2010) ("Because creditors should not suffer the losses that result from a violation of disclosure obligations under 11 U.S.C. § 521(a), the court will surcharge the debtor's exemption for the reasonable value of any cost to the estate."); Latman v. Burdette, 366 F.3d 774, 786 (9th Cir. 2004) ("We hold that the bankruptcy court may equitably surcharge a debtor's statutory exemptions when reasonably necessary both to protect the integrity of the bankruptcy process and to ensure that a debtor exempts an amount no greater than what is permitted by the exemption scheme of the Bankruptcy Code.").

4. In re Law, 401 B.R. 447 (Bankr.C.D.Cal. 2009)

5. In re Law, 2009 WL 7751415 (B.A.P. 9th Cir. Oct. 22, 2009)

6. In re Law, 435 F. App'x 697 (9th Cir. 2011)

7. United States v. Ron Pair Enterprises, Inc., 489 U.S. 235, 242, 109 S. Ct. 1026, 1031, 103 L. Ed. 2d 290 (1989) ("The plain meaning of legislation should be conclusive, except in the "rare cases [in which] the literal application of a statute will produce a result demonstrably at odds with the intentions of its drafters.").

8. Law v. Siegel, 134 S. Ct. 1188 (2014)

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