Download Supreme Court Draws the Line on a Bankruptcy Court’s Use of its General Equitable Powers (PDF)

Kenneth L. Baum ’92
Cole, Schotz, Meisel, Forman & Leonard, P.A.

For years, bankruptcy practitioners have relied on the court’s broad equitable powers under section 105(a) of the Bankruptcy Code (the “Code”) in seeking to fashion a variety of remedies, including, among other things, paying pre-petition claims of select creditors and extending the automatic stay to non-debtors. In the wake of the Supreme Court’s recent decision in Law v. Siegel1, however, practitioners may have to rethink that strategy.

Factual and Procedural Background

The facts of Law are uncomplicated. The petitioner, Stephen Law, filed a petition under Chapter 7 of the Code. The respondent, Alfred H. Siegel, was appointed Chapter 7 trustee. In his schedules, Law listed a house valued at $363,348, which was encumbered by liens in favor of Washington Mutual Bank for $147,156.52, and “Lin’s Mortgage & Associates” for $156,929.04. In addition, Law claimed an exemption of $75,000 in the house’s value pursuant to California’s homestead exemption law, and asserted that, as a result, there was no equity in the house available for creditors. Siegel, however, commenced an adversary proceeding in which he challenged the lien of “Lin’s Mortgage & Associates” as fraudulent. The underlying deed of trust reflected a debt to “Lili Lin,” which Siegel believed to be fraudulent. A former acquaintance of Law named Lili Lin responded to Siegel’s complaint by claiming that she never loaned Law money, and stipulated to a judgment disclaiming any interest in the house.

At the same time, however, a second “Lili Lin” claimed to be the beneficiary of the deed of trust, and fought Siegel in protracted litigation to avoid the deed of trust and sell the house. After five years, during which Siegel incurred more than $500,000 in legal fees, the bankruptcy court held that the purported loan to “Lili Lin” was a sham orchestrated by Law, intended to preserve his equity in the house. The court further found that Law had falsified documents relating to the deed of trust, and submitted false evidence in the case. In recognition of those findings, the court also granted Siegel’s motion to surcharge Law’s $75,000 homestead exemption to help pay Siegel’s legal fees. Law appealed the award of a surcharge, and both the Ninth Circuit Bankruptcy Appellate Panel and Ninth Circuit affirmed. Law filed a petition for certiorari, which the Supreme Court granted.

Analysis

In a unanimous decision, the Court reversed the Ninth Circuit and held that the bankruptcy court exceeded its authority when it imposed the surcharge on Law’s homestead exemption. The Court began its analysis by noting the bankruptcy court’s statutory authority, pursuant to section 105(a) of the Code, to, “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of” the Code. The Court added that a bankruptcy court, “may also possess inherent power … to sanction ‘abusive litigation practices.’”2 But, the Court noted, “in exercising those statutory and inherent powers, a bankruptcy court may not contravene specific statutory provisions.”3

The Court held that, in granting Siegel a surcharge against Law’s homestead exemption, the bankruptcy court contravened section 522 of the Code, which, by incorporating California’s state exemption laws, allowed Law to exempt $75,000 of the equity in his house from the bankruptcy estate. Moreover, pursuant to section 522(k) of the Code, the exempt amount was, “not liable for payment of any administrative expense [of the estate]….”4 The Court concluded that, “[t]he Bankruptcy Court thus violated § 522’s express terms when it ordered that the $75,000 protected by Law’s homestead exemption be made available to pay Siegel’s attorney’s fees, an administrative expense.”5 The Court added that, “[i]n doing so, the court exceeded the limits of its authority under § 105(a) and its inherent powers.”6

Siegel’s primary argument on appeal was that, notwithstanding his inability to employ section 105(a) in contravention of another section of the Code, section 522, “contains no directive requiring [courts] to allow [an exemption] regardless of the circumstances.”7 The Court rejected that argument on several grounds. First, the Court noted that, to the extent Siegel equated the surcharge with an outright denial of Law’s homestead exemption, because no party had objected to Law’s exemption in a timely manner, it was presumed to be valid.8

Next, the Court reasoned, even if the bankruptcy court could have reconsidered Law’s entitlement to the homestead exemption, there existed no basis upon which to deny the exemption. The Court cited to numerous specific statutory grounds for denying an exemption under the Code, including sections 522(c) (exempt property liable for debts arising from fraud in connection with taxes and student loans), 522(o) (homestead exemption denied to the extent the debtor acquired the homestead with nonexempt property in the previous 10 years, “with the intent to hinder, delay, or defraud a creditor”), and 522(q) (capping a homestead exemption at approximately $150,000 where the debtor has been convicted of a certain felony), none of which applied in Law’s case, and held that, “[t]he Code’s meticulous—not to say mind-numbingly detailed—enumeration of exemptions and exceptions to those exemptions confirms that courts are not authorized to create additional exceptions.”9

The Court also rejected Siegel’s reliance on its decision in Marrama v. Citizens Bank of Mass., 549 U.S. 365, 127 S.Ct. 1105, 166 L.Ed.2d 956 (2007). There, the Court considered whether a Chapter 7 debtor’s bad-faith conduct was a valid basis for refusing to convert his case to Chapter 13, notwithstanding that section 706(a) of the Code permits such a conversion, “at any time,” if the case has not been converted from Chapter 13 previously.10 As the Court noted, pursuant to section 706(d) of the Code, a debtor’s ability to convert from Chapter 7 to 13 is conditioned on his eligibility to be a debtor under the latter chapter. Because the debtor in Marrama had been found to have acted in bad faith, the application of section 1307(c) of the Code, which authorizes a court to dismiss or convert a Chapter 13 case to Chapter 7 “for cause” (which, in Marrama, the Court interpreted to include certain bad-faith conduct), supported the Court’s finding that the debtor would not have been eligible for Chapter 13. The Court distinguished its holding in Marrama, reasoning that, “no one suggests that Law failed to satisfy any express statutory condition on his claiming of the homestead exemption.”11 The Court added that, “Marrama most certainly did not endorse, even in dictum, the view that equitable considerations permit a bankruptcy court to contravene express provisions of the Code.”12

The Court acknowledged the potential impact of its ruling, noting that it would, “force[] Siegel to shoulder a heavy financial burden resulting from Law’s egregious misconduct, and that may produce inequitable results for trustees and creditors in other cases.”13 It specifically added, however, that, “in crafting the provisions of § 522, Congress balanced the difficult choices that exemption limits impose on debtors with the economic harm that exemptions visit on creditors…. The same can be said of the limits imposed on recovery of administrative expenses by trustees.”14

Conclusion

It is difficult to predict the consequences of the Court’s ruling in Law v. Siegel, particularly as it may affect the use of section 105(a) in various aspects of a bankruptcy case. It would seem clear, however, that for trustees considering whether to initiate complex litigation based on a debtor’s improper activity, where the availability of estate funds to finance that litigation is in question, it may be prudent to look before they leap.


1 Law v. Siegel, U.S., 134 S.Ct. 1188 (2014).
2 134 S.Ct. at 1194.
3 Id.
4 Id. at 1195 (quoting 11 U.S.C. § 522(k)).
5 Id.
6 Id.
7 Id.
8 Id. at 1196 (citing Taylor v. Freeland & Kronz, 503 U.S. 638, 643-644, 112 S.Ct. 1644, 118 L.Ed.2d 280 (1992))
9 Id.
10 11 U.S.C. § 706(a).
11 134 S.Ct. at 1197.
12 Id.
13 Id.
14 Id.

Kenneth L. Baum ’92 is a member of the Bankruptcy and Corporate Restructuring Department at Cole, Schotz, Meisel, Forman & Leonard, P.A., with offices in New York, NY, Hackensack, NJ, Wilmington, DE, Baltimore, MD, and Fort Worth, TX.