The “Law’s” Limits On The Bankruptcy Court’s Ability To Impose Sanctions For Debtor Misconduct

In the first six months of 2014 the Supreme Court has already issued two opinions concerning the authority of the bankruptcy courts. The first opinion, Law v. Siegel, 134 S. Ct. 1188 (2014), was issued in March. In Law, Justice Antonin Scalia delivered a unanimous opinion of the Supreme Court holding that a bankruptcy court may not “order that a debtor’s exempt assets be used to pay administrative expenses incurred as a result of the debtor’s misconduct.” And in Executive Benefits Insurance Agency v. Arkison, 573 U.S. ___ (2014), which was issued earlier this week, Justice Clarence Thomas delivered another unanimous opinion of the Court holding that “when . . . the Constitution does not permit a bankruptcy court to enter final judgment on a bankruptcy-related claim, the relevant statute nevertheless permits a bankruptcy court to issue proposed findings of fact and conclusions of law to be reviewed de novo by the district judge.” The subject of this post is Law, but an analysis of Executive Benefits will follow shortly on the Bond Bankruptcy Report.

Under Chapter 7 of the Bankruptcy Code, a debtor may liquidate assets to pay creditors, and the filing of the Chapter 7 petition creates an “estate” that, with limited exceptions, is comprised of all of the debtor’s property. 11 U.S.C. §§ 541(a)(1), 704(a)(1), 726, 727. Certain assets, however, may be “exempt” from the bankruptcy estate, and the debtor may keep those assets after he emerges from bankruptcy. 11 U.S.C. § 522(b)(1). The Code lists a number of exemptions that may be used unless prohibited by state law. 11 U.S.C. § 522(d). A debtor, however, may choose to use the exemptions provided by his state or local laws by foregoing the federal exemptions. 11 U.S.C. § 522(b)(3)(a).

The debtor in Law owned a house in California, and the house was the estate’s only significant asset. He valued it at approximately $360,000.00, but he claimed that $75,000.00 of the house’s value fell under California’s homestead exemption. The debtor further claimed that the house was subject to two liens, and that the two liens exceeded the house’s nonexempt value. Thus, he “represented that there was no equity in the house that could be recovered for his other creditors.”

The bankruptcy trustee commenced an adversary proceeding, alleging that the lien held by “Lili Lin,” as reflected on the deed of trust, was fraudulent. Two individuals claiming to be Lili Lin responded to the complaint. One of the individuals was from California. Although she knew the debtor, she denied loaning him money, and said the debtor had tried, on multiple occasions, “to involve her in various sham transactions relating to the disputed deed of trust.” She then “entered into a stipulated judgment disclaiming any interest in the house.” The other “Lili Lin” was “supposedly living in China and [spoke] no English,” but she managed to engage in protracted and costly litigation to contest the avoidance of the deed and the sale of the house.

Five years after the bankruptcy proceeding was commenced, the bankruptcy court entered an order finding that “the loan was a fiction, meant to preserve [the debtor’s] equity in his residence beyond what he was entitled to exempt.” The trustee had incurred more than half a million in attorney’s fees throughout the litigation, and thus, the court granted his “motion to ‘surcharge’ the entirety of [the] $75,000 homestead exemption, making those funds available to defray [the trustee’s] attorney’s fees.” Both the Ninth Circuit Bankruptcy Appellate Panel and the Ninth Circuit Court of Appeals affirmed the bankruptcy court’s order.

The Supreme Court, however, reversed the order because the “‘surcharge’ was unauthorized [as] it contravened a specific provision of the Code.”

Although bankruptcy courts may “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of the Bankruptcy Code,” 11 U.S.C. § 105(a), and hold the “inherent power . . . to sanction ‘abuse litigation practices,’” the bankruptcy courts “may not contravene specific statutory provisions.”

In imposing a surcharge to be drawn from the exempt portion of the estate, the bankruptcy court violated the provision of the Code stating that “exempt” property “is not liable for payment of any administrative expense,” with two limited exceptions that did not apply in Law.

The Bankruptcy Code makes clear that the attorney’s fees that the trustee incurred were, without a doubt, “administrative expenses.” Section 503(b)(2) states that “administrative expenses,” include “compensation and reimbursement awarded under” § 330(a), which authorizes “reasonable compensation for actual, necessary services rendered” by a “professional person employed under” § 327. Section 327 (a) allows the trustee to “employ one or more attorneys . . . to represent or assist the trustee in carrying out the trustee’s duties under this title.” The Supreme Court rejected the trustee’s argument that while attorney’s fees may be “administrative expenses” under § 503(b), attorney’s fees were not administrative expenses” under § 522(k). The trustee, however, did not provide the Court with any “reason to depart from the ‘normal rule of statutory construction’ that words repeated in different parts of the same statute generally have the same meaning.”

The trustee also argued that the surcharge did not exceed the scope of the Bankruptcy Court’s statutory authority. He submitted that while § 522 permits exemptions, the Code does not require judicial recognition of exemptions in every circumstance, and thus, the court, in response to misconduct, may deny an exemption through a surcharge on the exempt property. The United States, as amicus curiae, supported the trustee’s position. The Supreme Court, however, rejected those arguments because if the surcharge were treated as a denial, then the trustee’s objection was untimely, and “a trustee’s failure to make a timely objection prevents him from challenging an exemption.”

In another attempt to support his position, the trustee argued “that because § 522(b) says that a debtor ‘may exempt’ certain property, rather than that he ‘shall’ be entitled to do so, the court retains discretion to grant or deny exemptions when the statutory criteria are met.” (Emphasis in original). The Court rejected that argument, noting that “the subject of ‘may exempt’ in § 522(b) is the debtor, not the court, so it is the debtor in whom the statute vests discretion.”

“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.”

Finally, the Supreme Court noted that the Bankruptcy Code and Federal Rules of Bankruptcy Procedure already give bankruptcy courts the authority to sanction debtor misconduct, including subjecting the debtor to criminal prosecution. Bankruptcy courts, however, may not exceed the scope of their statutory authority:

“[W]hatever other sanctions a bankruptcy court may impose on a dishonest debtor, it may not contravene express provisions of the Bankruptcy Code by ordering that the debtor’s exempt property be used to pay debts and expenses for which that property is not liable under the Code.”

In Law, the Court appeared to express a unanimous concern about expanding the power of the bankruptcy courts beyond what Congress intended. This concern may stem from the bankruptcy judges’ status as Article I judges that do not enjoy the same constitutional benefits as Article III judges (i.e. lifetime tenure and protection from salary diminution). The bankruptcy courts, like other Article I courts, derive their authority entirely from laws passed by Congress, and thus, the scope of their authority may be limited by Congress in every respect. But Article III courts derive their authority from the Constitution itself, and under the Constitution, Congress may only limit the Supreme Court’s appellate jurisdiction. As will be discussed in a subsequent post on the Bond Bankruptcy Report, the distinctions between Article I and III courts, and the implications of those distinctions, were also at issue in Executive Benefits.