Stephen Law filed a Chapter 7 bankruptcy case in the Central District of California, valuing his Hacienda Heights home at approximately $363,000. He listed two liens on the property; one held by Washington Mutual for approximately $147,000, and another for some $157,000 held by “Lin’s Mortgage.” The remaining equity (approximately $59,000), he protected from liquidation under California’s $75,000 homestead exemption. The Chapter 7 Trustee (Siegel) challenged the second lien, with the Bankruptcy Court ultimately determining that it was a fiction created by Law to preserve the equity in his home.
As a result, there was in fact $216,000 equity in the house. Ordinarily, after Law subtracted $75,000 for his homestead exemption, there would only have been $141,000 available to the Trustee upon liquidation. However, because the Trustee had incurred over $500,000 in lawyer fees, the Trustee sought to have Law’s homestead exemption “surcharged” to defray those fees. The Bankruptcy Court granted the motion, and first the Ninth Circuit BAP, then the Ninth Circuit, affirmed.
On March 4, 2014, in a unanimous opinion written by Justice Scalia, the Supreme Court overturned the decision. (Law v Siegel, Docket No. 12-5196) While acknowledging that a Bankruptcy Court has “inherent power to sanction abusive litigation practices”, the Court also pointed out that such general permission must yield to a more specific prohibition found elsewhere. Here, Section 522 of the Bankruptcy Code expressly entitled Law to his $75,000 exemption, and protected that amount from use for any administrative expense.
Clearly Law engaged in reprehensible misconduct. And, as the Court noted, the decision forces the Trustee to shoulder a heavy financial burden. However, bankruptcy courts are not without other options: they can deny a dishonest debtor a discharge, and can sanction a dishonest debtor (with such sanctions surviving the bankruptcy case), but they can’t do what was done here. Thus, the decision represents a victory for debtors insofar as it restrains a bankruptcy court’s punitive powers within limits set by the Code.