JURIST Guest Columnist Harrison Thorne of UCLA School of Law discusses the role of bankruptcy courts in equity… Bankruptcy law, embodied in Title 11 of the United States Code (also known as “the Bankruptcy Code”), strives to balance the rights of creditors to receive payment for what they are owed with the rights of debtors to receive a fresh start. While bankruptcy laws have changed over time, the role of the bankruptcy court is to promote justice while following the letter of the law.

The Bankruptcy Code contains many specific provisions detailing the process, procedure and rules for parties to a bankruptcy case. One provision, 11 USC § 522, allows a debtor to exempt certain property from the bankruptcy estate. When a debtor exempts property, the debtor may keep the property even though the property would otherwise be liquidated and distributed to creditors under a Chapter 7 bankruptcy. In essence, this provision allows a debtor to keep certain possessions during and after he files bankruptcy, subject to exceptions.

Suppose John has more debt than he can pay and files bankruptcy under Chapter 7. Upon filing of a Chapter 7 bankruptcy case, a trustee is appointed to administer the bankruptcy estate and to liquidate the debtor’s non-exempt assets. The trustee discovers that John owns a home worth $500,000 and accordingly attempts to sell John’s home to distribute the sale proceeds to John’s creditors.

Under § 522(d)(1), John may exempt $20,200 of his home’s value from the bankruptcy estate. Suppose John’s home is encumbered by a secured note in favor of a bank in the amount of $485,000. The value of the note ($485,000) plus the value of the exemption ($20,200) means that John’s home (worth $500,000) will not yield any surplus that the trustee could provide to John’s creditors, as the home is “encumbered” in the amount of $505,200. If the trustee sold John’s home, he would have to pay the secured lienholder and return the exempt value to John, which would leave nothing for the trustee to distribute to creditors. Thus, the trustee would not sell John’s home but rather would abandon the estate’s interest in it, allowing John to retain his home after the bankruptcy case closes.

As John’s example demonstrates, many debtors invoke exemption in their bankruptcy cases and retain property that would otherwise be liquidated or distributed to creditors. However, many debtors engage in bad faith or misconduct in hopes of saving their homes. For example, a debtor may intentionally undervalue his home or overstate the allowed exemption in his bankruptcy schedules to entice the trustee to abandon the estate’s interest in their home.

Bad faith raises serious issues for bankruptcy judges. On one hand, the bankruptcy code allows a debtor to exempt value in his home. On the other hand, bankruptcy judges are reluctant to allow debtors to exempt value and save his home if the debtor made a fraudulent representation or intentionally misled the court or trustee. Accordingly, judges have invoked their equitably authority pursuant to § 105 to deal with this problem. Section 105 states that

“no provision of [the bankruptcy code] . . . shall be construed to preclude the court from, sua sponte, taking any action or making any determination necessary or appropriate to enforce or implement court orders or rules, or to prevent an abuse of process”.

In essence, when a court prohibits exemption under its § 105 authority, the court is reasoning that although the debtor has the codified right to exemption, the court will not allow exemption because to do so would constitute an abuse of process. However, in Law v. Siegel, the Supreme Court held that § 105 could no longer be used in this manner.

In Law v. Siegel, a debtor filed bankruptcy under Chapter 7. The debtor’s only significant asset was his home, which had a value of $363,348. The debtor asserted that his home was subject to a lien in favor of Washington Mutual Bank in the amount of $147,156.52 and another lien in favor of Lin’s Mortgage & Associates in the amount of $159,929.04. The debtor also claimed that $75,000 of the home’s value was covered under California’s homestead exemption. The debtor asserted that the trustee should abandon the estate’s interest in his home as there was no equity and a sale would yield nothing to be distributed to his creditors.

The trustee did not believe the debtor and subsequently initiated an adversary proceeding alleging that the lien in favor of Lin’s Mortgage & Associates was fraudulent. The trustee investigated the lien and expended more than $500,000 in attorney’s fees overcoming the debtor’s fraudulent misrepresentations. The trustee was correct that Lin’s Mortgage & Associates’ lien was fraudulent. Accordingly, the Bankruptcy Court determined that the trustee could surcharge the entirety of the debtor’s $75,000 exemption—effectively preventing the exemption. Upon review, the Ninth Circuit Bankruptcy Appellate Panel and the Ninth Circuit Court of Appeals affirmed the Bankruptcy Court’s holding. The Supreme Court granted certiorari to determine whether disallowing the debtor’s exemption was permissible.

Writing for the court, Justice Scalia noted that while bankruptcy courts possess power under § 105 to sanction abusive litigation practices, it may not use its power to contravene specific statutory provisions. In other words, where the Bankruptcy Code permits something—such as exemption—a court may not prohibit it based on a finding of fraud, misrepresentation, or bad faith. Accordingly, when the Bankruptcy Court authorized the trustee to surcharge the debtor’s exemption, it contravened § 522, which entitles debtors to exempt value in his home from the bankruptcy estate. Thus, the court reversed the Bankruptcy Court’s decision and remanded the case for further proceedings consistent with the court’s ruling.

Siegel‘s prohibition on contravening a specific provision in the bankruptcy code makes sense from a statutory construction point of view. When a statute gives a debtor the right to take some action, then any judicial ruling contravening the debtor’s right is in conflict with the law. However, Siegel makes less sense from a policy perspective. Bankruptcy courts are guided by the Bankruptcy Code. However, bankruptcy courts’ main role is to promote justice and reach equitable results. Indeed, bankruptcy courts are courts of equity that arose to prevent unfair practices, including debtors’ prisons and harsh treatments preventing debtors from obtaining a fresh start. While the Supreme Court conceded in Siegel that in some circumstances a bankruptcy court may be authorized to dispense with futile procedural niceties in order to reach more expeditiously an end result required by the [Bankruptcy] Code,” the court noted that “equitable consideration [may not] permit a bankruptcy court to contravene express provisions of the [bankruptcy] code.”

To square the canons of statutory construction with the equitable policy of bankruptcy law in general, Congress must specifically enumerate remedies that a bankruptcy court may issue upon a finding of fraud, misrepresentation and other acts of bad faith. For example, if there were a provision specifically allowing a bankruptcy court to deny exemption to a debtor upon a finding of fraudulent misrepresentation, courts would be able to prevent a windfall to a debtor. Indeed, the bankruptcy court in the Siegel proceeding below would have been able to reach the same result without being overturned above.

Harrison Thorne is a second-year law student at UCLA School of Law. After serving as an Articles Editor for the UCLA Entertainment Law Review, Harrison will head the journal as Editor-in-Chief for the 2015-2016 academic year. He currently serves as an extern for the US Bankruptcy Court for the Central District of California.

Suggested citation: Harrison Thorne, Bankruptcy Courts Are No Longer Courts of Equity, JURIST – Student Commentary, May, 2, 2015, http://jurist.org/dateline/2015/05/harrison-thorne-bankruptcy-courts.php.