Bankruptcy Punishment

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On June 6, 2011 the United States Court of Appeals, Ninth Circuit issued a fairly innocuous, unpublished opinion, rendered without oral argument, against an appellant appearing pro se in a bankruptcy matter.  The Order affirmed an order of a Bankruptcy Appellate Panel order affirming a bankruptcy court’s orders surcharging the appellant’s homestead exemption and imposing discovery sanctions. (In re: Stephen Law, Debtor, Stephen Law, Appellant, v. Alfred H. Siegel, Chapter 7 Trustee, Appellee, No. 09-60046).  Little did the parties or the Ninth Circuit know that the case would become a cause celeb for the Supreme Court of the United States, which is to hear oral arguments in the case on January 13, 2014.  (In the Supreme Court of the United States, Docket No.12-5196, Petition for Certiorari and Motion to Proceed in Forma Pauperis filed July 5, 2012 and granted June 17, 2013.)

Mr. Law filed a Chapter 7 petition for bankruptcy, claiming that his residence, his primary asset, was worth slightly more than $350,000.  Law identified liens totaling nearly $450,000 against the home.  One of the liens claimed by Law was one in favor of “Lin’s Mortgage & Associates” in the approximate amount of $150,000.  The lien was “a fiction”, in the words of the bankruptcy court, “designed to preserve…equity in his residence beyond what he was entitled to exempt as a homeowner, and a fraud on his creditors and the court.”  According to Law’s filings, there was no equity in his residence to fund a homestead exemption and little incentive to creditors to require a sale of the residence.  In all likelihood, the home would revert to Law in accordance with Sec. 554 of the then version of the bankruptcy code.  The home eventually sold for far more than its’ claimed worth, a sum which would have satisfied all creditors, provided for the bankruptcy Trustee’s costs, left Law with a bankruptcy exemption of $75,000 and a surplus as well.  (California, like many states, has opted out of the Federal bankruptcy exemptions, and at the time this case arose provided a homestead exemption of $75,000.  Maryland’s “homestead exemption” is found at Courts and Judicial Proceedings Article 11-504(f)(1)(i)(2), the value of which is tied to the federal homestead in 11 U.S.C. §522(d)(1), currently the amount a bankrupt debtor can exempt of their “owner-occupied residential real property” is $22,975.).)

Law attempted to establish the fake lien through the aid of another (who refused to go along with his scheme thereby causing him to create a fictitious promissory note holder) in an attempt to shield his assets in an ongoing tort matter.  He resisted every effort of the Trustee to ferret out the facts of the fictitious transaction, including numerous reviews of adverse decisions, and ran up a huge cost to the bankruptcy estate in so doing.  The bankruptcy court cited instances of the submission of false evidence and filings by Law on behalf of a non-existent person as evidence of his fraud.  The cost of Law’s fraud to the bankruptcy estate far exceeded the non-exempt equity in Law’s residence and his homestead exemption.  All creditors were eventually satisfied out of the proceeds of the sale of the house and there were virtually no other assets available to the trustee to satisfy the costs of the bankruptcy estate.  So, if the exemption were allowed the bankruptcy estate would not be fully compensated for its costs and Law would walk away with his homestead exemption intact.  Under the facts of the case, the bankruptcy court held that Law had forfeited his ability to claim a homestead exemption and it denied him a discharge in bankruptcy.  Law once again appealed and the Bankruptcy Appellate Panel affirmed the bankruptcy court order.  The Ninth Circuit affirmed and the United States Supreme Court then granted certiorari.

The bankruptcy court relied on Sec. 105(a) of the Bankruptcy Code which generally authorizes the court to issue “any order…necessary or appropriate…to carry out the provisions of this title… or to prevent an abuse of process.”  The trustee will argue before the Supreme Court that this general notion of preserving the integrity of the bankruptcy system trumps all else.  In essence, “bad” debtors should not be rewarded for “bad” acts.

Law argues before the Supreme Court that Sec. 522(k) of the Bankruptcy code prohibits the homestead exemption from being used to satisfy administrative costs of the estate.  Furthermore, under Sec. 522(q) of the Code, a criminal conviction for felony bankruptcy fraud (which had not occurred in this instance) would still permit the exemption to stand because the limitation amount of that section exceeds the amount of the California homestead exemption.

One may legitimately ask why the bankruptcy trustee felt compelled to incur such large costs in pursuing this matter.  The excessive cost of pursuing Law’s fraud may factor into the Supreme Court’s decision.  There is some evidence in Law’s Petition for Writ of Certiorari to the Supreme Court that at one point the Bankruptcy Appellate Court believed the trustee was seeking to shift costs to Law to “punish” him for his litigation tactics.

The conundrum confronting the Supreme Court, however, in this instance is to the effect that the denial of a discharge to Law is irrelevant – his creditors were ultimately satisfied by the sale of the home, even though the bankruptcy estate was not made whole for administrative costs.  So, will the Court accept the argument of the trustee to the effect that general bankruptcy court power to preserve the “sanctity” of the Bankruptcy Code permits forfeiture of Law’s homestead exemption or hold the specific sanction provisions of the Code supersede it?  The cost expenditure of the trustee and the conduct of the debtor may result in a decision that proves the old expression “bad cases make bad law.”

Topics:  Consumer Bankruptcy, Homestead Exemption, Sanctions

Published In: Bankruptcy Updates, Civil Procedure Updates, Residential Real Estate Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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