Law v. Siegel: The End Of Equitable Disallowance?

The question of whether a bankruptcy court may "equitably disallow" a creditor's claim-that is, direct that a creditor shall receive no distribution out of a bankruptcy estate on account of an otherwise valid claim-has long divided the courts. Section 510(c) of the Bankruptcy Code grants the bankruptcy courts the authority to "equitably subordinate" a claim-in essence, provide that a creditor holding an otherwise valid claim, but who has engaged in wrongful conduct that has harmed the bankruptcy estate, will not be paid until other valid creditors are paid in full. But there is no express statutory provision providing for "equitable disallowance." If anything, the Bankruptcy Code says the opposite, providing that a court "shall allow" a creditor's claim unless one of a number of specified conditions-not including the creditor's inequitable conduct-are met. 11 U.S.C. § 502(b).1 For this reason, courts have held, applying ordinary principles of statutory construction, that there is simply no such thing as "equitable disallowance" under the Bankruptcy Code.2

Other courts, however, have held that bankruptcy courts do have the authority to "equitably disallow" a claim.3 Those courts have typically relied on language in the Supreme Court's decision in Pepper v. Litton, 308 U.S. 295 (1939), which, while using the terms "disallowance" and "subordination" interchangeably, at least suggested that the "disallowance" of a claim might be an appropriate exercise of the court's equitable authority. Because the equitable authority of the bankruptcy court is now codified in Section 105(a) of the Bankruptcy Code, these courts have generally looked to that provision as the statutory authority for the remedy of equitable disallowance.4

The Supreme Court decision earlier this week in Law v. Siegel, No. 12-5196 (U.S. Mar. 4, 2014), which concluded that Section 105(a) provides no authority to exercise a remedy that is not included in the Bankruptcy Code's enumeration of statutory remedies-and is therefore implicitly excluded-may well put an end to that debate.5

Law was an individual debtor chapter 7 case. The debtor claimed that his house, which he said was worth approximately $365,000, was subject to two liens, each of approximately $150,000, such that debt secured by the house came to approximately $300,000. In addition, Law was entitled to "exempt" from his estate up to $75,000 in value in his homestead. As a result, there appeared to be no non-exempt value in...