Restructuring Alert - March 2014

U.S. Supreme Court Eliminates Equitable Surcharge on Exemption

A Chapter 7 debtor creates a fraudulent mortgage on his residence to cheat creditors and his Chapter 7 trustee. One would expect that the courts would penalize the debtor for such flagrant misconduct. But in a recent decision, Law v. Siegel,1 the Supreme Court reversed lower court rulings that had imposed the judge-made remedy of "equitable surcharge" against the debtor's statutory exemptions, and held that the Bankruptcy Code does not give bankruptcy courts the power to sanction debtors unless the Bankruptcy Code expressly authorizes such a remedy. While the result is unexpected, the decision fits squarely within the Supreme Court's "plain meaning" doctrine and its clear intent to restrict the equitable discretion of the bankruptcy courts.2

Background

On March 4, 2014 the U.S. Supreme Court held in Law v. Siegel that the plain meaning of the Bankruptcy Code deprives the bankruptcy court of any equitable power to allow a trustee to surcharge a debtor's statutory exemptions. While used infrequently, the remedy of "equitable surcharge" had been utilized by bankruptcy courts for years, typically in cases where, as here, the debtor had engaged in serious misconduct for the purpose of frustrating creditors.3 When employed, the equitable surcharge reduced the value of a debtor's statutorily exempt property dollar for dollar. For example, New York has a household exemption of $150,000 for a single individual. If an equitable surcharge of $50,000 were imposed, that exemption would be reduced to $100,000. But under the Supreme Court's ruling, the power to surcharge is restricted to specific provisions of Federal or state law.

Facts

When debtor Steven Law filed his chapter 7 petition, his only significant asset was his residence, which was encumbered by two deeds of trust and three judgment liens. The first deed of trust was issued to an institutional lender. Mr. Law alleged that a second deed of trust secured a $168,000 loan from a woman named Lili Lin. His Chapter 7 trustee contested the authenticity of this loan and the deed of trust, and the bankruptcy court found that the loan was fabricated by the debtor. Tthe bankruptcy court then imposed an equitable surcharge on the debtor's homestead exemption.4 That ruling was affirmed by the Bankruptcy Appellate Panel 5 and the Ninth Circuit.6

The Bankruptcy Code Penalizes Debtor Misconduct

The Bankruptcy Code sets forth several bases on which...