Breaking News

Argument preview: Justices assess penalties for lying bankrupt

It appears that the Court has developed an unexpected interest in the dark side of the bankruptcy courts.  Fresh from last year’s exploration in Bullock v. BankChampaign, N.A. of what it takes for a bankrupt to be guilty of “defalcation,” on Monday the Court in Law v. Siegel will consider whether egregious misconduct justifies depriving a bankrupt of his homestead exemption.

As you read that summary, you might be wondering to yourself about the “egregious” label.  “Egregious by whose standard?”  “Probably just what the creditor says, when the debtor is really just down on his luck.”  But not this time.  Law is the bankrupt whom every bankruptcy advocate hates to see, the bad example of almost unbelievable misconduct that would drive Congress into legislative action much more quickly than the widespread economic distress we’ve seen the last several years.

Stripped of a lot of procedural complexity, the basic facts here (at least as the Ninth Circuit has found them) are that Law filed for bankruptcy owning a home worth several hundred thousand dollars; he claimed a value of about $360,000.  His pleadings detailed a $150,000 first lien owed to a bank and a $160,000 second lien owed to “Lin’s Mortgage & Associates.”  Because California grants Law a $75,000 homestead exemption, this suggested that Law’s general creditors could get nothing from the house: the sum of the two liens (310,000) plus the exemption (75,000) is more than the claimed value (360,000).  Voilà!

It turns out, however, after years of contentious litigation (in which the bankruptcy trustee spent literally hundreds of thousands of dollars), that there never was a mortgage to Lin, and that Law’s claim of such a mortgage was a wholly fraudulent scheme to withhold the claimed amount of the mortgage from his creditors. Quaere: How much sense does it make for a trustee to spend $450,000 to prove a fraud that could amount at most to $160,000?

Predictably outraged, the bankruptcy court had few options to punish Law.  It could withhold a discharge (which it did), but the house had sold for a high price, so all of the pre-bankruptcy creditors already were paid. Because Law had no assets other than the house, there was no way to force him to pay the costs that the trustee spent ferreting out Law’s fraud.  Accordingly, the bankruptcy judge ordered Law to pay the trustee out of his $75,000 homestead exemption (the share of the sale that would have been released to Law at the end of the bankruptcy case). The judge justified that order not under any of the specific provisions of the Code, but rather under the general equitable power in Section 105 to “take any action necessary or appropriate to carry out the provisions” of the Bankruptcy Code. The sentiment was that the $75,000 would help the trustee recover at least some of its costs.

This kind of order is routine in the Ninth Circuit, so it was no surprise that the bankruptcy appellate panel and the Ninth Circuit affirmed.  It did, however, sufficiently spark the Court’s interest for it to invite the Solicitor General to weigh in.  The Solicitor General responded that the case did not warrant review, characterizing it as a routine exercise of authority to impose sanctions.  Still, the Court granted the petition.

The dispute on the merits is striking.  On the one hand, Law has the luxury of arguing that the Bankruptcy Code’s detailed scheme for sanctioning misconduct preempts any possible use of Section 105 to impose a penalty inconsistent with that scheme.  Perhaps the most telling point is that Section 522(k) specifically states that exempt property cannot be used to pay administrative expenses, with two narrow exceptions not relevant here.  Because the lower courts took what otherwise would have been the value of Law’s exempt homestead to pay the trustee’s litigation costs (the paradigmatic administrative expenses), the order certainly is in tension with that provision.

Law also scores points with Section 522(q).  That section specifies the misconduct that will justify limiting exemptions.  With respect to the homestead exemption, it indicates that a criminal conviction for felony bankruptcy fraud results in a limitation of the homestead exemption to $155,675 (misdemeanor bankruptcy fraud is OK?).  What that means here is that even a conviction for criminal bankruptcy fraud (which has not happened here) would not have cut into Law’s homestead exemption; Law persuasively argues that the more onerous order of the bankruptcy court is inconsistent with the logic of that section.

So to summarize, Law says this case is a duplicate of RadLAX Gateway Hotel v. Amalgamated Bank, a case from two Terms ago in which the Court held that a general authority to impose conditions on plans could not justify a specific condition that was prohibited in detail in a particular subsection – specific trumping the general, as the canon says.  Here, the specific provisions of Section 522 (among other things) trump any reading of the general grant of authority in Section 105.

On the other side, bankruptcy trustee Alfred Siegel has to argue that Section 105 reflects a broad general power to sanction misconduct. He does a magnificent job of detailing Law’s misconduct (to which the short summary above does not do justice).  At bottom, though, he has no substantial statutory argument.  Rather, he has a powerful plea that the Code is designed to protect only the “honest but unfortunate” debtor. How likely is it that Congress intended that a bankruptcy court would be powerless to punish a debtor so scandalous as Law? More generally, he emphasizes the general power of courts to punish abuse of their procedures, emphasizing the Court’s longstanding concerns about that topic.

The basic problem that Siegel faces is that Congress plainly has considered this misconduct already.  The Code is written from the perspective that denial of a discharge is tantamount to the death penalty, reserving it for serious misconduct like the conduct here.  This case sticks in the craw because that penalty has no effect at all for Law’s particular and egregious misconduct.  The question, then, is whether the inadequately punitive result in this case will trouble the Justices enough for them to accept the lax statutory practice of the Ninth Circuit’s approach.

And if the summary above makes that seem unlikely, it is worth noting that the Court traditionally has been quite hostile to the debtors in these cases, reflecting a populist antipathy to debt avoidance that would be quite sympathetic with Siegel’s approach.  Indeed, with the conspicuous exception of last year’s decision in Bullock (in which the nearly defalcating bankrupt prevailed), the Court has sided with the Office of the United States Trustee in the last five cases in which it has appeared in the Court, dating back to 2002.  So nobody should be surprised if the Justices take the same approach here.


Cases: Law v. Siegel

Recommended Citation: Ronald Mann, Argument preview: Justices assess penalties for lying bankrupt, SCOTUSblog (Jan. 10, 2014, 5:23 PM),