On March 4, 2014, the United States Supreme Court issued its decision in Law v. Siegel, 571 U.S. __ (Mar. 4, 2014) and held that the bankruptcy court exceeded its authority under section 105(a) of the Bankruptcy Code and its inherent powers by authorizing the chapter 7 trustee to "surcharge" the debtor's homestead exemption to defray litigation costs incurred in an adversary proceeding brought against the debtor. At play was a bankruptcy court's authority to "issue any order, process, or judgment that is necessary or appropriate to carry out the provisions" of the Bankruptcy Code. 11 U.S.C. § 105. The result turned on a very simple proposition: "it is quite impossible to [carry out the provisions of the Code] by taking action that the Code prohibits."
The debtor in Law listed his house on his bankruptcy schedules, claiming a homestead exemption in the amount of $75,000 under Cal. Civ. Proc. Code § 704.730(a)(1). The debtor represented that the house was encumbered by two liens: a note and deed of trust for $147,156.52 in favor of Washington Mutual Bank, and a second note and deed of trust for $156,929.04 in favor of "Lin's Mortgage & Associates." Based on these representations, the debtor made it appear as if there was no nonexempt value in the house that the trustee could realize for the benefit of the estate. The trustee, however, initiated an adversary proceeding against the debtor, alleging that the lien in favor of "Lin's Mortgage & Associates" was a sham. After expending over $500,000 in legal fees, the trustee was successful in proving that the debtor fabricated the second "loan" to defraud his creditors and the court. The United States Bankruptcy Court for the Central District of California granted the trustee's motion to "surcharge" the debtor's claimed homestead exemption to help pay for some of the trustee's legal fees; the Bankruptcy Appellate Panel of the Ninth Circuit and the Ninth Circuit affirmed.
Justice Scalia, writing for a unanimous Court, reinforced that "in exercising [its authority under section 105] and inherent powers, a bankruptcy court may not contravene specific statutory provisions." In the context of exemptions, the Code plainly states that exempt property "is not liable" for the payment of "any administrative expense." See 11 U.S.C. § 522(k). The Court held that the bankruptcy court's surcharging the debtor's exemption ran afoul of the prohibition stated in section 522(k), as the trustee's attorney's fees were "indubitably an administrative expense." The Court also observed that the "carefully calibrated exceptions and limitations" to the exemption statute are further proof that the courts do not have discretion to disturb a debtor's exemption based on other equitable considerations.
The Court's decision in Law serves as yet another limitation on a bankruptcy court's authority. Whereas the Court's decision in Stern v. Marshall, 564 U.S. 2 (2011) limited bankruptcy courts' authority to decide certain substantive matters, its decision in Law reshapes bankruptcy courts' equitable and inherent powers. Perhaps the most interesting aspect of the Law decision is its re-characterization of the Court's decision in Marrama v. Citizens Bank, 549 U.S. 365 (2007). Contrary to the Law decision, Marrama looked beyond the notion that the equitable powers of a bankruptcy court were constrained by specific provisions of the Code. At issue in Marrama was whether equitable considerations limited a chapter 7 debtor's right under section 706(a) to convert to a chapter 13 case. Marrama effectively permitted bankruptcy courts to invoke their equitable powers to prevent an abuse of the bankruptcy system, such that the seemingly absolute right of a chapter 7 debtor under section 706(a) to convert to a chapter 13 case was subject to an exception where the debtor abused the bankruptcy process. Although Justice Scalia acknowledged that the Marrama decision was partly based on the authority granted under section 105(a) and under inherent powers, he adamantly dismissed that aspect of the decision as mere "dictum" and highlighted that Marrama "certainly did not endorse . . . the view that equitable considerations permit a bankruptcy court to contravene express provisions of the Code."
Notwithstanding the statutory confinement of section 105(a) and inherent powers of bankruptcy courts, there remain, according to the Court, various devices for sanctioning misconduct in bankruptcy cases. Among them is the authority of bankruptcy courts to sanction misbehaving parties pursuant to section 105(a) and other inherent contempt powers. The courts, however, do not possess the power to design sanctions or other relief that are patently contrary to provisions of the Code. Therefore, debtors, creditors, and other parties in interest should be mindful that section 105(a) is not a vast reservoir of equitable authority to which parties in interest may flock in order to seek creative relief that contravenes the letter of the Code.
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