Loss of Homestead Exemption for Bad Faith Denied

Earlier this year, the United States Supreme Court decided that the bankruptcy courts fashion a remedy in excess of the express statutory authority set out in the Bankruptcy Code.

Law v. Siegel

The debtor filed for Chapter 7 bankruptcy in 2004; the only asset, for practical purposes, of the estate was the debtor’s home, valued about $363,000. The debtor, claiming California’s greater homestead exemption, instead of the lesser federal exemption, was able to exempt $75,000 of his equity in the house. The debtor claimed two liens on the house-one to a bank and the other a deed of trust to a Chinese entity-the sum of the two exceeded would have exceeded the value of the house, presumably entitling the debtor to retain his house. The bankruptcy trustee soon thereafter filed suit alleging that the lien held by the Chinese entity was fraudulent. After years of litigation, it was decided that the claimed lien was indeed fraudulent. Thus, the $75,000 homestead exemption was all that protected the debtor’s equity in his home.

The trustee spent over $500,000 in pursuing the fraudulent claim and obtained a court order for all of the $75,000 homestead exemption to help cover some of that litigation expense.

Inherent power vs. express power

While bankruptcy courts have the power to issue orders necessary to carry out the provisions of the Bankruptcy Code and to punish “abusive litigation practices,” those same courts may not violate express provisions of the Bankruptcy Code.

The purpose of the Bankruptcy Code’s exemptions is to allow debtors the essential assets necessary for the fresh start envisioned by the bankruptcy provisions. If an asset is exempted from the bankruptcy estate, it is unavailable for the payment for any of the administrative expenses of the bankruptcy. There are two narrow exceptions, neither of which is applicable under the current facts.

The United States Supreme Court decided that the attorney’s fees and other expenses that the trustee spent in having the Chinese lien declared fraudulent was undeniably an administrative expense, and the lower court in ordering so exceeded its inherent powers by directly contravening an express statutory provision.

Denial based upon equity

Bankruptcy courts have broad equity powers-a basic legal concept that requires a debtor to come to the court having acting fairly and not fraudulently. Here, the debtor certainly did not act fairly in that he tried to hide his equity through asserting a fake lien. The trustee argued that this conduct justified a denial of the homestead exemption. The Supreme Court decided that the homestead exemption, in effect, became final long before the surcharge was imposed or the trustee objected to the exemption. Also, there was nothing under federal law which allowed the exemption to be denied.

Other options

Other options remain to punish the debtor for his bad conduct. For example, a discharge could be denied-although in this case the debtor had settled with his primary debtor and there was no debts remaining.

Seeking help

If you find yourself in contemplating bankruptcy, it is advisable to contact an attorney experience in bankruptcy and debt relief to explore all your options. Although the Law debtor may have cut a fine line, the case does show that it is always imperative to be honest with your attorney and with the bankruptcy court in order to obtain the fresh start contemplated by the Bankruptcy Code.