Attorneys Examine Reach of Bankruptcy Courts' Equity Powers Under Law v. Siegel

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By Diane Davis

March 11 -- The U.S. Supreme Court's recent decision in Law v. Siegel, 2014 BL 57926, U.S., No. 12-5196, 3/4/14 (26 BBLR 311, 3/6/14), was clear that the bankruptcy courts' equitable powers have to be exercised within the confines of the Bankruptcy Code, Danielle Spinelli, a partner with WilmerHale, Washington, D.C., said March 11 during an American Bankruptcy Institute teleconference discussing the case.

Reading the case more narrowly, Lynne Riley, a partner with Casner Edwards LLP, Boston, opined that Bankruptcy Code Section 105(a)'s general power to issue any order is still there as a “gap filler” where there is ambiguity or no express provision in the Bankruptcy Code. There are still “practical reasons” for using Section 105, she said.

Spinelli agreed with Riley that Law does not “get rid of Section 105(a),” but opined that Section 105 has no basis when there is an express provision of the Bankruptcy Code.

The attorneys speaking at the ABI's teleconference wrote opposing amicus briefs in the case. Riley co-authored an amicus brief for the National Association of Bankruptcy Trustees on behalf of the trustee, and Spinelli co-authored an amicus brief on behalf of the National Association of Consumer Bankruptcy Attorneys in support of the petitioner/debtor. 

What About 'Egregious Fraud'?

In Law, Judge Scalia held that the bankruptcy court exceeded its authority when it ordered that the $75,000 protected by debtor Stephen Law's homestead exemption be made available to pay trustee Alfred H. Siegel's attorney's fees. Writing for a unanimous Court, Scalia concluded that the debtor's exempt assets could not be surcharged even for the debtor's misconduct.

There was “egregious fraud” by the debtor in this case, ABI Resident Scholar and moderator of the teleconference Prof. Charles Tabb said. Tabb is the Mildred Van Voorhis Jones Chair in Law at the University of Illinois. The trustee spent a half a million dollars on attorneys' fees in this case, he said. In the end, the debtor was able to keep $75,000 in his homestead exemption, Tabb said. According to Tabb, the trustee proved there was fraud, but it was not much of a victory because he could not get his fees. Surcharging the $75,000 exemption claim to obtain the attorneys' fees seemed like a great idea, Tabb said, citing the Ninth Circuit's reasoning in Law v. Siegel (In re Law),, 2011 BL 148411, 435 Fed. Appx. 697 (9th Cir. 2011).  

Plain Meaning Prevails

Agreeing with a plain meaning argument as advanced by the debtor, however, the Court found that the surcharge contravened an express provision of the Code--Section 522(k), which states that exempt assets are not liable for administrative expenses. “The Court clearly stated that a bankruptcy court cannot use its Section 105(a)'s general powers to issue any order to depart from the clear command of Section 522(k),” Spinelli said. The Court followed the basic canon of law that “specific provisions override general provisions,” she said.

According to Spinelli, the practical effect of this ruling will be to the practice of equitable disallowance. “That practice is not proper,” she said, and some courts have already said so. Spinelli also noted that releases for non-debtor claims may be something else to think about in the future based on Law. Some courts have said that it is okay under Section 105, she said. 

Did Marrama Survive?

Riley opined that Marrama v. Citizens Bank of Massachusetts, 549 U.S. 365 (2007) (19 BBLR 167, 2/22/07), is not “eviscerated.” The issue in Marrama was whether the debtor had an “absolute” right to convert his Chapter 7 case to a case under Chapter 13, despite his fraudulent conduct. According to Marrama, bankruptcy courts have authority to sanction a debtor's bad-faith litigation abuse and can order forfeiture of the otherwise available bankruptcy relief.

In Law, the Court said that “Marrama most certainly did not endorse, even in dictum, the view that equitable considerations permit a bankruptcy court to contravene express provisions of the Code.” The Court seemed to “pull back a little bit from Marrama,” Tabb said.

Spinelli agreed, noting that Marrama might have come out differently if it had been decided today. 

Trustee's Argument 'Difficult.'

The trustee had a difficult argument in this case, Riley said. What the trustee was arguing was that the administrative expenses in this case were not what Congress was speaking to in Section 522(k), but she acknowledged that Section 522(k)'s “prohibition was difficult to get around.” The problem, she said, is that the same administrative expense language is used in other provisions of the Code.

The case might have been a little different if it had come up under Section 522(c), rather than 522(k), Riley said. The decision might not have been so clear, she said, so maybe there would have at least been a divided Court, rather than a unanimous decision.

“What could the trustee have done differently?” Tabb asked the panelists, who noted that there couldn't have been “worse facts for the trustee” than in this case.

According to Spinelli, the trustee was able to sell the debtor's house and recoup most of his attorneys' fees so “it was not such a terrible case.” What the trustee decided to do in this case wasn't such a bad decision, she said, but the Court makes it clear that you “can't expect to use exempt property as a source for fees.”

According to Riley, the debtor's house sold close to $700,000, which is about twice what the debtor said the home was worth. The trustee received about $320,000 in this case, Riley said, and he received his full commission. According to Riley, trustees pursue this type of case all the time.  

Awareness of Rule 4003(b)(2)

Riley noted that now under Federal Rule of Bankruptcy Procedure 4003(b)(2), a trustee may “file an objection to a claim of exemption at any time prior to one year after the closing of the case if the debtor fraudulently asserted the claim of exemption.” Trustees are not left defenseless in the future, she said. The question is “how broadly do we read that rule?” Riley queried. The Law case opened the eyes of trustees to that rule, she said. They will be more aware of it after this case, according to Riley. Surcharging was “high on everyone's list,” she said, but Section 522(k) was the “trump card here.”

Spinelli, however, did not believe that Rule 4003 had any application here. She said that she was not sure that Rule 4003 would help this case.

When asked why the trustee in this case did not avoid and preserve the fraudulent deed of trust claim as a fraudulent transaction, Riley said she did not know why the trustee did not preserve the claim under Section 551. It probably would have been avoided under the trustee's “strong arm” power or as a fraudulent transfer, she said.

The Supreme Court made the assumption in Law that there was a valid exemption here, Tabb said. “Is the property even exempt in the first place if there is fraudulent concealment?” he queried.  

Door Left Open?

The answer has been left a “little unclear,” Spinelli said. The question, she said, is whether Law overrules those cases.

Riley noted that the Court mentioned three of those circuit cases in talking about the trustee's broad equity powers argument: In re Yonikus, 996 F.2d 866 (7th Cir. 1993); In re Doan, 672 F.2d 831 (11th Cir. 1982) (per curiam); and Stewart v. Ganey, 116 F.2d 1010 (5th Cir. 1940). The Court opened a door, however, Riley said, when it also mentioned In re Sholdan, 217 F.3d 1006 (8th Cir. 2000), in the same paragraph. “There is some internal inconsistency here,” she said.

“It is of course true that when a debtor claims a state-created exemption, the exemption's scope is determined by state law, which may provide that certain types of debtor misconduct warrant denial of the exemption,” the Court said, citing Sholdan. The Court goes on to say, however, that “federal law provides no authority for bankruptcy courts to deny an exemption on a ground not specified in the Code.”

“There may have been a different analysis under state law,” Spinelli said.

The Court used Marrama dictum to talk about dictum, Tabb said, quoting the Court's comment about “procedural niceties.” “At most, Marrama's dictum suggests that in some circumstances, a bankruptcy court may be authorized to dispense with futile procedural niceties in order to reach more expeditiously an end result required by the Code,” Scalia said.

According to Tabb, it will be “fun to see what constitutes 'procedural niceties.'”

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