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Exempt Assets Stay That Way, Even After Fraud

WASHINGTON (CN) - A bankrupt man who tried to defraud his creditors need not see his exempt assets cover attorneys' fees, the Supreme Court ruled Tuesday.

When Stephen Law filed for Chapter 7 bankruptcy, his estate's only significant asset was a house in Hacienda Heights, Calif., which he valued at more than $363,000.

Law claimed that California's homestead exemption covered $75,000 of that amount. With two liens on the house that supposedly exceeded the house's nonexempt value, Law said there was no equity in it for other creditors to recover.

Alfred Siegel, the court-appointed trustee, would have had no reason to pursue sale of the house if Law's representations had been accurate, but he claimed that the second note, for more than $156,000 in favor of "Lin's Mortgage & Associates," was fraudulent.

Siegel found a California woman named Lili Lin who said Law had repeatedly, and unsuccessfully, tried "to involve her in various sham transactions relating to the disputed deed of trust," Justice Antonin Scalia wrote for the unanimous court.

A second "Lili Lin" who spoke no English and supposedly lived in China meanwhile claimed to be the true beneficiary of the disputed deed of trust.

Though this individual engaged in extensive and costly litigation, including several appeals, contesting the avoidance of the deed of trust and Siegel's subsequent sale of the house, the Bankruptcy Court concluded in 2009 that "no person named Lili Lin ever made a loan to [Law] in exchange for the disputed deed of trust."

The court speculated that Law was behind all of the papers related to the Lili Lin in China and submitted false evidence in support of that fraud, ultimately causing Siegel to incur more than $500,000 in attorneys' fees.

To defray those costs, the court said Siegel could "surcharge" the entirety of Law's $75,000 homestead exemption, and both the 9th Circuit ultimately affirmed.

The Supreme Court granted Law a writ of certiorari in June and reversed Tuesday.

"It is hornbook law that §105(a) 'does not allow the bankruptcy court to override explicit mandates of other sections of the bankruptcy code,'" Scalia wrote. "Section 105(a) confers authority to 'carry out' the provisions of the code, but it is quite impossible to do that by taking action that the code prohibits. That is simply an application of the axiom that a statute's general permission to take actions of a certain type must yield to a specific prohibition found elsewhere."

Because the bankruptcy court's surcharge contravened a specific provision of the code, it was unauthorized, according to the ruling.

"The reasonable attorney's fees Siegel incurred defeating the 'Lili Lin' lien were indubitably an administrative expense, as a short march through a few statutory cross-references makes plain," Scalia wrote.

Also fatal to Siegel's claim is that no one timely opposed Law's homestead-exemption claim, according to the ruling.

"The code's meticulous - not to say mind-numbingly detailed - enumeration of exemptions and exceptions to those exemptions confirms that courts are not authorized to create additional exceptions," Scalia quipped.

There is some precedent for denial of a state-created exemption because of debtor misconduct, "but federal law provides no authority for bankruptcy courts to deny an exemption on a ground not specified in the code." (Emphasis in original.)

The ruling concludes with the sour realization that the precedent "forces Siegel to shoulder a heavy financial burden resulting from Law's egregious misconduct, and that it may produce inequitable results for trustees and creditors in other cases."

But ultimately, "it is not for courts to alter the balance struck by the statute," Scalia wrote.

It is worth noting, however, that "fraudulent conduct in a bankruptcy case may also subject a debtor to criminal prosecution under 18 U. S. C. §152, which carries a maximum penalty of five years' imprisonment," the ruling concludes.

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