Bankruptcy Court Limbers Up to Tackle Mental Gymnastics of Lien Avoidance

A Texas bankruptcy judge had to engage in some mental gymnastics to decide whether to avoid a lien on property exempted under the federal wildcard in In re Melissa Catherine Powell, No. 08-60204 (Bankr. W.D. Tex. 11/6/08). Powell presented some interesting facts. The debtor owned four tracts of real property. However, those properties were encumbered with a $1.1 million judgment lien. Ms. Powell had apparently been up to no good, since the judgment creditor subsequently obtained a non-dischargeable judgment against her. In the absence of bankruptcy, the debtor would have lost the three non-homestead properties. However, the debtor filed bankruptcy, claimed the property as exempt under Sec. 522(d)(1) and (5) and then sought to avoid the judgment lien as a lien impairing an exemption. While the result may raise a few eyebrows, the court faithfully followed the code sections.

The debtor was able to claim four properties as exempt because Texas allows use of the federal exemptions and each property had minimal equity. The debtor claimed total exempt equity of $7,406.43 between the four properties. The exempt values were determined based on the difference between the scheduled values and the non-judgment liens. No party objected to the exemptions, so that they became final. The debtor then moved to avoid the judgment lien as a non-purchase money lien impairing an exemption under Sec. 522(f). The creditor tried to hold the debtor to its scheduled exemption, arguing that the debtor had claimed $7,406.43 in exempt property and could not avoid the judgment lien to the extent that the equity in the properties exceeded this amount.

The Bankruptcy Court framed two issues for decision:

1. Exactly what was claimed and allowed as exempt?

2. Are the creditors, in defense of a lien avoidance motion under Sec. 522(f), foreclosed from challenging the exempt nature of the properties in question due to their failure to timely object to the Debtor's exemption claims?

The creditor's defense to the lien avoidance motion raised the question of what the debtor had claimed as exempt. Was it the property or was it a specific dollar value in equity? The court dryly noted, "Remarkably, this is an issue about which there has been some controversy."

The court pointed out that when a debtor claims an unknown amount as exempt or lists the exempt value at $1, she is putting creditors on notice that the entire value of the asset is claimed as exempt. On the other hand, when the debtor listed a specific dollar amount calculated as the difference between the scheduled value and the scheduled liens, creditors were not on notice that the debtor might claim a greater value. The court noted that there was a difference between "in kind" exemptions which apply to the entire asset and "not to exceed" exemptions which are limited to a dollar value.

The Court stated:

Section 522(d)(1) and (5) allow the Debtor to exempt her aggregate interest in the real property in question. There are not "in kind" statutes. However, when the Debtor places a value on her exemption under (d)(1) and (5) which is less than the monetary amount allowable under the statute and such value was reached by deducting the amount of debt from the value of each such listed property as set forth on Schedule A; it is clear, at least to this Court, that the Debtor's intention was to exempt the maximum allowable under the federal exemption statute. There is no intent to exempt the Properties in their entirety. Even so, this is not determinative of the issue at had as discussed below.

Slip op. at 8.

The issue is thornier because Sec. 522(f) allows the debtor to avoid a lien "to the extent that such lien impairs an exemption to which the debtor would have been entitled under subsection (b) of this section . . ." Thus, for purposes of lien avoidance, the issue is not what amount was exempted by the debtor, but what amount the debtor would have been entitled to. "For purposes of Sec. 522(f), the issue starts with the inquiry of whether we are dealing with property the debtor would have bene entitled to exempt not whether the debtor has scheduled them as such." Slip op. at 11.

Based on the "would have been entitled" language of Sec. 522(f), a debtor who under-exempts his property would be entitled to avoid the lien based on the full amount he was entitled to, while a debtor who over-exempted or claimed property which should not have been exempt at all could not resort to use of Sec. 522(f).

In the specific case, the amount actually claimed as exempt by the Debtor was $7,406.43. However, the Debtor was entitled to claim exemptions of $21,275.00 based on Sec. 522(d)(1) and (5). The lien would impair the exemption to the extent that it prevented the Debtor from realizing the value of $21,275 that she "would have been entitled" to. If there was less equity in the property than the maximum which could be claimed as exempt, then the lien "should be avoided in its entirety as the Debtor's claimed exemption is totally impaired." On the other hand, if the properties were worth more than the value of the unavoidable liens plus the Debtor's maximum exemption, then the "judicial lien would be preserved to the extent of such excess value." Although the Debtor's schedules indicated that there would not be any excess value for the lien to attach to, the court gamely offered that, "if the (creditors) would like to offer such proof, the court is amenable to holding a hearing for such purpose."

There are a number of important points to take away from this opinion.

1. Just because the Debtor is a bad person does not prevent them from using the tools available under the Code. While we frequently say that the Bankruptcy Court is a court of equity and that litigants must do equity to receive equity, that will not overcome a statutory command. In this case, the court, in discussing the creditors' claim, dropped a footnote stating, "There is no indication in the Complaint as to whether the Debtor was prosecuted for her alleged misdeeds; but, if they are true, prosecution would seem most appropriate." Where else but Bankruptcy Court would a party for whom "prosecution would seem most appropriate" prevail against the wronged party?

2. There are two types of exemptions: in-kind and not to exceed. An in-kind exemption exempts the entire property, while a not to exceed exemption just protects a dollar amount. As a result, failure to object to a "not to exceed" exemption does not make the entire property exempt unless the debtor clearly stated an intent to claim the entire asset or the asset was worth less than the allowable exemption. Therefore, if the debtor claims a $5,000 wildcard exemption on a million dollar asset, the debtor gets to keep $5,000 rather than $1,000,000.

3. Lien avoidance under Sec. 522(f) is based on what the debtor should have been entitled to exempt rather than what she actually claimed as exempt. Therefore, every lien avoidance hearing is also a hearing to determine what the exemption should have been.