Supreme Court Rules for Trustee in Exemption Dispute

The Supreme Court ruled today that when claiming Federal Exemptions, the Debtor is entitled to the dollar amount claimed rather than the actual property. As a result, a trustee could sell property claimed by the debtor as exempt where it proved to be more valuable than the amount claimed by the debtor. Schwab v. Reilly, 560 U.S. ___ (6/17/10).

The majority opinion was written by Justice Thomas and joined by Justices Stevens, Scalia, Kennedy, Alito and Sotomayor. Justice Ginsberg wrote a dissent which was joined by Chief Justice Roberts and Justice Breyer. This was another case of strange judicial bedfellows as conservative and liberal justices signed on to both opinions. The competing opinions each parsed the legislative language to arrive at their conclusions.

What Happened

Nadejda Reilly filed a petition for chapter 7 and claimed equipment from her catering business as exempt. She valued the property at $10,718. She claimed an exemption of $1,850 for tools of the trade under Sec. 522(d)(6) and $8,868 under the wildcard exemption under Sec. 522(d)(5). Thus, the debtor claimed the entire scheduled value as exempt. During the time for filing objections to exemptions, the Trustee obtained an appraisal valuing the equipment at $17,200. However, the Trustee did not object. Instead, the Trustee subsequently filed a motion to auction off the equipment and pay the Debtor the amount claimed as exempt.

The Trustee's request was rebuffed by the Bankruptcy Court, the District Court and the Third Circuit, but not the Supreme Court.

The Statutory Language

Both the majority and the dissent focus on the language of Sec. 522(l) which states that "Unless a party in interest objects, the property claimed on such list is exempt." However, they disagreed about what "the property claimed on such list" referred to.

The dissent contended that "the property claimed on such list" referred to the actual items listed on Schedule C and that when a Debtor claimed the full value as exempt, that the property would be exempt absent a timely objection.

The majority required several more steps to parse the language.

1. Section 522(l) allows the debtor to "file a list of property that the debtor claims as exempt under subsection b of this section."

2. Section 522(b) allows the debtor to claim property exempt under state law or other applicable law or under Section 522(d).

3. If the Debtor claims Federal Exemptions under Section 522(d), the exemptions in Sec. 522(d)(1)-(8) and 11(C) are defined in terms of "the debtor's aggregate interest, not to exceed $____ in value." On the other hand, the exemptions in Sec. 522(d)(9), (10), (11)(A)-(C) and 12 are not defined in terms of value.

4. If the Debtor claims a value limited exemption, the Debtor's exemption is in the value, not the property.

5. So long as the Debtor claims a dollar amount which is within the statutory limits, the Trustee is not required to object, because the Debtor has claimed a value allowed by law and only the value.

The majority rejected the Third Circuit's contention that "an unstated premise" of Taylor v. Freeland & Kronz was that a debtor who claims the full value of an item of property claims the property itself.

What It Means

In her dissent, Justice Ginsberg stated that:

In addition to departing from the prevailing understanding and practice, the Court's decision exposes debtors to protracted uncertainty concerning their right to to retain exempt property, thereby impeding the "fresh start" exemptions are designed to foster.

While the majority claims that its decision did not do violence to its prior holding in Taylor v. Freeland & Kronz, the practical problems are clear.

Under Section 541 of the Bankruptcy Code, all of the debtor's interests in property enter the estate. Under Section 522(b)and(l), property successfully claimed as exempt is no longer property of the estate. However, if the exemption applies to property subject to a dollar value limitation, the property doesn't leave the estate, merely the value. This means that the property (the res, as opposed to the value) remains property of the estate until it is abandoned under Section 552.

Under Section 552(a), the Trustee can voluntarily abandon a piece of property which is burdensome or of inconsequential value. If the property is properly scheduled and the court does not order otherwise, the property is automatically abandoned to the debtor when the case is closed. Furthermore, the debtor may request that the trustee be ordered to abandon the property under Section 552(b). Thus, the practical import is that if a debtor claims a value limited item of property as exempt and wants to dispose of the property, the debtor would need to file a motion to compel abandonment.

The new rule creates possibilities for mischief and malpractice. Assume that the debtor files bankruptcy and claims federal exemptions with regard to their homestead. At the time that they file, they believe that the value of the homestead is within the exemption limit. The trustee neither objects to the exemption nor closes the case. Two years later, the trustee files a motion to sell the debtor's home because values have gone up dramatically. Has the debtor's attorney committed malpractice by not filing a motion to compel abandonment? The trustee's gambit shouldn't work because Section 522(a)(2) defines value in terms of the petition date. However, if the debtor has an appraisal from a year prior to bankruptcy and the trustee has one from a year after the bankruptcy, how certain can the parties be about what the value was on the petition date. Will it be necessary to get an appraisal as of the petition date to protect the debtor?

Here is another facet. Under 11 U.S.C. Section 363(b), the trustee can lease property of the estate. If the homestead remains as property of the estate, could the trustee evict the debtors and lease the property out even if the value of the exemption exceeded the value of the property? If the exemption is in the value rather than the property, does the debtor have to be compensated for use of the property by the trustee?

Taking it further, let's assume that the house burns down without either the debtor or the trustee having insured it. Is the trustee subject to a claim on his bond?

As a practical matter, trustees will likely be motivated to close questionable value estates in order to receive their commission. However, the potential for trouble is tremendous.