Fifth Circuit Goes Further Down the Disappearing Exemption Rabbit Hole

In yet another blow to the finality of exemptions, the Fifth Circuit has ruled that a chapter 7 debtor who claimed an IRA as exempt but later withdrew the proceeds must pay the funds to the trustee.   Engelhart v. Hawk (Matter of Hawk), No. 16-20641 (5th Cir. 7/19/17).    The decision follows on the Court's ill-conceived Frost opinion and raises the specter that no exemption can ever be final.   (I am abandoning my usual stance of editorial neutrality to come out and say I think this is a terribly bad decision).   

What Happened

Gregory Hawk filed chapter 7 bankruptcy and Eva Engelhart was appointed trustee.   Hawk claimed an IRA account with over $133,000 in it as exempt.   No party objected to the exemption within the period allowed by the bankruptcy rules.   The Trustee filed a no-asset report.   However, a creditor objected to the Debtor's discharge.   In the course of discovery, the creditor learned that the Debtor had withdrawn most of the funds shortly after filing bankruptcy and had used them to pay living expenses.    The Trustee filed a motion for turnover.   The Bankruptcy Court ordered that all of the funds be turned over to the Trustee on the basis that they lost their exempt status when they were not reinvested into a new IRA.  The District Court affirmed.

Following Frost

 The Fifth Circuit's opinion in Hawk started out on a sound framework.

 “Unless a party in interest objects, the property claimed as exempt on such list is exempt.” 11 U.S.C. § 522(l). “Anything properly exempted passes through bankruptcy; the rest goes to the creditors.”

Opinion, p. 4.   The opinion should have ended there.   Indeed, the Debtors argued that under the "snapshot" rule the status of the exempt property was fixed either as of the petition date or the date that the exemption became final.

However, the Court was weighed down by its prior opinions in Matter of Frost, 744 F.3d 384 (5th Cir. 2014) and Matter of Zibman, 268 F.3d 298 (5th Cir. 2001) which dealt with proceeds from sales of homesteads.   The court stated that  "there are clear parallels between the Texas statutes governing retirement accounts and those governing homesteads."    Id.   The Court noted that the IRA accounts lose their exempt status if not reinvested in a new IRA within sixty days while proceeds from sale of a homestead remain exempt for six months.

In surveying its prior exemption jurisprudence, the Court stated that the “essential element of the exemption must continue in effect even during the pendency of the bankruptcy case.”   Opinion, p. 8.   Thus, a property is only exempt as long as it keeps its "essential element."  

When Frost sold his homestead, his “interest in his homestead changed from an unconditionally exempted interest in the real property itself to a conditionally exempted interest in the monetized proceeds from the sale of that property.” Id. Consequently, we concluded that “[o]nce the conditional exemption expired . . . Frost lost his right to withhold the sale proceeds from the estate.”

Opinion, p. 9.     Based on this logic, the Court found that Hawk's exemption in the IRA account lost its protected status when he withdrew the funds and did not reinvest them.

The Court distinguished away the Supreme Court's governing opinion in Taylor v. Freeland & Kronz, 503 U.S. 638 (1992) which held that failure to object to an exemption, even one without a colorable basis, forever barred a challenge to the exemption.   The Court wrote:

Nonetheless, the Supreme Court’s decision in Taylor is not fatal to the Trustee’s position in the present case. In Frost, we stressed that it was “the land itself—not its monetary value—that [was] protected under Texas law and ‘exempted under [§ 522].’” 744 F.3d at 391 (quoting 11 U.S.C. § 522(c)). In other words, “Frost’s homestead was exempted from the estate . . . by virtue of its character as a homestead.” Id. at 387. But when Frost sold the homestead, the property’s “essential character . . . changed from ‘homestead’ to ‘proceeds,’” permitting the trustee to “challenge[] the exemption of those proceeds from the estate.” Id. Likewise, when the Hawks claimed an exemption and no party in interest objected, the funds held in the IRA were exempted because of their essential character as “assets held in . . . an individual retirement account.” See Tex. Prop. Code § 42.0021(a). The funds would have stayed exempt during the bankruptcy proceeding so long as they remained in the IRA and continued to comply with Section 42.0021(a)’s requirements. However, when the Hawks withdrew the funds, the essential character of the property changed from assets held in a retirement account to “[a]mounts distributed from a [retirement] account,” see § 42.0021(c), which enabled the Trustee to contest the exemption of the distributed amounts.

Opinion, pp. 10-11.    Here is that notion of essential character again.  

The Court also rejected the argument that Frost could be distinguished because it was a Chapter 13 case while Hawk was a Chapter 7 case.   The Court noted that the only section construed in Frost was section 522 which had the same meaning in Chapter 7 and Chapter 13.

Why the Opinion Is Wrong

The Fifth Circuit's exemption jurisprudence took a wrong turn when it adopted the requirement that an exemption retain its "essential element" throughout the pendency of the case.    This requirement does not exist in the Bankruptcy Code.   It slipped into the Fifth Circuit's  Zibman opinion as a way to explain how bankruptcy law interacted with the Texas Property Code in a very specific situation.   However, it was completely unnecessary to the holding.     Here's why.

Zibman involved a debtor who sold his homestead prior to bankruptcy.   Thus, the asset he held on the petition date was proceeds, not the homestead itself.   Prior to the deadline for objecting to exemptions, the six month period expired.   The Trustee made a timely objection to the exemption on the basis that the proceeds had not been exempted within six months.

The result in Zibman was consistent with both Texas law and Taylor v. Freeland & Kronz.  The case was consistent with the U.S. Supreme Court holding because the Trustee filed a timely objection to the exemption.  It was consistent with Texas law because the exemption in proceeds had a temporal limitation.   Thus, because there was a timely objection and the proceeds had lost their exempt status by the time of the objection, the result was correct.   There was no reason to resort to the "essential element" argle-bargle to get to the result.    (Argle-bargle was coined by Justice Scalia in his dissent in the same-sex marriage case).

To reiterate, the Zibman case was correct because:  1)  the asset sought to be exempted on the petition date was the proceeds and not the homestead; and 2) there was a timely objection filed.   By reading out the timely objection requirement, the Fifth Circuit has effectively overruled Taylor v. Freeland & Kronz.   However, the "essential character" language was not correct.

Frost took the Court further down the rabbit hole.  The Court ruled that when a chapter 13 debtor sold his homestead during a chapter 13 proceeding, the proceeds lost their exempt status when they were not re-invested within six months.    According to the Court, after the sale of the homestead, Frost's “interest in his homestead changed from an unconditionally exempted interest in the real property itself to a conditionally exempted interest in the monetized proceeds from the sale of that property.”   Frost, at 389.   Thus, in Frost, the Fifth Circuit created the possibility that an unconditional exemption could be transformed into a conditional one.   This is more argle-bargle.

The Court in Frost cited Zibman.   However, Zibman did not apply to an unobjected to exemption of the homestead itself.   The only way that Frost made sense was because it was a chapter 13 case and under section 1306, assets received post-petition are added to the property of the estate. (The Bankruptcy Judge who tried the case has indicated that this was the basis for his ruling).    However, the Fifth Circuit did not cite the only reason that would cause its ruling to make sense.


Why the Opinion is Dangerous

In Taylor v. Freeland & Kronz, the Supreme Court announced a black letter rule that once property is claimed as exempt and no one objects, it leaves the estate never to return.   Zibman, Frost and Hawk have obliterated that rule.   Instead, the new rule is that an exemption is but a temporary respite that lasts so long as the asset in question retains its "essential character"

The problem is that the Courts have confused an enhancement with a limitation.   The general rule for exempt property is that the thing is exempt and its proceeds are not.   However, once the property leaves the estate, the debtor can do whatever he or she wants to with that asset.  Consider an exemption of household goods.   There is no exemption for proceeds of clothing and household furnishings. If the debtor decides to have a yard sale, can the trustee grab those proceeds?   Or consider this:  under Texas law, current wages are exempt.   Once wages are received, they cease to be current.    If the debtor claims the exemption for current wages, can the trustee grab them once they are received?   This may sound absurd, but Texas had to amend its turnover statute to prevent just this practice.

The court has also confused how exemptions work outside of bankruptcy with how they work inside of bankruptcy.    Outside of bankruptcy, a debtor's exempt property is constantly changing.   A debtor may sell a pickup truck and buy a shotgun.  Whether property is exempt is always determined at the particular moment that a creditor seeks to levy upon it.   Bankruptcy exemptions serve an altogether different purpose.   They seek to define what is property of the estate and what is not.  Once property leaves the estate, whether through exemption or abandonment, the debtor may exercise sole dominion over it as against his bankruptcy estate.   The property may lose its exempt status outside of bankruptcy but that does not bring it back into the bankruptcy estate.   For example, if a debtor sells his home and does not reinvest the proceeds, those proceeds are not exempt as to any post-petition creditors.  However, they are not property of the estate.    

 The current line of exemption cases destroy the finality of exemptions and create the opportunity for gamesmanship.   Under Taylor v. Freeland & Kronz, property claimed under a nonexistent exemption has more protection than a homestead that is sold post-petition.   While Taylor demanded a timely objection and proclaimed that deadlines have consequences, under the Fifth Circuit cases, a trustee can seek turnover of proceeds from once exempt property months or even years later without ever having objected.   This encourages trustees to leave cases open indefinitely in the hopes that a debtor will slip up and forfeit his exemption.  

A Plea to the Fifth Circuit

The Court's decisions have gone badly off the rails.   Each new decision takes the Court further from the law drafted by Congress and announced by the Supreme Court and deeper into a thicket of unintended consequences.    The Court needs to re-examine these precedents on an en banc basis and thoroughly repudiate the concept that "unconditional" exemptions can morph into "conditional" exemptions well after the property has left the estate.   The Court needs to recognize that when it comes to property of the estate, in is in and out is out.

Postscript

On motion for rehearing, the panel reversed itself holding that Chapter 7 is different than Chapter 13.