Thursday, March 20, 2014

Longtime Texas Bankruptcy Judge Larry Kelly Passes Away

Larry E. Kelly who served as U.S. Bankruptcy Judge for the Western District of Texas from 1986-2007, passed away on March 19, 2014.    Chief Bankruptcy Judge Ronald B. King announced the news to the bar. 
It is my sad duty to inform you that Judge Larry Kelly passed away this morning before 7:00 a.m.   I am in Waco today and he was too sick to see me yesterday, but I was planning to try again today.  Needless to say, we have suffered a big loss.   Larry was such a huge part of our court since 1986 when he began his tenure as a bankruptcy judge and became chief judge in 1988.   He retired from the bench in February, 2007, but practiced law and taught at Baylor until last fall and actually finished grading his final exams two weeks ago.
Judge Kelly's obituary can be viewed here.   His funeral will be on Saturday March 22, 2014 at 10:00 a.m. at First United Methodist Church of Waco, 4901 Cobbs Dr, Waco, TX 76710.

A short article that I wrote at the time of Judge Kelly's retirement in 2007 appears below.   I plan to write more after the memorial service.

Judge Kelly’s tenure spanned a period of great change in the Western District.    When Judge Kelly was appointed in 1986, judicial pay was low and the hours were long.   As one of only two bankruptcy judges, Judge Kelly along with Judge Ayers covered a territory larger than most states.     During the tumultuous 1980s, business bankruptcies made up 20% of the docket with the attendant demands on court time.

During his years on the bench, Judge Kelly handled many large and notorious cases in the Austin Division.    These included former Governor John B. Connally, homebuilder Nash Phillips/Copus, Inc., Circle C Joint Venture, Mr. Gattis, Inc. and Great Hills Baptist Church.   He also tried the litigation over the failed merger between El Paso Electric Company and Central & South West Corporation.   

Judge Kelly was a colorful presence on the bench.   His trademark phrase of “Let me tell you where I’m at” was used to speed resolution of cases.  When offering advice on how something could be done better, he often prefaced his remarks with “In my twelve years of practice …” (a phrase which became less frequent as his time on the bench eclipsed his years as a practicing attorney). 
Judge Kelly encouraged lawyers to a higher standard of practice and was concerned about how the bankruptcy system was viewed by the general public.  He would often comment about how a particular situation would look to the folks in “Warshington,” a concern which became more prominent as bankruptcy reform was in the spotlight for nearly ten years.    He took great pains to insist that disclosure statements actually contain meaningful information and that plans set out the mechanics of how they would work.   He expressed great frustration with lawyers who would submit ambiguous pleadings and orders and then ask the court to decide what they had meant.   He is rumored to have commented that Larry Kelly the lawyer would not have fared well in front of Larry Kelly the judge.   

Judge Kelly’s most lasting contribution will likely be his emphasis on technology.   He pushed and prodded the Western District into being the first district in the nation to go live with electronic filing in 2001.     He also was one of the first bankruptcy judges to use video court to better serve his far-flung divisions.   
Judge Kelly’s retirement marks the end of an era.   It has been 17 years since the last vacancy on the Western District Bankruptcy bench.      (Note:  This was written in 2007, so this statement is now a bit dated).


Friday, March 14, 2014

MtGox Chapter 15 Case Brings Japanese Insolvency Proceeding and Bitcoin Drama to Dallas Bankruptcy Court

Bankruptcy sometimes provides a window into unfamiliar worlds.   The recent chapter 15 filing by MtGox Co., Ltd. contains an interesting explanation of the bitcoin phenomenon as well as Japanese involvency proceedures.   In re MtGox Co., Ltd., No. 14-31229 (Bankr. N.D. Tx.).   Here are a few nuggets that I picked up from the initial filings.  

By way of introduction, MtGox Co., Ltd. is a Japanese company that operated a bitcoin exchange in Tokyo.  According to Wikipedia, MtGox is an acronym for “Magic:  The Gathering Online Exchange.”  Unforutnately for MtGox, the magic turned sour.   On February 28, 2014, it filed for reorganization in Japan after it found that it was missing bitcoins valued at $473 million which constituted about 7% of all of the bitcoins in circulation.   This raises the question of just what is a bitcoin and how does someone steal half a billion dollars’ worth of them.   

All About Bitcoin

According to the Declaration of Robert Marie Mark Karpeles (Dkt. #3), “Bitcoin is a form of digital currency that was first conceived of in 2008 by a person or group going by the name of Satoshi Nakamoto.”     Attributing the conception of bitcoin to a pseudonymous person or group suggests that this digital medium of exchange is to currency what Anonymous is to the internet, that is, a shadowy, disruptive force.    According to Wikipedia, Satoshi Nakamoto is probably not Japanese and is probably not an individual.   Whether he is an individual or a group, he launched the first Bitcoin software in 2009 and then handed it over to Gavin Andresen (an engineer with a degree from Princeton) in mid-2010.   For his or its troubles, “Nakamoto” ended up with a million bitcoins.   

Continuing on with the Declaration:
The first actual bitcoin was created, or "mined" in 2009. There are several ways in which a person can obtain bitcoin, including the following:

o Bitcoins are "created" through a computer software algorithm which, at any point in time, resides on thousands of computers on the Internet. Persons who accept to certify bitcoin transactions over the bitcoin peer-to-peer network are remunerated by the issuance of a fixed number of bitcoins which evolves over time. The certification is done by the solving of an "algorithm" with the use of ever-more powerful computers. These persons are called "miners" and the process of obtaining bitcoin in this fashion is called "mining."

o A person can also obtain bitcoins that have already been mined by buying them from another. These transactions can consist of "one-to-one" transactions between a buyer and seller. In addition, a person can buy or sell bitcoin through an online exchange, such as the exchange operated by MtGox on the website. In these exchange transactions, the buyer and seller create accounts at the exchange and then fund the account with currency funds, bitcoin or both. The user can then enter a buy or sell order online and the website will match the buy or sell order with one or more sell or buy orders. The buyer receives an increase in bitcoin in his/her account and the seller receives an increase in currency in his/her account. The bitcoin exchange receives a fee or commission for the transaction.

o A person can also obtain and use bitcoin through commercial or merchant transactions; that is, a person can use bitcoin in certain circumstances to pay for goods and services.

Users store bitcoins in a digital "wallet" using either the software provided as part of the bitcoin software or a wallet provided by various providers. MtGox provides a wallet feature. A wallet can be materialized on a piece of paper and bitcoins need not be stored on a computer.

The MtGox exchange allowed persons with MtGox accounts to buy and sell bitcoin among themselves. In this regard, a person was to first open an account at MtGox and was assigned an account number. Once a user wanted to start buying or selling bitcoin on the mtgox website, he or she would need to "fund" the account with currency, bitcoin, or both. In addition, the account holder would be subject to "anti-money laundering" ("AML") procedures.

Once the account was "funded," the account holder would have a "currency balance" in the account, corresponding to the amount of currency he or she had a right to withdraw; and, a "bitcoin balance" in the account, corresponding to the amount of bitcoin he or she had a right to withdraw.
 Declaration, pp. 2-4.

While the part about mining bitcoins by solving an algorithm using ever more powerful computers sounds really technical, I think it can be boiled down to this.  I think that what happened was that someone came up with the idea of bitcoin and persuaded other people to exchange currency or products in return for it.   This is basically the story of currency everywhere.   While we may have once relied upon coins made of precious metals, it still required an agreement that these shiny objects had value.  All money is based on the shared idea that it has value.    Once enough people agree that a thing has value, then it does—at least until people stop thinking it does.

Meanwhile, MtGox was founded in 2007 by Jed McCaleb as a site for trading cards like stocks.   In July 2010, McCaleb read about Bitcoin on Slashdot and decided to create an exchange for trading Bitcoin and regular currencies.   In March 2011, McCaleb sold MtGox to Mark Karpeles while retaining a 12% interest.   Karpeles is a software developer who was born in France in 1985 and moved to Japan in 2009.   

The problem with having something of value is that people who are not nice may try to take it from you.   This happened with MtGox.   Going back to the Declaration:
The website has been subject to numerous attempts by persons to breach its security, create denial of service ("DOS") situations, or to otherwise "hack" the system, and this has been the case since MtGox started operating the website in July 2011. In certain circumstances such attempts have led to the company shutting down the site for periods at a time.

On February 7, 2014, all bitcoin withdrawals were halted by MtGox due to the theft or disappearance of hundreds of thousands of bitcoins owned by MtGox customers as well as MtGox itself. The cause of the theft or disappearance is the subject of intensive investigation by me and others -- as of the present time I believe it was caused or related to a defect or "bug" in the bitcoin software algorithm, which was exploited by one or more persons who had "hacked" the bitcoin network. On February 24, 2014, MtGox suspended all trading after internal investigations discovered a loss of 744,408 bitcoins presumably from this method of theft.
 Declaration, p. 4.    This illustrates another peril of the digital world.   When your asset consists of computer code, there are going to be hackers who will want to breach your network and mess with your stuff, which is apparently what happened to MtGox.    While losing half a billion dollars of your customers’ non-corporeal assets to theft is embarrassing, it is not as bad as JP Morgan losing $5.8 billion from trading credit default swaps or MF Global losing $1.6 billion of customer funds from bad trades.

The Japanese Main Proceeding and the Dallas Chapter 15

While the internet does not exist within fixed borders, companies do.   MtGox was physically located in Tokyo, Japan.   While it is curious that the creator of bitcoin used a Japanese pseudonym, Mark Karpeles was already living in Tokyo when he acquired MtGox in 2011.   So what you have is a Frenchman living in Tokyo who acquires an exchange from an American for trading a digital currency developed by an anonymous person or collective using a Japanese name.    

Returning to the Declaration:
In order to protect the MtGox business as a going concern and retain its value while MtGox investigates the theft of the bitcoins under its control and addresses security defects in the bitcoin exchange, MtGox filed a petition (the "Japan Petition") for the commencement of the Japan Proceeding in the Tokyo Court pursuant to Article 21(1) of the JCRA on February 28, 20 I4, reporting that the company had lost almost 750,000 of its customers' bitcoins, and around 100,000 of its own bitcoins, totaling around 7% of all bitcoins in the world, and worth around $473 million near the time of the filing.

The Japan Proceeding is a civil rehabilitation. The purpose of a civil rehabilitation proceeding is to formulate a rehabilitation plan as consented to by a requisite number of creditors and confirmed by the court, to appropriately coordinate the relationships of rights between creditors and the debtor, with the aim of ensuring rehabilitation of the debtor's business or economic life.

In addition to the petition for commencement, MtGox also filed applications for a temporary restraining order and for a comprehensive prohibition order which were issued by the Tokyo Court on February 28, 2014. At the same time, the Tokyo Court issued orders for the appointment of a supervisor and examiner (collectively, the 'Tokyo Court Orders").

The Tokyo Court appointed Mr. Nobuaki Kobayashi, a Japanese attorney, as MtGox's supervisor and examiner. Under the Tokyo Court Orders, the Debtor cannot execute any agreement with any third party without the consent of the supervisor and examiner. The Debtor however remains free to initiate or pursue any legal proceeding provided that the costs of these proceedings be approved by the supervisor and examiner. On March 10, 2014, Mr. Kobayashi, pursuant to the powers conferred upon him by the Tokyo Court Orders, issued a consent allowing the Debtor to hire Baker & McKenzie to file this Chapter 15 case as counsel of Debtor, allowing the payment of Baker & McKenzie's fees and further acknowledging that this consent was granted at the condition that MtGox's sole Director and Chief Executive Officer, Mr. Karpeles, file this Chapter 15 case as the foreign representative of MtGox.

Under the current status of the Japan Proceeding, the supervisor/examiner does not have the powers to manage the assets of the Debtor. As a consequence, the current management of MtGox remains in place and is allowed to continue to operate its businesses as a debtor-in-possession. I understand that this is permitted under the JCRA and that MtGox has submitted the evidence legally required for the relief to be granted upon formal commencement.
Declaration, pp. 5-6.   In case you were wondering what a Japanese Insolvency order looks like, here is an image of one page:

From what I can discern, the JCRA allows something like our debtor-in-possession procedure with an independent supervisor and examiner who must approve certain actions but does not run the business.  According to a Brief filed by MtGox's American lawyers, Baker & McKenzie, the JCRA was modeled on Chapter X of the U.S. Bankruptcy Act of 1898. 

The Chapter 15 proceeding was filed in response to legal proceedings in the United States.    After Jed McCaleb sold his majority interest in MtGox to Mr. Karpeles, he founded a company named CoinLab, Inc. in the United States.    CoinLab filed suit against MtGox in the Western District of Washington in 2013.   Immediately after MtGox ceased operating, a class action was filed against it in the Northern District of Illinois.    When the Chapter 15 proceeding was filed, MtGox filed a Verified Petition for Recognition and Chapter 15 Relief in which it sought to have Mark Karpeles recognized as the “foreign representative” of MtGox.  It also requested that it be granted provisional relief pending recognition to have the automatic stay apply to MtGox in the United States.   

On March 10, 2014, Judge Harlin Hale entered an order providing that the automatic stay apply “to the Debtor and its assets until further order of this Court or as so ordered at the Recognition Hearing.    The Court scheduled a hearing on recognition of the foreign proceeding before Judge Stacey Jernigan to be commenced on April 1, 2014.    Somehow it seems fitting that the hearing for recognition of the bankruptcy for the exchange that had its digital crypto-currency pilfered will begin on April Fools’ Day.       

Saturday, March 08, 2014

Fifth Circuit Erodes Protection for Texas Homesteads Sold After Filing

Expanding upon its decision in Matter of Zibman, 268 F.3d 298 (5th Cir. 2001), the Fifth Circuit has ruled that the proceeds from sale of a Texas homestead lose their exempt character if they are not reinvested within six months--even when the sale takes place post-petition.   Viegelahn v. Frost (In re Frost), No. 12-50811 (5th Cir. 3/5/14).    The opinion can be found here.   The opinion creates a malpractice trap and arguably conflicts with this week's Supreme Court decision in Law v. Siegel.  

The Problem

The Bankruptcy Code states that "property exempted under this section is not liable during or after the case for any debt of the debtor that arose . . . before the commencement of the case" except for debts for taxes and domestic support obligations, unavoided liens, debts owed by an institution-affiliated party and debts for fraud incurred in obtaining a student loan.   11 U.S.C. Sec. 523(c).   Further, exempt property is not liable for administrative expenses except for the cost of recovering that property.   11 U.S.C. Sec. 522(k).  
These provisions should make it pretty clear that once property is allowed as exempt, it is not liable for pre-petition debts or administrative claims with very limited exemptions.   However, Texas has a vanishing exemption.    While Texas has one of the most generous homestead exemptions in the country, proceeds from sale of a homestead only remain exempt so long as they are reinvested within six months.   Texas Property Code Sec. 41.001(c).
In Matter of Zibman, the Fifth Circuit held that the Texas Property Code grants only a provisional exemption to homestead proceeds.   Where the homestead was sold prior to bankruptcy and the debtor held proceeds on the petition date, the exemption would be allowed subject to the reinvestment provision.  Zibman can be reconciled with section 522(c) and (k) for the reason that the limitation on the exemption existed on the petition date.   In other words, the debtor had an exemption in a fund of money so long as he used that money to purchase a new homestead within six months.   This is contrasted with the exemption in the homestead itself which was not subject to defeasance.  

The Frost Facts

Mark Frost filed a chapter 13 petition on November 30, 2009.   At that time, he owned a home in Cibolo, Texas.    On March 26, 2010, the Bankruptcy Court entered an order allowing him to sell his home.  The Trustee objected to the sale on the basis that the Debtor should be required to re-invest the proceeds within six months.    The Court allowed the sale but provided that any liens or interests not specifically provided for in the Order would attach to the proceeds and that the proceeds would be deposited with the Chapter 13 Trustee "pending further orders of this Court as to the validity, priority and extent of such liens and interests."    The sale closed on July 1, 2010 and resulted in net proceeds of $81,108.67.  
The Debtor subsequently proposed a plan that would pay creditors 1% on their claims.   On December 5, 2010, which was about seven months after the sale, the Trustee objected to the plan. The Trustee argued that the proceeds from sale of the homestead should be paid to creditors because they had not been reinvested within six months.   Of course, the proceeds could NOT have been reinvested within six months because the Trustee had been holding them.  
The Bankruptcy Court entered an interim order allowing the Trustee to retain sufficient funds to ensure a 100% distribution to creditors and returning $40,000 to the Debtor.  
On January 27, 2011, the Court conducted a hearing on the Trustee's Objection to the Motion to Sell Property Free and Clear of Liens.    This was odd because the prior order entered on March 26, 2010 did not indicate that the Court was reserving a ruling upon the Trustee's objection.   At this hearing, the Court ruled that the Debtor would be given six months in which to reinvest the proceeds.   Because the Trustee had been in possession of the proceeds, the Court held that the six month period would be tolled until January 27, 2011.    However, the Court also ruled that because the Debtor had spent $23,000.00 of the funds previously distributed to him for purposes other than buying a new homestead, that these funds had lost their exempt character and would have to be paid to creditors under the plan.   Thus, the Court gave and the Court gave away.   While the Court authorized payment of $40,000.00 to the Debtor, it took back $23,000.

The Debtor appealed to the District Court which affirmed.    The Court's ruling was limited to the $23,000 which was not reinvested.   While the record is not clear, apparently the other funds released to the Debtor were reinvested in a homestead since they were not mentioned again.

Note:   According to the Fifth Circuit, $18,000 was held in trust for the Debtor to purchase a new homestead and the remaining funds were paid to creditors.   This does not appear to accurately describe what transpired below.   The facts listed above are taken from my review of the Bankruptcy Court docket and orders rather than the Fifth Circuit's opinion.   

The Fifth Circuit's Ruling

The Fifth Circuit affirmed.   It held that Zibman applied to the post-petition sale of the homestead.   The Court found that while the Debtor's exemption was fixed on the petition date under the "snapshot" rule that "it is the entire state law applicable on the filing date that is determinative."   The Fifth Circuit rejected the argument that section 522(c) rendered the homestead and its subsequent proceeds permanently exempt.    The Court stated:
Frost’s homestead was exempted from the estate—when the rest of his assets were not—by virtue of its character as a homestead. As in Zibman, this “essential element of the exemption must continue in effect even during the pendency of the bankruptcy.” Id. Once Frost sold his homestead, the essential character of the homestead changed from “homestead” to “proceeds,” placing it under section 41.001(c)’s six month exemption. Because he did not reinvest those proceeds within that time period, they are removed from the protection of Texas bankruptcy law and no longer exempt from the estate.
Opinion, pp. 5-6.

The Fifth Circuit also ruled that the timing of the sale, whether pre or post-petition did not affect the analysis.  
This temporal distinction is insufficient to escape the holding of Zibman. The court’s insistence that an “essential element of the exemption must continue in effect even during the pendency of the bankruptcy case” indicates that a change in the character of the property that eliminates an element required for the exemption voids the exemption, even if the bankruptcy proceedings have already begun. Under this court’s precedent, (i) the sale of the homestead voided the homestead exemption and (ii) the failure to reinvest the proceeds within six months voided the proceeds exemption, regardless of whether the sale occurred pre- or post-petition.
Opinion, p. 6.   

The Court also rejected the argument that Schwab v. Reilly, 560 U.S. 770 (2010) preempted the Texas law.  Schwab v. Reilly divided exemptions into those which consist of a dollar amount versus those which attach to the thing itself. The Debtor argued that because the thing was exempt that it remained exempt.   As stated by the Debtor, Schwab held that "exempt is exempt."   The Fifth Circuit stated that "The rationale of Schwab simply does not apply to this case."    However, its stated rationale suggests that the Court did not understand the Debtor's argument.   The Court said that Schwab did not apply because Schwab involved an exemption limited by dollar amount and the Texas exemption was unlimited.   However, that really misses the Debtor's point that under Schwab, the thing itself was exempt and therefore could not return to the estate.

The Need for Reconsideration

The Fifth Circuit might want to take another look at this one.   For one thing, the opinion completely fails to appreciate the case's unique procedural posture which could have provided a more coherent basis for the Court's ruling.  It also seems to fumble the intersection between the Bankruptcy Code and Texas exemption law.   This could result in major mayhem in future cases.

This was a chapter 13 case.   As a result, property acquired post-petition is included in the estate.   11 U.S.C. Sec. 1306.   The proceeds from sale of the homestead could have been analogized to property acquired post-petition which would only be exempt if re-invested in a new homestead within six months.    As a result, the timing that would matter is whether the homestead was sold during the case or subsequently.    The expanded definition of property of the estate in a chapter 13 case could justify the result in the Frost case.   However, this was not discussed by the Court.  How would it be applied in a chapter 7 case?    Judge Tony Davis rejected the application of Zibman to a post-petition sale of a homestead in a chapter 7 case in a well-reasoned opinion in In re D'Avila, 498 B.R. 150 (Bankr. W. D. Tex. 8/21/13), which can be found here.   Hopefully the Circuit would agree with Judge Davis when faced with a Chapter 7 case.    However, like I said, the Frost decision does not make this clear.

I also think the Court was incorrect on the temporal issue.  When the Debtor filed bankruptcy on November 30, 2009, he owned a homestead.   By the time that he filed the Motion to Sell Property Free and Clear of Liens, the exemption on that property was final.   As a result, the property left the estate.   In the words of Neil Young, "once you're gone, you can't come back."   That applies to property of the estate as well.    Would the court hold that property sold free and clear of liens or abandoned could revert back to the estate after the debtor and third parties had acted in reliance?  I don't think so.
Additionally, the factual application of the case is contrary to Texas law.   Under Texas law, proceeds from a homestead remain exempt for six months.  The Debtor can do whatever he wants with the money during those six months.   If the Debtor spends the proceeds of the homestead on fine dining and poor investments, creditors can't get the money back.   However, the Bankruptcy Court held (and the reviewing courts agreed) that spending part of the homestead proceeds during the six month exemption period meant that a similar portion of the unexpended homestead proceeds lost their exempt character.   Huh?  That does not seem to make sense.   I think that the Debtor was on the right track.   Exempt is exempt with one caveat.   I would agree that if a debtor sells a homestead during a chapter 13 and has proceeds left over six months later, that the unexpended money would constitute property of the estate.   However, if the Debtor uses the money to buy a new home or spends it on wild living, it is simply not there to become property of the estate. 

The Court might also want to think about how Law v. Siegel affects this case.    In Law, the Ninth Circuit held that a Bankruptcy Court could surcharge a debtor's exempt property based on bad behavior.    The Supreme Court reversed, holding that the clear language of section 522(k) prevented the Court from using exempt property to pay administrative expenses regardless of the reason.   Section 522(c) says the same thing with regard to pre-petition claims.    Granted, Law v. Siegel was about the abuse of section 105 to override a clear statutory provision while the Court did not rely on section 105 in this case.   However, the result of undermining the statutory protection is the same and should make a difference.  

Proceed With Caution If This Opinion Remains the Law

If the Frost case remains good law, the only good advice to a debtor with a Texas homestead is plan to hold on to it indefinitely or be ready to buy a new homestead within six months.   Any other advice will place your client and your malpractice insurance at risk.   The other take away is never let the trustee hold the money from sale of your homestead.   Here, the trustee held on to the funds for six months and then tried to claim that the debtor had forfeited his exemption altogether.   Then when the Bankruptcy Court allowed some of the funds to be released to the Debtor without stating any conditions, the Court clawed that money back when it wasn't used for purchase of a homestead.   What the Debtor should have done in this case was to file his bankruptcy to get the benefit of the automatic stay and then dismissed or converted the case once the sale went through.   While this may seem like an abuse of chapter 13, it is a rational response to an irrational result.

Wednesday, March 05, 2014

Supreme Court Lays Down the Law in Law v. Siegel

In a unanimous decision, the Supreme Court struck down the Ninth Circuit’s imposition of an equitable surcharge against a debtor’s exempt property in Law v. Siegel, No. 12-5196 (3/4/14).  The opinion can be found here.    The opinion by Justice Scalia represents a limitation on the equitable powers of bankruptcy courts to override statutory protections, even when a debtor has behaved badly.   The case is a counterpoint to Marrama v. Citizen’s Bank, 127 S.Ct. 1105 (2007) which had read an equitable good faith requirement into the absolute right to convert a case.

What Happened

Debtor Law filed for chapter 7 protection in California which has a limited homestead exemption.   He claimed a $75,000 homestead exemption and also claimed that the property was encumbered by a first lien to Washington Mutual and a second lien in favor of “Lin’s Mortgage & Associates.” Had the liens been valid, there would have been no equity for the estate.   It turned out that the Lin lien was made up.   However, it took the trustee a lot of litigation to reach that result.    The Trustee spent over $500,000 trying to get to the bottom of the dispute, which involved a Lili Lin of Artesia, California who denied loaning the Debtor any money and a Lili Lin of China who most likely did not exist. 

When the Trustee ultimately sold the home, he sought to surcharge the Debtor’s $75,000 exemption with the costs of avoiding the fraudulent lien.    The Bankruptcy Court allowed the surcharge and was affirmed by the BAP and the Ninth Circuit.    Mr. Law submitted a pro se petition to the Supreme Court which granted cert.  I have previously written about the improbable grant of cert here.

The Ruling

Justice Scalia’s ruling is encapsulated in the first paragraphs of his analysis:
 A bankruptcy court has statutory authority to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of” the Bankruptcy Code. 11 U. S. C. §105(a). And it may also possess “inherent power . . . to sanction ‘abusive litigation practices.’ ” (citation omitted).   But in exercising those statutory and inherent powers, a bankruptcy court may not contravene specific statutory provisions.

It is hornbook law that §105(a) “does not allow the bankruptcy court to override explicit mandates of other sections of the Bankruptcy Code.”  (citation omitted).   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.  (citations omitted).   Courts’ inherent sanctioning powers are likewise subordinate to valid statutory directives and prohibitions.  (citation omitted).

We have long held that “whatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of” the Bankruptcy Code.  (citations omitted).  
 Opinion, pp. 5-6.

11 U.S.C. §522(k) expressly states that exempt property is not liable for any administrative expense except for costs incurred in allowing the debtor to avoid a transfer of exempt property.    Thus, the case posed a clear conflict between the statutory language of the Code and the Bankruptcy Court’s desire to punish a wrongdoer.

Justice Scalia easily brushed off the arguments made by the Trustee and the United States (appearing as amicus curiae).

The Trustee contended that his fees were not really administrative expenses, a contention that Justice Scalia promptly rejected.   

The Trustee and the United States argued that section 522 does not expressly prohibit denying an exemption based on bad conduct.   The U.S. argued that section 522 “neither gives debtors an absolute right to retain exempt property nor limits a court’s authority to impose an equitable surcharge on such property.”

Justice Scalia made the easy conclusion that the Trustee had waived his right to challenge the exemption by failing to object.    He went on to state that:
(E)ven assuming the Bankruptcy Court could have revisited Law’s entitlement to the exemption, §522 does not give courts discretion to grant or withhold exemptions based on whatever considerations they deem appropriate. Rather, the statute exhaustively specifies the criteria that will render property exempt. See §522(b), (d). Siegel insists that because §522(b) says that the debtor “may exempt” certain property, rather than that he “shall be entitled” to do so, the court retains discretion to grant or deny exemptions even when the statutory criteria are met.  But the subject of “may exempt” in §522(b) is the debtor, not the court, so it is the debtor in whom the statute vests discretion. A debtor need not invoke an exemption to which the statute entitles him; but if he does, the court may not refuse to honor the exemption absent a valid statutory basis for doing so.
Moreover, §522 sets forth a number of carefully calibrated exceptions and limitations, some of which relate to the debtor’s misconduct. For example, §522(c) makes exempt property liable for certain kinds of prepetition debts, including debts arising from tax fraud, fraud in connection with student loans, and other specified types of wrongdoing. Section 522(o) prevents a debtor from claiming a homestead exemption to the extent he acquired the homestead with nonexempt property in the previous 10 years “with the intent to hinder, delay, or defraud a creditor.”  And §522(q) caps a debtor’s homestead exemption at approximately $150,000 (but does not eliminate it entirely) where the debtor has been convicted of a felony that shows “that the filing of the case was an abuse of the provisions of ” the Code, or where the debtor owes a debt arising from specified wrongful acts—such as securities fraud, civil violations of the Racketeer Influenced and Corrupt Organizations Act, or “any criminal act, intentional tort, or willful or reckless misconduct that caused serious physical injury or death to another individual in the preceding 5 years.” §522(q) and note following §522. 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.   (citation omitted)(emphasis added).
Opinion, pp. 8-9.  

Justice Scalia also distinguished Marrama on the basis that it invoked a specific statutory condition (namely that the debtor could only convert if he was eligible to be a debtor under chapter 13) and that the Court was not so much overriding the statute as compressing multiple hearings into one.   He wrote:
True, the Court in Marrama also opined that the Bankruptcy Court’s refusal to convert the case was authorized under §105(a) and might have been authorized under the court’s inherent powers. Id., at 375–376. But even that dictum does not support Siegel’s position. In Marrama, the Court reasoned that if the case had been converted to Chapter 13, §1307(c) would have required it to be either dismissed or reconverted to Chapter 7 in light of the debtor’s bad faith. Therefore, the Court suggested, even if the Bankruptcy Court’s refusal to convert the case had not been expressly authorized by §706(d), that action could have been justified as a way of providing a “prompt, rather than a delayed, ruling on [the debtor’s] unmeritorious attempt to qualify” under §1307(c). Id., at 376. 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. 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.
Opinion, pp. 10-11.

Finally, Justice Scalia wrote that notwithstanding the burden to the Trustee, there were other avenues available to him under the Code and the Rules.
We acknowledge that our ruling 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. We have recognized, however, that in crafting the provisions of §522, “Congress balanced the difficult choices that exemption limits impose on debtors with the economic harm that exemptions visit on creditors.” (citation omitted). The same can be said of the limits imposed on recovery of administrative expenses by trustees. For the reasons we have explained, it is not for courts to alter the balance struck by the statute. (citation omitted).

* * *
Our decision today does not denude bankruptcy courts of the essential “authority to respond to debtor misconduct with meaningful sanctions.” Brief for United States as Amicus Curiae 17. There is ample authority to deny the dishonest debtor a discharge. See §727(a)(2)–(6). (That sanction lacks bite here, since by reason of a postpetition settlement between Siegel and Law’s major creditor, Law has no debts left to discharge; but that will not often be the case.) In addition, Federal Rule of Bankruptcy Procedure 9011—bankruptcy’s analogue to Civil Rule 11—authorizes the court to impose sanctions for bad-faith litigation conduct, which may include “an order directing payment. . . of some or all of the reasonable attorneys’ fees and other expenses incurred as a direct result of the violation.”  Fed. Rule Bkrtcy. Proc. 9011(c)(2). The court may also possess further sanctioning authority under either §105(a) or its inherent powers. (citation omitted). And because it arises postpetition, a bankruptcy court’s monetary sanction survives the bankruptcy case and is thereafter enforceable through the normal procedures for collecting money judgments. See §727(b). 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.

But whatever other sanctions a bankruptcy court may impose on a dishonest debtor, it may not contravene express provisions of the Bankruptcy Code by ordering that the debtor’s exempt property be used to pay debts and expenses for which that property is not liable under the Code.
Opinion, pp. 11-12.

What It Means

The way I read the opinion, Mr. Law gets to keep his $75,000 in exempt property, but is subject to sanctions under Rule 9011 and criminal prosecution under 18 U. S. C. §152.   The Trustee and the U.S. Attorney will no doubt figure this out so that Mr. Law’s victory may ultimately be hollow.   

Law v. Siegel reflects the tension between the fact that Bankruptcy Courts are nominally courts of equity but that they are subject to an often “mind-numbingly detailed” statutory scheme.   Any time there is a conflict between section 105 and another section, section 105 should lose out (especially if Justice Scalia is writing the opinion).   On the other hand, the statutory scheme and rules often creates alternative pathways to the desired result.  Here, the appropriate pathway was to allow the Debtor to keep his $75,000 in exempt property while imposing $500,000 in sanctions against him.    Mr. Law’s reward for having brought this abuse of equitable powers to the Supreme Court’s attention is that he may ultimately face a much more severe penalty.   

The Supreme Court’s decision in Law v. Siegel restores order to the bankruptcy universe.   Bankruptcy judges remain empowered to address misconduct in their courts.   However, they must do it using the tools granted by Congress in the Code and by the Supreme Court in the Bankruptcy Rules.   Justice Scalia has given the lower courts a reasonably low-key scolding that while the ends do not justify the means, if you look hard enough there is a legitimate means for every legitimate end.

On a more mundane note, the opinion contains a lot of good language about exemptions and equity which can be profitably quoted in a number of contexts.

Fifth Circuit practitioners may recognize that this case is reminiscent of In re Niland, 825 F.2d 801 (5th Cir. 1987).   In that case, Mr. Niland (who was a former Dallas Cowboy), obtained a loan on a condominium by claiming that it wasn’t his homestead.   The Bankruptcy Court granted a constructive trust against the property after voiding the invalid lien.   The Fifth Circuit reversed, finding that the Debtor could not be estopped from claiming his valid homestead rights.   However, he went to jail for two years for fraud.