Will the Supremes Trim Back Bankruptcy Courts' Powers?

In addition to the fair housing case that Alan noted, the Supreme Court also granted cert in a bankruptcy case, Law v. Siegel. Having listened to many bad jokes about my last name over the years, my initial reaction was to set up an over/under pool on how many bankruptcy newsletters and blogs will run articles under a title that has a bad pun on "Law v. Siegel" such as "Supreme Court Lays Down the 'Law' on Bankruptcy Exemptions." Because U.S. governmental authorities are protecting us from the tyranny that was InTrade, my over/under challenge will have to remain hypothetical.

My second reaction was to wonder what trivial bankruptcy issue the Court now had deemed cert-worthy while it seems to pass on more important cases. This time, however, the Court has picked up an important issue on which the lower courts had split. More significantly, the case presents an opportunity for the Court to address the universal solvent of the Bankruptcy Code--the provision that bankruptcy judges and lawyers seize upon when all else is against them--namely section 105 of the Bankruptcy Code.

This case started when the debtor claimed a first mortgage of $147,000 and a second mortgage of $157,000 on real estate valued at $363,000. The mortgages combined with the debtor's $75,000 homestead exemption seemed to leave no value for creditors. Upon investigation, the chapter 7 trustee came to suspect the second mortgage was perhaps entirely fictitious. The trustee's suspicions seem to have been well-founded. After years of litigation and numerous appeals, the bankruptcy court held the second mortgage invalid. By this time, the house had been sold. Had the debtor not falsely claimed a second mortgage, the sales price would have been enough to pay the first mortgage in full, unsecured creditors in full, and give debtor his $75,000 homestead exemption. Instead, in defending against the debtor's claims the trustee had incurred attorneys' fees that exhausted the funds available to pay creditors. Consequently, the bankruptcy court granted the trustee's motion to surcharge the debtor's homestead exemption with the consequence that $75,000 that would have gone to the debtor would instead go to the trustee.

The issue for the Supreme Court is whether the bankruptcy court has the power to surcharge a debtor's exemptions. On the one hand, the same Congress has included section 105 in the Bankruptcy Code which gives courts the power to "issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of" the Bankruptcy Code. Whatever else it might do, section 105 would seem at least to give courts the power to right the wrongs caused by a malefactious litigant. On the other hand, Congress has enacted a fairly detailed statutory scheme that lays out exactly the exemptions to which a bankruptcy filer is entitled, and the courts should not use the general language in section 105 to set asunder what Congress has specifically directed elsewhere.

Like many cases that make it to the Supreme Court, there are very strong legal arguments on both sides. The appeals courts have split on the issue with the First and Ninth Circuits ruling that section 105 permits a surcharge of exemptions and with the Tenth Circuit ruling it does not. If I got a vote, I probably would side with the First and Ninth Circuit for the practical reason that the bankruptcy courts do a good job on the whole and giving bankruptcy judges more discretion, not less, is usually a good thing.

What concerns me--and what I am guessing concerns the Supreme Court--is the unravelling of the statutory scheme that can occur once we start using section 105. In a moot court, a student once kept wanting to argue section 105 to me and constantly told me that section 105 gave a bankruptcy court "equitable powers." I kept pointing out the many other places in the Bankruptcy Code that specifically directed a result against his hypothetical client, but he kept coming back to section 105. Intrigued, I asked the student what he thought it meant for a court to have "equitable powers," and he gave a refreshingly candid answer: "It means the court can do whatever they need to do to reach a fair result." But, as I have discussed on the blog previously, this reasoning leads to the "Bill & Ted" problem: "If we can trust the courts to do what is right, why don't we just have one statute that reads 'Be excellent to each other.' Once you commit to the idea that the legislature writes the rules, the courts have constraints."

My example could perhaps be dismissed as only the legal argumentation of a lawyer-in-training, but my student was using section 105 only because there were cases that used section 105 to reach the result he was wanting. Also, the broad use of section 105 extends into large corporate reorganizations. With only a small amount of humorous exaggeration intended, a chapter 11 lawyer once told me that my business reorganizations class should just be a class in section 105. Many questionable practices that have arisen in chapter 11 reorganizations rely on section 105.

Given the egregious facts in Law v. Siegel, my guess is that the Supreme Court will be loathe to rule the courts lacked any power to sanction the debtor's conduct. At the same time, the current justices do not seem fans of unbridled judicial discretion. They very well could use the case to set out some guidelines and restrictions on the appropriate use of section 105. Such an opinion would not only change bankruptcy moot court as we know it but also have an even bigger and perhaps salutary effect on the bankruptcy system as a whole.