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How Bankruptcy Fails Creditors: The Loopholes for Exemption Fraud

The fraudulent assertion of property exemptions in bankruptcy— a specific type of perjury-- is an ongoing problem that represents an attack against creditors and the bankruptcy system. Within the Ninth Circuit, exemption fraud continues to occur for several reasons.

First, Congress facilitated it by creating an “exemption by default” scheme through which a claimed exemption is allowed if not timely challenged. See generally Taylor v. Freeland & Kronz, 503 U.S. 638 (1992). There may be risks to fraudulent exemption claims (such as the risk of having a discharge denied). Exemptions, however, have value. Therefore, debtors have an incentive to claim exemptions for which they do not qualify if the risks of doing so are perceived to be outweighed by the potential gain.

Second, the 2014 decision in Law v. Siegel, - U.S. -, 134 S.Ct. 1188 (2014), is widely understood as having overruled precedents authorizing bankruptcy courts to use their equitable powers under 11 U.S.C. § 105 to disallow exemptions claimed in bad faith. In Siegel, the Supreme Court indicated that Congress had carefully provided for the allowance and disallowance of exemptions and, by virtue of a statutory provision barring the use of an exemption to pay administrative expenses, courts could not use their Section 105 powers to “surcharge” a debtor’s homestead exemption to compensate for losses caused by debtor fraud. Nevertheless, the Court indicated that state exemptions are subject to state law and state law (as opposed to Section 105) might provide a basis for disallowing exemptions.

The efficacy of the “state law” approach remains to be seen. It has widespread potential application. California, for example, is an “opt out” state that requires California debtors to claim exemptions available under California law. The trick, then, is to find support in California law to disallow exemptions. Some courts have held California law authorizes the use of doctrines like equitable estoppel to disallow exemptions rooted in state law. See In re Lua, 692 Fed. App’x 851 (9th Cir. 2017) (reversing bankruptcy court for misapplication of equitable estoppel, but not its conclusion that equitable estoppel is available as a basis for disallowing exemptions); In re Gonzalez, 2017 WL 2787594, *7 (Bankr. C.D. Cal. 2017) (disallowing homestead exemption on grounds of equitable estoppel). At least one pro-debtor organization, however, is actively campaigning against these developments.

Third, until recently bankruptcy courts in the Ninth Circuit followed In re Carter, 82 F.3d 1027 (9th Cir. 1999). Carter interpreted Federal Rule of Bankruptcy Procedure 4003 as placing the burden of disproving a claimed exemption on the objecting party. Carter became untenable in 2000 with the decision in Raleigh v. Illinois Dep’t of Revenue, 530 U.S. 15, 120 S.Ct. 1951 (2000). It was not until after the decision in In re Jacobson, 676 F.3d 1193 (9th Cir. 2012) (recognizing that state exemptions are governed by all state law), however, that bankruptcy courts pushed back against the Ninth Circuit and issued decisions holding that Carter was no longer good law. These decisions (emanating from the Bankruptcy Court for the Eastern District of California in 2015) hit pay dirt in 2016 when the Ninth Circuit’s Bankruptcy Appellate Panel decided In re Diaz, 547 B.R. 329 (9th Cir. BAP 2016). Diaz holds that when a debtor is claiming a state exemption and the state exemption statute places the burden of proof on the debtor, the debtor—even though in bankruptcy—will have the burden of proof on his or her exemption claims as in state court. Id. at 337 (“[w]here a state law exemption statute specifically allocates the burden of proof to the debtor, Rule 4003(c) does not change that allocation”).

Fourth, some members of the consumer debtor bar view the exemption-by-default regime as a standing invitation to claim exemptions without any concern for their application. They seem to rationalize their conduct as “advocacy” for clients to which creditors are free to respond. These practitioners also appear to discount the risk their clients might be denied a discharge, for any attempt to deny a discharge through a showing of fraud can be met with an “advice of counsel” defense. Diaz restores some balance in favor of beleaguered creditors, but is of no use unless a trustee or creditor timely challenges the exemption claim.

Fifth, economics plays a role. Trustees, particularly in cases filed as “no asset” cases, are unlikely to exert themselves over exemptions claims of modest amount. Ordinarily exemption claims are challenged only when the claims are large and the challenger has some expectation the effort will be productive for the challenger. For this reason, most of the cases challenging exemption claims involve homesteads and retirement assets. Further, when the challenge is brought by a creditor the challenging creditor generally expects to enjoy the lion’s share of the benefits of the challenge (i.e., there are few “free riders” or the challenger’s claim against the debtor is of substantially greater magnitude than any other creditor claims).

Copyright (c) 2017, Charles Q. Jakob. All Rights Reserved.

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