Surcharging Exemptions

The bankruptcy court has the power to surcharge a debtor’s exemptions.  What does this mean?  When an exemption is surcharged, the court takes the exemption away from the debtor; because the debtor committed a wrongful act that caused waste to the bankruptcy estate.  This is a controversial practice because there is nothing in the Bankruptcy Code that explicitly permits the court to do this.  Instead, the court relies on its equitable powers under 11 U.S.C. § 105.  Basically, 11 U.S.C. § 105 is a catch-all provision that gives the court power to do things that are for the benefit of the integrity of the bankruptcy system, but not actually defined anywhere in the Bankruptcy Code.  This is controversial for two reasons.
Surcharging Exemptions Harms Debtors
First, it is controversial because it can hurt debtors very badly.  Imagine that you have a house with $85,000 in equity.  The Washington State homestead exemption protects up to $125,000 in equity.  When you file bankruptcy, you justifiably believe that your house is safe.  Now let’s say that you get into a dispute with the trustee over some property.  You choose to litigate the dispute and lose.  The trustee collects the property, but that property is worthless to your creditors, because the trustee had to pay litigation expenses.  So what does the trustee do?  The trustee files a motion to surcharge your homestead exemption.
If the court grants the motion to surcharge your homestead exemption, then the trustee gets to sell your house; but you don’t get to apply your homestead exemption.  This means that you could be current on your mortgage, have equity that is 100% protected by the homestead exemption, and still lose your house; all because you decided to litigate.  That is exactly what happened in the case of Law v. Siegel that is going to be heard by the US Supreme Court in October, 2013.
Surcharging Exemptions Is Not Regulated By Statute
The second reason that surcharging exemptions is controversial is that it is not regulated by statute.  A bankruptcy court cannot surcharge your exemptions simply because you litigated with the trustee and lost.  The court has to find that you committed some kind of act of bad faith or an act that was intended to harm either the bankruptcy estate or the integrity of the bankruptcy process.  The problem is that there is no clear standard for how a court determines your exemptions should be surcharged or whether your actions damaged the integrity of the bankruptcy process.  See Lattman v. Burdette, 366 F.3d 774, 785 (9th Cir. 2004) (originally a Seattle bankruptcy case).
Basically, “integrity of the bankruptcy process” is defined by the bankruptcy judge using their equitable authority under 11 U.S.C. § 105.  This is problematic because exemptions are defined under 11 U.S.C. § 522.  That section states what exemptions are available and the limitations on those exemptions.  Significantly, there is no provision for surcharging exemptions in Section 522.  This is problematic for bankruptcy practitioners, because it can be difficult to predict when you are at risk for having your exemptions surcharged.
Conclusion
Exemptions are only very rarely surcharged.  It is not something that the average debtor needs to worry about.  However, exemption surcharging is a very serious matter when it occurs.  In some cases, it is obvious why an exemption was surcharged.  For example, a debtor hid property or committed bankruptcy fraud.  In other cases, it is less clear.  My concern is that an aggressive creditor will push the trustee to litigate; and that litigation will result in surcharged exemptions.  This is a big issue in bankruptcy law that has been unresolved for some time.  Hopefully, the US Supreme Court will shed some light on whether surcharging exemptions is permissible and under what circumstances.  The ideal solution would be for Congress to amend the Bankruptcy Code to explicitly provide for or prohibit exemption surcharging.
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