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Could lies during personal bankruptcy bring exemption forfeiture?

According to the U.S. Supreme Court, the purpose of our nation’s Bankruptcy Code is to help the “honest but unfortunate debtor” get a fresh financial start, and the vast majority of people who file for personal bankruptcy under Chapter 7 and Chapter 13 fit just that description.

In a new case before the Supreme Court, however, the debtor was not honest. According to findings by the 9th Circuit, when this debtor filed for Chapter 7 he owned a home worth an estimated $360,000. The two mortgages against it, a $150,000 primary mortgage and a second for $160,000, however, justified the bankruptcy.

In Chapter 7, homes are at least partially exempt from liquidation. In this case, the homestead exemption was $75,000. Luckily for this debtor, the home sold at a price high enough that even after the $75,000 he got to keep, the proceeds paid off his creditors.

The problem was, the second mortgage was fake. The dedicated Chapter 7 trustee, however, only rooted out that fact after racking up some $450,000 in administrative fees.

Lying in bankruptcy is a bad idea. Not only can it be prosecuted as criminal fraud, it can result in the so-called bankruptcy “death penalty” -- a complete dismissal of the petition. This is the only and harshest weapon the courts were granted in the Bankruptcy Code.

Unfortunately, dismissing this debtor’s Chapter 7 petition didn’t have any impact because the creditors had already been paid. The only person still owed any money was the Chapter 7 trustee. And, while debtors can be held responsible for administrative fees, homestead exemption money can’t be used to pay them.

Dismissal could not be the only punishment allowed, the outraged bankruptcy judge decided. He pointed to a section of the Bankruptcy Code giving courts the right to “take any action necessary or appropriate to carry out the provisions” of the law and ordered the debtor to fork over his $75,000 to the trustee. Two appellate courts agreed.

Yet the statutory footing of the “any action” ruling is shaky. Such a general rule wouldn’t ordinarily be considered to overrule more specific provisions in the code such as those laying out the penalty for lying and the prohibition against using homestead exemption funds for administrative purpose.

Will the Supreme Court allow a penalty the Bankruptcy Code doesn’t specifically authorize? A ruling is expected sometime this fall.

Source: SCOTUSblog, "Argument recap: Justices find little sympathy for lying bankrupt," Ronald Mann, Jan. 15, 2014

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