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Mar 4, 2014

Steve Gubner and Mike Davis Appear in Los Angeles Daily Journal

Steve Gubner and Mike Davis wrote an article titled “Justices consider bankruptcy tale of ‘Lili Lin of China,'” which appeared in the Los Angeles Daily Journal on February 27, 2014.

A full version of the article can be found below:

Justices consider bankruptcy tale of ‘Lili Lin of China

By Steven Gubner and Michael Davis

To bankruptcy practitioners, it was probably something of a shock that last year the Supreme Court granted certiorari in two bankruptcy cases. In Executive Benefits Insurance Agency v. Arkison, 12-1200, the Supreme Court is expected to revisit, clarify, or modify altogether its holding in Stern v. Marshall, 131 S.Ct. 2594 (2011), which called into question the constitutionality of the bankruptcy courts’ longperceived authority to enter final judgments in preference and fraudulent conveyance cases. The second case, and the subject of this article, is Law v. Siegel, 12-5196, which involves the nature and extent of a bankruptcy court’s power, pursuant to 11 U.S.C. Section 105(a), to order equitable forfeiture of a claim to a statutory exemption. In Law, the exemption at issue is a homestead exemption, and its forfeiture would compensate the bankruptcy estate and its professionals, at least partially, for the fees and costs incurred as a direct result of a debtor’s manipulation of the bankruptcy system and sustained bad-faith litigation tactics.

The facts before the Supreme Court in Law are not subject to reasonable dispute. The debtor lied, and lied often. He lied about the nature and extent of his assets and his debts. He lied about the value of his home. He lied about the amount of debt encumbering his residence. He undertook an extensive and pervasive effort to create a fictional woman, “Lili Lin,” to whom he supposedly owed a debt secured by his residence (and not surprisingly, that lien created the fiction that the debtor had no equity in his personal residence). The trustee argued that the lien was filed by the debtor in advance of an anticipated state-court judgment against him; again an effort by the debtor to evade his creditors. Unfortunately, due to the requirements that an objection to an exemption must be filed within 30 days of the completion of the 341(a) examination (see Rule 4003, Federal Rules of Bankruptcy Procedure), the trustee did not object to the bad-faith homestead exemption because the fraud was discovered much later in the case.

The trustee, suspicious of the lien claimed against the debtor’s residence, commenced an adversary proceeding against Lili Lin (the alleged lienholder). Eventually a “Lili Lin of Artesia, California,” came forward and admitted to the trustee that the debtor had in fact approached her and asked her to be a participant in the fraud. Lili Lin of Artesia refused to facilitate the debtor’s fraud on the bankruptcy court. Faced with this reality, the debtor’s story changed. Although Lili Lin admitted to speaking with the debtor about the fraud, the debtor noted that it was a different Lili Lin for whose benefit the lien had been recorded. This “Lili Lin” apparently lived in China and spoke no English. The debtor promulgated these lies for nearly six years. Eventually, after appeals of more than a dozen related bankruptcy court orders, and at great expense to the bankruptcy estate and its employed professionals, the trustee prevailed – the debtor’s misconduct was brought to light, and the lien in favor of “Lili Lin of China” was avoided.

All of this litigation was not without expense to the estate. In response to the debtor’s conduct, the estate’s professionals incurred hundreds of thousands of dollars in attorney fees. The debtor’s nonexempt assets were not sufficient to repair the harm done to the estate by virtue of the debtor’s fraudulent statements and meritless appeals. The trustee then sought to “surcharge” the equity in the debtor’s home that had been claimed exempt pursuant to California Civil Code Section 704.730 (the “homestead exemption”). Based on the debtor’s misconduct, the bankruptcy court eventually found that the debtor’s egregious and sustained misconduct was a basis, pursuant to 11 U.S.C. Section 105(a), to order the forfeiture of the debtor’s homestead exemption in the amount of $75,000. These funds were to be directed to the estate, as partial compensation for the costs incurred by the trustee and his professionals in connection with the bad-faith litigation commenced by the debtor, which persisted for nearly a decade. Naturally, the debtor appealed that bankruptcy court’s ruling. In 2009, the Bankruptcy Appellate Panel for the 9th Circuit affirmed that ruling, finding that the debtor had “engaged in inequitable conduct, bad faith, and fraud on a truly egregious scale.” Yet again, the debtor appealed. In 2011, the 9th U.S. Circuit Court of Appeals affirmed. Believe it or not, the debtor then sought review by the U.S. Supreme Court. The matter was argued Jan. 13, and is currently under submission.

The lower courts were asked to determine whether the debtor had acted in such an appalling manner that forfeiture of his homestead exemption was necessary. The issue before the Supreme Court goes beyond the debtor’s bad conduct. It will decide the nature and extent of the bankruptcy court’s inherent equitable/sanctioning authority under 11 U.S.C. Section 105(a). The question is not whether the debtor’s bad-faith conduct justified the court-ordered forfeiture of the homestead exemption, but rather, if 105(a) does not grant this authority then what resources does the Bankruptcy Code provide to bankruptcy judges (or bankruptcy trustees) to police abusive debtors?

This case highlights the bankruptcy courts’ need for workable mechanisms to enforce the underlying spirit of the Bankruptcy Code, especially in extreme circumstances like those presented by Law v. Siegel. In fact, this case is of particular significance because if the debtor’s conduct is not enough to permit a bankruptcy court to surcharge his exempt assets to compensate an estate, then it is likely that no conduct will. And if no conduct suffices, then it is likely that bad-faith debtors more likely than not will get away with the type of conduct discussed herein, especially when the assets of any given estate are minimal. If it is not economically feasible for bankruptcy trustees to ferret out this type of conduct in order to preserve the integrity of the bankruptcy system, then who can? More importantly, who will?

Steven Gubner is a partner with Brutzkus Gubner LLP. He can be reached at sgubner@bg.law.

Michael Davis is an associate with Brutzkus Gubner LLP. He can be reached at mdavis@bg.law.

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