A recent decision of the United States Court of Appeals for the First Circuit highlights a brewing conflict among the federal circuit courts regarding the scope, nature and extent of the U.S. Bankruptcy Court’s equitable powers under §105(a) of the Bankruptcy Code. On August 15, 2012, the First Circuit issued its decision in Malley v. Agin, 2012 WL 3326629 at *1, ___ F. 3d ___ (1st Cir. August 15, 2012), in which the First Circuit upheld the order by a Bankruptcy Judge for the District of Massachusetts imposing a surcharge on a Chapter 7 debtor’s interest in exempt property as a means of remedying that debtor’s improper concealment of other property of the bankruptcy estate from the Chapter 7 trustee and his creditors. The decision is contrary to a holding by the court of appeals for the Tenth Circuit in the case In re Scrivner, 535 F. 3d 1258 (10^th Cir. 2008) in which the court of appeals for that circuit overturned a similar order by the U.S. Bankruptcy Court for the Western District of Oklahoma.

The First Circuit in the Malley v. Agin decision rejected the reasoning of the Tenth Circuit in Scrivner and instead concurred in the Ninth Circuit decision, Latman v. Burdette, 366 F. 3d 774 (9^th Cir. 2004), which upheld the use of a surcharge of exempt property under §105(a) as a remedy for fraudulent concealment of non-exempt property by a debtor. These decisions are of interest both as a potential arrow in the quiver of a trustee where creditors are injured by a debtor’s concealment of assets that should have been included in the bankruptcy estate and also for the broader, statutory issue of the extent to which the bankruptcy court may use the broad grant of equitable powers under §105(a) to issue an order that is arguably inconsistent with other statutory provisions of the Bankruptcy Code. This was the dilemma that the courts wrestled with in these decisions.

Statutory and Legal Background

The bankruptcy court is a court of equity. Consistent with that status, the U.S. Bankruptcy Code includes a provision, §105(a), which provides a broad grant of authority to the Bankruptcy Court to issue “any order, process or judgment that is necessary or appropriate to carry out the provisions of this title [i.e., title 11 of the United States Code, which is the Bankruptcy Code].” The statute further provides that, “No provision of this title providing for the raising of an issue by a party in interest shall be construed to preclude the court from, sua sponte, taking any action or making any determination necessary or appropriate to enforce or implement court orders or rules, or to prevent an abuse of process.”

This statute has been used by courts as a basis to issue injunctive relief against prosecution of claims against non-debtor officers and shareholders of a debtor during the pendency of a case to prevent interference with the debtor’s reorganization efforts and to impose sanctions for misconduct by debtors and others in various factual circumstances. The statute has also been used to support the issuance of orders aimed at promoting the express statutory goals and provisions of the Bankruptcy Code and to prevent an abuse of its provisions, such as to grant in rem relief orders to make a relief from stay order binding on real property in the face of multiple, abusive filings.

On the other hand, the United States Supreme Court in Norwest Bank v. Ahlers, 485 U.S. 197 (1988) made it clear that the broad equitable powers of §105(a) cannot be used by the bankruptcy court in a manner that is inconsistent with express statutory provisions of the Bankruptcy Code: “whatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of the Bankruptcy Code.” See Norwest Bank v. Ahlers, 485 U.S. at 207.[1]

The Split Among the Circuits

In Malley v. Agin, the debtor had wrongfully concealed from the Chapter 7 trustee and his creditors his receipt of $25,000 in proceeds from the sale of his residence, which should have been included in his bankruptcy estate. The funds had been expended, and the only asset the debtor had as a source of possible recovery of the value of the funds that should have been included in the estate was his interest in a motor vehicle, which was exempt under the provisions of the Bankruptcy Code and had been claimed by the debtor as exempt on his schedules without objection.

The vehicle was a truck the debtor used in his business and was the only significant asset available to the debtor to be used for his fresh start. Nevertheless, when the Chapter 7 trustee discovered the undisclosed $25,000 in funds which should have been included in the estate, the Chapter 7 trustee sought an order of the bankruptcy court surcharging the debtor’s otherwise exempt vehicle for the amount of the missing, undisclosed assets.

The bankruptcy court imposed the surcharge as a sanction for the debtor’s violation of his duties of disclosure and to compensate the estate for the loss resulting from the non-disclosure and the loss of the sale proceeds. The First Circuit affirmed and found that the order met all the requirements of §105(a) as it was issued to prevent an abuse of process, was necessary to prevent that abuse and was issued to implement the provisions of the Bankruptcy Code — namely the requirement for full and complete disclosure of a debtor’s assets under §521 of the Bankruptcy Code.

The court rejected the debtor’s argument that issuance of the order violated the code provisions that made the property in question exempt and therefore was an improper equitable order issued in violation of an express statutory provision of the code, since the First Circuit reasoned the exemption provisions were intended to apply to “legitimate” exemptions and not to allow a debtor to obtain additional exempt assets through fraud and non-disclosure.

The First Circuit also addressed the contrary ruling of the Tenth Circuit in the Scrivner case. In Scrivner, the Tenth Circuit reversed an order surcharging a debtor’s exempt retirement account funds to compensate the estate for the debtor’s receipt of non-exempt distributions, which the debtor should have turned over to the estate but failed to. The Tenth Circuit held that the traditional remedy for violation of a court order was civil contempt and that other statutory provisions of the Bankruptcy Code; namely, the code provisions for objecting to a debtor’s discharge, enumerated the remedies available to the Court to impose on a debtor for non-disclosure or concealment of estate assets. The Tenth Circuit reasoned that the imposition of the surcharge was contrary to the express statutory scheme enacted by Congress, and as a result, was beyond the bankruptcy court’s equitable powers under §105(a).

Although cognizant of the Ninth Circuit’s ruling in Latman v. Burdette, supra, the Tenth Circuit ruled that “because the surcharge of exempt property is inconsistent with the Code’s provisions governing exemptions and debtor misconduct, it is beyond the scope of a bankruptcy court’s equitable authority under §105(a). Section 105(a) does not empower courts to create remedies and rights in derogation of the Bankruptcy Code and Rules.” See In re Scrivner, 535 F. 3d at 1265.

In rejecting the Tenth Circuit’s more narrow view of the bankruptcy court’s equitable powers under §105(a) in these circumstances, the First Circuit viewed the misconduct by the debtor and remedying that misconduct as the paramount concern that authorized the Bankruptcy Court to act. As the court stated, “[T]here could not be a clearer example of foiling abuse of process than a surcharge order mitigating the effect of fraud in retaining non-exempt assets and thus enhancing the set-aside for a fresh start beyond the amount Congress provided for the honest debtor.” See Malley v. Agin, 2012 WL 3326629 at *2.

The concern of the First Circuit seemed to be providing effective monetary remedy to the estate to restore at least in part the assets of the bankruptcy estate, so that the estate would have the additional assets that should have been in the estate, but for the debtor’s misconduct, and so that the debtor would not benefit by retaining additional property beyond the amount of property he would have had if he had properly disclosed his assets. As a result, these rulings by the First and Ninth Circuits have great practical appeal and promote the interests of creditors by restoring assets to the estate that should have been available for creditor distributions.

The Tenth Circuit’s contrary ruling creates a direct split among the circuits on this issue. Therefore, in light of the binding effect of the circuit court rulings on bankruptcy courts within their jurisdictions, until the issue is resolved by the Supreme Court, similar misconduct by debtors will result in different remedies being imposed depending upon the district in which the case is filed. While the issue cries out for a definitive ruling by the U.S. Supreme Court, it is uncertain when and if one of these cases will be presented to the Supreme Court for determination given that amounts involved are often modest, as this case illustrates.

Lesley Anne Hawes, a partner in the Los Angeles office of McKenna Long & Aldridge, LLP, specializes in the representation of secured and unsecured creditors in bankruptcy proceedings and in the representation of federal equity receivers appointed in civil enforcement actions by federal agencies such as the Federal Trade Commission and Securities and Exchange Commission. Hawes is a regular contributor to the Monitor and other legal journals, and she has lectured for the National Business Institute and other organizations. She graduated Order of the Coif from University of Southern California law school and earned her undergraduate degree in political science magna cum laude from University of Southern California.