Supreme Court decision may benefit debtors

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A U.S. Supreme Court decision that went against a debtor last week may actually prove to be a boon for future consumer debtors.

In a 6-3 decision authored by Justice Clarence Thomas, the court ruled that a bankruptcy trustee could seek to recover a debtor's personal property that she had declared exempt in her Chapter 7 case.

In Schwab v. Reilly (PDF), the debtor had indicated in her bankruptcy schedules that she wished to exempt certain property and the trustee failed to object during the 30-day time period. But he later objected to the exemption when an appraisal revealed that the value of the property might exceed the debtor's estimated value.

Although the debtor technically lost, the decision "is a positive one for debtors generally," explained Henry Sommer, a Philadelphia attorney and former president of the National Association of Consumer Bankruptcy Attorneys, because the court provided language that a debtor can use if he or she intends to exempt the full value of an asset.

"Lawyers [just] have to be very aware and use the 'magic words' provided by the Court if a debtor wants an asset to be fully exempt," Sommer said.

While the road map provided by the justices will guide debtors' counsel, O. Max Gardner III, a bankruptcy practitioner in Shelby, N.C., said that the decision will result in a greater burden on bankruptcy trustees and increased workload for bankruptcy courts.

"The decision will create a tremendous amount of work for trustees because if the trustee doesn't object to the debtor's exemption and it turns out that the full value of the property exceeds the amount of the exemption, the estate loses," he said.

As a result, trustees will routinely object to debtors' exemptions, Gardner predicted.

The burden may also fall on Chapter 13 trustees, he noted, because many Chapter 13 bankruptcy filings end up converting to a Chapter 7. In those cases, the Chapter 13 trustee would need to object to an exemption in order to preserve the objection for the Chapter 7 trustee in the event of conversion.

And an increase in objections and fights over exemptions means more paperwork and legwork for the courts, Gardner said.

Trustee objects

In the Schwab case, debtor Nadejda Reilly filed for Chapter 7 bankruptcy protection when her catering business failed.

On her Schedule B listing of assets, she included an itemized list of cooking and other kitchen equipment which she described as "business equipment" and gave it an estimated market value of $10,718.

She then claimed two different exempt interests in the equipment on her Schedule C, which totaled the same amount ($1,850 as "tools of the trade" under 11 U.S.C. §522(d)(6) and $8,868 as a "wildcard" exemption under §522(d)(5)).

The trustee did not object to the exemption within the 30-day period prescribed by Federal Rule of Bankruptcy Procedure 4003(b). But when an appraisal showed that the property could be worth as much as $17,200, the trustee filed a motion to sell the property in order to recover for creditors the amount above the claimed exemption.

The bankruptcy court, a U.S. District Court and the 3rd Circuit all disagreed, holding that the debtor had indicated her intent to exempt the equipment's full value.

But the justices disagreed.

The trustee had no duty to object to the property the debtor claimed as exempt because the stated value of each interest was within the limits allowed by the Bankruptcy Code, the court said.

"Accordingly, we hold that [the trustee] was not required to object to [the debtor's] claimed exemptions in her business equipment in order to preserve the estate's right to retain any value in the equipment beyond the value of the exempt interest," the court said.

Justice Ruth Bader Ginsburg wrote a dissent in which Chief Justice John G. Roberts, Jr. and Justice Steven Breyer joined.

The magic words

Most importantly for consumer debtors and their attorneys, the Court added some clear directions for future consumer bankruptcy cases.

"Where, as here, it is important to the debtor to exempt the full market value of the asset or the asset itself, our decision will encourage the debtor to declare the value of her claimed exemption in a manner that makes the scope of the exemption clear, for example, by listing the exempt value as 'full fair market value (FMV)' or '100% of FMV.' Such a declaration will encourage the trustee to object promptly to the exemption if he wishes to challenge it and preserve for the estate any value in the asset beyond relevant statutory limits. …

"If the trustee fails to object, or if the trustee objects and the objection is overruled, the debtor will be entitled to exclude the full value of the asset. If the trustee objects and the objection is sustained, the debtor will be required either to forfeit the portion of the exemption that exceeds the statutory allowance, or to revise other exemptions or arrangements with her creditors to permit the exemption," the court said.

Going forward, "it is malpractice" for a debtor's lawyer not to use the magic words, Gardner cautioned.

Some lawyers are already prepared for the new language.

Marc Stern, a bankruptcy practitioner in Seattle, said that because he had faced the issue in several cases, he already includes language in his clients' schedules to indicate that they wish to exempt the entire value of the asset.

One concern addressed by Justice Ginsburg in her dissent: pro se debtors filling out their bankruptcy forms won't know the "magic words."

Sommer said that he has already heard rumors that the Bankruptcy Rules Committee may amend the forms to put a checkbox or to add some additional information to guide debtors.

The decision also serves as a reminder to practitioners to act like lawyers and not petition preparers, Stern said.

"Some people think bankruptcy is about simply filling out forms, but you really have to think about this stuff," he said. "Think about when to file and how to file – think about what you are disclosing, and think carefully about what your intention is and how you claim exemptions."

Correy Stephenson can be reached at [email protected].