The case, In re David Hill (Stornawaye Financial Corporation v. Hill), 562 F. 3d 29 (1st Cir. 2009), addressed the debtor’s right to claim a homestead exemption on property that was the subject of a prepetition fraudulent conveyance where title to the property was returned to the debtor prior to the bankruptcy filing in the face of pressure by a creditor. The stakes in the Hill case were high for creditors: the property was the debtor’s residence, the homestead exemption was in the amount of $500,000 under Massachusetts state law, and the exemption amount effectively wiped out any potential equity available for creditors from that asset.

The Bankruptcy Court ruled that the debtor was not entitled to that exemption given that he had fraudulently transferred his interest in the property prepetition. The Bankruptcy Appellate Panel for the First Circuit reversed, and the First Circuit affirmed the Bankruptcy Appellate Panel’s decision, holding that the plain language of the Bankruptcy Code’s exemption statute, 11 U.S.C. §522, did not support denial of the exemption when the factual circumstances of the recovery of the property did not fit within the terms of the statute and that the courts were bound to apply that plain language regardless of the Bankruptcy Court’s view of the equities between the parties.

Factual Background
The debtor, David Hill, had personally guarantied a loan to a corporation. The loan was acquired by the creditor Stornawaye Financial Corporation, which held the note to the corporation and the related personal guaranty. Four years later, the debtor and his wife sold their residence and purchased a $1 million residence as tenants by the entirety in Massachusetts, with a $450,000 mortgage and the remainder of the purchase price paid in cash. Within a few months after the purchase, the debtor and his wife transferred title to the Massachusetts residence into the name of the wife for $1 and the wife recorded a declaration of homestead.

The creditor subsequently sued to collect the balance owed on the guarantied debt and sought an attachment against the property, alleging the debtor and his wife fraudulently transferred title to the Massachusetts residence to the wife. In the face of these allegations, the debtor’s wife reconveyed title to the residence into the name of both the debtor and his wife as tenants by the entirety, and immediately after title to the property was restored to the debtor and his wife, the debtor recorded a declaration of homestead.

Approximately three months after the suit was commenced by the creditor, and two months after the restoration of title to the property to the debtor and his wife and recordation of the homestead, the debtor filed a voluntary Chapter 7 petition. The debtor elected the state exemption scheme as generally permitted under the Bankruptcy Code, including the $500,000 homestead exemption provided under Massachusetts law.

The creditor filed an adversary proceeding against the debtor in Bankruptcy Court seeking denial of a discharge and also seeking denial of the debtor’s right to assert the homestead exemption, in addition to other relief. The Bankruptcy Court ruled the debtor should be denied a discharge based on the debtor’s failure to disclose and turn over tax refunds timely as well as his prepetition fraudulent transfer of the residence. The Bankruptcy Court also held that the debtor’s fraudulent transfer of the property should preclude him from asserting a claim of exemption as to the transferred property, under Bankruptcy Code §522(g), because the property had been voluntarily transferred and then recovered through the creditor’s efforts. The First Circuit Bankruptcy Appellate Panel affirmed the denial of the discharge but held that the provisions of §522(g) of the Bankruptcy Code did not preclude the debtor from asserting his homestead exemption as to the residence because the statute only precludes the debtor from asserting such an exemption where the trustee recovers the property for the estate.

Statutory Framework
At the heart of the decision is the language of §522(g), which allows the debtor to exempt property that had been transferred and “that the trustee recovers under §510(c, 542, 543, 550, 551 or 553) of the Bankruptcy Code if two conditions are met. First, the transfer must not have been a voluntary transfer by the debtor. See 11 U.S.C. §522(g)(1)(A). Second, the debtor must not have concealed the property that was transferred. See 11 U.S.C. §522(g)(1)(B).

The creditor argued that this statute precludes a debtor who voluntarily transfers property that is later recovered and included in the bankruptcy estate from asserting any exemption covering that property. The creditor argued that the debtor in that case voluntarily transferred the property and the property was only recovered in the face of the creditor’s lawsuit. The creditor also asserted that the provisions of §522(g) are intended to punish a debtor by depriving the debtor of the right to assert an exemption as to property, which the debtor voluntarily transferred or concealed. The First Circuit disagreed with all of these arguments.

Plain Language and Equitable Purposes of the Statute
The First Circuit analyzed the provisions of §522(g) and refused to extend the clear statutory terms to the recovery of property through by a creditor’s actions prepetition. The First Circuit pointed out that the only property subject to the provisions of §522(g) by its plain language is property “that the trustee recovers” under the specified provisions of the Bankruptcy Code. The court found that the trustee in that case had not recovered the interest in the residence, that the property was voluntarily conveyed back to the debtor prior to the bankruptcy filing, and that even if the transfer of the property back to the debtor had been made under the threat of the creditor’s claim, the property at most could be said to have been recovered by the creditor, not by the trustee.

Since the statute only states that property recovered by the trustee under specified Bankruptcy Code provisions cannot be exempted by the debtor, the statute did not apply to the property in that case recovered either through a voluntary transfer by the debtor or arguably by a creditor. The court noted that the bankruptcy estate was not in existence at the time the property was “recovered” in that case such that it was impossible to suggest that the trustee recovered the property or that the property was somehow recovered for the estate under any of the enumerated provisions of the Bankruptcy Code set forth in §522(g), circumstances, which provide the necessary factual prerequisite for denial of the exemption based on the express terms of the statute.

The First Circuit also rejected the contention that the interpretation and application of the statute according to its plain meaning was in any way inconsistent with or undermined the intent of Congress regarding the statute’s application or effect. The creditor argued that allowing the debtor to assert the homestead exemption, an exemption, which effectively removed all net equity in the property from the reach of creditors, given the debtor’s voluntary fraudulent transfer of the property would be “absurd.” The creditor contended that the provisions disallowing the exemption under §522(g) are intended to be punitive and to prevent a debtor who has engaged in misconduct from receiving the benefit of the exemption of the property transferred or concealed. The First Circuit again rejected the creditor’s contentions both based on the language of the statute and its interpretation of the congressional intent underlying the statute.

The Court of Appeals noted that the statute is phrased positively and permissively, in that §522(g) states that, “the debtor may exempt” property that has been recovered by the trustee so long as it was not transferred voluntarily or concealed. Further, the exemption statute as a whole does not suggest that any of its provisions are intended to be punitive but rather the primary concern of the statute is implementing a “fresh start” for the debtor. The court also noted that rather than punishing a debtor, §522(g) increases the property subject to exemption by allowing the debtor to exempt property recovered by the trustee after the petition date so long as the conditions of the section are met.

Further Analysis
The creditor’s frustration at the debtor’s ability to exempt virtually all the equity in this asset after fraudulently transferring his interest is apparent from the decision. The creditor’s argument that the intent of §522(g) was to prevent a debtor from exempting property recovered for the estate that the debtor wrongfully transferred or concealed has a strong equitable appeal under the facts presented, which likely persuaded the Bankruptcy Court to reach that conclusion and deny the exemption. However, as the U.S. Supreme Court has cautioned in bankruptcy cases, the court’s role as a court of equity cannot be used to rewrite or create new provisions of the Bankruptcy Code not found in the statute as enacted by Congress. See Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 206 (1988), where it was decided that “whatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of the Bankruptcy Code.”

If the plain language of §522(g) is drawn too narrowly, and if Congress intends that any property voluntarily transferred or concealed by the debtor and later recovered and included in the bankruptcy estate cannot be exempted by the debtor, then the statute must be revised to so provide. Despite the frustration of the creditor’s collection efforts under the facts of the Hill decision, the First Circuit correctly applied the statute as drafted and enacted by Congress.

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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.