U.S. Supreme Court Reverses Third Circuit on Duty of Trustee to Object to Claims of Exemption in Bankruptcy Case

by Lesley Anne Hawes September 2010
Claims of exemption can be critical to a debtor that seeks a fresh start through bankruptcy. In addition, they allow a debtor to retain certain categories of property up to a specified dollar value, including equipment and other tools of the trade, vehicles, clothing and household goods. Such assets can provide essential assets for the debtor to start or continue to work and recover financially after bankruptcy.

In the context of claims of exemption, a debtor is required to file a schedule listing the assets claimed as exempt along with a statement as to the value of the exemption claimed. Rule 4003(b) of the Federal Rules of Bankruptcy Procedure establishes a deadline of 30 days after the conclusion of the §341(a) first meeting of creditors for a trustee in bankruptcy or creditor to object to the debtor’s claims of exemption. Failure to object, in a timely manner, results in a waiver of the objection and exclusion of the asset from the debtor’s bankruptcy estate, even if the claim of exemption was improper and exceeds the value of the exemption authorized under the Bankruptcy Code (See Taylor v. Freeland & Kronz, 503 U.S. 638, 642-643 (1992)). The timely assertion of objections to the debtor’s claimed exemptions can be important to create or preserve value for unsecured creditors, particularly in larger individual Chapter 11 cases in which a lessor or secured creditor may have a substantial unsecured claim against the individual based on a personal guaranty of corporate debt.

The Issue to Be Determined by the Court
In Schwab v. Reilly, 560 U.S. ____,130 S.Ct. 2652 (2010), decided by the United States Supreme Court on June 17, 2010, the question determined by the court was whether a Chapter 7 trustee that failed to object to claims of exemption asserted by the debtor could nevertheless administer and liquidate property subject to the claimed exemption when the trustee determined that the value of the property exceeded the amount of the statutory limit on the claimed exemption. In that case, the property in question was kitchen equipment from the debtor’s failed catering business.

There was no dispute that the equipment properly fit a claim of exemption for equipment and tools of the trade, and that the debtor also could properly claim a “wild card” exemption for the value of the equipment that exceeded the statutory exemption limit for tools of the trade. The debtor listed the value of the property in her claim of exemption and in her schedule of personal property as being equal to the combined statutory dollar limit of the exemptions for tools of the trade and the “wild card” exemption, which she asserted for those assets.

The debtor argued that by listing these assets as exempt for the full dollar amount of the exemption limits, the debtor demonstrated an intent to claim the entire value of those assets as exempt, and without any timely objection having been filed to the claim of exemption, the property itself, regardless of its actual value, was exempted from the reach of creditors and removed from the bankruptcy estate. As a result, the trustee could not administer or liquidate the asset since the trustee failed to object to the claim of exemption for that property.

The debtor prevailed in the bankruptcy court and on appeal to both the District Court and the Court of Appeals for the Third Circuit. The Chapter 7 trustee argued unsuccessfully in the lower courts that as a matter of statutory construction, the claim of exemption applies to exempt an “interest” of the debtor in property. The trustee contended there was no reason for him to object to the claims of exemption because the debtor properly listed the claims of exemption of her interest in the assets in question in an aggregate amount that was within the statutory exemption limits for those categories of property. Therefore, the claim of exemption as asserted was valid. The trustee did not contend that the debtor was not entitled to the value of her interest in the assets in question claimed as exempt. Instead, he, as trustee, argued that he was entitled to liquidate the assets, which were worth several thousand dollars more than the amounts listed on her schedules and in the exemption claim, and pay the debtor the value of her interest with the estate, retaining the excess proceeds from the liquidation for the benefit of creditors.

The Ruling: Claims of Exemption Apply to a Debtor’s ‘Interest’ in Property
In a majority decision in which six justices concurred, the Supreme Court sided with the Chapter 7 trustee and reversed the ruling of the Third Circuit. The court first analyzed the claim of exemption form itself and the interpretation of that form when a debtor lists property as exempt within the statutory exemption dollar limits. The court concluded that the trustee should not have to infer from such a statement that the debtor intended to exempt the property regardless of its value when the value stated for the asset and the exemption was within the statutory exemption dollar limits and was thus facially valid.

The court also analyzed the provisions of Bankruptcy Code §522(l) and concluded that the property claimed as exempt as defined under the Bankruptcy Code is an “interest” in property, not the property itself. The court noted that §522(l) refers back to §522(b) which in turn refers to §522(d), which contains a list of 12 categories of property the debtor can exempt, generally in reference to the debtor’s “interest” in a specified type of property up to a certain dollar limit set forth in the Bankruptcy Code. Since the property subject to exemption listed in §522(d) consists of the debtor’s “interest” in that property, when the debtor valued the interest in an amount consistent with the statutory dollar limits, the court concluded that the trustee had no duty to object to the claim of exemption because the dollar value claimed as exempt was within the statutory dollar limits, and there was no dispute that the type of property claimed as exempt was properly subject to exemption under the Bankruptcy Code sections cited by the debtor.

The court also noted that the key entries of concern to the trustee that should govern whether an objection is required to preserve the estate’s claim to any excess value in the asset is the description of the property claimed as exempt (to be sure the property fits one of the statutory categories), the Bankruptcy Code provisions governing the claimed exemptions, and the amounts listed by the debtor as the “value of claimed exemption” and that any market value listed by the debtor for the property is “superfluous” to the claim of exemption issue, since that value merely aids the trustee in administering the estate and determining if excess value might exist in the property. The debtor’s estimate of the market value of the property subject to the exemption claim does not bind the trustee or remove the property from the estate if it is equal to the value claimed by the debtor for the exemption, according to the court.

The Supreme Court also addressed the policies of the Bankruptcy Code underlying the claims of exemption and the goals of the bankruptcy process. The debtor argued that her interpretation of the claim of exemption, which would allow her to retain the property claimed exempt if no objection is made, promotes the fresh start principles of the Code. The court rejected that contention not only because such policy considerations could not override the provisions of the Bankruptcy Code and its interpretation under the Supreme Court’s Taylor decision, but also because those policy considerations would nevertheless not warrant a trustee objecting to a claim of exemption that is facially valid and complies with the statutory claim of exemption provisions.

Practical Issues Highlighted by the Decision
In addition to the significance of the ruling in resolving the conflict among the courts on this specific issue, the ruling highlights for creditors the importance of reviewing the debtor’s schedules and claims of exemption closely for potential objection and the limited time available for creditors to file their objections. Well to do principals of a corporation or partnership obligor may have valuable artwork, jewelry, fur coats and even household furnishings such as pianos, crystal or other collectibles, that may well have substantial liquidation value and is likely outside the dollar limits of the claims of exemption. If the dollar value asserted for the claim of exemption exceeds the proper statutory limits, failure to object in a timely manner to the claims of exemption will result in a loss of that asset for creditors.

The Schwab v. Reilly decision is noteworthy because if the claims of exemption appear valid on their face in terms of the dollar amounts claimed for the exempt property, the estate may still have an interest in any liquidation value in excess of the statutory exemption limits that can be pursued even if no objection to the claim of exemption has been filed. As a practical matter, it often falls to the creditors to obtain appraisals and demonstrate to a trustee in a Chapter 7 that certain assets may be worth pursuing. In a Chapter 11 case, the same deadline for objections to exemptions applies; and if creditors believe value exists in the assets subject to claims of exemption, creditors will need to address that excess value with the debtor as a debtor-in-possession, usually in the context of plan objections or negotiations.

Lesley Anne HawesLesley 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.

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