Approaching the Limits of the Bankruptcy Code: Does Surcharging a Debtor’s Exempt Assets Go Too Far?

American bankruptcy law developed as a means to benefit both insolvent debtors and their unsatisfied creditors. Since an insolvent debtor typically owes more to creditors than there are assets for distribution, a bankruptcy proceeding encourages both sides to work together in dividing up the available assets instead of allowing a potentially destructive race to the courthouse. However, in addition to its role in overcoming the collective action problem among creditors, the Bankruptcy Code was enacted in order to provide debtors, unable to pay their debts, with a “fresh start.” This fresh start is accomplished by distributing estate property to creditors and thereafter relieving the debtor of any further obligations (referred to as a “discharge” of debt). In order to operate properly, however, bankruptcy proceedings require the parties to follow the stringent regulations set forth in the Code; otherwise, the delicate balance between creditors’ and debtors’ interests may be disturbed.

The Bankruptcy Code includes important provisions intended to provide debtors with a suitable standard of living during and after the bankruptcy proceeding. An individual debtor filing for bankruptcy is permitted to exempt a number of assets from the bankruptcy estate, which the creditors may not reach, in order to allow the debtor to begin a “fresh start” with an adequate quality of life. Once a creditor accepts a debtor’s list of exempt assets, those assets are considered exempt under the Bankruptcy Code. Sometimes, however, debtors attempt to retain property that should be distributed to creditors by improperly concealing or refusing to turn over nonexempt assets that belong to the bankruptcy estate. If the creditors uncover the assets, the court will order the debtor to turn them over. However, if the debtor consumes the nonexempt assets after filing for bankruptcy (in lieu of using his exempt assets) the creditors may no longer be able to reach those assets to satisfy their claims. Therefore, the debtor would retain more property than he is permitted under exemption statutes, but his creditors would not be able to reach the nonexempt property because it no longer exists. In these situations, the Code authorizes the court to impose sanctions on debtors or to provide remedies for the wronged creditors. For instance, the court may refuse to discharge a debt, issue an order to turn over property, or even dismiss the case. One circuit court and several district courts have additionally allowed courts to use their equitable powers, granted in 11 USC § 105(a), to “surcharge” a debtor’s exempt assets in order to compensate for the nonexempt assets improperly hidden or retained by the debtor. Creditors in these cases surcharge, or reach, a debtor’s exempt assets and extract the value of the nonexempt estate property.