Posted by Todd Zywicki: Bankruptcy Property Exemptions: A number of readers have asked what is the deal with bankruptcy exemptions, and homestead exemptions in particular? A quick primer on exemptions and their relationship to bankruptcy.
Even though the Bankruptcy Code is federal, exemptions are primarily a creature of state law. This reflects a deal cut when the first permanent bankruptcy act was enacted in 1898. Basically, representatives of farm states were concerned that big-city bankers were going to foreclose on farms, so to protect farmers, they provided that state law would control what property a debtor could protect from his creditors in bankruptcy. Today, the pro-farmer roots of the state control over exemptions continues to be reflected in the fact that many of the states that have an unlimited homestead exemption are farm states--Iowa, Kansas, and South Dakota--and even Texas was originally a cattle ranch exemption. Florida also has an unlimited homestead exemption (I'm not sure of the historical provenance) and the District of Columbia I believe does as well. At least one alert reader has observed that the state-based nature of exemptions appears to violate the Constitution, in that one of Congress's enumerated powers in Article I, section 8 is to enact "uniform" bankruptcy laws. In Hanover Bank v. Moyses (1902), the Supreme Court held that this �personal� nonuniformity in treatment among individuals was permissible, so long as �geographical� uniformity was preserved. Thus, debtors and creditors in different states may receive different treatment, so long as the debtors and creditors within the same State are treated the same. The �uniformity� requirement does, however, forbid �private� bankruptcy laws that affect only particular debtors. So the bankruptcy reform legislation does several things to limit fraud and abuse of the homestead exemption. First, a debtor who relocates to a new state (such as OJ Simpson buying a house in Florida) would have to wait 40 months before he could take advantage of that state's unlimited homestead exemption. Second, it creates a 10 year reachback period for attacking fraudulent use of the homestead exemption. Third, it places a cap on the value of the homestead exemption as applied to judgments obtained for securities fraud--essentially depriving Ken Lay and Scott Sullivan of the ability to assert their Texas and Florida homestead exemptions against victims of securities fraud by Enron and WorldCom. The legislation, however, does not place a flat cap on the value of the homestead exemption that an individual can exempt in bankruptcy. Why not? First, because as noted, historically the primary beneficiaries of the homestead exemption were Kansas and Iowa farmers. A flat cap would apply to these farmers as much as it would to wealth Florida doctors. Once it is recognized that the issue is about both farmers and doctors, for many people it becomes a much more difficult political and policy question, and it certainly is not so clear that everyone would agree that a South Dakota family farmer is abusing the bankruptcy system by using his unlimited state homestead exemption. Indeed, were such a cap to be imposed, I suspect that the critics of the legislation would probably say that it is unfair because it would force farmers off their land just to satisfy their creditors. Second, the bill does target what most people do think of as unquestionably bankruptcy abuse--borrowing money in a low-exemption state then relocating to a high-exemption state on the eve of bankruptcy. Moreover, it allows targeting of special claims that don't involve farmers, such as fraudulent use of the homestead exemption and securities fraud. This also explains why the abuse we usually hear about usually involves Texas or Florida--fat cats are more likely to buy a beach house in Florida to evade creditors rather than a wheat farm in South Dakota. Third, although reasonable minds can disagree, it appears that most of the costs of the unlimited homestead exemption are borne by individuals within that state. According to a paper a few years ago by Gropp, Scholz, and White, residents of unlimited homestead exemption states have higher interest rates, are more likely to be denied credit, and get access to less credit than residents of other states. Thus, it appears that the ability to protect more property ex post in bankruptcy is factored into the risk assessment ex ante at the lending stage. Much of the cost thus appears to be kept in state and there is not much evidence of interstate spillovers. Given the apparent lack of interstate spillovers, it can be reasonably argued that this particular decision is justifiable on federalism grounds--combined of course with the limitations that the reform legislation imposes on relocating right before bankruptcy (before the creditor can adjust its lending behavior to take account of the heightened risk). Fourth, the potential for abuse appears to be unique to the unlimited homestead exemption. As I suggested in [1]my post earlier today, Bankruptcy Courts have long had the power to attack debtors who attempt to use trusts, exemptions, and other vehicles to try to protect excessive property in bankruptcy. In a famous case (Northwest Bank Nebraska v. Tveten), the court denied the bankruptcy discharge of a doctor who cashed out all of his non-exempt assets and converted them to an exempt annuity purchased from a fraternal organization, which at the time had an unlimited exemption under state law. Notwithstanding this legal status, the 8th Circuit permitted the exemption, but then denied the detor's discharge (he had almost $19 million in debts and $700,000 in assets). Courts can also attack these sorts of schemes as fraudulent transfers and have a variety of tools at their disposal. This is the reason why it is so unlikely that the hypothetical concerns about the asset protection trust will turn out to be real--because bankruptcy courts can easily attack those naked efforts to protect assets. In contrast to other exemptions which have generally been subjected to an implicit reasonableness requirement, the unlimited homestead exemption has often been treated as sacred, especially in Florida where it appears that it may even protect property even for someone convicted of fraud or criminal behavior (for a discussion see [2]here and [3]here). So, as noted in the [4]discussion earlier today, the bankruptcy reform legislation is designed to target real, documented abuses of the system, and not willy-nilly chasing made-up or hypothetical bankruptcy abuses. Congress never amended the code to place a flat exemption on abuse of the unlimited exemption for annuities purchased from fraternal organizations, because existing law worked just fine to take care of that problem. It seems pretty clear that courts will also take care of the problem of asset protection trusts if the situation arises--just as they have taken care of foreign asset protecion trusts. I personally don't have strong views on the specific weighing of the federal bankruptcy concerns for uniformity versus the federalism concerns and I think either position is reasonable--so long as the forum-shopping problem is alleviated, which it is by the bill. So next time you hear someone ranting about how the bankruptcy reform legislation does nothing to crack down on the unlimited homestead exemption, mentally substitute "Kansas family farmer" for "Florida millionaire" and see if you still feel that the bankruptcy reform legislation's failure to close this "loophole" is an unfair sop to the rich. References 1. http://volokh.com/archives/archive_2005_03_27-2005_04_02.shtml#1112359704 2. http://www.hodgsonruss.com/article_326.html 3. http://floridaassetprotection.blogs.com/alperlaw/2004/04/will_the_havoco.html 4. http://volokh.com/archives/archive_2005_03_27-2005_04_02.shtml#1112359704 _______________________________________________ Volokh mailing list [email protected] http://highsorcery.com/cgi-bin/mailman/listinfo/volokh
