Can A Trustee Challenge The Debtor’s Claimed Exemption?

A trustee can challenge the debtor’s right to claim an exemption. Although this can happen in Chapters 7 and 13 — and in the rare Chapter 11 where the Court appoints a Trustee — this sort of challenge typically happens in Chapter 7 bankruptcy. Why?

Chapter 7

In a typical Chapter 7, debts are discharged in one fell swoop without the creditors getting anything. From the creditors’ perspective this is a pretty big hit. Therefore, there are a few limitations. One limitation is on what the debtor gets to keep. If you are a Chapter 7 debtor, you get to keep those assets you can exempt from seizure by the Chapter 7 Trustee; but there is at least the potential for you to lose assets in Chapter 7. This idea of exemptions is a creature of personal bankruptcies and does not exist in business bankruptcies. How does this work?

We list the debtor’s assets in the bankruptcy papers, and using the appropriate exemption table divide them into exempt and nonexempt categories. Although the Bankruptcy Code has an exemption table, California has opted out of it. Instead, we have two exemption tables: One for homeowners with equity, the other for everyone else — the so-called renter’s table. Each table has a list of asset categories. Some categories have dollar limits, others have no dollar limits. Our goal is to exempt as much of the debtor’s assets as possible by judiciously using the table. Anything we can’t exempt is fair game for the Chapter 7 Trustee to seize and sell for the benefit of the creditors.

However, simply appealing to an exemption doesn’t guarantee that the asset is exempt. Sometimes people misuse exemptions. Therefore, the law permits anyone who wants to, to object to the use of an exemption. The objector must file the objection no later than 30 days after the conclusion of the meeting of creditors. Why did I emphasize the word, “conclusion?” Because sometimes the Trustee will continue a hearing several times while investigating the debtor’s assets.

If somebody (typically the Trustee) feels that there’s been an illegitimate use of an exemption, that person may object to the exemption. If someone objects to an exemption, the debtor can, of course, oppose the objection. The dispute must ultimately be resolved by the Judge assigned to the case.

If a creditor objects to an exemption, the Trustee will not defend the debtor because the Trustee has no reason to get involved. Instead, the Trustee’s goal is to grab as much nonexempt property as possible, and liquidate it for the benefit of creditors.

Chapter 13

In Chapter 13, the debtor proposes a plan of reorganization to pay the creditors over time. Since the creditors are being paid, the debtor gets to keep the assets. However, there is still the potential for someone to object to an exemption. Why?

One of the requirements of a Chapter 13 plan is that over its life it must pay the general unsecured creditors at least as much as they would have received in a Chapter 7 liquidation. Therefore, an important factor in determining how much the debtor will repay is the dollar value of the nonexempt assets. If a debtor has improperly exempted an asset, then the debtor has understated the Chapter 7 liquidation amount, and thus may end up shortchanging the creditors. As a consequence, either the Chapter 13 Trustee or creditors may challenge the misuse of the exemption.

Chapter 11

As with Chapter 13, the debtor proposes a plan of reorganization to pay creditors over time. And as with Chapter 13, the Chapter 11 plan must satisfy the Chapter liquidation requirement.

However, in a standard Chapter 11 there is no Chapter 11 Trustee — unless something has gone terribly wrong, and the Judge appoints one. Therefore, any challenge to an exemption will probably come from a creditor.

One exception: If the debtor is in a Subchapter V version of Chapter 11, then there is a Subchapter V Trustee. Since the Subchapter V Trustee’s primary statutory duty is to work toward plan confirmation, that Trustee might challenge a misused exemption.

Conclusion

In sum, the long-winded answer to the question posed is, “Yes, the trustee can challenge a debtor’s exemption.”

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