Restructuring

Contributed by Hannah Geller
Typically, when an individual debtor files for bankruptcy, all of his or her belongings become part of the big “property of the estate” pot that the court ladles up pro rata among hungry creditors.  But debtors need to eat too.  Exemption law allows individual debtors and their families to keep some basic property, such as the clothes on their backs and roofs over their heads.  The roof part was the subject of the recent Fifth Circuit decision In re Brown, third in a line of Texas decisions grappling with conflicts between state homestead exemptions and the federal snapshot rule. 
A debtor may choose whether to apply the exemptions of the state where he or she is domiciled or those listed under section 522(d) of the Bankruptcy Code.  Most states, as well as the Bankruptcy Code, provide for some type of homestead exemption, but the details vary widely.  Federal law limits the debtor’s homestead exemption to $22,975.  Texas takes an ostensibly more generous approach, allowing a debtor to exempt the entire homestead itself, regardless of its value, from the estate.
The In re Brown Decision  
But what if the debtor’s home is essentially worthless?  The Fifth Circuit dealt with such a situation in the recent opinion In re Brown.  There, the debtor, Michael Glyn Brown, filed for bankruptcy in 2013 but died intestate shortly thereafter.  Michael’s wife, Rachel, and children were living in his house in Texas.  After the debtor’s representative claimed a homestead exemption, she learned that the property was deeply encumbered by debt.  Making matters worse, the United States Bankruptcy Court of the Southern District of Texas entered an order allowing a creditor to foreclose upon the house.  Rachel and the children were forced to move out.
At that point, the representative amended her schedule to claim an exemption of $45,000 of cash instead of the homestead, which would have benefitted Brown’s family.  The representative argued that she was able to do so under Texas Estates Code section 353.053, which provides a debtor’s surviving spouse with a cash allowance of up to $45,000 in lieu of a homestead exemption when the house is “so encumbered with liens that its permanency as a home may be defeated at the will of the lienholder.”  The Fifth Circuit upheld the bankruptcy court’s judgment that the representative could not claim the cash exemption.  The $45,000 was treated as property of the estate, for distribution to Michael’s creditors.
Context: The Snapshot Rule in Other Texas Homestead Exemption Cases
The Brown opinion relied on the Fifth Circuit’s snapshot rule, citing the 2001 decision In re Zibman and the 2014 decision In re Frost for the principle that all exemptions are determined at the time of filing and do not change based on subsequent events.  Here, the $45,000 cash exemption’s availability would have depended on a subsequent event: the debtor passing away.  The language of Texas Estates Code section 353.053 made clear that the cash in lieu of homestead exemption would only be available to surviving spouses of debtors, and Michael was very much alive when he filed his bankruptcy petition.
Brown’s representative had argued that Zibman and Frost rendered the snapshot rule inapplicable.  Both Zibman and Frost dealt with section 41.001 of the Texas Property Code, which exempts the proceeds of the sale of a homestead from seizure by creditors for six months after the sale date.  As Frost explained, the Texas legislature’s objective was “solely to allow the claimant to invest the proceeds in another homestead, not to protect the proceeds in and of themselves.”  Apparently, the Texas legislature believed that terminating the proceeds exemption after six months would be the best way to encourage debtors to buy another house with that money “to support the public policy of preventing homelessness.”
In Zibman, the debtors, a couple who owned two jewelry stores in Texas, sold their home in Houston for $120,000 three months before they filed for chapter 7.  The couple then took the cash in lieu of homestead exemption under Texas law and moved into a rental townhouse in Massachusetts.  Three months later (i.e., six months after the Zibmans had sold their Houston home), the chapter 7 Trustee objected to the Zibmans’ homestead exemption of the $120,000 in cash, arguing that, under Texas property law, the $120,000 was due to revert to the estate.  The lower court held that, under the snapshot rule, the exemption of the cash froze as of the date of filing, and would not expire after six months under section 41.001.
The Fifth Circuit Court of Appeals overturned the lower court decision, holding that, although the snapshot rule freezes the exemption determination on the date of filing, “it is the entire state law applicable on the filing date that is determinate,” and “courts cannot apply a judicial airbrush to excise offending images necessarily pictured in the petition-date snapshot.”  In other words, when the Zibmans, upon filing, elected to use the state law on exemptions, they took the “fat along with the lean” and signed on to the limitation that the cash for homestead exemption expires after six months if the debtor does not reinvest the proceeds in another house.
The Fifth Circuit upheld In re Zibman in the 2014 decision In re Frost.  There, debtor Mark Alan Frost claimed the Texas homestead exemption for his house when he filed his bankruptcy petition.  Subsequently, he sold the property and failed to use the proceeds to purchase a new home within six months.  Despite Frost’s best attempt to distinguish his situation from Zibman on the grounds that Frost sold the house postpetition, the court affirmed the lower court’s decision, and the proceeds from the sale became estate property after six months, for distribution among creditors.
Takeaway: The Current State of Texas Homestead Exemptions
Theoretically, applying Zibman and Frost to Brown would mean that the Fifth Circuit would need to take Texas law in its entirety, under which a cash in lieu of homestead exemption of $45,000 would become available to a debtor’s spouse after the debtor died.  But the Fifth Circuit picked up its discarded airbrush here to paint away Texas Estates Code §353.053.  The Brown court distinguished Zibman and Frost, explaining that the snapshot must be untouched when the offending image is a loss of exemption money for the debtor.  Evidently, though, when the image is a benefit to the debtor, the Fifth Circuit will paint freely.  Debtors in Texas had better get the picture right the first time around, because the Court of Appeals is a merciless photo editor.
Hannah Geller is at Weil Gotshal & Manges, LLP in New York.