Insights

As we have previously reported in Basis Points, the student lending world has recently seen some pretty big changes. Another change might be on the horizon, but this time due to the United States Supreme Court, not to Congress or the Federal Reserve Board. And this change does not affect only private student loans—it affects all student loans and, potentially, all categories of debt that are currently non-dischargeable under the Bankruptcy Code.

At issue in Espinosa v. United Student Aid Funds, Inc., is whether Chapter 13 of the Bankruptcy Code allows a debtor to discharge student loan debt without proving that the debtor would suffer “undue hardship” if the bankruptcy court required the debtor to pay the loan back. Whether the debtor would suffer “under hardship” is a fact-specific inquiry that the Bankruptcy Code generally requires the debtor to resolve through an adversary proceeding against the creditor.

The U.S. Court of Appeals for the Ninth Circuit heard the case in 2008 (Espinosa v. United Student Aid Funds, Inc., 545 F.3d 1113 (9th Cir. 2008)), and the student lender, USAF, petitioned the Supreme Court for a writ of certiorari. The Court granted certiorari and heard oral argument on December 1, 2009. The Court has not yet issued an opinion, and it is difficult to determine from the oral argument how the Court will ultimately rule on this issue. If the Supreme Court affirms the Ninth Circuit’s holding, student loan creditors could effectively lose the benefit of the statutory requirement that the debtor prove “undue hardship” in an adversary proceeding in order to discharge student loan debt. An affirmation of the Ninth Circuit’s holding could also prompt Congress to undertake significant revisions to the Bankruptcy Code. The Ninth Circuit’s opinion, discussed below, provides a comprehensive analysis of the relevant issues.

The Case

Francisco J. Espinosa filed a Chapter 13 petition and proposed plan that provided for repayment of $13,250 in student loans to USAF. USAF received notice of the petition and filed a proof of claim in the amount of $ 17,832.15. The difference in these two amounts was attributable to interest and other fees. The bankruptcy court eventually confirmed the plan, and the Chapter 13 Trustee mailed USAF a notice advising USAF that its claim would be paid according to the plan, instead of according to USAF’s proof of claim. The notice also advised USAF of its right to object to the Trustee’s treatment of its proof of claim and instructed USAF on how to do that. USAF did not object. Espinosa successfully completed the plan, including paying $13,250 to USAF.

Three years later, USAF started intercepting Espinosa’s federal income tax returns to recover the unpaid portion of the student loan debt (the interest and fees). Espinosa petitioned the bankruptcy court for an order holding USAF in contempt for violating the discharge injunction. USAF moved for relief from the bankruptcy court’s order confirming the plan, on the grounds that the court had violated USAF’s rights under the Code when it entered the order. USAF argued that the Bankruptcy Code requires a debtor to prove that repaying the student loan will cause the student “undue hardship” through an adversary proceeding against the creditor before a bankruptcy court can discharge a student loan. USAF acknowledged that although the Trustee sent proper notice of the plan and USAF’s right to object to the plan, the Code requires Espinosa to serve USAF with an adversary proceeding complaint and summons seeking to have the bankruptcy court declare the debt dischargeable for “undue hardship.” Espinosa simply listed the debt in his Chapter 13 plan, made the payments, and the bankruptcy court entered a discharge order.

The bankruptcy court denied USAF’s motion, noting that USAF should have objected before the court approved the plan, and held that USAF had violated the discharge order injunction. USAF appealed to the U.S. District Court for the District of Arizona. The District Court reversed the bankruptcy court, holding that the bankruptcy court had violated USAF’s due process rights by discharging the debt without requiring Espinosa to file an adversary proceeding. Espinosa appealed.

That’s where the Ninth Circuit stepped in—to answer the often-litigated question that the federal circuit courts have not yet agreed on: Can a student loan debtor discharge student loan debt by simply listing the debt in a Chapter 13 petition, paying the plan amount and having the balance discharged through the Chapter 13 case?

According to the Ninth Circuit: Yes.

The Ninth Circuit’s Opinion

In reversing the District Court’s ruling and holding that the bankruptcy court properly discharged Espinosa’s student loan debt, the court focused on two questions:

(1) Should the bankruptcy court have set aside Espinosa’s discharge because Espinosa didn’t comply with the procedures specified in the Code for student loan discharge?

(2) Were USAF’s due process rights violated because it was not served with a complaint and summons before the bankruptcy court discharged Espinosa’s student loan debt?

The Bankruptcy Court Should Not Have Set Aside Espinosa’s Discharge: In holding that the bankruptcy court acted properly in refusing to set aside the discharge order, the court relied on its prior ruling in Great Lakes Education Corporation v. Pardee (193 F.3d 1083) (9th Cir. 1999). The facts in Pardee were nearly identical to those in Espinosa, and the court reiterated its position that a discharge is a final judgment that “cannot be set aside or ignored because a party suddenly claims, years later, that the trial court committed an error.” Espinosa at 1118.

The court acknowledged, but disposed of, cases in the Tenth Circuit and Second Circuit that held the other way. According to the Ninth Circuit, those cases unnecessarily wrestled with a phantom conflict between the Code’s finality-of-discharge provision and the Code’s requirement that the debtor file an adversary proceeding before getting a discharge of student loan debt. Instead of viewing these provisions as conflicting with one another, the Ninth Circuit explained that both provisions can operate together, “within their proper spheres.” Espinosa at 1118.

The Ninth Circuit took the position that the provision giving student loan creditors a right to “special procedures” (a demonstration of “undue hardship” through an adversary proceeding) comes into play when the case is pending before the bankruptcy court. If a debtor proposes a discharge without filing an adversary proceeding, the court explained, the creditor’s remedy is to object to the plan. When a creditor gets notice of the proposed plan, the creditor has “a full and fair opportunity” to invoke the special provisions regarding discharge of student loan debt by objecting to the plan on grounds that the debtor has not demonstrated “undue hardship.” Espinosa at 1118.

Discharge Orders are Final Judgments, but Finality Does Not Preclude a Debtor From Opening the Order to Enforce an Injunction: The court then explained that the Code’s finality provision comes into play later in the game, after the bankruptcy proceedings are over. A bankruptcy discharge order is final. If the order was not final, the court reasoned, no judgment would ever be conclusive, because the aggrieved person could re-litigate errors that the bankruptcy court allegedly committed. Once a discharge order is final and the time for an appeal has run, the Code permits the bankruptcy court to reconsider the order and overcome the order’s finality only under a limited set of circumstances. The standard for reconsideration is high – “when deciding whether an order is “void”… courts must look for rare instances of a clear usurpation of power.” Espinosa at 1119 (citing United States v. Hartwell, 448 F.3d 707 (4th Cir. 2004)). The court again acknowledged, but disposed of, cases from the Tenth Circuit and Second Circuit that held that a debtor could not reopen a discharge order for purposes of enforcing the discharge order injunction against a creditor. The court explained that the other circuits had mistakenly relied on the doctrine of res judicata in concluding that a debtor could not reopen the order. Res judicata, the court explained, gives a case preclusive effect on a subsequent case. In Espinosa (and in the court’s view, in the previous cases before the Tenth and Second Circuits), res judicata was not an issue, because there was no “subsequent case.” Instead, Espinosa sought merely to reopen the discharge order for the limited purpose of enforcing the discharge order injunction against a creditor who had violated the discharge order by intercepting his income tax returns.

USAF Was Not Denied Due Process: The court rejected USAF’s argument that it was denied due process because Espinosa did not serve USAF with a complaint and summons in an adversary proceeding. The court noted that as an initial matter, a court that enters judgment against a defendant who does not receive notice of a lawsuit, or who receives inadequate notice, violates the defendant’s due process rights. In Espinosa, however, USAF received notice of Espinosa’s bankruptcy filing and responded to that notice with a proof of claim. USAF also received notice from the court that the court would confirm the lower proposed plan amount instead of USAF’s higher proof of claim amount, unless USAF filed an objection. In light of all of these notices, the court concluded that USAF received actual notice for purposes of due process. The court stated:

We cannot say that [USAF] was taken by surprise or was denied due process. Quite the contrary: [USAF] appears to have been a willing participant, perfectly happy to receive the benefits of the Chapter 13 plan, but unwilling to suffer the consequences of its failure to file an objection.

Espinosa at 1123. The Ninth Circuit distinguished contrary holdings from the Second, Fourth, and Tenth Circuits by explaining that the other circuits had a “different understanding” of what due process requires. According to the Ninth Circuit, the other circuits mistakenly concluded that a creditor that is entitled to heightened notice by statute (such as a student loan creditor entitled to an adversary proceeding before discharge) is also entitled to heightened notice as a matter of due process. The Ninth Circuit explained that, in its view, due process requires only that a party affected by litigation receive sufficient notice so that it can defend its interests. USAF, the court held, received sufficient notice via the bankruptcy petition, proposed plan and accompanying notice concerning USAF’s right to object to plan confirmation. Deviating from the Second, Fourth, and Tenth Circuits, the court refused to equate heightened notice requirements in a student loan discharge context with heightened notice requirement in a due process context, as follows:

Congress made it quite clear that a creditor need only get ordinary notice of a Chapter 13 plan to be bound by its terms…That Congress provided heightened notice requirements for an adversary proceeding, which didn’t take place here, is of no consequence…We reject the idea that a creditor who is in the business of administering student loans has a constitutional right to ignore a properly served notice that clearly specifies that its debt will be discharged on successful completion of the plan (emphasis in original).

Espinosa at 1121. In concluding its opinion, the Ninth Circuit gently accused other courts of “re-casting what may be a simple statutory violation as a denial of due process so that they can set aside judgments with which they’re unhappy.” Espinosa at 1124. The court stuck firm to its previous holdings that a Chapter 13 debtor can discharge student loan debt by way of a Chapter 13 plan if the creditor does not object after receiving notice of the plan.

The Supreme Court

Unsatisfied with the Ninth Circuit’s holding, USAF petitioned the Supreme Court for a writ of certiorari. The Court granted the petition and heard oral argument on December 1, 2009. The Court sought specifically to resolve the following two issues:

1. Student loans are statutorily non-dischargeable in bankruptcy unless repayment would cause the debtor an “undue hardship.” Debtor failed to prove undue hardship in an adversary proceeding as required by the Bankruptcy Rules, and instead, merely declared a discharge in his Chapter 13 plan. Are the orders confirming the plan and discharging debtor void?

2. Bankruptcy Rules permit discharge of a student loan only through an adversary proceeding, commenced by filing a complaint and serving it and a summons on an appropriate agent of the creditor. Instead, debtor merely included a declaration of discharge in his Chapter 13 plan and mailed it to creditor’s post office box. Does such procedure meet the rigorous demands of due process and entitle the resulting orders to respect under principles of res judicata.

The transcript of the oral argument does not provide much insight into how the Court will rule on these issues. The Justices agreed that the Bankruptcy Code requires debtors to commence adversary proceedings against student loan creditors as a precondition to discharge of student loan debt. Beyond that, the Justices’ specific questions and the nature of the oral argument do not reveal the Justices’ inclinations regarding the two issues set forth above. Much of the argument revolved around the textual specificities of the Code and the interplay between different Code sections. On more than one occasion, USAF’s attorney tried to make the point that if the Court does not reverse the Ninth Circuit’s holding, the Court would effectively be giving bankruptcy courts the authority to discharge not just student loan debts through declaration, but also the other categories of statutorily non-dischargeable debt (including, but not limited to, alimony, child support, and most federal, state and local taxes). The Justices did not appear too persuaded by, or interested in, the “slippery slope” argument. A good portion of the oral argument was devoted to a discussion of what degree of flexibility and authority bankruptcy court judges have when approving plans that propose discharge of statutorily recognized non-dischargeable debts.

What Does It All Mean?

The issues that surfaced in Espinosa are not issues of first impression. As the Ninth Circuit noted several times in its opinion, the other federal Circuit Courts have addressed many of these same issues in the past. The importance of Espinosa is that Espinosa finally took these issues to the Supreme Court level.

If the Supreme Court decides that the bankruptcy court acted inappropriately in discharging USAF’s debt, it seems that not too much will change from student loan creditors. If, however, the Supreme Court decides that the bankruptcy court acted appropriately, and that a student loan creditor that fails to object to a plan loses its right to engage in an adversary proceeding prior to discharge, student loan creditors will have to re-evaluate and fine-tune their policies to ensure that no proposed plan that is unacceptable to the creditor goes unanswered. Effectively, a holding in Espinosa’s favor will mean that student loan creditors will lose their statutory right to rely on the adversary proceeding requirements to have otherwise non-dischargeable student loan debt discharged by a showing of “undue hardship.”

Given the specific attention that the Supreme Court gave to the text of the Bankruptcy Code and the interplay between arguably vague Code sections, it will also be interesting to see if Congress will, in response to the ultimate holding in Espinosa, undertake yet another Code revision of the kind we saw in 2005.

Maya Hill is an associate in the Maryland office of Hudson Cook, LLP. Basis Points readers can reach Maya at (410) 782-2356 or by email at mhill@hudco.com.