Student lenders must now, more than ever, tighten up their practices in cases where their debtors file for bankruptcy protection. In December 2009, the U.S. Supreme Court heard oral argument in the case of United Student Aid Funds v. Espinosa. At issue was whether bankruptcy law permitted a debtor to discharge a student loan “by declaration” through a Chapter 13 bankruptcy plan, or whether bankruptcy law required the debtor to bring an adversary proceeding against the creditor to obtain a discharge.
Until the U.S. Court of Appeals for the Ninth Circuit ruled that declaration was sufficient when the creditor had notice of the proposed discharge but failed to object to the plan and confirmation, most student lenders only needed to worry about responding when a debtor brought a formal adversary proceeding. Even after the Ninth Circuit’s opinion, especially in light of the fact that other Circuit Courts were divided on the issue, it was widely believed that a debtor could not discharge student loans merely by declaration, because the only grounds for discharge required proof of undue hardship.
Now, the United States Supreme Court has spoken – and student lenders need to make changes immediately if they have not already done so. In a unanimous opinion issued on March 23, the U.S. Supreme Court affirmed the Ninth Circuit’s holding. The Supreme Court was faced with two questions: (1) whether a district court order confirming a plan and discharging the student loan was void; and (2) whether the order confirming the plan and discharging the student loan satisfied due process requirements entitling the order to respect under principles of res judicata.
As a general rule, student loans are statutorily non-dischargeable in bankruptcy unless repayment would cause the debtor an “undue hardship.” The determination as to whether undue hardship warrants discharge under the Bankruptcy Code can be adjudicated only in an adversary proceeding after formal service of process on the student lender. In Espinosa, however, the debtor did not prove undue hardship in an adversary proceeding but instead, merely requested a discharge by declaration in his Chapter 13 plan. The district court issued an order confirming the plan and discharging the student loan, giving rise to the question as to whether the order was void and/or violated due process rights of student lenders.
As to the first question, the Supreme Court held that the order confirming the plan and discharging the debt was not void. As to the second question, the Supreme Court held that Espinosa’s failure to serve USAF with a complaint and summons did not violate USAF’s due process rights because USAF had actual notice of the proposed discharge.
In holding that the bankruptcy court’s confirmation order was not void, the Supreme Court focused its discussion on the interplay between finality of confirmation orders and Federal Rule of Civil Procedure 60(b)(4). The Court explained that a confirmation order is a final judgment and usually cannot be re-opened or altered in any way. Rule 60(b)(4), however, allows a party to seek relief from a final judgment (i.e., alter the judgment) if the party can show that the final judgment was void. The standard for what constitutes a “void” judgment is a difficult one to satisfy. “A void judgment is one so affected by a fundamental infirmity that the infirmity may be raised even after the judgment becomes final.” A judgment is not void “simply because it is or may have become erroneous.” A “void” judgment for purposes of Rule 60(b)(4) is a judgment that is either premised on: (1) a jurisdictional error; or (2) a violation of due process that deprives a party of notice and a right to be heard.
The Supreme Court rejected USAF’s argument that the confirmation order was void for lack of due process. Espinosa’s failure to commence an adversary proceeding deprived USAF of a right arising out of a procedural bankruptcy rule, but the inquiry does not end there. The Court distinguished a deprivation of USAF’s procedural right from a denial of due process. The Court explained that constitutional due process requires notice “reasonably calculated, under all the circumstances, to apprise interested parties of the pendency of the action and afford them an opportunity to present their objections.” Constitutional due process does not require actual notice. Even if constitutional due process required actual notice, USAF had actual notice of Espinosa’s proposed plan when it received proper notice of the proposed plan and confirmation. The Court held that the notice USAF received “more than satisfied” USAF’s due process rights. The confirmation order was therefore not void.
The Court also rejected USAF’s argument that the confirmation order was void because Sections 523(a)(8) and 1325(a)(1) of the Bankruptcy Code, when read together, do not allow the bankruptcy court to confirm a plan without finding that the debtor would suffer undue hardship if the debtor had to pay the loan back. USAF argued that because Section 523(a)(8) makes student loan debt nondischargeable unless the court finds undue hardship, and because Section 1325(a)(1) permits bankruptcy courts to confirm only plans that comply with the Bankruptcy Code, the bankruptcy court was statutorily prohibited from entering the confirmation order. The Court found that the bankruptcy court’s failure to find undue hardship was not “on par” with the very limited circumstances that make a final judgment void under Rule 60(b)(4). Accordingly, the Court concluded that USAF could not rely on Sections 523(a)(8) and 1325(a)(1) to prove that the confirmation order was void. The Court also noted that neither Section 523(a)(8) nor Section 1523(a)(5) impose requirements that, if violated, would result in a denial of due process.
On behalf of a unanimous Court, Justice Thomas wrote:
Given the Code’s clear and self-executing requirement for an undue hardship determination, the Bankruptcy Court’s failure to find undue hardship before confirming Espinosa’s plan was a legal error . . . But the order remains enforceable and binding on [USAF] because [USAF] had notice of the error and failed to object or timely appeal.
As a result of this ruling, a lender will need to diligently review bankruptcy petitions and proposed plans. A lender can no longer assume that a borrower will file suit to avoid paying a student loan obligation. Moreover, a student lender can never ignore a debtor’s request for discharge or inclusion of a debt in a Chapter 13 plan. The only way to preserve the full rights of the lender is to ensure that a timely objection is filed, forcing the debtor to bring a formal adversary proceeding to discharge the student loan.
Maya P. 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.