Supreme Court Rules Unanimously to Dismiss Former Student's Debt

March 23, 2010

In a unanimous ruling, the U.S. Supreme Court on Tuesday upheld an appeals-court decision allowing a former student to discharge a portion of his student-loan debts in bankruptcy without a legal proceeding to show that repaying the loans would cause him "undue hardship."

While the ruling focuses somewhat narrowly on procedural issues, allowing a judge's final bankruptcy ruling to trump federal bankruptcy rules in the case of an error, it may also open an avenue for some student-loan holders to more easily dismiss their debts in bankruptcy without the time and cost of more legal maneuvers.

Under federal law, student loans cannot be dismissed in bankruptcy unless borrowers can prove to a judge that they are unable to repay those debts at the time of filing bankruptcy or in the future. Some advocates of overhauling student-loan laws have argued that the rules to prove undue hardship put an unfair and inconsistent burden on borrowers who are already in financial distress. Lenders and guarantors, however, say the stringent requirement, which treats student loans the same as court-ordered child support, is necessary to protect taxpayers from unscrupulous borrowers who may try to shirk their debts.

Effect of a Legal Error

In the case, United Student Aid Funds Inc. v. Espinosa (No. 08-1134), the Supreme Court considered the situation of a former student, Francisco J. Espinosa, who filed for Chapter 13 bankruptcy in 1992 and, over five years, paid all but the interest on his $13,250 in student loans. A bankruptcy-court judge dismissed his debts in bankruptcy in 1997, although Mr. Espinosa should have, under the federal rules, initiated a separate court proceeding to prove that he was unable to pay the nearly $4,000 in interest that the loan's guarantor said he still owed.

The guarantor of the federally backed loans, United Student Aid Funds Inc., had been notified of the repayment plan on several occasions during the proceedings but did not object, even when the bankruptcy judge gave a final order dismissing Mr. Espinosa's remaining debts without considering the "undue hardship" standard for student-loan debt.

That was a mistake, according to the Supreme Court's decision, but not a big enough mistake to void the lower court's final order, because the lender was given adequate notice and opportunity to challenge the bankruptcy proceedings.

"Where, as here, a party is notified of a plan's contents and fails to object to confirmation of the plan before the time for appeal expires, that party has been afforded a full and fair opportunity to litigate, and the party's failure to avail itself of that opportunity will not justify ... relief," Justice Clarence Thomas wrote in the court's opinion.

The Supreme Court's decision not only affirms a ruling by the U.S. Court of Appeals for the Ninth Circuit but also overturns opinions in five other circuits.

A Narrow Ruling

While Tuesday's ruling preserves the finality of a bankruptcy judge's order, it does not excuse the error by the bankruptcy court, said Mark Kantrowitz, publisher of FinAid, a Web site about student aid.

"It just means that lenders will need to scrutinize filings more carefully and object, if necessary," to force borrowers and courts to follow the rules to show undue hardship, Mr. Kantrowitz said.

At oral arguments before the Supreme Court in December, lawyers for United Student Aid Funds argued they would be besieged by borrowers trying to circumvent bankruptcy rules if Mr. Espinosa prevailed. But the company began "long ago" to more closely scrutinize Chapter 13 bankruptcy plans, said Robert P. Murray, vice president for corporate communications for the guarantor.

Justice Thomas included stern warnings in the court's decision to lawyers who may try to use this ruling as a loophole, Mr. Murray said.

While his company lost its court battle, Mr. Murray said, it was a positive ruling because it provided clarity on the conflicting rulings in the federal circuit courts, and it upheld the requirement that borrowers must prove undue hardship to excuse their debts.

But Rafael I. Pardo, an associate professor at Seattle University's School of Law, said the Supreme Court's ruling provides some flexibility in how that determination of undue hardship is made and could give some borrowers the opportunity to expedite the process to show that they are in such circumstances.

In particular, Mr. Pardo said, the Supreme Court acknowledged that additional legal proceedings could be skipped if the borrower and creditor agree that repayment would cause undue hardship.

"In such a case, there is no reason that compliance with the undue-hardship requirement should impose significant costs on the parties or materially delay confirmation of the plan," Justice Thomas wrote.

The court's call for an "independent determination" of undue hardship when "the creditor fails to object or appear in the adversary proceeding" also may suggest that a judge could excuse some debt through a Chapter 13 bankruptcy plan without going through the additional legal proceedings, Mr. Pardo said.

But, he added, that possibility will have to be tested in future courts.