The U.S. Supreme Court is scheduled to hear arguments in a case this week that weighs federal rules for dismissing student debt in bankruptcy proceedings against the authority of a judge’s final court orders.
The case, United Student Aid Funds Inc. v. Espinosa, highlights the complex and sometimes contradictory nature of bankruptcy law that makes student loans as difficult to excuse as court-ordered child support. To dismiss student loans in bankruptcy, borrowers must show that repaying the loans would be an “undue hardship,” a legal standard that has been applied inconsistently over time.
Higher-education and legal experts do not expect the Supreme Court’s decision to broadly change how student loans are treated in most bankruptcies. Instead, the court is more likely to narrowly rule on the question of whether a final bankruptcy-court decision should stand if errors were made in the process.
In the case before the Supreme Court, United Student Aid Funds Inc., a student-loan guarantor, is asking the court to reverse a ruling by the U.S. Court of Appeals for the Ninth Circuit, which allowed a borrower to excuse a portion of his student loans without a special court proceeding to show that paying the debt would have caused “undue hardship.” United Student Aid Funds argues that if the Supreme Court does not rule in its favor, lenders will be swamped with efforts to circumvent the normal rules, cheating them out of money they are due.
The borrower in the lawsuit, Francisco J. Espinosa, argues that the guarantor is barred from collecting money after his bankruptcy was finalized and most of his student loan repaid.
Missed Opportunity?
Mr. Espinosa filed for bankruptcy under Chapter 13 in 1992, owing nearly $18,000 in principal and interest to United Student Aid Funds, the guarantor of his federally backed student loans.
In his repayment plans, Mr. Espinosa proposed to pay back just the principal of his loans, $13,250, over a five-year period. The guarantor was notified of the plan and filed a claim for an amount $4,000 higher, including interest, but the judge approved the borrower’s plans. United Student Aid Funds was again notified of the plan and given 30 days to dispute the amount they would receive, but the company raised no objections.
After Mr. Espinosa had fully repaid the principal, a bankruptcy judge declared the case closed. But three years later, United Student Aid Funds began efforts to collect the unpaid interest on the loan, and the two sides went back to court.
Lower federal courts split on whether Mr. Espinosa should pay the extra amount, and the case landed in the Ninth Circuit Court of Appeals. There, Judge Alex Kozinski ruled that the guarantor had missed its opportunity to challenge the terms of repayment and that the bankruptcy order was indeed final.
“It makes a mockery of the English language and common sense to say that Funds wasn’t given notice, or was somehow ambushed or taken advantage of,” Judge Kozinski wrote.
But United Student Aid Funds says the final discharge order is invalid because Mr. Espinosa failed to show that repaying the loans would cause him an “undue hardship.” In order to pass that test, debtors must initiate a separate legal action, called an adversary proceeding, that demonstrates their good-faith effort either to pay the loans or defer them on time and have little likelihood of earning enough in the future to make payments.
Richard Lieb, a professor at St. John’s University School of Law, said he was concerned about the precedent that could be set if the Supreme Court overturns the Ninth Circuit’s decision. Weakening the finality of court orders, he said, could undermine confidence in the entire legal system and give parties less reason to settle their disputes with student-loan companies or any entities at all.
If the Supreme Court overturns the Ninth Circuit’s decision, creditors would be given the opportunity to continue to pursue debts even after a borrower’s slate has been wiped clean by the bankruptcy process, said Mr. Lieb, who wrote a brief on behalf of a group of law professors supporting the Ninth Circuit ruling.
Unclear Meaning of ‘Undue Hardship’
Although the court’s ruling in Espinosa is expected to be focused largely on procedural issues, the broader question of how courts should apply the “undue hardship” standard also needs to be revisited, some higher-education experts say.
Mark Kantrowitz, publisher of FinAid, a Web site about student aid, says Congress should either better define “undue hardship” or remove it from the law.
“The problem is that Congress did not define what it meant by ‘undue hardship,’ and even the most commonly accepted principles are not widely used,” Mr. Kantrowitz said.
Congress first applied the “undue hardship” standard to federally guaranteed student loans in the 1970s. At the time, lawmakers were responding to anecdotes of wealthy professionals filing for bankruptcy to avoid paying off debts for law and medical degrees.
In 2005, Congress applied the same standard to private student loans, including them in the categories of debt that are not automatically discharged in bankruptcy. By comparison, mortgages, credit-card balances, and even gambling debts can be excused without showing undue hardship.
Rafael I. Pardo, an associate professor at Seattle University School of Law, has researched how courts apply the “undue hardship” standard and says the problem is not just that there is a stringent standard, but also that the standard is applied inconsistently. “It’s a crapshoot whether you get relief or not,” he said.
In addition, the process of proving “undue hardship” is difficult and costly, requiring a lawyer and adding to the financial burden of people already in dire straits, he said.
Decisions in two recent bankruptcy cases illustrate how the student-loan debt of people in similarly difficult situations can be treated differently by the courts.
Larry D. Gaylord earned college credits at 10 institutions, completing two degrees. He holds a bachelor’s degree in philosophy and religion from Friends University, which he received in 1996, and a graduate degree from Texas Chiropractic College, earned in 2002. But he struggled with mental and physical health problems and was unable to successfully complete the state-licensing tests to work as a chiropractor.
At the time of his bankruptcy trial in November 2005, Mr. Gaylord was 51 years old, had accrued nearly $162,000 in student loans, and was living on Social Security, with an income of about $10,500 a year. He had not been employed since the mid-1980s, was divorced, and was living with his mother.
The bankruptcy judge dismissed all but $12,000 of Mr. Gaylord’s loans, but the guarantor appealed. The U.S. District Court in Houston reversed the lower court’s ruling, even though the federal judge found that his expenses of $942 a month exceeded his Social Security income of $882.
“Gaylord has an extensive education and several degrees,” Judge Melinda Harmon concluded in her 2007 ruling. “As the bankruptcy court noted, he presents himself well and speaks well and moves well.”
Stephen L. Halverson also faced a series of personal calamities but eventually had better luck than Mr. Gaylord in dismissing most of his student debt.
As the single parent of two sons, he racked up about $132,000 in student loans between 1988 and 1994 earning master’s degrees in both special and vocational education from the University of Minnesota. In 1995 he went back to work full-time as a teacher in the Minnesota public schools, but was laid off two years later.
While substitute teaching and taking care of his widowed mother and his two children, Mr. Halverson managed to pay off $26,000 of his loans. But he deferred payments often, accruing fees that increased his total debt to nearly $300,000.
Last February, Judge Robert J. Kressel, of the U.S. Bankruptcy Court for the District of Minnesota, dismissed all but $11,000 of Mr. Halverson’s debts. In doing so, the judge said that “unlike the high-earning potential graduates whom Congress sought to rein in, Halverson is a teacher who has simply been unable to make much money.”
Varied Statistics on Borrowers
Estimates on the number and amount of student loans discharged through bankruptcy vary. In one study of 115 student-loan bankruptcy proceedings in Western Washington, Mr. Pardo found that as many as half of borrowers who sought to have their loans discharged because of “undue hardship” got at least a portion of their debts dismissed. But those decisions, Mr. Pardo found, were often based more on the particular judge in the case or the experience of the lawyer representing the debtor rather than on any calculation about a person’s ability to repay the loans.
However, figures from Educational Credit Management Corporation, which services bankrupt loans for 25 lenders and the U.S. Department of Education, show that a much smaller proportion of borrowers are able to prove undue hardship. The company holds the loans of 72,000 student borrowers in bankruptcy. In 2008, just 276 borrowers asked a judge to dismiss their debts; 134 of those cases have been resolved, and 29 had all or part of their loans excused by the courts.
Bobbie J. Sweeney, chief of business operations for Educational Credit Management, said it should be tough to excuse student loans in bankruptcy because college students who get federally backed loans have a responsibility to taxpayers.
“I hate to be cynical, but some of these people are going to be abusing the system,” Ms. Sweeney said. “It may be that some of these people, their intention is not to repay.”
