Courts Must Ask Debtors To Establish Hardship

By Lawrence Hurley
Daily Journal Staff Writer, March, 2010
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WASHINGTON - In a unanimous ruling, the U.S. Supreme Court concluded Tuesday that the failure of a debtor to show that he would struggle to pay what he owed did not void a bankruptcy court judgment discharging his student loan debt.

But the court stressed that in the future, bankruptcy courts should always order debtors to prove "undue hardship," a requirement for those seeking to discharge student loan debt via a Chapter 13 bankruptcy.

The outcome means that although the debtor in question, Francisco J. Espinosa, won his case, bankruptcy courts are on notice that they have to order an undue hardship determination if the debtor does not raise it first. Student loan companies, which had raised concerns about debtors abusing the system, welcomed this part of the ruling. United Student Aid Funds Inc. v. Espinosa, 2010 DJDAR 4307.

The decision comes a week after the Administrative Office of the U.S. Courts announced that non-business bankruptcy filings increased by 32 percent during 2009.

The case also saw the Supreme Court affirm the 9th U.S. Circuit Court of Appeals for the first time this term, although it narrowed the scope of the lower court's ruling.

The 9th Circuit was the only circuit that had allowed debtors to discharge debts without showing undue hardship. Chief Judge Alex Kozinski wrote the opinion for a unanimous three-judge panel in October 2008.

The case focused on the efforts of Indianapolis-based nonprofit student loan company United Student Aid Funds Inc. to recover the $4,000 in interest that Espinosa failed to pay on his $13,250 loan after he filed a Chapter 13 petition in 1992. In his Chapter 13 plan, Espinosa agreed to pay back the principal but not the interest. He did not file a claim asserting undue hardship, but the bankruptcy court nevertheless endorsed the plan in 1993.

The loan company did not object until the U.S. Department of Education got involved in 2000 after the government was assigned the unpaid debt. In 2003, Espinosa then petitioned the bankruptcy court to stop the government from intercepting his income tax refunds on the grounds that he had already paid everything covered by his bankruptcy plan. This prompted United Student Aid to argue in a cross-motion that the 1993 order was void because there had been no finding of undue hardship.

A year later, Tucson, Ariz.-based bankruptcy judge, Eileen W. Hollowell, said she was bound by 9th Circuit precedent to find in favor of Espinosa. In 2006, U.S. District Judge Raner C. Collins in Arizona found in favor of the student loan company before the 9th Circuit reversed.

Justice Clarence Thomas wrote in the opinion issued Tuesday that the bankruptcy court's order was not void because it was a final judgment of which the loan company had failed to appeal.

The failure of the bankruptcy court to make an undue hardship finding was a legal error but did not void the final judgment, he added.

The Supreme Court differed with the 9th Circuit on one key point. Thomas wrote that bankruptcy courts should not sign off on a bankruptcy plan in such cases unless there is an undue hardship determination. Kozinski had suggested that courts could unless the creditor objected.

Thomas acknowledged that "unscrupulous debtors" could try to abuse the process by hoping that bankruptcy judges will overlook the undue hardship question, but he noted that both debtors and attorneys could face penalties for improper conduct under the bankruptcy code.

"The specter of such penalties should deter bad-faith attempts to discharge student loan debt without the undue hardship finding Congress required," Thomas wrote.

Bob Murray, vice president of corporate communications at United Student Aid Funds, welcomed the clarifying language in Thomas' opinion that will "broadcast loud and clear" that bankruptcy judges have to ensure that undue hardship determinations are made before entering a final judgment.

Thomas had also sent "a pretty strong message" to debtors and their lawyers that should prevent any abuse, he added.

Murray noted that the loan company's own lawyers are also now much more proactive about monitoring all Chapter 13 plans to ensure that debtors don't attempt to circumvent the law.

Bankruptcy law expert G. Eric Brunstad, Jr., a partner at Dechert in Hartford, Conn. who filed an amicus brief in support of Espinosa, also had praise for the ruling because it recognizes the finality of bankruptcy plans endorsed by a judge.

"If you get a plan and the court approves it, that's a final order and creditors can't come and upset that," he said. "It's a great principle."

lawrence_hurley@dailyjournal.com