Supreme Court Considers Student Loan Discharge in Bankruptcy

As NPR reported this week, more than a third of students enrolled in post-high school classes borrow money to advance their education. In sum, the federal government guarantees most student loans at a cost of $618 billion.

To discourage students from simply walking away from their debt, federal bankruptcy law makes it difficult to discharge a student loan debt—even in Chapter 13 bankruptcy—except in cases of undue hardship. Debtors must prove that the loan presents an undue hardship, such as an injury that prevents the type of work for which the degree was earned. Additionally, the debtor must have made a good faith effort to repay the loan. In the alternative, the Code does permit restructuring of a debt to make it repayable. The question now before the Supreme Court is what the obligations of the lender and the borrower are when a student cannot pay back their debt.

In the current case before the nation’s highest court, a student loan debtor, Francisco Espinosa, was allowed to enter a Chapter 13 plan without ever proving undue hardship to the bankruptcy court.  A bankruptcy trustee working with Espinosa's lawyer, in turn, worked out a payment plan for Espinosa to pay off the loan plus any bankruptcy fees. They plan absolved Espinoa of paying the $4,000 accrued interest. The lender, United Student Aid Funds Inc. (USAF), was notified in writing of the proposed repayment plan and filed no objections. A federal bankruptcy judge later approved the plan. Absent any appeal from the lender, Espinosa paid off his student debt in installments over the maximum five-year period permitted under law, absent the interest.

In 1997, the bankruptcy court declared the debt paid in full and discharged. Two years later, though, United pursued Espinosa for the interest, placing a lien on his tax refunds. Espinosa's lawyer asked the bankruptcy court to hold United in contempt.

According to the NPR report, the student loan company now argues that the bankruptcy court should have held a special hearing to determine whether Espinosa’s circumstances qualified as an undue hardship, and have required USAF to appear in court. USAF argues further that because the hearing was never held, undue hardship was never established, and the loan discharge was therefore illegal and void.

Espinosa's attorney has countered that USAF was properly notified and did not raise any objections at the time.  As NPR reported, a federal appeals court ruled against United, declaring that "it makes a mockery of the English language and common sense" for United to claim that it "was somehow ambushed or taken advantage of." Backed by the U.S. government, 24 states and the entire student loan industry, United appealed to the U.S. Supreme Court.

Stay tuned in the coming months for this potentially landmark bankruptcy case. In it, the Supreme Court will hopefully determine when a lender can assert their rights and raise objection to a Chapter 13 bankruptcy plan—and, in the alternative, when bankruptcy judgments, like that for Francisco Espinosa, are truly final.