Chapter 5 A Practice Guide to Student Loan Litigation in Bankruptcy Court

• Jurisdiction: United States

Chapter 5 A Practice Guide to Student Loan Litigation in Bankruptcy Court

This chapter focuses on the unique procedural aspects of adversary proceedings filed under § 523(a)(8).⁴⁶¹ The types of student loan debts described in § 523(a)(8) are automatically excepted from discharge, unless the debtor files an adversary proceeding and affirmatively establishes that excepting the debt from discharge "would impose an undue hardship on the debtor and the debtor's dependents."⁴⁶² In this chapter, we look at the procedural implications of § 523(a)(8) litigation as opposed to the substantive meaning of "undue hardship."⁴⁶³

All adversary proceedings are governed by the same set of procedural rules set forth in Part VII of the Federal Rules of Bankruptcy Procedure (the "Bankruptcy Rules")⁴⁶⁴ Part VII of the Bankruptcy Rules incorporates the Federal Rules of Civil Procedure, with certain modifications specific to bankruptcy.⁴⁶⁵ This chapter assumes that the reader is equipped with a working knowledge of these rules and does not attempt a comprehensive recap of bankruptcy litigation in general. Instead, this chapter concentrates on providing an overview of the procedural nuances of adversary proceedings filed under § 523(a)(8).

A. When Is Litigation the Best Option?

Before filing a complaint, counsel should carefully consider whether litigation is the debtor's best option. Unless the debtor has a good chance of proving undue hardship, litigation may not be worth the cost to the debtor. Because of the difficulty of proving undue hardship and the large number of potential plaintiffs, student loan creditors tend to aggressively defend these cases and are reluctant to settle without putting the debtor to his proof:⁴⁶⁶

In any case initiated to determine "undue hardship," the debtor and debtor's counsel should not initiate the action unless they are fully prepared to go through trial, and possibly also an appeal. Because rulings can impact future cases, many student loan creditors tend to litigate these cases vigorously. Creditors will often not even discuss settlement until after full discovery is completed, and even then they will not agree to a discharge of the loans in the absence of compelling facts.⁴⁶⁷

For this reason, many debtors' lawyers direct their clients to other solutions (particularly administrative repayment programs) in preference to filing an adversary proceeding under § 523(a)(8), citing the cost of litigation and the perceived difficulty of success.

Despite this, empirical studies indicate that debtors have a surprisingly good chance of success when they do initiate action under § 523(a)(8). A 2012 empirical study by Jason Iuliano found that roughly half of the 217 debtors who filed § 523(a)(8) adversary proceedings in 2007 received some form of relief.⁴⁶⁸ Of this group, 25% of the plaintiffs received a complete discharge, 14% received a partial discharge and 12% entered an administrative repayment plan.⁴⁶⁹ Of 81 cases in which plaintiffs discharged some part of their student loan debt, approximately 70% (57 cases) were resolved through settlement and 25% (20 cases) were resolved through a favorable trial verdict.⁴⁷⁰

In addition to measuring rates of success, Iuliano's study attempts to determine the demographic and financial characteristics of debtors who are successful in these actions. As a group, debtors who filed § 523(a)(8) actions tended to be "female (68%), unmarried (68%), employed (60%), [have] no dependents (54%), and [claim] medical hardship (51%)."⁴⁷¹ Within this group, debtors who received successful outcomes in their cases were more likely to have a medical hardship and less likely to be employed.⁴⁷² Rafael Pardo and Michelle Lacey reached similar conclusions in an earlier study, finding that successful § 523(a)(8) plaintiffs had lower monthly incomes and expenses than unsuccessful debtors, and were more likely to have medical problems.⁴⁷³

Several salient points can be drawn from these studies. First, although creditors have strong incentives to litigate aggressively, they are sometimes willing to settle these claims without going to trial. Second, § 523(a)(8) claims are fact-intensive. Under the substantive law of undue hardship, a debtor is more likely to prevail if her circumstances are dire and unlikely to improve.⁴⁷⁴ To meet this standard, a debtor may be required to face intensive discovery requests, locate expert witnesses, and prove her diligence in seeking employment. If a debtor is able to marshal this type of proof, her § 523(a)(8) action may be successful.

B. Initial Filing Considerations

1. Section 523(a)(8) Requires an Adversary Proceeding

Bankruptcy Rule 7001(6) provides that any action to determine the discharge-ability of a debt must be brought as an adversary proceeding. Actions to determine the dischargeability of student loan debts are included in this provision and are properly brought by filing an adversary proceeding.⁴⁷⁵ Despite the rule's plain mandate, debtors have occasionally attempted to circumvent the adversary-proceeding requirement by modifying student loan debt in a chapter 13 plan. This approach was rejected in United Student Aid Funds Inc. v. Espinosa,⁴⁷⁶ in which the Supreme Court held that it was error for a bankruptcy court to discharge student loan debt without an independent determination of undue hardship through an adversary proceeding.⁴⁷⁷ After Espinosa, it is clear that actions to determine the dischargeability of student loans must be brought as adversary proceedings.

2. Objections to the Creditor's Claim

In addition to adversary proceedings, bankruptcy litigation can take the form of abbreviated "contested matters" under Bankruptcy Rule 9014.⁴⁷⁸ Although disputes about the discharge of student loan debt require an adversary proceeding, other types of challenges to student loans may be appropriate for decision as contested matters. For example, § 502(b)(1) allows the debtor to object to the creditor's claim on the ground that it is "unenforceable against the debtor and property of the debtor, under any agreement or applicable law."⁴⁷⁹ This provision allows the debtor to use a contested matter to file an objection to a claim asserting defenses, counterclaims or claims for setoff without filing an adversary proceeding.

In In re Hann, the First Circuit addressed a debtor's ability to use the claims-allowance process to determine the satisfaction of her student loan debt.⁴⁸⁰ Hann had financed her legal education with three Stafford loans originated between 1990 and 1992. Hann contended that she had repaid these loans in full before filing a chapter 13 bankruptcy case in 2004. The creditor, ECMC, did not acknowledge the repayment and filed an unsecured proof of claim in the amount of $54,756 in Hann's chapter 13 case. Hann filed an objection to ECMC's claim, asserting that ECMC had failed to submit documentation to support its claim, that ECMC had provided conflicting information about the amount of the claim, and that Hann's own records showed payments in excess of the loan amounts.

The bankruptcy court held an evidentiary hearing on Hann's objection. ECMC did not appear at the hearing or respond to Hann's objection. After taking extensive payment evidence from the debtor, the bankruptcy court sustained Hann's objection and allowed ECMC's claim in the amount of $0.00. ECMC did not appeal. After Hann's chapter 13 case was closed in 2010, ECMC resumed its attempt to collect on Hann's loans. Hann then reopened her bankruptcy case and filed an adversary proceeding to have ECMC held in contempt.

The First Circuit agreed with the lower courts that the issue in Hann's case was "not whether the debt was dischargeable, but instead whether ECMC's claim was disallowed 'on the grounds of pre-petition payment in full.' If so, discharge was irrelevant because 'there is no need to except from discharge a debt which no longer exists.'"⁴⁸¹ The court drew a distinction between the allowance of a claim, which deals with the creditor's rights against the estate, and dischargeability, which addresses whether the debtor remains personally liable for a debt after receiving a bankruptcy discharge.⁴⁸²

In this case, the bankruptcy court's order disallowing ECMC's claim was based on the court's conclusion that the debt had been repaid, a factual finding that had nothing to do with undue hardship. It followed that Hann's objection to ECMC's claim was not a sub rosa attempt to litigate undue hardship as a contested matter, but instead a bona fide objection that ECMC's claim should be disallowed as satisfied. The bankruptcy court's order in Hann's favor was supported by substantial unrebutted evidence. On these facts, the First Circuit also upheld the bankruptcy court's award of sanctions against ECMC as a proper exercise of the bankruptcy court's equitable powers under 11 U.S.C. § 105(a).

3. Impact of Stern v. Marshall

Section 157(b)(2) of title 28 of the U.S. Code contains a nonexhaustive list of "core proceedings" and gives bankruptcy judges statutory power to hear and determine these matters through entry of a final judgment. The core proceedings listed in § 157(b)(2) are matters that Congress has deemed both fundamental to the bankruptcy process and within the powers of bankruptcy judges. The statutory grant of judicial power conferred by § 157(b)(2) is necessary because bankruptcy judges are appointed pursuant to Article I of the Constitution and are not afforded the full protection conferred on the federal judiciary by Article III.⁴⁸³

In Stern v. Marshall,⁴⁸⁴ the Supreme Court held that bankruptcy judges, as Article I judges, lacked the constitutional authority to decide all of the matters listed within the statutory authority granted by § 157(b)(1). Stern specifically addressed whether the bankruptcy court had the power to enter a final judgment on the debtor's state law counterclaim for tortious interference, filed in response to a creditor's claim against the estate. The...