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Justices Weigh Discharge of Student Loans in Bankruptcy

The U.S. Supreme Court today waded into the complexities of the student-loan industry, hearing a lender's challenge to a bankruptcy plan approved by lower courts that allowed an Arizona man to discharge some of his student loan debt without proving "undue hardship," as federal law requires.

Student loans are one of several debts, including back taxes and child support, that cannot easily be discharged in bankruptcy. Debtors must prove "undue hardship" to receive relief.

The case involves Francisco J. Espinosa, an airline ramp agent in Phoenix who in the late 1980s received some $13,250 in student loans to attend trade school. In 1992, Espinosa filed for Chapter 13 bankruptcy protection, and he proposed paying $274 per month over five years to United Student Aid Funds Inc., an amount that would cover his principal but not some $4,000 in interest on the loans.

Espinosa did not initiate an adversary court proceeding to prove undue hardship, as federal bankruptcy statutes require for discharging student loan debt. Instead, the bankruptcy court in Phoenix sent a notice to United Student Aid Funds alerting it of the proposed discharge plan, and giving the lender the chance to respond. The lender did not object to the bankruptcy court's confirmation of the plan.

Later, under a reinsurance plan for the federally backed loans, the U.S. Department of Education began collection efforts against Espinosa for the outstanding interest from his student loans. Espinosa went back to the bankruptcy court seeking it to order the creditors to cease their collection efforts. (United Student Aid Funds, a private lender based in Indianapolis, eventually recalled the loan from the federal Education Department and pursued its claims.)

Espinosa eventually won a ruling from the U.S. Court of Appeals for the 9th Circuit, in San Francisco, that his bankruptcy plan was valid and that the lender could not collect any more from him.

In an oral argument today that was heavy on the intricacies of the bankruptcy statute, lawyers for United Student Aid Funds and the Obama administration warned that upholding Espinosa's lower-court victory would give a green light to many more debtors to try an end run around the statutory requirements for student loan relief.

"We are talking about a statutory right here, and the fact that Congress has specifically provided that certain categories of debts, for very important public policy reasons, are carved out from discharge," Madeleine C. Wanslee, the lawyer representing the lender, told the justices. "And the reason [Espinosa's plan] is void is because it violates the plain language of the statute."

Toby J. Heytens, an assistant to the U.S. solicitor general who was arguing on the side of United Student Aid Funds, also noted there is "an important public interest at stake here, which is that the [federal] Department of Education is reinsuring all of these loans."

"There is a powerful interest in ensuring the integrity of the student loan system as a whole, that, regardless of the decisions that an individual debtor and perhaps an individual creditor are willing to make in particular cases, Congress has an overriding policy that student loans should not be discharged unless there is a determination that this is the extraordinary case, rather than the ordinary," Heytens added.

Michael J. Meehan, the lawyer representing Espinosa, conceded that the bankruptcy court did not follow the letter of federal law in approving his client's discharge plan. But, given the tremendous strains on the bankruptcy system, "I think that ... if a creditor and a debtor wanted to come in and stipulate that there would be a discharge of a portion of the student loan without a finding of undue hardship, that certainly they can do so."

The justices questioned both sides aggressively.

"Your reading is, even if the debtor is silent, totally silent, says nothing about hardship, unless the creditor objects, then the discharge will be proper; the plan can be confirmed," Justice Ruth Bader Ginsburg said to Meehan. "So you are taking a burden that Congress has put on the debtor and switching it to the creditor."

But in an exchange with Wanslee, Justice Anthony M. Kennedy wondered about a creditor that is represented in the bankruptcy court proceeding but does not object to the court's discharge of student loan debt.

"Can the creditor come in 10 years later and say this is a void judgment?" Justice Kennedy asked. When Wanslee said the creditor could, Justice Kennedy said, "I think that's an astounding conclusion."

The case, United Student Aid Funds Inc. v. Espinosa (No. 08-1134), should be decided by next July.

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