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Justices Back Student in College Loan Bankruptcy Case

In a case watched closely by the student loan industry, the U.S. Supreme Court today ruled in favor of a student who had discharged his college loan interest in bankruptcy without having to prove he faced "undue hardship," as federal bankruptcy law requires.

In an opinion for a unanimous court, Justice Clarence Thomas said the bankruptcy judge had committed "legal error" in approving the discharge plan for an Arizona man, but the man's lender had notice of the plan and failed to object to it in a timely manner.

A federal procedural rule that the lender sought to use to declare the debt discharge void "does not provide a license for litigants to sleep on their rights," Justice Thomas said in United Student Aid Funds v. Espinosa (Case No. 08-1134).

"United had actual notice of the filing of Espinosa's plan, its contents, and the Bankruptcy Court's subsequent confirmation of the plan," Thomas wrote. "United therefore forfeited its arguments regarding the validity of service or the adequacy of the Bankruptcy Court's procedures by failing to raise a timely objection in that court."

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 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.

When the case was argued in December, both the lender and the Obama administration expressed concerns that a ruling for the student could yield abuses in bankruptcy proceedings involving student loan debt.

Justice Thomas addressed some of those arguments in his opinion by saying that while the lender in this case could not void the approval of Espinosa's bankruptcy plan, bankruptcy judges should make sure that undue hardship exists before approving a plan that discharges student loan debt.

"To comply with [the language of federal bankruptcy law], the bankruptcy court must make an independent determination of undue hardship before a plan is confirmed, even if the creditor fails to object or appear in the adversary proceeding," Justice Thomas wrote.

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