Major New Student Loan Opinion: 9th Circuit Allows Chapter 13 Discharge of Student Loans WITHOUT Adversary Proceeding by Mere Inclusion in Plan

By Andrew Toth-Fejel, Bankruptcy Litigation Support for Attorneys, Andy@BLSforAttorneys.com


Espinosa v. United Student Aid Funds, Inc.
9th Circuit No. 06-16421
Filed October 2, 2008
NOTE: Opinion written by Chief Judge of the 9th Circuit, Alex Kozinski

Can a Chapter 13 debtor discharge a student loan by including it in the plan but without filing an adversary proceeding to determine debtor's undue hardship, if the student loan creditor fails to object to the plan? In this opinion filed by the 9th Circuit yesterday, its Chief Judge Kozinski emphatically answered: "yes."

This is an amazing opinion. It is one of the most colorful opinions I've read in months (see some of that "color" quoted below). In overturning the District Court appellate decision and following its own 9th Circuit precedents, it strongly rejected constitutional arguments to the contrary by the 4th, 6th & 7th Circuits as well as statutory arguments to the contrary by the 2nd and 10th Circuits. (This 2007 10th Circuit opinion was an en banc decision--one decided by the full court of judges in the Circuit--which overturned one of its own 1999 opinions, this now overturned earlier 10th Circuit opinion having been previously used by the 9th Circuit in support of ITS own 1999 opinion, which in contrast Judge Kozinski here reaffirmed as good law!) This Espinosa opinion also explicitly overruled a trio of recent 9th Circuit BAP opinions, as well as some published bankruptcy court opinions within the Circuit.

Special Plan Language

The Chapter 13 plan in this case contained some critical and exceptionally specific language:

One section of the plan is titled "Educational Loan(s)" and lists all of [the student loan creditor's] loans, for a total of $13,250. The plan specifies that this amount should be paid in full, followed by a paragraph stating as follow:

The amounts claimed by [the student loan creditors] for capitalized interest, penalties, and fees shall not be paid for the reasons that the same are penalties and not provided for in the loan agreement between the Debtor and the lender.

The subsequent paragraph provides as follows:

Any amounts or claims for student loans unpaid by this Plan shall be discharged.

Statutory Argument

§ 1328(a)(2) of the Code lists some of the debts which are excluded from a Chapter 13 discharge, including "debts . . . of the kind specified in paragraph . . . (8) . . . of section 523(a) . . . ." § 523(a)(8) contains the familiar language about excepting debts from discharge for " an educational benefit overpayment or loan made, insured, or guaranteed by a governmental unit . . . ", unless excepting such a debt from discharge "would impose an undue hardship on the debtor and the debtor's dependents . . . ." So if the Chapter 13 discharge does not discharge a student loan unless that loan imposes an undue hardship on the debtor, and there is no determination of that undue hardship in an adversary proceeding, how can this student loan be deemed discharged merely by creditor not objecting to the plan?

Indeed the student loan creditor's statutory argument was that the bankruptcy court should set aside the discharge order entered at the end of the Chapter 13 case because the debtor did not file such an adversary proceeding to determine undue hardship. Judge Kozinski's quick response was to cite 9th Circuit precedent: "Great Lakes Higher Educ. Corp. v. Pardee (In re Pardee), 193 F.3d 1083, 1086 (9th Cir. 1999), which is on all fours with our case, forecloses this argument." "In essence, Pardee held that a discharge is a final judgment and cannot be set aside or ignored because a party suddenly claims, years later, that the trial court committed an error."

Espinosa rejects the recent arguments of the 2nd and 10th Circuits which found conflict between § 1327(a), the Chapter 13 plan confirmation "finality provision," and the Code sections and Rules calling for an adversary proceeding to discharge student loans. "We see no such conflict; both provisions can operate fully, within their proper spheres." If a debtor proposes a plan which includes a discharge or partial discharge of a student loan and does not file an adversary proceeding to establish undue hardship, the creditor can object to the plan.

But there are many reasons a student loan creditor might not object to such a Chapter 13 plan. The creditor might, for example, believe that the debtor would be able to make a convincing showing of undue hardship, and thus see no point in wasting the debtor’s money, and its own, litigating the issue. Or, the creditor may decide that a Chapter 13 plan presents its best chance of collecting most of the debt, rather than spending years trying to squeeze blood out of a turnip. Or, the creditor may hope that the debtor will make some payments on the plan but ultimately fail to complete it, in which case the creditor will have collected a portion of the debt and still be free to collect the rest later. [Footnote pointing out that statistically about 2/3rds of Chapter 13 cases fail.] Or, the creditor may overlook the notice or fail to understand its legal implications. Regardless, when the creditor is served with notice of the proposed plan, it has a full and fair opportunity to insist on the special procedures available to student loan creditors by objecting to the plan on the ground that there has been no undue hardship finding. Rights may, of course, be waived or forfeited, if not raised in a timely fashion. This doesn’t mean that these rights are ignored, or that a judgment that is entered after a party fails to assert them conflicts with the statutory scheme or is somehow invalid.

The opinion then makes clear that a bankruptcy discharge order is a final judgment, which "cannot be ignored or set aside just because it was the result of an error." After the discharge order is entered and not appealed from, it, like any judgment, can be reconsidered only under the very limited circumstances (such as mistake, excusable neglect, fraud) permitted under Rule 60(b) of the Federal Rules of Civil Procedure.

This Espinosa opinion rejected the 2nd and 10th Circuits' res judicata argument, that the order confirming a plan should not be given preclusive effect and the student loan discharged with the discharge order because undue hardship was not adjudicated on the merits at the time of confirmation. Judge Kozinski retorted that

the creditor in our case (as in those other cases) did get proper notice of the proposed Chapter 13 plan, and so knew perfectly well that if the plan were approved and satisfied, the debtor would be granted a discharge of the student debt listed in the plan. Had the creditor wanted to insist on an adversary, it could have objected to the Chapter 13 plan on the ground that there was no judicial finding of undue hardship. . . . . But [the creditor] didn’t object to the plan and didn’t appeal the order confirming the plan, as it well could have. Instead, it accepted the payments made by the debtor during the plan’s life and then acted as if the whole thing never happened.

It makes a mockery of the English language and common sense to say that Funds wasn’t given notice, or was somehow ambushed or taken advantage of. The only thing the creditor was not told is that it could insist on an adversary proceeding and a judicial determination of undue hardship. But that’s less a matter of notice and more of a tutorial as to what rights the creditor has under the Bankruptcy Code—a long-form Miranda warning for bankers. If that were the standard for adequate notice, every notification under the Bankruptcy Code would have to be accompanied by Collier’s Treatise, lest the creditor overlook some rights it might have under the Code.
. . . .
After all, we aren’t talking here about destitute widows and orphans, or people who don’t speak English or can’t afford a lawyer. The creditors in such cases are huge enterprises whose business it is to administer the very kinds of debts here in question. If this kind of notice to sophisticated parties who have ample resources to protect their rights is inadequate for purposes of res judicata, then the concept of notice has no meaning and res judicata is a fairy tale. [Citations omitted.]

Constitutional Argument

The student loan creditor argued that it was denied due process as to the discharge order because it was not served with a summons and complaint for determination of undue hardship as is required by Rule 7004 of the Federal Rules of Bankruptcy Procedure. The 9th Circuit acknowledged that within the last few years three different Circuits have been persuaded by that argument, but found

the due process argument even less persuasive than the statutory argument, despite the eagerness of some of our sister circuits and other courts to adopt it. What appears to be going on is that courts are re-casting what may be a simple statutory violation as a denial of due process so that they can set aside judgments with which they’re unhappy. This approach is not consistent with the theory of objective judging, which calls for us to apply the law fairly to the facts and let the chips fall where they may.

The Judge Kozinski continued to focus on the order confirming plan as a final judgment, and looked at what would be constitutionally inadequate notice to a student loan creditor, one in violation of due process. He cited the familiar U. S. Supreme Court opinion of Mullane v. Cent. Hanover Bank & Trust Co., 339 U.S. 306, 314 (1950) for the standard of constitutionally adequate notice: “notice reasonably calculated, under all the circumstances, to apprise interested parties of the pendency of the action and afford them an opportunity to present their objection.”

The Court noted that the student loan creditor here had received actual notice, been "warned [in the notice] of the consequences of failing to object--which is more than due process requires," had filed a proof of claim, and had failed to object to the treatment laid out clearly in the plan.

We cannot say that [the student loan creditor] was taken by surprise or was denied due process. Quite the contrary: ]the creditor] appears to have been a willing participant, perfectly happy to receive the benefits of the Chapter 13 plan, but unwilling to suffer the consequences of its failure to file an objection.

The Ninth Circuit rejected the argument of its "sister circuits" that where the Code and Rules require a greater degree of notice through an adversary procedure, "due process entitles a party to receive such notice before an order binding the party will be afforded preclusive effect," quoting the 4th Circuit opinion. To the contrary Judge Kozinski said

we find it both wrong and dangerous to hold that the standard for what amounts to constitutionally adequate notice can be changed by legislation. The constitutional standard, as we understand it, requires that a party affected by the litigation obtain sufficient notice so that it is able to take steps to defend its interests. Congress can, of course, give rights to additional notice, but we find it difficult to see how this can affect the floor provided by due process—either to increase or diminish it.

Beside, the Court said that Congress did not try to change the constitutional standard here: it "made it quite clear that a creditor need only get ordinary notice of a Chapter 13 plan to be bound by its terms. That Congress provided heightened notice requirements for an adversary proceeding, which didn’t take place here, is of no consequence."

Not Need En Banc Review

The coup de grace of Judge Kozinski's opinion was his repeated assertions that his three-judge panel did NOT need to call for an en banc rehearing in spite of conflicts with so many other Circuits, as well as with a number of decisions in the 9th Circuit BAP and 9th Circuit bankruptcy courts. Why?: He simply did not find those other cases persuasive.

[W]e have taken a close look at the contrary holdings of our sister circuits in order to determine whether we have strayed off course, in which case we would call for rehearing en banc to correct our caselaw. But we don’t find the reasoning of the two other circuits persuasive. Seeing no reason to change course, we continue to follow [9th Circuit precedent] Pardee.
. . . .
We do not find this [due process] reasoning [by the 4th, 6th & 7th Circuits] persuasive and thus have no occasion to call for rehearing en banc to consider overruling [9th Circuit precedent] In re Gregory.

I can't help but muse whether he had other reason for not asking for en banc review: Did he perhaps harbor some fear that the en banc 9th Circuit would not stand by him, or he did not want to tempt such challenge to his "authority" as chief judge among his brother and sister judges? Note that his opinion barely cites any authority outside the Ninth Circuit, other than a 58-year old Supreme Court decision. And he is pushing a rationale based in large part on a 10th Circuit case that was repudiated last year by an en banc decision of the 10th Circuit. Principled and gutsy, or stubborn and erroneous, in any event it's an entertaining opinion.

by: Andrew Toth-Fejel
Bankruptcy Litigation Support for Attorneys
Andy@BLSforAttorneys.com

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