Should Chapter 13 Plans Discharge Student Loans

Should Chapter 13 Plans Discharge Student Loans

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The Tenth Circuit Bankruptcy Appellate Panel's (BAP) recent decision in In re Mersmann, 318 B.R. 537 (10th BAP 2004), underscores the continuing tension between chapter 13 plan provisions discharging student loans, and implies that such discharge provisions are contrary to law and should not be enforceable.2 Courts considering the issue have either focused on the res judicata effect of confirmed chapter 13 plans and the finality of orders, or have found such plan discharge provisions contrary to due process requirements and unenforceable.3 Debtors argue that the need to effectuate the fresh-start concept of bankruptcy overrides any procedural due process that creditors are entitled to. Educational lenders, whether private or governmental, decry such provisions as contrary to the pleading requirements of civil suits—the necessity of a summons and complaint—and at odds with 11 U.S.C. §523(b)(8)'s mandate that the debtor must prove undue hardship before obtaining a discharge of a student loan. By including discharge provisions in chapter 13 plans, consumer lawyers use the chapter 13 plan process to circumvent the weight of authority, making student loans difficult to discharge by employing a streamlined process of plan confirmation to achieve a beneficial result to debtors.


11 U.S.C. §523(a)(8) formerly provided that a student loan would not be discharged unless it "became due more than seven years (exclusive of any applicable suspension of the repayment period) before the date of the filing of the petition...." "In the alternative, if the loan was less than seven years due, the debtor could discharge the student loan if "excepting such debt from discharge under this paragraph will impose an undue hardship on the debtor and the debtor's dependents...." 11 U.S.C. §523(a)(8).

On Oct. 7, 1998, President Clinton signed the Higher Education Amendments of 1998 (1998 HEA), which provided federal funding for education loans at a reduced rate of interest. Section 971 of the 1998 HEA eliminated the automatic seven-year discharge requirement of §523(a)(8). In addition, §484 of the 1998 HEA provided that the United States may register a state court judgment for an unpaid student loan in federal district court by filing a certified copy of the judgment and a copy of the assignment or transfer. As such, the United States no longer has to file a complaint to secure a separate judgment for an unpaid student loan that has been adjudicated by a state court. As a result, student loans can no longer be discharged because of the age of the obligation.4 Debtors5 have to file dischargeability complaints to contest the dischargeability of the student loans as being an undue hardship on the debtor and/or the debtor's dependents (absent provisions in a confirmed chapter 13 plan to the contrary).

The elimination of the seven-year discharge provision does suggest, however, that Congress now views "undue hardship" not as a debtor protection, but rather as a creditor protection. Consequently, fresh start should no longer be the issue, but rather whether the non-payment of the student loans violates public policy. The bar to having a student loan discharged has been raised, and the circumstances that warranted an undue-hardship discharge are more onerous than previously considered.

After the 1998 HEA amendments, several courts grappled with the harsh consequences of an "all-or-nothing" approach to the discharge of student loans. In an effort to make student loan discharge decisions more equitable and to effectuate the notion of a fresh start, a number of courts adopted a partial discharge of student loans premised on the debtor's ability to pay. These courts theorized that having debtors repay their loans on the basis of ability to pay tempered the creditor's need to obtain some payment on a non-dischargeable debt with the need to provide providing debtors with some finality in the payment of their student loans.

For example, in Tennessee Student Assistance Corp. v. Hornsby (In re Hornsby), 144 F.3d 433, 439 (6th Cir. 1998), the court concluded that an "all-or-nothing treatment [of student loans] thwarts the purpose of the Bankruptcy Act." The Sixth Circuit believed that the equitable powers of the bankruptcy court (11 U.S.C. §105(a)) trump Congress's overriding directive that student loans should not be discharged. Id. at 440. The Hornsby court found that the harshness of an "all-or-nothing" approach contradicts the principal objective of bankruptcy, which is the fresh start. As such, the Sixth Circuit reasoned that a partial discharge preserves the objectives of requiring some repayment of student loans while affording the debtor a chance of having a true fresh start. Id.

The Ninth Circuit adopted the use of a partial discharge in Graves v. Myrvang (In re Myrvang), 232 F.3d 1116 (9th Cir. 2000), and found that §105 allows a court to grant a partial discharge in a debt arising out of a divorce decree. Id. at 1123-24; 11 U.S.C. §523(a)(15). The Myrvang court held that a total discharge or "all-or-nothing" approach to discharge thwarts the purpose of the Bankruptcy Code, which is the adjustment of the creditor/debtor relationship in achieving a fresh start. Myrvang also held that the court's analysis under §523(a)(15) would equally apply under §523(a)(8). See, also, Saxman v. Dept. of Educ. et al. (In re Saxman), 263 B.R. 342, 345 (W.D. Wash. 2001).

The Sixth and Ninth Circuit Court of Appeals hold that the equitable powers of §105 provide bankruptcy courts with the authority to effect partial discharges of student loans where full repayment of all the debt would be an undue hardship. Hornsby, 144 F.3d at 440; Griffen v. Eduserv (In re Griffin), 197 B.R. 144, 147 (Bankr. E.D. Okla. 1996).

Section 105(a)—the "equitable powers" of the bankruptcy court—has on many occasions been invoked to allow a bankruptcy court the means to effectuate a decision that otherwise would not be supported under statutory construction. Section 105(a) authorizes the bankruptcy court to fashion such orders as are required to further the substantive provisions of the Code. It gives the bankruptcy court general equitable powers; however, these powers may only be used in a manner consistent with the Code. Young v. PHEAA (In re Young), 225 B.R. 312, 317 (Bankr. E.D. Pa. 1998). However, §105 does not give the bankruptcy courts the power to create substantive rights that would not be available under the Code. Id.; Peel v. Sallie Mae, et al. (In re Peel), 240 B.R. 387 (Bankr. N.D. Cal. 1999).

The preceding discussion evidences a progression in some courts to weaken, if not alter, the effect of §523(a)(8). The use of a confirmed plan to discharge student loans, even with proper notice to the student loan creditor, is yet one further attempt to limit the debtor's obligations to repay money lent in furtherance of the debtor's education. Curiously, since 1998, Congress has not evidenced a similar attitude toward the non-payment of student loans. In fact, during the ongoing debate to "reform" the Bankruptcy Code, there has been little interest in Congress to abrogate a debtor's obligation to pay his/her student loans.

In re Mersmann

The Tenth Circuit BAP's decision in Mersmann is both symbolic and representative of the current debate on chapter 13 provisions discharging student loans. In Mersmann, the debtor clearly and unequivocally stated that upon completion of payment of 10 percent to all general unsecured creditors under the plan, all unsecured general debts, including school loans that are non-dischargeable in chapter 7 cases, shall be discharged. Mersmann, 318 B.R. at 539.6 Several months later, the debtor amended the plan to include the following language:

School loans that are non-dischargeable in chapter 7 case—to be treated as general unsecured creditors... Upon completion of plan and payment of said 10 percent of allowed general, unsecured creditors, all remaining unsecured debts, including school loans that are non-dischargeable in chapter 7 cases, shall be discharged. Said completion of the plan shall result in a finding that it would be an undue hardship for the debtor to have to pay any additional monies to the special class of school loans not otherwise dischargeable. Id. at 539 (emphasis added).

The Mersmann court noted the impact of the amended plan provision: The debtor sought an express finding that payment of the student loan would be an undue hardship. Id. at 540. The creditor did not object to the original plan or the amended plan. Id. Years later, and several months after discharge, the creditor recognized its dilemma and filed a motion to amend the confirmation order and amended plan under F.R.C.P. 60(b). The bankruptcy court denied the motion.7

The Tenth Circuit BAP acknowledged that the procedures for obtaining a student loan discharge required the filing of a complaint and summons and seeking court adjudication on the issue of undue hardship to pay the student loan. That said, the Mersmann court was constrained to follow the Tenth Circuit's prior ruling in Andersen v. UNIPAC-NEBHELP (In re Andersen), 179 F.3d 1253 (10th Cir. 1999), wherein the court upheld a similar plan provision regarding a finding of undue hardship under principles of res judicata and policies favoring the finality of confirmation orders. Id. at 541. Like Mersmann, the debtor in Andersen did not establish undue hardship in an adversary proceeding. Id. Moreover, the Mersmann court recognized that in situations (like Andersen) where a chapter 13 plan has a specific finding of undue hardship, the court must allow the language to stand. Id.8

The Mersmann court maintained that a creditor must be vigilant in monitoring plan provisions involving a finding of undue hardship to protect its interests. Id. Moreover, the creditor's obligation to be vigilant cannot be delegated to the bankruptcy court or chapter 13 trustee. Id., citing In re Szostek, 866 F.2d 1405, 1414 (3rd Cir. 1989). In addition, the BAP found that after the plan is confirmed, the policy favoring the finality of confirmation orders is stronger than the court's and trustee's obligation to verify Code compliance. Id. (citation omitted). The Mersmann court noted that the necessity of the filing of a summons and complaint, and the need for due process, was abrogated by the creditor's failure to object to the confirmed plan and amended plan. Id. at 544. While the court agreed with the creditor's argument that a summons and complaint is necessary in discharging a student loan, the holding of Andersen required the court to determine that the student loan had been discharged by the confirmed and amended plan. Id. Moreover, had the creditor in Mersmann been the United States, it is questionable that the order confirming plan could have survived an argument under F.R.C.P. 55(e). Under Rule 55(e), a party cannot take a default (i.e., the failure to answer or respond) against the United States without first establishing that the claimant has a claim or right to relief by evidence satisfactory to the court.

Why the Courts Are Wrong in Upholding Such Plan Provisions

The analysis in support of chapter 13 plans that contain a finding of undue hardship has become a familiar one. Courts rationalize their holdings on at least three arguments: res judicata, the finality of confirmation orders and the need of a fresh start. While there is merit to each position, each position is not without challenge. For example, many courts maintain that a chapter 13 plan should have res judicata effect. Yet there have been some courts that recognize that the finality of a chapter 13 plan is not absolute. For example, the Fourth Circuit found that a creditor's lien cannot be avoided by merely listing the secured claim as unsecured and not providing for the continued existence of the lien in a chapter 13 plan. Cen-Pen Corp. v. Hanson (In re Hanson), 58 F.3d 89 (4th Cir. 1995); accord, In re Holloway, 261 B.R. 490 (M.D. Ala. 2001) (liens not provided for in chapter 12 plan will not be extinguished upon confirmation).

Hanson involved a chapter 13 plan that treated a lien on the primary residence as unsecured. The creditor did not object to the confirmation of the Hansons' chapter 13 plan or file a secured proof of claim. Hanson, 58 F.3d at 91. Further, the confirmed chapter 13 plan provided that "to the extent that the holder of a secured claim does not file a proof of claim, the lien of such creditor shall be avoided upon the entry of the order of discharge...." Id. at 92. The debtors subsequently received their discharge and filed a complaint in bankruptcy court to avoid the creditor's lien, arguing that it had been discharged by the order confirming plan. Id.

The bankruptcy court agreed with the debtors that the lien was discharged by operation of the order confirming plan. The district court reversed, finding that confirmation of the plan vested in the debtors the same interest in the residence that they had before filing bankruptcy—a residence subject to a lien. Id.

The Fourth Circuit declined to follow the debtors' argument that confirmation of the debtors' plan under §1327 is res judicata as to the validity of a lien. Id. In addition, the Fourth Circuit held that "[f]or a debtor to extinguish or modify a lien during the bankruptcy process, some affirmative step must be taken toward that end." Id. (citation omitted). Further, "[t]he simple expedient of passing their residence through the bankruptcy estate could not vest in the Hansons a greater interest in the residence than they enjoyed prior to filing their chapter 13 petition." Id. at 93. The Fourth Circuit recognized that the validity of a lien can only be raised in the context of an adversary proceeding. Id.

In Campbell v. Eastland, 307 F.2d 478 (5th Cir.), cert. denied, 513 U.S. 905 (1962), the Fifth Circuit found that Rule 55(e) rests on the rationale that the taxpayers should not have to bear the burden of a windfall awarded against the government. The Fifth Circuit also found that a claimant should not be relieved of proving the elements of its claim without requisite proof. Id. As a result, Rule 55(e) affords the United States a substantial protection against judgments for baseless claims. Id. As such, where the government fails to act, the ability of the debtor to avoid the protections of Rule 55(e) comes into play.

Second, many courts have focused on the finality of orders confirming plans. A plan can still be final, and provide for only partial repayment of a student loan, but not provide a debtor with an adjudication of undue hardship without proving same. The debtor can also retain the right to contest liability through an adversary proceeding. This would be no different than if the debtor's plan provided for the discharge of a valid finding of discrimination against the debtor or that the debtor had violated an environmental regulation.

Finally, many courts maintain that a debtor must obtain a "fresh start." While this is true, Congress obviously recognized in §523 that there are a number of obligations or debts that by either their nature or on policy grounds should not be discharged. In many instances, §523 exceptions to discharge are either deemed non-dischargeable or must be contested through an adversary proceeding. The use of a plan provision to discharge an otherwise non-dischargeable debt defeats congressional intent.


1 The views expressed in this article are Mr. Gargotta's and do not necessarily reflect the views of the Department of Justice or Department of Education. Return to article

2 See Great Lakes Higher Educ. Corp. v. Pardee (In re Pardee), 193 F.3d 1083 (9th Cir. 1999) (discharging student loan); Banks v. Sallie Mae Corp. (In re Banks), 299 F.3d 296 (4th Cir. 2002) (refusing to discharge student loan). Return to article

3 Cf. Education Credit Management Corp. v. Whelton (In re Whelton), 299 B.R. 306 (Bankr. D. Vt. 2003), aff'd., 312 B.R. 508 (D. Vt. 2004) (summons and complaint necessary to satisfy creditor's due process rights); In re Ruehle, 296 B.R. 146 (Bankr. N.D. Ohio 2003), aff'd., 307 B.R. 28 (6th BAP 2004) (due process requires a summons and complaint, and the rule is no less clear for student loans); In re Lemons, 285 B.R. 327 (Bankr. W.D. Okla. 2002) (such plan provisions are sanctionable); with Andersen v. UNIPAC (In re Anderson), 179 F.3d 1253 (10th Cir. 1999) (finality of confirmation order more important than legality of provision). Return to article

4 The statute of limitations regarding the collection of student loans was eliminated in 1991 to remove any statute of limitations for collecting on student loans. 20 U.S.C. §1091a(a); see, e.g., United States v. Phillips, 20 F.3d 1005 (9th Cir. 1994); United States v. Hodges, 999 F.2d 341 (8th Cir. 1993). Return to article

5 The burden of proof to show undue hardship is clearly on the debtor. Bachner v. Illinois (In re Bachner), 165 B.R. 875, 880 (Bankr. N.D. Ill. 1994); Evans v. Higher Education Assistance Foundation (In re Evans), 131 B.R. 372, 374 (Bankr. S.D. Ohio 1991). Return to article

6 The use of the language "that are non-dischargeable in chapter 7 cases" is noteworthy in that student loans by statute are non-dischargeable in chapter 13 cases. See 11 U.S.C. §1328(a)(2). Return to article

7 In fact, the bankruptcy court considered three other chapter 13 plans involving similar plan provisions. Mersmann at 540, n.8. Return to article

8 Compare the Tenth Circuit's holding in Poland v. Educational Credit Management Corp. (In re Poland), 382 F.3d 1185 (10th Cir. 2004), wherein the court found that absent a specific finding of undue hardship in a confirmed plan, a plan provision discharging a student loan is not binding. Return to article

Journal Date: 
Tuesday, March 1, 2005