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bluefieldphotos bp [CC BY-SA 2.0 (https://creativecommons.org/licenses/by-sa/2.0/)], via FlickrUnder the federal Bankruptcy Code, certain debts are not eligible for discharge by a bankruptcy court at the end of a case. Nondischargeable debts include certain tax debts, 11 U.S.C. § 523(a)(1); spousal and child support, id. at § 523(a)(5); and debts that resulted from fraud, theft, and other deceptive or unlawful acts, id. at §§ 523(a)(2), (4), (6). For many, perhaps most nondischargeable debts, a rationale based on public policy seems clear. This might not be the case, however, with regard to student loans, including both public loans, which are backed by the federal government, and private loans. Rather than attempting to deduce a public benefit from making student loans nondischargeable, it is worth looking into how they became nondischargeable in the first place.

Student loans are only subject to discharge in bankruptcy if a debtor proves that continuing to make payments would cause an “undue hardship” to them and their dependents. 11 U.S.C. § 523(a)(8). No single legal standard applies throughout the country for determining whether a debtor has established “undue hardship.” The Ninth Circuit, which includes California, has adopted a three-part test known as the Brunner test, found in Brunner v. N.Y. State Higher Educ. Serv. Corp., 831 F.2d 395, 396 (2d Cir. 1987). Other circuits have adopted a test known as the “totality of the circumstances,” first developed in In re Andrews, 661 F.2d 702, 704. (8th Cir. 1981). Both tests require a court to examine a debtor’s financial situation and determine whether it is possible that conditions might improve enough to allow the debtor to continue paying the loans. In other words, bankruptcy courts must attempt to predict the future.

Student loans therefore differ in at least one important way from other nondischargeable debts because there is an exception provided in the statute itself. As noted earlier, most nondischargeable debts have some obvious justification, such as the fault of the debtor in the case of a debt incurred through fraud, or the need of a dependent in the case of child support. Student loans, as it turns out, became nondischargeable quite incrementally.

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By Guillaume Paumier (Own work) [CC BY 3.0 (http://creativecommons.org/licenses/by/3.0)], via Wikimedia CommonsFederal prosecutors filed bankruptcy fraud charges against a reality television star in October 2015, alleging that she attempted to conceal income from the court during a bankruptcy proceeding. United States v. Miller, No. 2:15-cr-00212, indictment (M.D. Pa., Oct. 13, 2015). The indictment lists a total of 20 counts:  two counts of bankruptcy fraud, five counts of concealing assets, and 13 counts of false declarations. The investigation reportedly began when a bankruptcy judge familiar with the defendant’s case saw her television show and began to doubt her claims. In the age of social media, and the associated climate of over-sharing details of our lives, full disclosure in bankruptcy cases and other legal proceedings takes on an ever greater importance.

When an individual or married couple files for bankruptcy, they must provide the bankruptcy court with a detailed accounting of their assets, debts, and income. The debtor presents this information on “schedules,” using forms provided by the court. Federal criminal law prohibits debtors from concealing assets from the court or the trustee, intentionally or knowingly failing to disclose material information to the court or trustee, making false statements, and a wide range of other fraudulent or deceptive acts. 18 U.S.C. § 152. A debtor who makes a false statement in the course of a bankruptcy proceeding may also be subject to prosecution for bankruptcy fraud. 18 U.S.C. § 157. A conviction under either statute can result in imprisonment for up to five years.

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Legal News GavelA federal appellate case has the potential to make substantial changes to the way American bankruptcy courts handle student loans. Federal bankruptcy law does not allow courts to discharge student loan debt, unless the debtor can show that they and their dependents would suffer “undue hardship” if they were forced to repay the debt. 11 U.S.C. § 523(a)(8). The statute does not define “undue hardship,” so courts have had to apply their own interpretations. Most federal circuits have adopted the Brunner test, named for Brunner v. N.Y. State Higher Educ. Servs. Corp., 831 F.2d 395 (2d Cir. 1987), which uses a three-part test to establish “undue hardship.” The current case, Murphy v. Sallie Mae, et al., No. 14-1691 (1st Cir., Jun. 30, 2014), is in a circuit that has not expressly adopted any standard for “undue hardship.” This has made the case the center of a battle between consumer advocates on one side and student-loan lenders, with the support of the federal government, on the other.

The elements that a debtor must prove under the Brunner test made sense in 1987, but they are not necessarily as widely applicable in the world of 2015. A debtor must prove that they would not be able to maintain a basic standard of living, based on their current income and expenses, without discharge of the loans; that their current financial hardship is likely to continue for most of the repayment period; and that they have attempted to repay the loans in good faith. The second part of the test seems especially difficult, since it asks the court to predict the future, but the third part has also produced results that seem remarkably unjust.

The debtor in Murphy is 65 years old and has been out of work since he lost his job as the president of a manufacturing company in 2002. He has been unable to find work since that time. According to the district court that heard his case in 2014, he blamed his ongoing unemployment on his age and level of qualifications, as well as “the shrinking American manufacturing base.” Murphy v. Educ. Credit Mgt. Corp., 511 B.R. 1, 2 (D. Mass. 2014). From 2001 to 2007, he took out multiple loans, totaling more than $220,000, to finance his three children’s college educations.

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Legal News GavelWhen a debtor files a bankruptcy petition, the automatic stay prevents any pending litigation involving the debtor from moving forward. 11 U.S.C. § 362. Once a bankruptcy case is closed, or once a bankruptcy judge lifts the automatic stay, pending lawsuits and other proceedings may continue. A creditor in a California bankruptcy case recently raised a concern about the effect of an order from the bankruptcy court on a state court lawsuit that was still subject to the automatic stay. The legal doctrine of res judicata holds that once a court has made a final ruling on the merits of a specific claim or issue, that issue cannot be relitigated. The district court, hearing the creditor’s concern on appeal, held that the question of whether res judicata applies must be left to the state court. Restoration Homes, LLC v. Taniguchi, No. 3:15-cv-00032, order (N.D. Cal., Aug. 7, 2015).

The debtor and his wife purchased real estate in 2004. He obtained a mortgage loan modification in 2009, which lowered the total balance and the monthly payments, deferred part of the balance, and adjusted the annual interest rate. In June 2013, the creditor bought the debtor’s loan. It initiated foreclosure proceedings that October, claiming that the debtor had not made payments since July. The debtor disputed this and filed suit to enjoin the foreclosure in California state court. The court granted the debtor’s injunction, on the condition that he post a $40,000 bond. The debtor filed for bankruptcy, since he could not afford the bond.

The creditor’s proof of claim included over $53,000 in prior defaults, $47,000 in payment shortfalls, and other costs and charges. The debtor objected, claiming that the proof of claim was based on the original loan, not the 2009 loan modification. The bankruptcy court partly sustained the objection, ruling that the debtor could cure the default based on the loan modification provisions. The court’s order included a paragraph stating that the order was “without prejudice” to any “claims or defenses” in the state court case, specifically including the amounts owed to the creditor. Taniguchi, order at 3.

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By bocian (Open Clip Art Library image's page) [CC0], via Wikimedia CommonsCurrent and former students in the U.S. reportedly owe more than $1 trillion in public and private student loans. For many, the burden of student loan debt nearly eliminates any benefit of the education obtained with the loan proceeds. Making matters worse is the fact that federal bankruptcy law specifically excludes student loans from discharge. The U.S. Department of Education (DOE) recently announced two changes to student loan repayment rules, which apply to loans made through various DOE programs. The new rules do not affect a student loan debtor’s rights in bankruptcy in any way, but they may ease their debt burden in other ways.

Consumer Protections

Federal and state regulators have gone to great lengths to prevent financial marketing that could potentially mislead students. The Credit Card Accountability Responsibility and Disclosure (Credit CARD) Act of 2009, for example, largely prohibits credit card marketing on college campuses.

The first new rule announced by the DOE addresses prepaid debit cards and similar financial products. Numerous colleges have deals with banks that allow them to market prepaid cards to students as a convenient means of accessing student loan funds, sometimes without clearly disclosing overdraft and other transaction fees.. The DOE’s new rule requires schools to let students choose where to deposit their student loan funds, and it prohibits them from creating an impression that students must use a particular kind of account for their funds. 80 Fed. Reg. 67125 (Oct. 30, 2015).

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Legal News GavelThe bankruptcy process allows individuals and families to rebuild their finances after they find themselves unable to continue paying their debts with their existing income. Under the federal Bankruptcy Code, bankruptcy judges can make rulings regarding the payment of debts and, at the end of many cases, the discharge of remaining debts. Disputes may arise between a debtor and one or more creditors, which the court may have to resolve. A recent decision by a Los Angeles federal court reviewed a bankruptcy court’s authority to modify the amount of a debt, which is a common topic of dispute. In re Spellman, No. 2:15-cv-00507, opinion (C.D. Cal., Sep. 17, 2015). It held that the bankruptcy court could not modify the debt because it was the result of a state court judgment.

The debtor is the beneficiary of a trust that includes a spendthrift clause limiting his access to the trust proceeds until his 35th birthday in 2017. In early 2007, the debtor hired an attorney to represent him in a lawsuit filed by members of his family disputing money received by the trust. The parties settled the lawsuit in September 2009. The debtor’s attorney, as part of the settlement, sought the removal of the spendthrift clause in order to claim his fee. The debtor claimed that he was unaware until then that the attorney would claim one-third of the trust proceeds, or approximately $200,000. He notified the attorney that he was terminating their attorney-client relationship, but the attorney reportedly continued working on the case until the court approved the settlement. The attorney filed suit against the debtor in December 2009 to collect his unpaid fee.

The debtor and the attorney submitted the case to arbitration. The arbitrator awarded the attorney 33 percent of the trust proceeds. The trustee of the trust obtained an order from the probate court setting aside the removal of the spendthrift provision, but the attorney obtained an order from the superior court confirming the arbitrator’s award and entering a judgment against the debtor for more than $214,000. With the spendthrift clause in place, the debtor was personally liable for the judgment amount. The debtor filed for Chapter 13 bankruptcy in March 2012.

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Legal News GavelA bankruptcy court recently denied a creditor’s motion to reopen a Chapter 7 case after discharge, finding that the creditor had failed to follow the proper procedure to preserve their claims. In re Lavandier, No. 14-bk-12553, mem. dec. (Bankr. S.D.N.Y., Aug. 27, 2015). The creditor sought to extend the deadline to claim an exception from discharge, 11 U.S.C. § 523; and to object to discharge, 11 U.S.C. § 727. The court held that, by not following the procedures established by the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure, the creditor had not established good cause to reopen the case.

The creditor, a money transmitter, entered into an agency agreement with a corporation wholly owned by the debtor in 2009. Under this agreement, the corporation would accept money from customers on the creditor’s behalf to send overseas. The debtor signed a guaranty agreement making him personally liable for all money owed by the corporation to the creditor.

In 2013, the creditor filed suit in state court to recover amounts owed under the agency agreement. It obtained a default judgment holding the corporation and the debtor jointly and severally liable for more than $54,000. The debtor filed for Chapter 7 bankruptcy in September 2014.

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Legal News GavelThe bankruptcy court system deals with a substantial number of cases, with thousands of new cases filed every year. The Federal Rules of Bankruptcy Procedure establish certain uniform standards and procedures, and district and bankruptcy courts may establish local rules to assist judges and court staff. Failure to comply with these rules can result in setbacks, delays, or even outright dismissal. A debtor recently appealed the dismissal of her Chapter 13 bankruptcy case to a federal district court in Los Angeles. The district court, after finding that the debtor had failed to comply with local rules, dismissed her appeal and denied her motion to reconsider. In re Pulliam, No. 5:15-cv-00250, order (C.D. Cal., Jun. 23, 2015).

The debtor filed a Chapter 13 proceeding in the Bankruptcy Court for the Central District of California in 2014. The district court’s order states that the bankruptcy court dismissed her case on January 30, 2015 in connection with the Chapter 13 confirmation hearing, although it does not state the specific grounds for the dismissal. The debtor promptly filed an appeal with the district court.

The district court issued a notice in February, advising all parties that they must comply with the Federal Rules of Bankruptcy Procedure and the Local Rules Governing Bankruptcy Appeals, Cases, and Proceedings for the Central District of California. It also stated that it would issue a briefing schedule once the appellate record was complete and that any party requesting an extension of time must do so “well in advance of the due date, and must specify good cause for the requested extension.” Pulliam, order at 2. The court cautioned the parties that a failure to comply with any applicable rules could result in dismissal.

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Legal News GavelA California federal district court recently affirmed a bankruptcy court’s order lifting the automatic stay in a Chapter 13 proceeding, finding that the matter in question was not subject to the automatic stay under one or more exceptions found in the Bankruptcy Code at 11 U.S.C. § 362(b). The district court’s most recent ruling on the issue referenced two earlier orders:  In re Silva, No. 2:15-cv-02061, order denying appellant’s motion for stay pending appeal (“Silva I”) (C.D. Cal., Apr. 24, 2015); order denying appellant’s ex parte motion for reconsideration (“Silva II”) (May 1, 2015). The court incorporated those orders’ reasoning in the most recent order (“Silva III”), issued on June 22, 2015. The various orders draw on dense statutory language in the Bankruptcy Code, which frequently defines exceptions to the automatic stay entirely by reference to other code sections.

The debtor/appellant has, according to the court, lived in her home since 1988. She and her husband/co-debtor borrowed $125,000, secured by a first-mortgage lien on the property, in 2004. They took out a second mortgage the following year for $30,000. At some point, they began to discuss modifying the first mortgage loan, but they then defaulted on the second mortgage in 2008. The second-mortgage lender sold the property to a family trust (the “Buyer”) in a foreclosure sale in August 2009. Several weeks later, an employee of a property management company owned by the Buyer (the “Company”) went to the residence to inform the debtor of the sale, but the debtor reportedly did not believe him because of the ongoing loan modification negotiations with the first-mortgage lender.

Although the Buyer had an executed trustee’s deed, it did not record the deed right away, opting “to allow [the debtor] and her husband to remain in the property rent-free until the property increased in value.” Silva I at 3. In April 2010, the first-mortgage lender recorded a foreclosure notice. The debtors filed for Chapter 13 bankruptcy in August 2010, but no one recorded a notice of the bankruptcy proceeding in the property’s chain of title. In October 2014, the Buyer recorded the trustee’s deed and then executed and recorded a quitclaim deed transferring title to the Company. Neither party was aware of the pending bankruptcy proceeding at the time.

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Legal News GavelThe federal Bankruptcy Code gives wide discretion to individual bankruptcy judges to issue orders, including the authority to impose sanctions on a debtor or other party for acts that it finds to be unlawful or otherwise counter to the purpose of a bankruptcy case. A “sanction” is a punishment for conduct that takes place during the litigation process. A federal district court recently affirmed a bankruptcy court’s sanctions order in a Chapter 7 case, which found bad faith on the part of the debtors and assessed monetary damages. In re Kellogg-Taxe (“K-T I”), No. 2:15-cv-00084, order (C.D. Cal., Dec. 7, 2015).

Multiple federal statutes and rules permit courts to impose sanctions. The Bankruptcy Code gives courts broad power to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.” 11 U.S.C. § 105(a). See also, e.g. Fed. R. Civ. P. 11; Fed. R. Bankr. P. 9011; Chambers v. Nasco, Inc., 501 U.S. 32 (1991). In the order under appeal in the Kellogg-Taxe case, the bankruptcy court reviewed the caselaw interpreting § 105(a), which recognized “the inherent power to sanction vexatious conduct presented before the court.” In re Kellogg-Taxe (“K-T II”), No. 2:13-ap-01781, mem. of dec. at 13 (Bankr. C.D. Cal., Dec. 16, 2014), quoting In re Rainbow Magazine, Inc., 77 F.3d 278, 284 (9th Cir. 1996).

To sanction a party or its counsel, a court must find that the conduct in question “constituted or was tantamount to bad faith.” K-T II at 13, quoting Leon v. IDX Sys. Corp., 464 F.3d 951, 961 (9th Cir. 2006). A bankruptcy court’s “inherent sanction authority,” however, differs from federal district courts’ “civil contempt power.” K-T I at 6, citing In re Dyer, 322 F.3d 1178, 1196 (9th Cir. 2003). While civil contempt authority allows a court to impose sanctions for violations of specific orders, inherent sanction authority goes further, “allow[ing] a bankruptcy court to deter and provide compensation for a broad range of improper litigation tactics.” Dyer, 322 F.3d at 1196.

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