Articles Posted in Exceptions to Discharge

Published on:

Student loans are not dischargeable in Chapter 7 or Chapter 13 bankruptcy, except in narrowly defined circumstances. A debtor must establish that continued payment of the student loan debt would cause “undue hardship” to them and their dependents. 11 U.S.C. § 523(a)(8). Most U.S. jurisdictions apply a three-part test to determine whether a debtor has met this burden. A student loan debtor is currently appealing the denial of discharge in a Chapter 7 case to the U.S. Supreme Court, arguing in part that the three-part test is improper, or alternatively that it should be modified. Tetzlaff v. Educ. Credit Mgt. Corp. (“Tetzlaff Petition”), No. 15-485, pet. for writ of cert. (Sup. Ct., Oct. 15, 2015).

Most federal appellate courts, including the Ninth Circuit, have adopted the Brunner test to determine whether a student loan debtor has met the statutory requirement of proving “undue hardship.” A debtor must prove, by a preponderance of evidence, that:

1. Based on their current levels of income and expense, repayment of the loans would prevent them from supporting themselves or their dependents at a “minimal standard of living”;
2. This situation is likely to continue for most or all of the repayment period; and
3. They have “made good faith efforts” to make timely payments on the debt. Brunner v. N.Y. State Higher Educ. Svcs. Corp., 831 F.2d 395, 396 (2d Cir. 1987).

Continue reading

Published on:

Under 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.

Continue reading

Published on:

A 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.

Continue reading

Published on:

A 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.

Continue reading

Published on:

A California bankruptcy court ruled that a debtor couple’s federal tax liabilities were subject to discharge under Chapter 7 of the Bankruptcy Code. In re Martin, 508 B.R. 717 (Bankr. E.D. Cal. 2014) (PDF file). The debtors did not file Form 1040 tax returns for those tax years before the IRS assessed the amount of tax liability and began efforts to collect the debt. The court had to determine when tax liability becomes a “debt” for purposes of bankruptcy law:  when the IRS assessed the debt or when the debtors filed their returns. It ruled that the filing of the returns was the critical factor, and therefore it ruled for the debtors.

According to the court’s ruling, the debtors, a married couple, did not file federal income tax returns for the tax years 2004, 2005, and 2006. The IRS conducted an audit of the debtors in June 2008. The following August, it sent them a “notice of deficiency” for each of the three years. An accountant completed the three tax returns for the debtors in December 2008, but the debtors did not sign the returns or send them to the IRS until June 2009.

Meanwhile, in March 2009, the IRS assessed the debtors’ total tax liability and sent them several notices and demands for payment. It issued a due process notice, which initiated the collection process, in late May 2009. The debtors signed the returns and mailed them to the IRS about a week later.

Continue reading

Published on:

Student loan debt is among the largest financial burdens Americans face, with many estimates placing the total amount of debt at more than $1 trillion. Bankruptcy law, unfortunately, only offers limited relief. Since 2005, nearly all student loans are excepted from discharge in bankruptcy cases, except in very limited circumstances. Many debtors must consider other options in addition to bankruptcy if their student debt becomes overwhelming. A series of debt relief measures recently announced by the federal Department of Education (DOE) may offer relief to some debtors. One can hope that the DOE’s actions also offer hope for additional reforms in the future.

The Bankruptcy Code identifies certain debts that are not dischargeable in bankruptcy. 11 U.S.C. § 523. These exceptions could be broadly categorized as (1) debts owed to the government or subject to a court order, such as certain tax debts or child support obligations; and (2) debts incurred through some fault of the debtor, such as those arising from civil judgments for fraud or other injury.

Student loans do not quite fit into either category. Prior to 2005, the only student loans excepted from discharge were those “made, insured or guaranteed by a governmental unit,” or made by an organization that receives government funding. 11 U.S.C. § 523(a)(8) (2004). The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. 109-8, amended that section to include private student loans as well.

Continue reading

Published on:

Business owners, entrepreneurs, and investors often create business entities as a means of protecting themselves from liability, as well as protecting their business or investment from their own liability. If an individual debtor has some form of individual liability for unlawful business activity, however, those activities may be considered a factor in the bankruptcy proceeding. This was the case in a claim brought by the U.S. Department of Labor (DOL) against a business owner accused of withholding employee retirement contributions in violation of the Employee Retirement Income Security Act (ERISA), 29 U.S.C. § 1001 et seq.

The debtor was the sole member and manager of a limited liability company (LLC) organized in Massachusetts. The LLC operated a weight loss business through a Jenny Craig franchise at eight locations around New York state. It established a retirement plan and trust for its employees in 2012, with the debtor named as the plan’s fiduciary and trustee. Employees funded the plan through contributions withheld from their paychecks. The debtor was responsible for transferring the withheld amounts to the employees’ retirement plan accounts.

The DOL claimed that the debtor failed to transfer a total of $8,646.00 to the plan during pay periods in 2012 and 2013. Under ERISA, funds withheld from an employee’s paycheck for the purpose of contributing to a retirement plan automatically become an asset of that plan, and the plan’s trustee has a fiduciary duty to remit those funds to the plan promptly. The debtor, according to the DOL, violated ERISA by failing to transfer those funds to the retirement plan. Continue reading

Published on:

An extravagant lifestyle was not enough to overcome the presumption that debts incurred prior to filing for bankruptcy, including tax debts, are dischargeable, according to the Ninth Circuit. Hawkins v. Franchise Tax Bd. of California, No. 11-16276, slip op. (9th Cir., Sept. 15, 2014). The court considered whether the debtor’s tax debt was not subject to discharge under the exception for “willful[] attempt[s]…to evade such tax.” 11 U.S.C. § 523(a)(1)(C). After noting that the question of the mental state required to prove a “willful attempt to evade tax” was a matter of first impression, it held that the statute requires proof that a debtor specifically intended to evade tax liability. The debtor’s spending prior to filing bankruptcy, while “lavish,” was not out of the ordinary for him, and the tax debt was therefore dischargeable in bankruptcy.

The debtor made a substantial amount of money in the technology industry. He was an early employee of Apple, which he left to found the software and video game company Electronic Arts (EA). In 1990, he left EA to run a newly-created EA subsidiary called 3DO, which was entering into the video game and console market. By 1996, his net worth was around $100 million. He sold much of his EA stock and invested in 3DO. The Ninth Circuit’s opinion describes a series of accounting techniques using offshore corporations in order to claim losses on the sales of EA stock.

3DO filed for Chapter 11 bankruptcy in 2003 and later converted the case to a Chapter 7 liquidation. The debtor never received any substantial payouts from the liquidation of the business. The IRS began challenging his tax shelters in the late 1990s, and in 2005 it and the California Franchise Tax Board (FTB) assessed a total balance of over $36 million in unpaid taxes, penalties, and interest. The debtor sold some real property and applied all of the proceeds to the IRS balance in 2006, and the FTB also seized some financial accounts. In September 2006, the debtor and his wife filed for bankruptcy. The IRS and FTB filed proofs of claim for $19 million and $10.4 million, respectively. Continue reading

Published on:

A federal district court in California considered a request to discharge federally guaranteed parent loans, which the debtors took out to pay for one of their children’s education. In re Mees, No. 2:13-cv-01892, order (E.D. Cal., Jul. 22, 2014). Student loan debt is not dischargeable in bankruptcy except in rare case of “undue hardship.” 11 U.S.C. § 523(a)(8). The bankruptcy court ruled that the parent loans were not dischargeable, applying the same legal standard used for student loans. The debtors appealed, arguing in part that the bankruptcy court erred in applying this standard. The district court considered this question but ultimately remanded the case to the bankruptcy court, finding that it applied the test incorrectly.

The debtors, a married couple, took out federally guaranteed parent loans for their son, the older of two, to pay for his college education. Parent loans, known as PLUS Loans, typically have a much higher borrowing limit and might be used to cover any gaps in financial aid available directly to the student. Unlike a student loan co-signed by parents, the student is not liable on a PLUS loan. No payments are due until the student completes or leaves school.

The debtors’ son never completed his degree. The balance of the parent loans is about $35,000. By the time of the court’s ruling, both of the debtors had been unemployed for substantial periods of time:  three years for the husband and 30 years for the wife. Their younger son is still a minor. The debtors filed for Chapter 7 bankruptcy in September 2011. They filed an adversary proceeding several months later, seeking discharge of the parent loans. The bankruptcy court ruled against them, citing the three-prong test for determining “undue hardship,” known as the Brunner test after Brunner v. New York State Higher Educ. Svcs., 831 F.2d 395 (2d Cir. 1987). Continue reading

Published on:

A creditor filed an adversary proceeding in a Chapter 13 bankruptcy case, seeking an exception from discharge based on alleged fraud and willful and malicious injury. The creditor had been involved in a business venture with the debtor and made numerous allegations of accounting irregularities and financial misrepresentations. After a bench trial, at which the plaintiff-creditor presented expert testimony from a forensic accountant and a certified public accountant, the bankruptcy court held that the plaintiff did not meet his burden of proof under either claimed exception to discharge and ruled in favor of the defendant/debtor. In re Olsen, No. 2:13-bk-60733, memorandum (D. Mont., Aug. 28, 2014).

The facts of the case might be best summarized as a business venture where the parties had different understandings of the business relationship. The defendant was the majority shareholder of Human Interactive Products, Inc. (HIPinc), a “business incubator” engaged in a wide range of activities, known as as “profit centers,” under different trade names. HIPinc had a system, including accounting methods, for evaluating the performance of its profit centers.

The plaintiff, a native plant restoration specialist, approached the defendant about starting his own business in 2006. He accepted an offer of employment with HIPinc as “Operations Manager/Senior Restoration Ecologist” with a venture called Great Bear Restoration (GBR). The defendant would be his supervisor. The plaintiff did not contribute any capital towards GBR but received a salary from HIPinc. Continue reading