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United Student Aid Funds, Inc. v. Espinosa: A Tale of Two Holdings

Karen Cordry, Bankruptcy Counsel

Karen Cordry, NAAG Bankruptcy Counsel

It was the best of decisions; it was the worst of decisions.” 1 Well, perhaps a bit overstated – but the Supreme Court’s recent decision in United Student Aid Funds, Inc. v. Espinosa, 130 S. Ct. 1367 (March 23, 2010) was a distinctly mixed bag vis-a-vis the states’ interests in bankruptcy cases. The decision dealt solely with student loan discharges but its ramifications are universal. The Court’s first holding places greater burdens on overburdened staff to catch debtors who violate the Bankruptcy Code and the Rules. Its second holding, though, does ensure that bankruptcy judges are enrolled in the battle and that efforts of states to work together and share the burden will be rewarded.

Bankruptcy cases, in many ways, are a unique area of the law. They combine a global umbrella proceeding by the bankruptcy court to divide the debtor’s assets among its creditors with many subsidiary actions that decide individual issues relating to the debtor’s claim to assets and its potential liabilities for claims. The cases typically proceed much faster than other litigation, they are brought at a time and place of the debtor’s choosing, and they often involve fairly small amounts, particularly relative to the likelihood of recovery.

Perhaps most significant is the sheer volume of the cases and the paper they generate. There are about a thousand or less large Chapter 11 reorganization cases a year, perhaps ten times that many Chapter 11 cases altogether, and nearly a million and a half consumer bankruptcies. Those small cases are about five times as many as all other federal civil and criminal matters combined. Even that number greatly understates the paperwork since, as noted, each umbrella bankruptcy filing can subsume anywhere from one to thousands of separate claim objections, lien avoidance actions, discharge complaints, and similar disputes.

To keep up with this avalanche of paper, the Bankruptcy Code and Rules set up different types of proceedings with different notice and service methods for each type. Matters in the overall case are generally brought by motion, under a caption that simply says “In re Debtor,” and are mailed out addressed simply to “Company X.” Many actions, though, must be brought by an “adversary proceeding.” That proceeding is equivalent to a traditional federal suit, and is initiated by filing a complaint that is given a separate proceeding number, is captioned as “Debtor vs. Creditor” (or vice versa), and must be served with a summons. On receiving the summons and complaint, the creditor can readily determine that its interests are at stake and it must take action to protect them. And, while the Bankruptcy Rules (unlike the Federal Rules of Civil Procedure) allow the “service” of such actions to be by mail, the letter must be addressed to “the attention of an officer, a managing or general agent, or to any other agent authorized . . . to receive service of process,” not just the company generically.

It will be more difficult, though, for a creditor to assess whether it will be affected by the general pleadings in the case. Even in the smallest case, it is likely to receive dozens of documents in that case, most of which have no bearing on its interests. One can read the title, which is not always fully informative, one can try to skim the document – which is difficult when hundreds of pages arrive each day, and one can hope that a proposed order conforms with the motion (which is not always the case). And, even when the documents are relatively small – as is the case with consumer reorganization plans in Chapter 13 – the cumulative impact of dealing with dozens or hundreds of such cases can become problematic. That is particularly true these days when government budgets are stretched far past the breaking point, layoffs are common, and employees who remain are sent home on frequent furloughs while their work piles up.

In short, handling bankruptcy cases, at least for governmental units, has increasingly become a game of triage. Adherence by debtors to the proper form of action, notice, and service, can assist in carrying out the ranking process. An envelope addressed to “Jones Company President,” enclosing a document labeled “Complaint” and captioned “Debtor versus Jones Company” is the equivalent of a red card on a patient saying “Treat Me First!” Those aspects can be readily identified for mailroom personnel or other staff receiving mail so that those documents can be routed to the agency’s lawyers without delay. (The latter point is critical since many bankruptcy response deadlines are much shorter than in other litigation.)

Discharge complaints, in particular, are matters to which this sorting process is critical. In many cases, a creditor’s only goal is to have its debt excepted from the general discharge, since most consumer cases pay little or nothing from the bankruptcy estate. The creditor’s only hope is to collect later when there is less competition. What is received in the case is relatively unimportant; the creditor’s main focus is to ensure that it contests any discharge complaint. Espinosa, in particular, concerned a student loan debt. Under the Bankruptcy Code, such debts are nondischargeable unless the debtor affirmatively shows in an adversary proceeding that repaying the debt would be an “undue hardship.”

Mr. Espinosa, though, merely wrote into his proposed Chapter 13 plan that liability for the unpaid interest on his student loan debt would be discharged at the end of his plan. He did not file an adversary proceeding, he did not serve a complaint on the student loan creditor, and he did not show that paying the interest would be an undue hardship. Further, he did not use the special rules for service of an adversary; rather he simply sent it addressed to the student loan agency at a lockbox address intended solely to receive payments. The lender did not deny that the plan was received at that address but it is not clear that it was ever brought to the attention of the sort of officer or agent that are required for an adversary proceeding.

In any event, the lender did not oppose the plan and it was confirmed and performed by the debtor. There were a series of procedural confusions thereafter, but eventually the case boiled down to the lender arguing that the plan could not discharge its right to continue collecting the unpaid interest because that would have required an adversary proceeding. The debtor argued that, regardless of whether the plan could legally have attempted to discharge the debt, it did do so, and the court’s order confirming the plan was res judicata of the issues. The lender countered that it was entitled to relief under Federal Rule of Civil Procedure (“FRCP”) 60(b)(4) in that the decision was void due to lack of proper notice and service, in that a) using a plan to discharge the debt was not proper and b) that even if an adversary could be combined with the plan, it had not received the proper notice (and service of an adversary) that it was entitled to.

The Espinosa case was by no means the first to present these issues. This approach – often referred to as “discharge by ambush” – had popped up in the mid-1990s and spread after the Ninth and Tenth Circuits initially upheld such plans on res judicata grounds. It died back though, after courts began to resist, noting that inclusion of such provisions was improper and could subject the debtor – and his counsel – to sanctions for including them. And, starting as early as 1995, Circuit Courts began to hold that plans with these sorts of provisions (and analogous ones relating to voiding liens) were void on the ground advanced by the lender in Espinosa – namely that the procedural failures resulted in a lack of due process. By 2008, seven Circuits (the 2nd, 3rd, 4th, 6th, 7th, 11th, and the 10th in an en banc reversal) agreed that using plans to avoid adversary proceedings made them void to that extent and creditors could obtain relief from the judgment beyond the one-year period for such relief under other portions of FRCP Rule 60(b).

Due to the procedural quirks noted above, Espinosa was not finally decided by the Ninth Circuit until 2009 by which time this practice had largely died out, both due to the threat of sanctions and the voidness analysis discussed above. The Ninth Circuit though strongly rejected that latter analysis, held that the only issue was whether the creditor had received notice of something that might affect its interest (i.e., the plan), and that the creditor was required to object to the plan, even though the plan could not lawfully include the provision at issue. The debtor’s violations could have been challenged, the court held, but, having failed to do so after it received at least some actual notice, albeit in the wrong form and sent to an improper address under the Rules, the lender was bound by res judicata to the plan’s terms.

Even worse, the Ninth Circuit then held that, not only could a creditor waive its right to an adversary, but that it had done so here – and it conclusively presumed that any other creditor that did not affirmatively object to a plan provision had actually decided to waive its rights and agree to the plan. Accordingly, the court held, bankruptcy judges not only were not obligated to review such plan provisions, they had no power to do so or to interfere with that “choice” by the creditor.

When the case went to the Supreme Court, 34 states filed an amicus brief that asked the Court to adopt the voidness analysis. The filing was a “Brandeis brief” that argued that bankruptcy was a uniquely challenging environment in which strict adherence to procedure was critical to ensure that litigants actually had due process. The states argued that the nominal “actual notice,” in these circumstances, did not satisfy Mullane v. Cent. Hanover Bank & Trust Co., 339 U.S. 306, 315 (1950) (“When notice is a person’s due process, which is a mere gesture, is not due process. The means employed must be such as one desirous of actually informing the absentee might reasonably adopt to accomplish it.” Emphasis added). Further, they strongly urged the Court, no matter what approach it took on the notice issue, to reverse the Ninth Circuit’s holding that bankruptcy courts could not take steps to deal with this abusive practice.

“Worst of Decisions”

In its decision, the Supreme Court gave no shrift at all to the due process arguments. Its discussion began and ended with the statement that actual notice had been received and nothing more was needed to find that the decision was not void. While the process used was incorrect, such violations did not automatically void the decision. As such, if the issues were not raised within the time periods set by other portions of Rule 60(b), Rule 60(b)(4) could not be used to give the creditor an unlimited time to attack the judgment. That portion of the decision is regrettable since it will allow debtors to intentionally game the system, knowing that, at worst, if caught, they must simply remove the language. And, if they get lucky, the unlawful provision will eventually become inviolate. If that were the end and the Court had let stand the Ninth Circuit’s bar on review by bankruptcy courts, discharge by ambush – and other abusive plan provisions – would have been back with a vengeance, making this the “worst of decisions.”2

“Best of Decisions”

However, this was also the “best of decisions.” After rejecting the belated attack on this plan provision, the Court clarified that the language was improper and should have been removed if challenged. It then held that “the Code makes plain that bankruptcy courts have the authority – indeed, the obligation – to direct a debtor to conform his plan to the requirements of [the Code].” Espinosa, 130 S. Ct. at 173-174. It made clear that courts should remove such provisions sua sponte unless there was affirmative evidence that a party agreed to the treatment proposed. To be sure, creditors, including the states, must still assume that parties will try to sneak improper provisions into plans and that such provisions will govern if not discovered and removed. But, other than the limited category of provisions that dealt with matters that did not belong in plans at all, that has long been the state of affairs in bankruptcy.

“You snooze, you lose” is the favorite mantra of debtors’ counsel, and speakers at NAAG bankruptcy seminars emphasize that counsel should assume that plans will have improper provisions that will have to be rooted out. The final holding in this opinion will be an extremely helpful tool in attacking such provisions. Initially, it makes clear that a plan with unlawful provisions should not be confirmed even if no one objects. Courts have limited time to review plans as well but, to the extent that they see unlawful language, they have a duty to demand its removal. The use of form plans in Chapter 13 cases in many districts should make this easier since a variation from the norm will be more obvious. Sanctions against debtor’s counsel that are repeat offenders can also be easily imposed and undoubtedly will have a chastening effect.

Further, states can pool their efforts to review and challenge plan provisions in Chapter 11 cases that may affect multiple jurisdictions. In the past, if one state challenged a blatantly illegal plan provision, the debtor often would simply “carve out” that state, leave the provision in place, and tell the first state that it no longer had standing to raise the issue on behalf of other states. Under the Espinosa language, courts, once alerted to an issue, should have no discretion to ignore it, whether or not other states also object, and should require its removal in toto. Texas has already been active in demanding – and obtaining – removal of such provisions in a number of cases. By sharing the work load of finding and objecting to these provisions, states may be able to ensure that they all benefit from their collective efforts. If so, the standard NAAG motto can be “One for all and all for one.”3


[1] With apologies to Charles Dickens and A Tale of Two Cities, a tale dealing with the French Revolution.

[2] A two-part article discussing the merits of the Supreme Court’s analysis and the prior case law in more depth will appear in the July/August and September 2010 issues of the American Bankruptcy Institute Journal.

[3] With further apologies to Alexander Dumas and The Three Musketeers.

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