For many graduates, the weight of student loan debt can be overwhelming, particularly in a weak job market. However, for at least one, that burden has been reduced just a bit by virtue of a bankruptcy discharge. In a recent decision, the U.S. Court of Appeals for the Ninth Circuit reversed an Oregon district court judgment in Hedlund v. Educational Resources Institute, No. 12-35258, D.C. No. 6:11- cv-6281-AA, finding that court's de novo review of a Section 523(a)(8) proceeding to be improper and holding that the bankruptcy court's good-faith finding should be reviewed solely for clear error. In its opinion, the Ninth Circuit held that the bankruptcy court's review of the evidence, and its finding that the student loan debtor had made good-faith efforts to repay his loans, was not clearly erroneous.
Michael Hedlund's story is one that is playing out repeatedly across the country. He is a law school graduate, married and the father of one child, living and working in Klamath County, Ore. Like most law school students, Hedlund financed his law school education with Stafford loans, which in 1999, shortly after graduation, went into repayment. At that time, his outstanding balance was over $85,000, and his monthly payments totaled over $800. Unfortunately, Hedlund never successfully passed the Oregon bar exam, but did maintain a full-time job as a juvenile counselor. Despite Hedlund's efforts to consolidate his loans and negotiate a more feasible payment schedule, he was unable to make headway, resulting in the two companies servicing his loans taking judgments against him and commencing garnishment of his wages.
As a result, in 2003, Hedlund filed a Chapter 7 bankruptcy petition. He also commenced an adversary proceeding against the loan servicers, seeking a partial discharge under Section 523(a)(8) of the Bankruptcy Code. While most student loan debt is presumptively non-dischargeable under Section 727, Section 523(a)(8) provides an exception, wherein student loan debt may be dischargeable when such debt "would impose an undue hardship on the debtor and the debtor's dependents." The bankruptcy court partially discharged Hedlund's debt (all but $30,000).
However, the Ninth Circuit's Bankruptcy Appellate Panel (BAP), following a direct appeal by one of the loan servicers, reversed the lower court's decision and noted in Hedlund v. Pa. Higher Education Assistance Agency (In re Hedlund), 368 Fed. Appx. 819, 821 (9th Cir. 2010), that "it would not be unconscionable for Hedlund to eliminate a number of claimed expenses, including a new car payment." As a result, Hedlund's debt was reinstated in full.
Hedlund then appealed the BAP decision to the Ninth Circuit. The circuit court found that the bankruptcy court failed to sufficiently consider all of the available evidence, including the question of whether Hedlund could reduce his expenses to meet a greater portion of loan expenses, or whether he could increase income either by he or his wife taking on a part-time job. As a result, the Ninth Circuit vacated and remanded, instructing the bankruptcy court to apply the three-factor "undue hardship" test as set forth in Brunner v. New York State Higher Education Services, 831 F.2d 395 (2d Cir. 1987).
On remand, the bankruptcy court applied the Brunner test, under which a court must determine whether "(1) the debtor cannot maintain, based on current income and expenses, a 'minimal' standard of living for himself and his dependents if required to repay the loans; (2) additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period; and (3) the debtor had made good-faith efforts to repay the loans." In doing so, the bankruptcy court determined that Hedlund had sufficiently maximized his income, based, in part, on the fact that there was no evidence to suggest that he could earn a higher salary as a licensed attorney. Despite his failure to fully minimize expenses, Hedlund's budget did not tip the balance away from a good-faith finding. Moreover, the bankruptcy court determined that he satisfied his burden of showing good faith through his efforts to negotiate a repayment plan and his payment history.
On appeal, the district court reviewed the good-faith finding, de novo. Contrary to the bankruptcy court's findings, it found that Hedlund failed to make sufficient efforts to obtain employment, his attempts to reduce expenses were "immoderate," and that his lack of effort in negotiating a repayment plan was "even more vexatious."
Hedlund's subsequent appeal to the Ninth Circuit related to the bankruptcy court's finding of good faith and the standard of review applied by the district court to such good-faith finding. In the Ninth Circuit, "good faith is measured by the debtor's efforts to obtain employment, maximize income and minimize expenses." Although the bankruptcy court and the district court reviewed the same evidence and came to differing conclusions with respect to Hedlund's good-faith efforts to repay his loans, the Ninth Circuit found that "even though some might disagree with the bankruptcy court's good-faith finding, it was not clearly erroneous. The court relied on substantial evidence in the record, and its factual inferences were permissible."
The Ninth Circuit now makes it clear that district courts are to apply a deferential clear-error standard when reviewing the factual findings underlying a bankruptcy court's good-faith finding. The court also emphasized, however, that a clear-error standard of review does not preclude an appellate court from finding error as a matter of law: "Although good faith is primarily a question of fact reviewed for clear error, it can encompass questions of law that must be reviewed de novo."
The Ninth Circuit's decision may provide bankruptcy courts with a little more latitude in considering a Section 523(a)(8) request for discharge by graduates saddled with debt that imposes an "undue burden." Provided the bankruptcy court correctly applies the Brunner test to the facts presented, the district court will only be able to reverse such discharge upon a finding of clear error.
Originally published in The Legal Intelligencer
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