Debtor’s Chapter 13 Plan Cannot Favor Student Loans

The U.S. District Court in Alexandria, in the case of Gorman v. Birts, while approving the bankruptcy court’s test to consider the debtor’s chapter 13 plan, reversed its decision to confirm the plan because it unfairly discriminated against unsecured creditors by proposing to pay the debtor’s student loans student loans outside of the plan.

Bankruptcy Code Section 1322(b)(5) permits a plan to provide for the curing of any default within a reasonable time and maintenance of payments while the case is pending on any unsecured claim or secured claim on which the last payment is due after the date on which the final plan is due.  In Gorman the debtor’s student loans would qualify as this type of long term debt.

The parties in Gorman agreed that Bankruptcy Code Section 1322(b)(5) is subject to the unfair discrimination limitation described in subsection (b)(1).  By proposing to pay her student loan outside of the plan the debtor in Gorman designated a separate class of unsecured claims.  As a result of the proposal, the student loan lender would be paid more than three times as much in dollar amounts as the other unsecured creditors, even though the student loan debt constituted only one-third of the total unsecured debt.  Accordingly, the question presented was whether the differential treatment constituted “unfair” discrimination under Bankruptcy Code Section 1322(b)(5).

As the bankruptcy court in Gorman recognized, courts across the country have not settled on a uniform test to assess whether a classification unfairly discriminates within the meaning of the statute.  Courts have developed two primary tests to evaluate what constitutes unfair discrimination, neither of which has been adopted by the 4^th Circuit (our local circuit).  The 8^th Circuit’s test in the case of In re Lester (a 1991 case) has been widely applied.  Bankruptcy courts in this District have also applied a slightly different test from the case of In re Linton (from an E.D. of Virginia bankruptcy court in 2011).  The bankruptcy court in Gorman applied a hybrid version of the Lester and Linton cases.  The Circuit Court in Gorman found that the proposed test of the bankruptcy court included all of the factors relevant to a reasonable determination and was the proper test to apply in this case.  However, the Circuit Court found that the decision of the bankruptcy court in Gorman that the plan did not unfairly discriminate against the non-student loan creditors was clearly erroneous.

Using the non-dischargeable nature of student loans, as cited by the bankruptcy court in Gorman, as a basis for discrimination would eviscerate the detailed priority system of Bankruptcy Code Section 507 and make preferential treatment of student loans the rule rather than the exception.  The Circuit Court agreed with the view that there are strong policy considerations underlying the student loan program that would favor preferential treatment of student loan debt; however, that is not the law.  By not designating student loans as priority claims under Bankruptcy Code Section 507, Congress chose not to categorically treat them differently.  Otherwise, the bankruptcy court in Gorman relied on the debtor’s status as a single mother with three children in concluding that the discrimination was reasonable.  The debtor did not point to any case law supporting her view that student loans are properly favored under these circumstances.  The Circuit Court found that the bankruptcy court erred in finding a reasonable basis for the discrimination. The court sided with the bankruptcy trustee, who challenged the bankruptcy court’s good faith finding by arguing that the debtor had acted in bad faith by failing to pledge her entire disposable income to the plan, instead proposing to retain the disposable income of half of the amount she dedicated to the plan for these creditors.  The Circuit Court in Gorman ruled that the bankruptcy court abused its discretion in failing to consider the effect of the disposable income issue on its finding of good faith.