Discharge of Federal Student Loans: Alfes Case Clarifies Sixth Circuit Position


The U.S. Court of Appeals for the Sixth Circuit recently affirmed the district court’s judgment affirming the bankruptcy court’s order granting summary judgment (dismissal) in favor of a guarantor of student loans. The case is Alfes v. Educational Credit Management Corporation (ECMC) released on March 12, 2013.


Procedural History

Here is an overview of the case history. Alfes took out student loans that were funded in whole or part by the Federal Family Education Loan Program (FFELP). Alfes then consolidated the student loan debt. On the final consolidation, SunTrust Bank (SunTrust) was the lender and obligee and Pennsylvania Higher Education Assistance Agency (PHEAA) was the guarantor. Alfes filed for Chapter 7 bankruptcy and the bankruptcy court entered a general discharge of his debts.


Next, Alfes sought a declaration that the debt had been discharged with PHEAA and SunTrust named as defendants. Alfes asserted that since the loans were consolidated, the promissory note no longer could be defined as an “educational loan” under the Bankruptcy Code (11 U.S.C.§ 523(a)(8)(A)); and therefore, was discharged along with his ordinary debt.


SunTrust and PHEAA failed to file a timely answer to Alfes’ complaint. SunTrust had assigned its interest under the note to PHEAA. Then the bankruptcy court entered a default judgment against SunTrust ordering that SunTrust’s claim against Alfes was dischargeable.


In the meantime, ECMC filed a motion to substitute for PHEAA and answered Alfes’ complaint. ECMC’s motion stated PHEAA transferred the note to ECMC who then was the real party in interest. However, the transfer was not completed until weeks later. The bankruptcy court denied the motion to substitute for lack of standing. PHEAA then filed an answer to Alfes’ complaint to avoid default, but the bankruptcy court clerk had entered a default against PHEAA that very day. So ECMC filed a second motion to substitute for PHEAA and to set aside the default. Yet, the bankruptcy court entered a default judgment against PHEAA and closed the bankruptcy case.


Eventually, the bankruptcy court reopened the adversary proceeding and granted PHEAA’s motion to set aside the default judgment. Then the court entered a stipulated order to substitute ECMC for PHEAA. On the cross motions on whether consolidated loans are “educational loans” under the Bankruptcy Code, the bankruptcy court granted ECMC’s motion to dismiss and denied Alfes’ motion for summary judgment. The court concluded that the holder of consolidated student loans is an educational lender under the applicable section of the Bankruptcy Code—and therefore, the consolidated loan was nondischargeable without evidence of undue hardship. Alfes did not appeal this decision.


The note was transferred back to SunTrust by ECMC where its servicer started collecting on it once again. Alfes decided not to pay, stating the debt had been discharged due to the previous default judgment entered against SunTrust. So Alfes filed a motion to reopen the adversary proceeding, asserting that the servicer was bound by the default judgment and was in turn enjoined from collection on the note. Alfes sought a new order prohibiting SunTrust—or any future parties in interest—from collecting on the note, and sought sanctions for knowing and intentional violation of the discharge order, and for related attorney’s fees.


The note was then transferred from SunTrust back to ECMC to defend against Alfes’ claims. PHEAA, ECMC, and SunTrust filed a joint response to Alfes’ motion to reopen. Their argument was that guarantors have separate and distinct claims from those received by assignment from lenders of student loans; and, therefore, the default judgment against SunTrust as lender did not bind PHEAA and ECMC as guarantors.


Then the parties entered into a confidential settlement agreement where Alfes agreed to limit his claim against SunTrust to costs and attorney’s fees. In exchange, ECMC agreed any further claims regarding Alfes’ obligation regardless of the theory of liability or whether arising under promissory notes, guaranty, or otherwise would be brought on or before a specific deadline. On the date of the deadline, ECMC filed a complaint asking for a declaratory judgment that the debt was nondischargeable due to the earlier judgment in its favor. ECMC amended the complaint to clarify ECMC/PHEAA’s rights as guarantor under the note. Alfes moved to dismiss, stating the new claim should have been barred by the settlement agreement deadline. The bankruptcy court denied Alfes’ motion because the amended complaint related back; it did not assert a substantively different claim—and did not unfairly surprise him.


The parties filed cross motions for summary judgment. Alfes argued the default judgment against SunTrust should bar ECMC’s nondischargeability claim as res judicata. ECMC argued that the subsequent dismissal order in its favor should bar Alfes’ claim and the default judgment against SunTrust did not bind ECMC/PHEAA as guarantors. The bankruptcy court granted ECMC’s motion.


The court held that its previous order granting ECMC/PHEAA’s motion to dismiss had preclusive effect—as the order was a final decision on its merits, the current action was between the same parties, and the issue of whether Alfes debts were dischargeable was already litigated. Moreover, the court held the earlier default against SunTrust did not bar ECMC’s claim because SunTrust was not a party in the second adversary proceeding. The court avoided addressing ECMC’s claim of separate and distinct rights as guarantor.


The district court affirmed on appeal the bankruptcy court’s denial of Alfes’ motion to dismiss ECMC’s amended complaint. The court also affirmed that the previous final judgment in ECMC’s favor was a complete bar to Alfes’ claims in the second adversary proceeding. On the issue of res judicata, the court held that the default judgment was binding against SunTrust, the bankruptcy court set aside the default against PHEAA, and ECMC successfully litigated on the merits of the case. The court also noted that Alfes did not appeal the bankruptcy court’s judgment in favor of ECMC and so the time period to challenge that final order had passed some time ago.

Appeal to the U.S Court of Appeals for the Sixth Circuit

The main question on appeal concerned the scope of ECMC/PHEAA’s interest in its separate and distinct capacity as guarantor—and whether the default against SunTrust discharged that interest and thereby extinguished ECMC’s rights obtained by assignment from PHEAA.


Additionally, the court asserted that it is well settled that once a debtor gains a discharge through bankruptcy, the guarantor holds a claim against the debtor and is considered a creditor for the purpose of bankruptcy proceedings. Such a guarantor holds a contingent claim against the debtor that becomes fixed at such a time when the guarantor pays the creditor. Since a guarantor is a creditor, a right exists to collect on and defend the nondischargeability of the note in bankruptcy proceedings.


ECMC obtained its guarantor rights by assignment before the default judgment against PHEAA. Moreover, this default judgment was set aside, and the bankruptcy court entered a judgment in favor of ECMC holding the debt nondischargeable. So the Court of Appeals stated that while the default judgment against SunTrust limits ECMC’s claim as assignee of the note, this had no effect on its separate and distinct rights as guarantor.


Regarding res judicata—which literally means “the thing has been decided”—the court stated ECMC’s guaranty claim was not precluded by the default judgment against SunTrust because its claims as guarantor originate from PHEAA. Then the court stated that Alfes’ claim should receive res judicata effect because it involved Alfes and ECMC as guarantor. The final decision was in ECMC’s favor, and Alfes did not appeal. So the court found that the district court correctly held that the judgment in ECMC’s favor declaring the debt nondischargeable had binding res judicata effect.


Next, the question was whether the amended complaint set forth a new claim under a different theory and whether the relation back doctrine applied. The court found after close analysis of the original and amended complaints that the asserted claims were nearly identical; so the district court did not err in finding these were the same substantive claims.


Also, Alfes stated the limitations period for asserting the claim was truncated by the deadline in the settlement agreement. Yet, the court countered this with the fact that relation back doctrine is based upon the idea that a person who has been given notice of litigation based on an occurrence or transaction has been provided all the same protections of the statute of limitations. Furthermore, Alfes was aware of ECMC’s claims as guarantor for years as well. Therefore, the court found that the bankruptcy and district courts did not err in holding that the amended complaint related back. No substantively different claims or undue surprise existed.


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