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Student Loan Discharges under 11 U.S.C. § 523(a)(8)

One of the hallmarks of the United States Bankruptcy Code is that debtors can receive discharges of their unsecured debts, and the effects of the discharge are shouldered by the debtor’s unsecured creditors in pro rata fashion.  However, not all debts are dischargeable; for example, taxes or customs duties cannot be discharged, nor can debts be discharged that are the result of fraud.1 One interesting exception to the discharge rule that is currently being brought to the forefront of the political spectrum is the ability or more aptly put, the impossibility of receiving a discharge of student loan debt.2

Student debt is the second largest debt held by Americans today at approximately $ 1.2 Trillion, second only to mortgage debt, and the rate at which the debt is growing is of concern.3 Depending on which side of the argument you are on, the lack of a realistic discharge option in bankruptcy is either a requirement to make more private funding available to students, or it is an impregnable roadblock to financial freedom when other reasonable alternatives have evaporated. There is not one option that is perfect, but other options exist that can ease the burdens of struggling students and makes universities and lending institutions more accountable. Before discussing alternatives, though, it is important to understand why lenders do not want to be discharged.

Before 1978, it was possible for students to get a discharge of their loans in bankruptcy, but shortly after the Bankruptcy Reform Act of 1978, there was a concerted effort by the lending industry to get student loans excepted from discharges in bankruptcy and they succeeded.4

Despite some people, including the CFPB Student Loan Ombudsman, suggesting that the discharge standard should change, the lending industry is not without persuasive arguments for the need of a discharge exception.5 At the time of lending, students are most likely to have very little in assets that they can pledge to secure their loan with; additionally, even if the student is older and does have assets, the rules governing the ability to pledge consumer assets as security are restrictive and any assets of value, a house for example, are probably encumbered by a lien. This would leave banks as an unsecured lender in bankruptcy, and as an unsecured creditor you possess minimal rights and most of the time your claim to the bankruptcy estate is discharged or your collection is significantly reduced.6 The student loan discharge exception makes lenders feel more secure in lending and as such, they make capital available in the lending markets for students. The intuitive response to this is that if the exception was pulled, so too would capital in the student lending markets, which would restrict students’ ability to attend school.

Despite the lending industry’s economically sound argument, very few exceptions exist in the bankruptcy code and the majority of the exceptions are fraud, penalty, or tax based; the exceptions sound in the equitable treatment of wrong-doers, but the student loan discharge just gives banks enhanced creditor’s rights.  The exceptions for student loans essentially gives an unsecured lender, the bank, rights that are as good if not better than those of a secured creditor. This insulation that banks have creates a significant moral hazard problem that resembles that of the sub-prime mortgage crisis.  (Similar in the sense that continued lending, even to borrowers who should not have qualified, generated more fees and revenues). Banks are incentivized to lend as much as they can because that debt cannot be discharged, and the bank will likely be able to collect over the lifetime of the debtor.

When student loans were first excepted, it was more reasonable to pay off student loan debt. During the 70s and 80s, it did not cost nearly the amount of money that it does to attend school as it does now, and state budgets for education are continuing to be squeezed, forcing tuition prices and loans to increase even more.7 The burdens on students and their parents have shifted, and it is time that we amended our discharge policy in bankruptcy to more accurately reflect the current state of our educational lending environment.

Currently, If and when a student decides that paying their loan off is infeasible, whether it is due to a disability or an incredibly dim prospect of attaining employment to pay down the loan, the debtor must demonstrate an undue hardship. The standard most frequently used is the standard articulated the Second Circuit in Brunner v. New York State Higher Educ. Services Corp.8 In order to qualify, a debtor must show that (1) the debtor will be unable to maintain a minimal standard of living for herself and dependents if forced to repay the loans, (2) circumstances exist that indicate the state of affairs is likely to persist for a significant portion of the repayment period, and (3) the debtor has made good faith efforts to repay the loans.9 All three questions are fact sensitive and are for the bankruptcy court to decide. Some factors the bankruptcy court examines are the time between default and the initiation of the suit, has the borrower discussed options with the lender or sought refinancing, has the debtor maximized her earning potential or minimized her expenses, and were the events surrounding the debtor’s financial woes within her control. In the event that the debtor can maintain a minimal standard of living, the biggest question becomes what her future earning look like. If there is potential for increased earnings at some point during the future, the chances of a discharge become smaller.10

As the law stands now, creditors are overly protected and student borrowers are grossly under protected. Rather than have a blanket law that excepts student loans, we should have a more progressive solution. While the student loan issue is expansive and amending the bankruptcy code will not solve it, addressing the discharge-ability of the loans is one part of the equation. As long as banks are sheltered by the difficult standards of Brunner and the undue hardship test, banks will continue to inject capital into the student lending markets with minimal downside risk. There are some potential options to explore to solve this issue. One solution could be placing the burden with universities whose students fail to secure the employment necessary to pay down their loans, by having Universities indemnify lending institutions for their loss, or we could grant partial discharges, with universities indemnifying the discharged portion. An additional alternative would be to allow the discharge in bankruptcy with a more reasonable standard for doing so. Banks are certainly capable of spreading the risk of unsecured defaults through insurance, more selective lending, or securitization. Banks and universities have none to minimal risk involved in the transaction when the discharge standard is as high as it currently is. While amending the discharge rule for bankruptcies won’t end the student loan issue, it is a start in the right direction that may free tied up capital on the consumer side to be utilized elsewhere than institutionalized lending.

  1. 11 U.S.C. § 523(a)(7 

  2. Carrie Sheffield, CFPB’s Loan Report Attacks Lenders Rather Than Empowering Students, Forbes (Oct. 29, 2014, 9:30pm), 

  3. Dan Friedman, Americans owe $1.2 Trillion in student loans, surpassing credit card and auto loan debt totals, NY Daily News (Oct. 29, 2014, 9:30pm), 

  4. Llana Greene, Student Loans for Life, Forbes (Oct. 29, 2014, 9:30pm), 

  5. Carrie Sheffield, CFPB’s Loan Report Attacks Lenders Rather Than Empowering Students, Forbes (Oct. 29, 2014, 9:30pm), 

  6. Lynn Lopucki and Elizabeth Warren, Secured Credit, 98, 119, 7th ed. 2012 

  7. Carrie Sheffield, CFPB’s Loan Report Attacks Lenders Rather Than Empowering Students, Forbes (Oct. 29, 2014, 9:30pm), 

  8. Brunner v. New York State Higher Educ. Servs. Corp., 831 F.2d 395 (2d Cir. 1987 

  9. Id. 

  10. Rosemary E. Williams, Dischargeability of Educational Loans and Overpayments in Cases by Natural Persons Under 11 U.S.C.A. § 523(a)(8), 116 Am. Jur. Proof of Facts 3d 205 (2014