Federal law has long excepted student loans from discharge in bankruptcy in all but the rarest instances, recognizing the problems (and costs) associated with allowing borrowers to wipe out defaulted debts through a bankruptcy filing. However, as the issues of access to college and affordability become frequent topics in political discourse, new ideas for radical changes to the treatment of student loan debt in bankruptcy have been proposed. Lenders and servicers need to be up to speed on those proposals and ready to adjust their operations if any become law.
The American Bankruptcy Institute’s Commission on Consumer Bankruptcy Law released its Final Report and recommendations on April 12, 2019. The commission was created in 2016 to research and develop recommendations to improve the consumer bankruptcy system. The Final Report included the following recommendations regarding student loans:
- Return to the Seven-year Rule: The commission recommends that the Bankruptcy Code return to the pre-1998 rule that allowed student loans to be discharged after seven years from the time the loan first became payable. Before the seven-year mark, student loans would be dischargeable only upon a finding of undue hardship. The commission reasoned that if a debtor has not been able to find lucrative employment to repay the loan by year seven, it is unlikely the debtor’s circumstances will change.
- No Protection for Non-Governmental Loans: The commission recommends that private student loans–any loan that is not made by a government entity or guaranteed or insured by the government–may be discharged. The commission explained that allowing debtors to discharge government loans could threaten the financial viability of government student loan programs. This recommendation to allow private loans to be discharged returns Section 523 of the Bankruptcy Code to its pre-2005 state.
- Protecting Non-Student Debtors: The commission recommends that § 523(a)(8) should limit non-dischargeability to the student who benefited from the loan—not third-parties, such as parents that have guaranteed the student loan debt. The commission reasoned that these third parties did not benefit from the loans, and, therefore, should not have their discharge impaired.
- Priority for Student Loan Debt and Treatment in Chapter 13: The commission believes that non-dischargeable student loans should be entitled to a priority status under § 507. Specifically, the commission recommends that loans should be treated as a new 11th priority, which would become the lowest bankruptcy priority. This would cause student loans excepted from discharge to be paid after all other priority claims. The commissioned reasoned that giving non-dischargeable student loans a priority will improve their treatment in a Chapter 13 plan.
- The Brunner Test: Due to the open-ended nature of the Brunner test, the commission recommends that the third factor of Brunner (i.e., that the debtor has made good faith efforts to repay the loans) incorporate bad faith. Courts should deny the discharge of student loan debt in situations where the debtor has acted in bad faith in failing to make payments before filing for bankruptcy.
- Brightline Rules: The commission recommends that the government employ a more cost-effective and efficient approach for collection from student loan borrowers who have filed for bankruptcy. Specifically, the commission believes that the Department of Education should not oppose the dischargeability of student loans for those (1) who are eligible for Social Security or veterans’ disability benefits or (2) who fall below certain poverty-level thresholds.
- Avoiding Unnecessary Costs: Student loan collectors often litigate student loan discharge proceedings regardless of costs. Therefore, the commission recommends that informal litigation processes be used to lower costs for both the borrower and the creditor. For example, formal litigation discovery processes should be a last resort. If the borrower is able to provide satisfactory evidence of undue hardship, the creditor should agree that the debtor is entitled to a discharge of the student loan debt.
- Alternative Repayment Plans: Statutory amendments should be created to address how Chapter 13 bankruptcy interacts with student loan repayment programs. Additionally, § 1322(b)(5) should be interpreted to apply to the cure and maintenance of student loan payments, and the Department of Education should accept this treatment under Chapter 13 plans. The commission reasoned that this would increase student loan payments and avoid unnecessary collection costs.
Congress has responded to the student loan bankruptcy debate, as it has in the past, with proposed legislation. On May 9, 2019, U.S. Sens. Elizabeth Warren (D-MA) and Dick Durbin (D-IL) and U.S. Reps. Jerrold Nadler (D-NY-01) and John Katko (R-NY-24) introduced a bicameral bill titled Student Borrower Bankruptcy Relief Act of 2019, which would eliminate the section of the Bankruptcy Code that makes federal and private student loans non-dischargeable. This would cause student loans to be treated like almost all other types of consumer debt under the Bankruptcy Code. The Senate bill has 15 additional Democratic co-sponsors, and the House bill has 12 additional Democratic co-sponsors.
We will continue to report developments in this area. Solutions have been proffered but a feasible framework remains elusive.
If these are areas you would like to learn more about, we encourage you to join us for our “Student Loans in Bankruptcy: What’s on the Horizon?” webinar, which is scheduled for Thursday, June 20, from 11:30 a.m. to 12:30 p.m. CT. This webinar will provide an overview of the debate on student loans and the ability to discharge such debts in bankruptcy. In particular, we will focus on the recently issued Final Report and recommendations from the American Bankruptcy Institute’s Commission on Consumer Bankruptcy, as well as the recently introduced legislation on the subject.