Student Loans in Bankruptcy: What’s on the Horizon? | Bradley Arant Boult Cummings LLP

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Federal law has long excluded student loans from bankruptcy discharge in all but the rarest cases, acknowledging the problems (and costs) associated with allowing borrowers to write off overdue debts through of a bankruptcy filing. However, as issues of college access and affordability become frequent topics in political discourse, new ideas for sweeping changes to the treatment of student loan debt in bankruptcy have been proposed. Lenders and managers should be aware of these proposals and prepared to adjust their operations if they 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 established in 2016 to research and develop recommendations to improve the consumer bankruptcy system. The final report included the following recommendations regarding student loans:

  • Back to the seven-year rule: The commission recommends that the Bankruptcy Code revert to the pre-1998 rule that allowed student loans to be canceled after seven years from when the loan first became due. Before the seven-year mark, student loans would only be repayable in the event of undue hardship. The commission found that if a debtor has not been able to find gainful employment to repay the loan by the seventh year, the debtor’s situation is unlikely to change.
  • No protection for non-government 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 – ​​can be forgiven. The commission explained that allowing debtors to repay government loans could threaten the financial viability of government student loan programs. This recommendation to authorize the discharge of private loans returns Article 523 of the Bankruptcy Code to its pre-2005 state.
  • Protect non-student debtors: The committee recommends that § 523(a)(8) limit the non-discharge to the student who benefited from the loan, and not third parties, such as parents who guaranteed the student loan debt. The commission considered that these third parties did not benefit from the loans and that, therefore, their discharge should not be compromised.
  • Priority for student loan debt and treatment in Chapter 13: The commission believes that non-dischargeable student loans should be entitled to priority status under Section 507. Specifically, the commission recommends that the loans be treated as a new 11th priority, which would become the lowest priority in the event of bankruptcy. Thus, student loans exempt from discharge would be paid after all other senior claims. The commission found that prioritizing non-dischargeable student loans would improve their treatment in a Chapter 13 plan.
  • The Brunner Test: Due to the open nature of the Brunner test, the commission recommends that the third factor of Brunner (i.e. the debtor made good faith efforts to repay the loans) incorporate bad faith. Courts should deny student loan debt discharge in situations where the debtor acted in bad faith by failing to make payments before declaring bankruptcy.
  • Brightline Rules: The commission recommends that the government adopt a more cost-effective and efficient approach to recovering from student borrowers who have filed for bankruptcy. Specifically, the commission believes that the Department of Education should not oppose the release of student loans for those (1) who are eligible for Social Security or Veterans’ Disability benefits or (2) who fall below certain poverty lines.
  • Avoid unnecessary costs: Student loan collectors often litigate student loan release proceedings, regardless of cost. Therefore, the commission recommends that informal litigation processes be used to reduce costs for both borrower and creditor. For example, formal dispute discovery processes should be a last resort. If the borrower is able to provide satisfactory evidence of undue hardship, the creditor must agree that the debtor is entitled to a release from student loan debt.
  • Alternative repayment plans: Legislative changes should be created to address how Chapter 13 bankruptcy interacts with student loan repayment programs. Further, Section 1322(b)(5) should be construed as applying to curing and maintaining student loan repayments, and the Department of Education should accept this treatment under the plans of the chapter. 13. The commission felt that this would increase student loan repayments and avoid unnecessary collection costs.

Congress responded to the student loan bankruptcy debate, as it has done in the past, with a bill. On May 9, 2019, U.S. Senators Elizabeth Warren (D-MA) and Dick Durbin (D-IL) and U.S. Representatives Jerrold Nadler (D-NY-01) and John Katko (R-NY-24) introduced a bicameral titled invoice Student Borrower Bankruptcy Relief Act, 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 on developments in this area. Solutions have been proposed, but a workable framework remains elusive.

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