Federal Student Loans In Bankruptcy: A New Direction?

Recent actions taken by the Department of Education have made the path easier to discharge student loans through bankruptcy, but messages about future acts remain unclear.

At present there is an estimated $1.75 trillion in outstanding student loan debt owed by approximately 46 million Americans – one out of every eight people.  After home mortgages, student loans represent the next highest category of debt. 

Under current bankruptcy law, student loan borrowers seeking to discharge this debt need to prove that repayment of their loans would present an “undue hardship”.  This represents a higher standard for obtaining a discharge.  Other forms of debt, such as credit cards and medical debts, do not require this showing and are therefore more easily discharged. 

To add to the confusion, the term “undue hardship” is not defined in the Bankruptcy Code, which allows judges in their discretion to decide whether a bankruptcy filer has met this standard.  Most courts follow the Brunner test, which was articulated in a 1987 case from New York.[1] To satisfy this test, the borrower must prove:

  1. If forced to repay the loan, the debtor would be unable to maintain, based on current income and expenses, a “minimal” standard of living for the debtor and his/her dependents.
  2. Additional circumstances exist which indicate that this state of affairs would be likely to persist for a significant period of the student loan,
  3. The debtor has made good faith efforts to repay the loan.

A borrower who tries to discharge student loans must also file what is known as an “adversary proceeding” which is essentially a suit brought in the bankruptcy court against the student loan lender.  The borrower has to show that he or she meets the undue hardship standard while the lender tries to prove otherwise, and the judge renders a decision.  Most student loans are provided by the federal government which usually opposes the borrower.  As a practical matter, proving eligibility for discharge is a time consuming and cumbersome process.  But change may be on the way . . .

Earlier this year, bankruptcy courts in Delaware and Alabama granted a borrower’s discharge request of over $100,000 in student loan debt over the government’s opposition.[2]  Both cases turned to a great extent on the individual debtor’s substantial medical problems, which essentially precluded employment.  In both cases, the federal Department of Education immediately appealed the rulings, as had been its regular practice.  Following public outcry, the department withdrew both appeals, thus permitting the rulings to stand.  The message to the public remains muddled:  the government appears (for now) committed to opposing student loan discharges yet seems resigned to accept decisions that go in the borrower’s favor. 

The government seems to have acknowledged that its position and approach to discharge of federal student loans needs to change.  The Secretary of Education has told Congress that the Biden administration was exploring its options for modifying how the government will approach student loans in bankruptcy.  Some reform advocates have urged that the government simply discontinue its practice of opposing student loan discharge adversary proceedings if certain criteria (such as persistent poverty or reliance on public benefits as the primary or sole source of support) can be met. If this becomes policy, a significant increase in the number of discharges sought and obtained would likely result.

Any change to the Bankruptcy Code requires an act of Congress.  Last year a bipartisan group of senators introduced the Fresh Start Through Bankruptcy Act, which, if enacted, would eliminate the undue hardship standard for borrowers who have been in repayment for at least the preceding 10 years.  This would mark a return to the way in which student loan debt was treated before 1998, when a borrower could seek discharge after repaying loans for seven years.  However, the bill has not advanced, and a ten-year repayment period prior to obtaining relief would remain a nearly insurmountable hurdle for many even if the legislation passed.

Although media reports suggest that the Biden administration intends to cancel all or a portion of student loan debts, without action by Congress, such a move would likely face numerous legal challenges from private parties who have capital invested in loan servicers. 

Another point to keep in mind is that only federal student loans are governed by these proposals.  Private student loans continue to be subject to the undue hardship test and lenders will continue to challenge aggressively any attempt to discharge these loans.

[1] Brunner v. New York St. Higher Educ. Svces. Corp., 831 F.2d 395, 396 (2d Cir. 1987)

[2] Wolfson v. DeVos (In re Wolfson), 2022 Bankr. LEXIS 103 (Bankr. D. Del. 2022) and Wheat v. Great Lakes Higher Educ. Corp. (In re Wheat), 2022 Bankr. LEXIS 168 (Bankr. M.D. Ala. 2022)

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