Student Loans in Bankruptcy: Policy Analysis and Portfolio Risk for Lenders
April 14, 2006
James L. "Jim" Fly- Orlando
Student Loans: A Unique Form of Debt
Student loans are a unique form of unsecured consumer debt. Lenders who make unsecured loans typically look to the borrower’s current financial condition in order to determine whether to extend credit. However, with student loans, the parties to the transaction focus solely on the borrower’s future prospects of achieving financial strength through a current investment in education.
One of the primary goals of bankruptcy law is to allow people to obtain a “fresh start” on their finances. Until recently, however, the bankruptcy discharge often allowed only one party to the student loan to reap the long-term benefit of the relationship – the debtor. Congress now recognizes that student loans are incurred to enhance borrowers’ earnings potential over a lifetime. Accordingly, Congress recently eliminated the discharge for all student loan debt except for those debtors who face exceptionally bleak financial prospects.
Student Loans Under Section 523(a)(8)
Until recently, the Bankruptcy Code discouraged for-profit lenders such as banks and financial institutions from making student loans that were not made, insured or guaranteed by governmental units or nonprofit institutions. Under the former Section 523(a)(8) of the Bankruptcy Code, if a for-profit lender were to make such a loan and the borrower thereafter filed a petition for bankruptcy relief, the loan would be discharged in bankruptcy. See generally, In re Reis, 274 B.R. 46 (Bankr. D. Mass. 2002) (loan extended by private party was “not made pursuant to a student loan program of a governmental unit or nonprofit entity”). In contrast to loans made by for-profit lenders, loans that were made, insured or guaranteed by governmental units or nonprofit institutions received different treatment under the Bankruptcy Code. Such loans were nondischargeable unless debtors could prove that the loans would impose an undue hardship on them and their dependents. The purpose of former Section 523(a)(8) was to reduce the risk that taxpayers and nonprofits would be required to absorb the loss of nonpayment.
With the recent enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), however, all student loans are now given equal treatment under the Bankruptcy Code. (Technically speaking, the loans must meet the definition of a qualified educational loan as defined in Section 221(d)(1) of the Internal Revenue Code.) Revised Section 523(a)(8) now provides that student loans made by for-profit lenders will be nondischargeable unless debtors persuade bankruptcy judges that student loan debts will impose an undue hardship on them and their dependents. Accordingly, for-profit lenders face substantially less portfolio risk with respect to student loans because other unsecured debt is discharged, a provision that should increase the debtor’s ability to repay the student loan debt.
Discharging Student Loans in Bankruptcy: Procedural and Substantive Hurdles Now Faced by Debtors
Student loans are presumptively nondischargeable in bankruptcy. In re Hanson, 397 F.3d 482 (7th Cir. 2005). The first procedural hurdle debtors must overcome to discharge student loan debt is the filing of an adversary proceeding, which requires the service of a summons and complaint. Rather than comply with the formal requisites of an adversary proceeding, some Chapter 13 debtors have instead attempted to improperly insert undue hardship findings or student loan or loan interest provisions in their proposed plans. Alternatively, other debtors may attempt to address the discharge of student loans by way of contested matter. In either case, lenders are encouraged to require that debtors comply with the heightened procedural safeguards afforded through adversary proceedings.
Once an adversary proceeding is commenced, the debtor has the burden of proving undue hardship. See Pennsylvania Higher Education Assistance Agency v. Faish (In re Faish), 72 F.3d 298, 301 (3d Cir. 1995). “Debtors can overcome this presumption by making an affirmative showing that exception of the student loan debt from discharge would impose an undue hardship on the debtor or the debtor’s dependents.” In re Hanson, 397 F.3d 482, 485 (7th Cir. 2005). The standard used by most bankruptcy courts to determine whether student loans constitute an undue hardship is the Brunner test, which requires showing: “(1) that the debtor cannot maintain, based on current income and expenses, a ‘minimal’ standard of living for herself and her dependents if forced to repay the loans; (2) that additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period of the student loans; and (3) that the debtor has made good faith efforts to repay the loans.” Brunner v. New York State Higher Education Services Corp., 831 F.2d 395 (2d Cir. 1987); cf. Hicks v. Educational Credit Management Corp. (In re Hicks), 331 B.R. 18 (Bankr. D. Mass. 2005) (rejecting Brunner and applying “totality of circumstances” test). Debtors face a heavy burden in proving that dire financial circumstances will exist for a significant portion of the loan repayment period. Accordingly, lenders should vigorously oppose debtors’ efforts to discharge student loans in bankruptcy.
Special Concerns for Schools That Make Student Loans: Releasing Transcripts to Debtors During Bankruptcy Reduces Portfolio Risk
Schools constitute a subset of lenders that make student loans. Outside of bankruptcy, schools typically will not release transcripts to borrowers who are not current on their student loans. Hence, schools view the withholding of transcripts as a means of forcing borrowers to repay their student loan debt. However, schools should consider taking a different tack when borrowers file for bankruptcy protection. Upon the filing of a bankruptcy petition, schools should release transcripts to debtors at their request. This will enable the schools to minimize legal fees and monetary sanctions associated with bankruptcy cases as well as facilitate the rehabilitation of debtors during the pendency of the bankruptcy case. Yet, once the debtor has received her discharge in bankruptcy, schools may resume enforcing the policy of withholding transcripts.
There is a split of authority as to whether a school, which makes student loans violates the automatic stay by withholding transcripts from debtors who make post-petition requests for release of transcripts when the student loans are in default. Certain courts have concluded that, in the absence of a school’s motion for relief from the automatic stay, the withholding of transcripts constitutes a violation thereof. Other courts have determined that there can be no violation of the stay because withholding transcripts simply maintains the status quo. Public policy suggests that schools should release transcripts to debtors who have filed bankruptcy, especially in light of the presumptively nondischargeable status now conferred on all student loans under revised Section 523(a)(8).
Most bankruptcy courts considering the issue have concluded that a school’s withholding of a transcript constitutes an act to collect, assess, or recover a claim and, thus, is a violation of the automatic stay. For example, in In re Hernandez, 2005 WL 1000059 (Bankr. S.D. Tex. 2005) (unreported), the court concluded that the failure to provide a transcript is “clearly an act to collect or to recover a prepetition claim against the debtor.” The Hernandez court considered that a school’s policy of withholding transcripts from any borrowers who are in default (irrespective of whether such borrowers filed bankruptcy) may not be enforced against borrowers who file for bankruptcy relief. At a minimum, the Hernandez court imposes a duty on schools to seek relief from the automatic stay in order to withhold transcripts from debtors.
Fewer bankruptcy courts have concluded that refusing to release transcripts to debtors in bankruptcy does not result in a violation of the automatic stay. In In re Billingsley, 276 B.R. 48, 49 (Bankr. D.N.J. 2002), the court held “that where the student loan is concededly nondischargeable, a private educational institution does not violate the automatic stay by withholding the transcript of a student debtor who has defaulted on her loan.” The Billingsley court believed that the university’s withholding of the debtor’s transcript “is wholly consistent with the very purpose of the automatic stay: ‘to maintain the status quo that exists at the time of the debtor’s bankruptcy filing.’” Id. at 53-54. Since the borrower could not otherwise compel the university to release a transcript outside of bankruptcy, the court concluded that a borrower should not enjoy greater rights under her contract with the university inside bankruptcy than what she would enjoy outside of bankruptcy.
Harmonizing these two lines of conflicting authority relative to the propriety of withholding transcripts can be challenging for schools. On the one hand, schools consider the ability to withhold transcripts as critical to collection of delinquent loans. On the other hand, schools do not wish to be sanctioned for violating the automatic stay. In light of the revisions to Section 523(a)(8) under BAPCPA, it should be easier for schools to adopt an exception to any existing policy for withholding transcripts which provides for the release of transcripts upon request to those borrowers who file bankruptcy. See In re Walker, 336 B.R. 534 (Bankr. M.D. Fla. 2005) (private university violated automatic stay by withholding debtor’s transcripts) (quoting In re Reese, 38 B.R. 681, 683 (Bankr. N.D. Ga. 1984)). Schools will have a better chance of recovering nondischargeable student loans when they assist debtors who seek gainful employment or continue their educations. Furthermore, the legal fees and sanctions associated with bankruptcy cases should decrease.
Conclusion
By making all student loans presumptively nondischargeable in bankruptcy,
Congress has recognized that lenders are entitled to receive the benefit of
their bargain with respect to a borrower’s long-term investment in human
capital. Debtors who file for bankruptcy protection and comply with the
significant procedural and substantive burdens of proving “undue hardship”
will likely constitute a small portion of a lender’s total portfolio of
student loans. Private and public schools that make student loans should
release transcripts upon request to debtors who file bankruptcy in order to
minimize their exposure to legal fees and sanctions and to improve the
likelihood of repayment.
For more information, e-mail James Fly at
james.fly@hklaw.com or call toll free, 1-888-688-8500.