NBC Student Loan Dischargeability Position Paper

Position Paper

Student loan debt now exceeds $1.4 trillion, and continues to rise every year. The negative impact on the U.S. economy from this burgeoning student debt is undeniable. The Federal Reserve Bank of New York recently reported that former students carrying student loans are far less likely to be able to purchase a first time home. The Federal Reserve Bank of Philadelphia found that high levels of student debt are “a drag on small business formation.” Other reports indicate that Americans with student loans are likely to delay buying a car, getting married, starting families, and saving for retirement.

The National Bankruptcy Conference has closely studied the issue of student loans and how they could be more fairly dealt with in the bankruptcy process. It has proposed a number of changes to our current bankruptcy laws that we believe will rationalize those laws to deal fairly with student loan debt in ways that better serve the needs of the American people and economy.

This position paper outlines those proposed changes and describes the evolution of the student loan exception to discharge.

JANE VRIS
Chair, National Bankruptcy Conference
PMB 124, 10332 Main Street
Fairfax, VA 22030-2410
Phone: (434) 939-6008 Fax: (434) 939-6030
E-mail: info@nbconf.org
Web: www.nbconf.org

For legislative inquiries, please contact:
MICHAEL ST. PATRICK BAXTER
Legislative Committee Chair
Covington & Burling LLP
One CityCenter
850 Tenth Street, N.W.
Washington, DC 20001-4956
Tel: (202) 662 5164
email: mbaxter@cov.com

Position Statement of the National Bankruptcy Conference on Student Loan Dischargeability

A. History of Student Loan Exception to Discharge

The special limitations of discharge applicable to student loans have gone through a number of changes. Congress first established the Guaranteed Student Loan Program in the Higher Education Act of 1965. Until 1976, student loans were dischargeable like other unsecured debt, as no provision of the Bankruptcy Act or the Higher Education Act prohibited the discharge of student loans.

Data from the period when student loans were dischargeable without limitation had shown that most consumers did not elect to discharge student loans in bankruptcy. A Government Accountability Office (GAO) study on the topic found that only a fraction of one percent of all matured student loans had been discharged in bankruptcy. A House Report summarized the GAO’s findings:

First, the general default rate on educational loans is approximately 18%. Of that 18%, approximately 3-4% of the amounts involved are discharged in bankruptcy cases. Thus, approximately ½ to ¾ of 1% of all matured educational loans are discharged in bankruptcy. This compares favorably with the consumer finance industry.¹

The GAO study also found that debtors who discharged student loans in bankruptcy had other significant indebtedness, suggesting that the filings of some debtors were based on other financial problems and not motivated by an attempt to discharge student loans.

The Report issued by the Commission on the Bankruptcy Laws of the United States in 1973 recommended that there should not be an unlimited discharge of student loans.² Following the Commission’s recommendation, the first restrictions placed on student loan dischargeability came in 1976. Congress passed legislation making loans insured or guaranteed under the Higher Education Act dischargeabable in bankruptcy after the loan had been subject to repayment for a period of five years or if the bankruptcy court determined that “payment from future income or other wealth will impose an undue hardship on the debtor or his dependents.”³ This general framework, providing for discharge after a five year waiting period or upon proof of undue hardship, was then incorporated into the Bankruptcy Code in 1978.⁴

In 1984, Congress expanded the discharge exception by deleting the phrase “of higher education” from section 523(a)(8).⁵ Amendments in 1990 extended the waiting period for an unconditional discharge from five to seven years.⁶ Before 1990, section 523(a)(8) did not apply to chapter 13 cases, so that debtors who paid their disposable income for three years under a chapter 13 plan obtained a discharge that included any listed student loan debts. This option changed in 1990, when amendments to the Code made both the undue hardship test and the seven-year waiting period applicable in chapter 13.⁷ Finally, in 1998, Congress eliminated the waiting period option for dischargeability.⁸ In its October 20, 1997 report, the National Bankruptcy Review Commission recommended to Congress that the exception to discharge for student loans be eliminated:

The Commission recommends that Congress eliminate section 523(a)(8) so that most student loans are treated like all other unsecured debts. In so doing, the dischargeability provisions would be consistent with federal policy to encourage educational endeavors. The Recommendation would also address the numerous application problems that have resulted from the current nondischargeability provision. No longer would Chapter 13 debtors who made diligent efforts to repay be penalized after completing a plan with thousands and thousands in compounded back due interest. Litigation over “undue hardship” would be eliminated, so that the discharge of student loans no longer would be denied to those who need it most. In 2005, an amendment to section 523(a)(8) enacted by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 added an exception to discharge for qualified education loans, which includes most private student loans. The 2005 amendments also reorganized the structure of the statutory language in section 523(a)(8).

B. Educational Debt Covered by Current Exception to Discharge

In its present form, section 523(a)(8) provides that if no undue hardship determination is made, the discharge an individual debtor receives in a bankruptcy case does not discharge the debtor from the following type of debt:

• (A)
  such loan first became due before five years before the date of the filing of the petition; or
• (B)
  excepting such debt from discharge ... will impose an undue hardship on the debtor and the debtor's dependents....

(A)(i) an educational benefit overpayment or loan made, insured, or guaranteed by a governmental unit, or made under any program funded in whole or in part by a governmental unit or nonprofit institution; or

(ii) an obligation to repay funds received as an educational benefit, scholarship, or stipend; or

• (B)
  any other educational loan that is a qualified education loan, as defined in section 221(d)(1) of the Internal Revenue Code of 1986, incurred by a debtor who is an individual.

1. Loans by Government Units and Non-Profits

Under subsection (A)(i) of section 523(a)(8), the undue hardship restriction on dischargeability applies to “an educational benefit overpayment or loan made, insured or guaranteed by any governmental unit, or made under any program funded in whole or in part by a government unit or a non-profit institution.” There are two parts to the exception contained in subsection (A)(i) of section 523(a)(8). First, it covers overpayments or loans made, insured, or guaranteed by a governmental unit. This language has always covered Stafford loans, Federal Direct loans, Perkins loans, and older Supplemental Student Loans (SLS). Although an “educational benefit overpayment” is covered by this provision, such overpayments are not common.⁹

The second part of the subsection addresses a loan that has been made under a “program funded in whole or in part by a governmental unit or nonprofit institution.” Determining when this language applies has sometimes been difficult.¹⁰ Courts have had to examine the relationship between various lending entities and governmental units or non-profits that were affiliated in some way and determine that the entities acted under an existing program.¹¹

Certain educational debts are not “loans” or “overpayments” for purposes of subsection (A)(i) and therefore may be dischargeable. For example, courts have held that debtors may discharge tuition debts if there is no loan involving a transfer of funds or a formal agreement specifying repayment terms.¹² The debtor’s decision not to pay tuition does not create a loan. However, certain deferred tuition payment agreements have been construed to be loans when they provide for specific due dates and payment terms.¹³

Most courts hold that it is the purpose for which the loan was made that controls, rather than the use of the loan proceeds.¹⁴ Thus, if the borrower intended to use the borrowed funds to cover costs related to education, the fact that the borrower later used the proceeds for other purposes will not affect the loan’s status under section 523(a)(8).¹⁵

2. Funds Received as an Educational Benefit, Scholarship, or Stipend

The student loan dischargeability exception was extended in 1990 to “an obligation to repay funds received as an educational benefit, scholarship, or stipend.” This provision, which is now found in subsection (a)(ii), generally applies to educational benefit grants involving funds received by the debtor or advanced on the debtor’s behalf. For example, an obligation to repay a stipend that included an agreement to teach in an “other race” institution after receiving a degree,¹⁶ a scholarship grant received to finance medical training in exchange for an agreement to practice in a designated physician shortage area,¹⁷ and the requirement of a former employee to repay funds for tuition and books received under an employer’s educational expense reimbursement program,¹⁸ have been held to be nondischargeable under this language.

Several recent court decisions have noted that subsection (A)(ii) is not a “catch–all” provision designed to include every type of credit transaction that creates an educational benefit for a debtor.¹⁹ Most importantly, these courts have held that subsection (A)(ii) does not apply to loans.²⁰ For example, the court in In re Cambell noted that the application of subsection A)(ii) to loans is inconsistent with the current arrangement of the subsections in section 523(a)(8).²¹ Both subsections (A)(i) and (B) refer expressly to loans. If subsection (A)(ii) applied so broadly as to encompass loans as well, this would render subparts (A)(i) and (B) superfluous. The 2005 amendments creating subpart (B), applicable to private loans, came well after the 1990 amendments that added the language now appearing in subpart (A)(ii). Congress would not have needed to add subpart (B) if an obligation to “repay funds received for an educational benefit, scholarship or stipend” already included all loans of any type. However, other courts In re Christoff, 527 B.R. 624, 634 n. 9 (B.A.P. 9th Cir. 2015). In re Christoff, 527 B.R. 624, 634 (B.A.P. 9th Cir. 2015); In re Campbell, 547 B.R. 49 (Bankr. E.D.N.Y. 2016); In re Decena, 2016 WL 1371031 (Bankr. E.D.N.Y. 2016).

have held that subsection (A)(ii) applies to loans.²²

If a court decides that subsection (A)(ii) applies to a loan, there may still be a question as to whether the loan is related to a governmental unit or non-profit. The 2005 amendments to section 523(a)(8) reorganized the placement of subsection (A)(ii). Prior to 2005, the governmental unit or non-profit requirement was included as part of the subsection (A)(ii) language. In In re Nunez²³ the court held that the punctuation change in section 523(a)(8) did not alter the application of the subsection (a)(ii) language, and therefore found that a flight school program loan was dischargeable because the lender was not affiliated with a non-profit or governmental unit. However, other courts have held that the 2005 punctuation changes make the governmental unit or non-profit requirement no longer tethered to subsection (A)(ii).²⁴

Finally, the requirement under subpart (A)(ii) that there be “funds received” requires some transfer of funds either to the educational institution or the debtor. This limitation would exclude, for example, deferred tuition payment agreements.²⁵

3. Private Student Loans

Subsection (B), added to section 523(a)(8) in 2005, provides that an obligation that is a qualified educational loan as defined in section 221(d)(1) of the Internal Revenue Code (IRC) is nondischargeable. This language covers many private student loans which qualify under the IRS definition for a taxpayer interest deduction.²⁶ This definition focuses on the types of expenses for which the loan was incurred, the timing of the loan, and the type of institution attended.

In re Christoff, 527 B.R. 624 (B.A.P. 9th Cir. 2015); In re Shojayi, 515 B.R. 329, 333 (Bankr.

• D.
  Kan. 2014); In re Oliver, 499 B.R. 617 (Bankr. S.D. Ind. 2013).

To qualify for a tax deduction under the IRC, a student loan must be incurred solely to pay for “qualified higher education expenses.” The definition of these expenses is broad and incorporates the definition of “cost of attendance” at an educational institution from the Higher Education Act of 1965.²⁷ To be considered a qualified education loan under subsection (B), the loan must have been taken out to pay expenses for education furnished during a period in which the recipient was an eligible student.²⁸ Finally, qualified higher educational expenses must be for attendance at an “eligible education institution.” Eligible institutions are defined as institutions that are eligible to participate in a Title IV program.²⁹

C. Discharge of Educational Debt Based on “Undue Hardship”

If an educational debt falls within the coverage of section 523(a)(8), it may be discharged only if the bankruptcy court determines that “excepting such debt from discharge would impose an undue hardship on the debtor and the debtor’s dependents.”

The phrase “undue hardship” is not defined in the Bankruptcy Code. The House and Senate Reports issued in connection with the enactment of the Bankruptcy Code do not provide any discussion of the meaning of “undue hardship.” One court observed that the phrase was “lifted verbatim from the draft bill proposed by the Commission on the Bankruptcy Laws of the United States,”³⁰ and the Commission Report was relied upon by Congress in drafting certain provisions of the Bankruptcy Code.³¹ The 1973 Commission Report describes “undue hardship” as follows:

In order to determine whether nondischargeability of the debt will impose an “undue hardship” on the debtor, the rate and amount of his future resources should be estimated reasonably in terms of ability to obtain, retain, and continue employment and the rate of pay that can be expected. Any unearned income or other wealth which the debtor can be expected to receive should also be taken into account. The total amount of income, its reliability, and the periodicity of its receipt should be adequate to maintain the debtor and his dependents, at a minimal standard of living within their management capability, as well as to pay the education debt.³²

The 1973 Commission Report focuses on the debtor's inability to maintain a minimum standard of living while repaying the loans. It refers to a debtor maintaining this “minimal standard of living” based on “adequate” income. The Report also focuses on the debtor’s

26 U.S.C. § 221(d)(1)(C).

present and future condition. It does not refer to any of the debtor’s pre-bankruptcy past, such as the debtor’s attempts to repay the student loans or her decision to incur student loan debt.

In the years following the enactment of the Bankruptcy Code, nine of the Circuit Courts of Appeal have adopted a similar test for determining “undue hardship.” It is often referred to as the “Brunner” test, as it was first developed by the Second Circuit in Brunner v. New York State Higher Educ. Servs. Corp.³³

The Brunner test requires the debtor to show that:

• (1)
  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 student loans;
• (2)
  additional circumstances exist indicating that the hardship is likely to persist for a significant portion of the repayment period of the student loans; and
• (3)
  the debtor has made a good-faith effort to repay the loans.³⁴ The Second Circuit’s Brunner test has been adopted by the Third, Fourth, Fifth, Sixth, Seventh, Ninth, Tenth and Eleventh Circuits.³⁵ The debtor must establish all three prongs of the Brunner test before a court can make a finding of undue hardship.

The Eighth Circuit has adopted a “totality of circumstances” test for determining undue hardship.³⁶ The First Circuit has not adopted an undue hardship test, though the Bankruptcy Appellate Panel for the First Circuit has embraced the totality of circumstances test.³⁷

831 F.2d 395 (2d Cir. 1987).

The statute compels the courts to engage in the discretionary determination of when “hardship” becomes “undue.” Courts generally agree that “ordinary” or “garden variety” hardship, however defined, is not sufficient. On the other extreme, many courts have required a showing of a “certainty of hopelessness” or “extraordinary circumstances” in applying Brunner’s second prong, which looks at additional circumstances showing that the hardship is likely to persist.³⁸ Some courts have required that the exceptional circumstances must be something beyond the likely persistence of the debtor’s financial problems, and may require proof of serious illness, psychiatric problems, incapacity or disability of a debtor or dependent. This consideration, albeit formulated differently, may also appear in the totality of the circumstance test’s first and third prongs.

The Seventh Circuit has recently observed that requiring such demanding forms of proof may not be consistent with section 523(a)(8), noting that it is “important not to allow judicial glosses of the statutory language, such as the language in [Brunner], to supersede the statute itself.”³⁹

D. The Conference’s Recommendations

1. Repeal of Section 523(a)(8)

Section 523(a)(8), which renders most educational loans nondischargeable in the absence of an undue hardship, is not based on any wrongful conduct of the debtor or on any special needs of the creditor that might outweigh the fresh start policy of the Bankruptcy Code. Student loans should not be treated differently than other loans for dischargeability purposes, which was the state of the law before the middle of the 1970s. Consistent with that view, in 1997, the National Bankruptcy Review Commission recommended the repeal of section 523(a)(8).

It may be argued, however, that despite a debtor’s temporary financial distress, a quality education enhances the human capital of the debtor, which distinguishes student loans from other types of financing. The enhancement of the debtor’s human capital ordinarily improves the debtor’s earning ability long after the bankruptcy case is over. Therefore, requiring a debtor to pay for that long-term benefit may be warranted despite the debtor’s discharge in bankruptcy.

This argument is weakened by the fact that many student loans are for ineffective educational programs or programs that the debtor never completes, from which the debtor reaps no benefit. As the Government Accounting Office stated in a report to Congress in 1997, “many student borrowers have little or no means to repay their loans because they attended poor quality proprietary schools that failed to provide them with marketable skills.”⁴⁰ However, even considering reputable colleges and universities, rather than proprietary trade schools, it has been reported that almost half of all students who enter college do not graduate and receive a degree.⁴¹ Students who have some college but do not obtain a degree often struggle with student loan debt. In 2007, more than 43 percent of debtors in bankruptcy had some post-secondary education but did not earn a four-year college degree, and these debtors who did not complete their educations owed virtually the same amount of student loan debt as borrowers who earned degrees.⁴²

Congress may have intended that a debtor burdened with unmanageable student loan debt could obtain a discharge of that debt by showing its repayment would prevent the debtor from satisfying ordinary and necessary living expenses. However, the current “undue hardship” method of discharge is random, arbitrary and unfair.⁴³ The phrase “undue hardship” has been construed by courts to require a showing of exceptional circumstances and a “certainty of hopelessness.” Debtors are faced with the impossible task of proving a negative – “They must somehow prove that their future is as hopeless as their present.”⁴⁴ And they are required to litigate this in a separate adversary proceeding. This requires filing a complaint, often responding to extensive discovery by student loan creditors, and preparing and offering evidence for trial. Most debtors have few, if any, resources to pay for legal representation. Those who are truly financially distressed and desperately need relief are often unable to afford the costs of this litigation. Such proof requirements and litigation burdens eviscerate the fresh start potential inherent in the Code’s allowance for discharge.

For these reasons, the Conference recommends that section 523(a)(8) be repealed so that student loans are treated like all other unsecured debts.

2. Recommendations for Amendments to Bankruptcy Code

If section 523(a)(8) is not repealed, the Conference recommends that it be amended to provide that only loans made, insured, or guaranteed by the United States are nondischargeable.

The amendment would also permit the discharge of government student loans after a five year waiting period, as was provided in the 1978 Bankruptcy Code.

A change in the bankruptcy law permitting discharge of government student loans after a five year waiting period should not have a significant impact on participation in the Department of Education’s income based repayment programs. Consumers generally do not file bankruptcy if there are manageable ways for them to deal with their debt burden. Even consumers who would benefit from bankruptcy often do not file because of the stigma and challenges associated with filing bankruptcy. A RAND study of American families during the Great Recession found that by April 2010, 39 percent of households had experienced financial distress.⁴⁵ However, there were only 1.54 million nonbusiness bankruptcies in 2010, which was less than 1.4 percent of the 116.7 million households in 2010. Despite slow economic recovery since 2010, bankruptcy filing rates have continued to decline, with 819,760 nonbusiness bankruptcy filings in 2015.⁴⁶

The Conference also believes a new basis for discharge should be added to section 523(a)(8) dealing with the failure to complete an educational course. This provision should cover a co-obligor on the student loan or a parent who obtained a federal Parent Plus or other similar loan on behalf of a student who did not complete the educational course.

As discussed earlier, the current “undue hardship” language has created an extremely difficult standard to satisfy. The “undue hardship” tests developed by the courts have been applied unevenly and have produced inconsistent results. The Conference therefore believes that the “hardship exception” should no longer require a finding of “undue” hardship. Rather, the debtor’s inability to pay under current financial circumstances should be sufficient to result in the discharge of the educational loan.

The Conference therefore recommends that section 523(a)(8) be amended as follows:

for an educational loan made, insured, or guaranteed by the United States, that first became due after five years before the filing of the petition, unless

• (A)
  the proceeds of the loan were used to pay for a student’s educational program, the student’s enrollment in the program has terminated for any reason, and the student is not likely to complete the program, or

• (B)
  excepting such debt from discharge under this paragraph will impose a hardship on the debtor or a dependent of the debtor.

The Conference also recommends amending section 1322(b) to provide for more effective payment of student loans in chapter 13 cases. Absent a finding of hardship under section 523(a)(8), debtors in chapter 13 cases are obligated to pay upon completion of their chapter 13 case the amount owed on student loan debt that has not been paid during the plan. This includes any unpaid interest on the debt that has accrued during the plan.⁴⁷ Thus, it is often in the debtor’s interest to pay off as much of the student loan debt in the chapter 13 plan as is permissible. One way to pay more on the student loan than on other unsecured debts is to provide in the plan that the debtor will maintain direct ongoing monthly payments to a student loan creditor under section 1322(b)(5).

However, some courts refuse to give effect to section 1322(b)(5) as a distinct Code provision and have required debtors proposing to pay ongoing student loan payments directly from current income to satisfy the unfair discrimination test under section 1322(b)(1).⁴⁸ If the court does not find that this separate classification will fairly discriminate and therefore requires the debtor to make pro-rata distributions rather than ongoing contractual payments to student loan creditors, a debtor who is current on student loan payments when the bankruptcy is filed will be thrown into default. This undermines the goal of paying back the government debt to help the federal treasury, which is often touted as one of the purposes of student loan nondischargeability. It also causes various other consequences to the debtor, such as loss of current status for administrative repayment and loan forgiveness programs.⁴⁹

Another obstacle in using section 1322(b)(5) to maintain ongoing student loan payments during the plan is a provision added to the Code by the 2005 amendments. Section 1322(b)(10) states that if a chapter 13 plan provides for the payment of ongoing postpetition interest on a nondischargeable debt, the interest “may be paid only to the extent that the debtor has disposable income available to pay such interest after making provision for full payment of all allowed claims.”⁵⁰ In other words, the debtor would have to propose to pay all unsecured creditors’ claims in full during the chapter 13 case if the debtor wanted to continue making student loan payments that include interest. A few courts have accepted this broad view of section 1322(b)(10).⁵¹ Other courts take the view that section 1322(b)(5) is a specific provision that can be read consistently with the more general language of section 1322(b)(10).⁵²

For these reasons, the Conference recommends that sections 1322(b)(1) and 1322(b)(10) be amended as follows:

• (1)
  (A) Subject to subparagraph (B) of this paragraph, designate a class or classes of unsecured claims, as provided in section 1122 of this title, but may not discriminate unfairly against any class so designated; however, such plan may treat claims for a consumer debt of the debtor if an individual is liable on such consumer debt with the debtor differently than other unsecured claims;
• (B)
  a plan may designate a separate class or classes of claims consisting only of claims for a consumer debt if an individual is liable on such debt with the debtor or claims for a debt of the kind specified in section 523(a)(8) of this title, and may treat such claims differently than other unsecured claims, and such treatment shall not be considered to discriminate unfairly against any other class of unsecured claims.
• (10)
  provide for the payment of interest accruing after the date of the filing of the petition on an unsecured claim claims that is are nondischargeable under section 1328(a), except that if such claim is not of the kind specified in paragraph (1)(B) of this subsection, such interest may be paid only to the extent that the debtor has disposable income available to pay such interest after making provision for full payment of all allowed claims; and…

E. Conclusion

Student loan debt continues to grow. Its negative impact on U.S. households and the economy are undeniable. Since the 1980s, the road to a fresh start in bankruptcy for student loan borrowers has been blocked by an increasing number of barriers. After close study, the National Bankruptcy Conference believes that it is time to revisit the way in which student loans are treated under the Bankruptcy Code.

Currently, the Bankruptcy Code renders most educational loans nondischargeable in the absence of undue hardship. However, this special treatment for student loans is not based on any wrongful conduct of the debtor or on any special needs of the creditor that might outweigh the fresh start policy of the Bankruptcy Code. For this reason the Conference recommends, first and foremost, that the Bankruptcy Code not treat student loans differently than other loans for dischargeability purposes. If, however, student loans continue to receive special treatment under the Bankruptcy Code, that treatment should be narrowed. Specifically, only loans made, insured, or guaranteed by the United States should be afforded special protection. Even then, such protection should be limited to five years after payments become due on the loan. Additionally, more flexibility should be provided to debtors seeking to pay student loan obligations in chapter 13.