Bankruptcy is supposed to give debtors a fresh start—unless they’re struggling with student loans. But a little-known provision is helping these borrowers take their creditors to court.
Submitted by New Jersey Bankruptcy Lawyer, Lee M. Perlman.
In 2005, Chuck Stewart’s life had come to a screeching halt. His partner was in the hospital with a terminal illness and he had only $300 in his bank account. He couldn’t find a job, and the $60,000 in student loans he took on for a doctorate in education weren’t going anywhere. That’s when he decided to file for bankruptcy.
“I spoke to two lawyers and they both said the same thing: ‘It’s going to be extremely expensive and you are going to lose,’” he said.
In a typical bankruptcy, Stewart would have to show that his income was below the median level for the state or that his expenses outweighed his disposable income. With a tower of medical bills and unable to find employment, he likely would have qualified. But because his loans were for school, lawyers said it would be impossible.
Historically, U.S. bankruptcy laws have been passed to give debtors a fresh start: If you’re drowning in credit card bills, an underwater mortgage, or even gambling debt, you can file for bankruptcy and start over. Not so if that same money was spent on an education. Today, student loans—which total more than $1.3 trillion—are one of just a few types of debt that do not generally qualify for bankruptcy, putting them in a category with unpaid child support and criminal fines.
It wasn’t always like this. Bankruptcy rights for student debtors were slowly eroded over years as legislators enacted law after law to curtail students’ access to bankruptcy.
For centuries, Congress has protected debtors by creating relieving bankruptcy codes during economic crises that threatened to throw large portions of the population into nearly inescapable debt. Several bankruptcy laws were passed during the Great Depression alone to aid the ailing population. In 1934, the Supreme Court ruled in Local Loan v. Hunt that bankruptcy “gives to the honest but unfortunate debtor…a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of pre-existing debt.”
“You’re going up against lawyers who do this every day …”
But in 1970s, that clear, unhampered field began to change for students. Congress grew concerned about the default rates on federal student loans and government-backed private loans. Between 1973 and 1975, the number of students filing for bankruptcy had jumped from just under 30 percent to nearly 60 percent (though some have argued that the rise in filings was due to an overall increase in students attending college and taking out loans). In 1976, the bankruptcy code was amended to prevent the discharge of student loans during borrowers’ first five years of repayment (they could still be discharged after that). Then, a succession of laws added private student loans to the list of debts ineligible for bankruptcy, and extended and then eliminated the waiting period, permanently blocking students from discharging their debt.
Many—including students, lawyers, judges, and representatives of Congress—have called for a revision to the laws, arguing that they are unfair and can be exploitative, especially in the case of private loans. Currently, the only way for debtors like Stewart to start fresh is to make use of a little-known clause that allows debtors to declare bankruptcy if they can prove intolerable economic hardship.
Honest but unfortunate debtors
When Stewart decided to file, he said the process was intimidating and left him feeling “utterly hopeless.” Debtors like Stewart must undergo “adversary” proceedings, arguing against their creditors in court to prove that loan payments create an “undue hardship” for them. It’s a hazily defined legal concept that can vary from case to case and judge to judge, making proof difficult.
“That’s the nerve-wracking part” Stewart said. “You’re going up against lawyers who do this every day and you’re expected to defend yourself.”
“You see more and more judges siding with debtors for humane reasons.”
To determine if someone like Stewart qualifies, most courts use an informal, three-pronged tool called the Brunner test. To pass, the student has to prove that he has made an honest effort to repay the debt, that a minimal standard of living cannot be maintained while continuing to repay the debt, and that his financial situation is likely to persist into the future.
The test was adopted in 1987 in the case of Marie Brunner v. New York State Higher Education Services Corp. Brunner was ten months out of graduate school when she filed for bankruptcy, and the court believed she wasn’t genuine in her request for relief. The judge ruled that because she had only made one payment on her loan and there was no reason to believe that she would be unable to find a job in the future, Brunner’s application was invalid.
But recently, some debtors have fared better, thanks largely to the decisions of judges.
In 2013, in Myhre v Department of Education, the DOE argued that Bradley A. Myhre, an unemployed quadriplegic whose expenses exceeded his income, should be put on a payment plan. The same year, in Roth v Educational Credit Management Corporation, the creditor, ECMC, claimed that Janet Roth, a 68-year-old woman who was unemployed and whose only income came from Social Security checks, was capable of making payments for the next 25 years on a debt that had ballooned from $33,000 to $95,000 with fees and interest.
“If the floodgates ever opened, a lot of people would gain relief …”
In both the Myhre and Roth cases, the judges ruled in the debtors’ favor. Though ECMC argued that Roth, who had never made a voluntary payment on her loans, could not therefore have made a good faith effort to repay, the court ruled that a repayment plan would be “disastrous” for her estate. In the case of Myhre, who took out a student loan after becoming a quadriplegic, the DOE argued that because he had not enrolled in an income-based repayment plan and did not put an inheritance check towards his loan, he had also not made a good faith effort in repayment. Here, too, the judge ruled that Myhre deserved to have his loans discharged—and that he was entitled to use his discretionary income to maintain a basic standard of living.
“You see more and more judges siding with debtors for humane reasons,” said Richard Fossey, a professor at the University of Louisiana who studies student bankruptcy cases. “It’s [judges] who are setting a trend with their decisions.”
Fossey said he believes that in cases involving student debtors, courts are becoming more compassionate and leaning toward the original driving force behind bankruptcy: a fresh start. “You see the judge saying, in his ruling: An honest but unfortunate debtor should not have to lie awake at night worrying about 25 years of debt,” he said.
A different landscape
Isaac Bowers has met plenty of people who are fearful of the debt they carry: “It’s basically a small mortgage,” he said of the loans of students he works with. Based on his experience as director of law school engagement and advocacy at Equal Justice Works, an organization that helps law students who want to work in public service despite the expensive debt they incur during school, Bowers said the best way to avoid debt is to borrow responsibly. Students can use net-price calculators, like this one just released by the DOE, to make informed decisions about how much education really costs—and what a degree is worth.
But many, like Roth, started out with manageable loans that ballooned in size because of fees and interest. The challenge is magnified for those who never completed their education, or who were defrauded by their colleges into taking on private student loans that do not come with the same protections as federal loans, like interest-rate caps and income-based repayment plans.
“Lenders as well as borrowers have a responsibility to lend [and borrow] responsibly,” Bowers said. “And that can’t happen if those bankruptcy protections aren’t in place for those who need them.” In other words, a responsible lending system requires a safety net for those in extreme circumstances.
Although bankruptcy offers a net, Fossey said the undue hardship clause keeps most student debtors assuming it’s out of reach. It’s a reality that, according to Fossey, benefits creditors. “If the floodgates ever opened, a lot of people would gain relief and I don’t think they want to see that happen,” he said.
A 2007 study by Harvard researcher Jason Iuliano showed that 69,000 of the people who had already filed for bankruptcy on non-student debt that year, would have also qualified to discharge some student loans (based on their income, employment status, and other experiences). Only 300 of them tried.
“Student debt is a part of the landscape for more students now.”
The government has taken steps to aid students by offering extended income-based repayment options. In July, the DOE issued guidelines for loan holders about when they should refrain from opposing bankruptcy. And in March, Senator Dick Durbin (D-IL) introduced the Fairness for Struggling Students Act. It’s a bill that, if passed, would roll back restrictions to where they were in 2005—essentially allowing private loans to be discharged in bankruptcy after a period of seven years.
Both Stewart and Fossey argue that such an amendment does not go far enough and that the law should return to where it was in 1998: After seven years, all student loans would be eligible for bankruptcy without having to prove undue hardship in an adversary.
“Higher education just isn’t the same as it was in 1998,” Fossey said. Since more students are going to college than ever and more jobs require degrees, “student debt is a part of the landscape for more students now,” he said.
Stewart reached a settlement before his court date came up: He would pay $50 a month for 10 years, a term that is just coming to a close. He said he will end up paying $6,000—just 10 percent of what he initially owed—and the remainder will be considered discharged.
Stewart said that talking with people about his experience has revealed a common misperception that discharging student loans through bankruptcy is impossible.
“A lot of people don’t understand that you have a right to file this as an adversary,” said Stewart, who has sometimes been criticized as a free-loader trying to cheat the government. “The government hasn’t made this a secret, people are just misinformed.”