Guest Post: A Bankrupt Policy

By Deanne Loonin

As most readers of Higher Ed Watch know, current bankruptcy law treats students who face financial distress the same severe way as people who are trying to discharge child support debts, alimony, overdue taxes and criminal fines. It’s difficult to separate fact from fiction when trying to understand the logic behind this policy, but one thing is clear — the restrictions came about without any empirical evidence that students were more likely to “abuse” the bankruptcy system.

Unfortunately, the legislative history of the student loan bankruptcy provision sheds little light.

The bare facts are that in 1976, Congress made student loans generally non-dischargeable except five years after default or if the borrower could prove “undue hardship.” Since then, there have been three significant legislative changes. First, in 1990, the five year period was extended to seven years. In 1998, Congress eliminated the seven-year floor primarily as a budget savings gimmick to pay for student loan changes it made when it reauthorized the Higher Education Act that year. Finally, in 2005, lawmakers included private loans in the non-dischargeability category as part of comprehensive bankruptcy amendments (the change primarily affected for-profit lenders because private loans made by nonprofit providers were already exempt). If there were reasons to consider restricting bankruptcy for federal loans, there was absolutely no such basis for extending the policy to high-cost private loans.

The “Soft Fraud” Theory

In an excellent article, John Pottow, a law professor at the University of Michigan, lays out a number of plausible theories for why student loans should be nondischargeable. The most commonly cited reason is what Professor Pottow calls “soft fraud” or “opportunism.” According to this theory, most students go to school with good intentions and only think about discharging their student loans later. Once they get out of school (or if they drop out), they find that jobs are hard to get, salaries are lower than expected, and many good jobs require even more education and more debt (hardly a far-fetched scenario in this economy). They see a long debt-burdened road and start looking for the bankruptcy exit.

Before addressing whether the current system is designed to address this issue, it is important to note that there is no evidence that student loan debtors are more likely than other borrowers to file for bankruptcy. In fact, a 1977 study by the General Accounting Office – which Congress appears to have ignored — found that only a fraction of 1 percent of all matured student loans had been discharged in bankruptcy. “This compares favorably with the consumer finance industry,” the study stated.

The “soft fraud” theory also assumes that the decision to file bankruptcy is cost-free when in fact there are many negative consequences, such as damage to credit rating. Further, in 2005, Congress added a number of new elements to the personal bankruptcy system, such as a means test and counseling requirements, that make it more difficult for all consumers to file bankruptcy, especially those who have assets to pay their debts. In any case, the bankruptcy code has always included safeguards to prevent discharge in cases where debt is obtained through false pretenses or fraud.

An Arbitrary System

Even accepting “soft fraud” as a concern, the problem is that the current system does not target only those who are supposedly abusing the bankruptcy system. While it may catch some student borrowers who can afford to pay their loans, it also snares those who are truly financially distressed and desperately need relief.

Under current law, most federal and private student loans can only be discharged if the debtor can show that payment will impose an undue hardship on the debtor and the debtor’s dependents. The student must seek the hardship determination in court through a separate proceeding.

The system is strikingly arbitrary. Anyone who has handled one of these cases can tell you how random it is. A legal aid lawyer I know in the South tells me that the judge in her area almost always grants discharges. Other attorneys I work with practice in districts where the judges almost never grant discharges, regardless of the circumstances.

Judges are granted extraordinary discretion to make these decisions, especially since the code provides no definition of “undue hardship.” An academic study of 261 reported decisions affirmed the randomness in the application of the undue hardship test. The study found few statistically significant differences between the debtors granted discharges and those that were not. The study also found that students seeking bankruptcy relief were in fact suffering financial distress. The authors conclude that judicial discretion has come to undermine the integrity of the undue hardship system.

Another problem with the current system is that it is pretty much stacked up against the most financially distressed borrowers. These borrowers have few, if any, resources to pay for legal assistance to prove to judges that they suffer from undue hardship. The sad fact is that there are very few lawyers that are willing to handle these cases through free legal services or on a pro bono basis.

Without legal assistance, these borrowers must litigate undue hardship while going up against aggressive creditor lawyers. Proving hardship requires independent evidence of medical conditions if the borrower is disabled. Borrowers also must show that their financial distress will last indefinitely. Some courts have adopted a nearly impossible to prove “certainty of hopelessness” standard.

A Middle Ground?

Many courts, recognizing the inequity of this system, have begun to create an ad hoc middle ground. Some allow partial relief by discharging a portion of the debt or by discharging some, but not all, of the loans. Some courts have allowed a restructuring of the loan, for example by discharging collection fees and accrued interest and even by delaying the student’s obligation to start making payments, during which time no further interest accrues.

Whether a borrower gets the benefit of a middle ground approach depends entirely on where she happens to live and the judge she happens to draw. This is unfair, but the judges have a point. They are flying by the seat of their pants without any foundation in the bankruptcy code because they understand that the current all or nothing approach doesn’t work for everyone.

There might be room for a middle ground approach for some borrowers, as long as that policy was administered across the board. The new income-based repayment system in the federal loan programs is especially promising as it gives borrowers the opportunity to manage their debts outside of bankruptcy. Once it is available in July 2009, this program will allow most federal student loan borrowers with economic hardships to repay their loans based on a formula that takes income and total indebtedness into account (though, as currently designed, it may not be as helpful to borrowers who are already in default as it should be.)

Regardless, the program, however, is available to only federal loan borrowers. The lack of this type of option in private loans is a good reason why restoring bankruptcy rights for private loan borrowers is such a critical step.

There might also be ways to incorporate some of the ad hoc policies into the bankruptcy system through partial discharges or by separately classifying student loans in Chapter 13 plans so that borrowers can make a bigger dent in these nondischargeable debts during the course of the plan.

These middle ground approaches should be considered, but not as a substitute for full bankruptcy rights for the neediest borrowers. If, however, the undue hardship system is retained for these borrowers, the standard should be refined to target those in the most distress and to ease the burden of proof. But this is not enough. Congress should also restore the waiting period as an alternative ground for discharge. A five year waiting period has the benefit of allowing a more straightforward process so that borrowers who cannot access the system are not unfairly penalized and of weeding out those borrowers who can work, but are choosing not to. If they truly have assets and income, their loan holders can try to collect during the waiting period. At a bare minimum, full bankruptcy rights must be restored for financially distressed private loan borrowers.

These solutions are not perfect, but can help correct a skewed system that unfairly penalizes students who discover that their education has not paid off as expected.

Deanne Loonin is a staff attorney with the National Consumer Law Center and the director of the center’s Student Loan Borrower Assistance Project. She focuses on consumer credit issues generally and more specifically on student loans, credit counseling, and credit discrimination. She is the principal author of numerous publications, including “Paying the Price: the High Cost of Private Student Loans and the Dangers for Student Borrowers.“ Her views are her own and do not necessarily reflect those of the New America Foundation.