Undo Undue Hardship: A Better Way to Discharge Student Loans in Bankruptcy

Guest post by Aaron N. Taylor.

America’s love-hate relationship with debt has found a new dread: student loans. With the housing crash still fresh on everyone’s mind, fear of a new bubble filled with worthless student loan debt has come to fore. This heightened (if not hyper) state of concern is understandable.

Topping $1 trillion, student loan debt now exceeds credit card debt (though that may not be a bad thing). Last year alone, students borrowed $100 billion for school. Additionally, a recent study found that 27% of federal student loan borrowers in repayment have past due balances, with 10% being delinquent. Many more are making reduced payments through income-based plans.

This data is concerning and portends an increase of debtors seeking to discharge their student loan debt in bankruptcy. Unfortunately, our means of assessing the propriety of such discharges are woefully subjective and inconsistent. The result is a highly inefficient system that falls far short of notions of justice and fairness. In this article, I propose an objective framework for assessing the propriety of federal student loan bankruptcy discharges.

Before I get into the specifics of the proposal, let me correct the ubiquitous misconception that student loans are virtually impossible to discharge. Student loans are dischargeable in bankruptcy—both in theory and in fact. Surprisingly, not much empirical research has been done on the topic. But in a 2003 study, 57% of debtors seeking to discharge student loans were successful. A follow-up study of bankruptcy cases filed between 2002 and 2006 found similar trends. At the very least, this limited data debunks the “impossibility” meme. Discharge is possible. It happens. It’s just difficult to predict when and to what extent.

Why We Need To Undo Undue Hardship

A debtor seeking to discharge student loans in bankruptcy must prove that paying the debt would cause an “undue hardship” upon him and his dependents. Undue hardship, however, is an undefined concept. Should the words be construed literally or conceptually? Should they be defined separately or together? One bankruptcy court stated that undue hardship was a “phrase with a particular legal meaning and function”. Conversely, another court (in the same circuit, no less) reasoned that “the plain, ordinary meaning” of the words was sufficient in taking a “common sense” approach to defining the concept.

Courts also struggle with determining the extent or degree of hardship that should be embedded in their definitions. One court stated that in order for a hardship to be “undue,” there must be a “certainty of hopelessness” about a debtor’s ability to make the payments. In contrast, another court stated that such a standard is antithetical to the fresh start ideal of bankruptcy, and thus required debtors to show only a “reasonable” chance that paying their loans would force them to live below poverty.

Adding to the muddle are at least four undue hardship “tests” that courts use. The most popular test, Brunner, requires a debtor to show that his loan payments would require him to sacrifice a “minimal standard of living” into the future and that he has made good faith attempts to repay the debt. But what is a minimal standard of living? How is future inability to pay predicted? And what constitutes good faith efforts to repay?

The Johnson test requires a debtor to first demonstrate a current and future inability to make loan payments. She must also show that her living expenses are reasonable. She must then show either that she has made good faith efforts to repay or that she has received little financial benefit from her education and discharging student loans is not her overwhelming reason for filing bankruptcy. Got that? Like Brunner, critical elements of the Johnson test are based on ambiguous and subjective concepts.

Some courts take a “totality of the circumstances” approach. These courts attempt to account for factors relevant to assessing a debtor’s prospects for repaying their student loans, but they also embrace the subjectivity and moral judgments that lead to inconsistent undue hardship determinations.

Inexplicably, the most objective test is the least popular. The rarely used Bryant test ties undue hardship to federal poverty guidelines. If a debtor’s net income is “at, near or below” the poverty rate or if a debtor’s income is above the rate, but he has sufficiently “unique” or “extraordinary” expenses, the payments represent an undue hardship. Even though the Bryant test is the most objective, it’s still subjective. It’s up to individual judges to determine if expenses are unique or extraordinary.

Even in cases when discharges are granted, there’s inconsistency in the type of relief granted. Some courts only grant full discharges of student loan debt. Others courts grant partial discharges up to the point when the debt subjectively ceases to be an undue hardship. Others, still, take a “hybrid” approach, where they consider individual loans making up the total indebtedness, and discharge some but not necessarily all.

So to summarize, judges define “undue hardship” differently; they use different undue hardship tests; and when undue hardship is found, relief is often dependent upon judicial philosophy rather than the merits of the case. In the end, similarly-situated debtors (and creditors) are treated differently based on the courts in which they find themselves, leaving an irony where inconsistency is the most consistent aspect of the standard’s application.

How To Undo Undue Hardship

My proposed framework eliminates the undue hardship standard. Eligibility under my proposal would be at first dependent upon the type of program in which the student loan debt was incurred. In order to be eligible for discharge of loans obtained in a bachelor’s degree (or lower) program, the debtor must be in repayment for at least five years. For loans obtained in a graduate or professional school program, the debtor must be in repayment for at least ten years.

In addition, the following criteria would apply to all debtors seeking student loan discharge:

  • The debtor must have participated in the federal Income-Based Repayment (IBR) Plan or a similar plan for at least three years for all student loans for which discharge is being sought.
  • The debtor’s “Standard” federal loan monthly payment amount (aggregated over the year) must have been above pre-set maximum debt service thresholds for five consecutive years leading up to the discharge petition.

The purpose of the mandatory repayment periods is to allow debtors an opportunity to realize some benefit from their education and to make loan payments before resorting to bankruptcy. The longer mandatory repayment period for graduate and professional school debtors reflects the favorable employment prospects afforded these individuals, compared to those with lower levels of education. To the extent that the solvency of the federal student loan program would be threatened by this framework, debtors in the best position to leverage their education in the job market should be encouraged to make payments on their loans.

The requirement that debtors participate in an income-based repayment plan for at least three years is intended to ensure that debtors take advantage of options other than bankruptcy before seeking discharge. By reducing the debtor’s monthly payment, such plans may be effective at directing debtors away from bankruptcy.

Pre-set debt service thresholds will be used to determine whether a debtor’s student loan payments, relative to her disposable income, are high enough to warrant discharge. The maximum annual amount a debtor can dedicate to student loan payments is calculated in the following manner:

  • Determine disposable income by calculating the difference between the debtor’s gross income and 150% of the federal poverty threshold for similarly-situated individuals. Gross income is defined as income from all sources, including employment and domestic support.
  • The following student loan debt service thresholds are then applied to the disposable income calculation:

$1-49,999 (disposable income): 20% (debt service threshold)

$50,000-74,999: 22.5%

$75,000-99,999: 25%

$100,000-124,999: 27.5%

$125,000+: 30%

So a debtor with gross income of $40,000 and two dependents (other than the debtor herself) would have disposable income of $12,205—which is the difference between the debtor’s gross income and 150% of the poverty threshold ($27,795) for her family. The applicable student loan debt service threshold is 20%–which means that for purposes of her bankruptcy petition, the maximum amount this debtor could dedicate to student loan payments for the year in question is $2,441 ($203.41 per month), or 6% of her gross income. Student loan obligations above that amount would render the payments, in effect, an undue hardship for that year.

Higher gross income or smaller family size can lead to higher maximum annual student loan payments. For example, a debtor with gross income of $60,000 and two dependents would have disposable income of $32,205 ($60,000–$27,795). The applicable student loan debt service threshold is 20%–which means that for purposes of his bankruptcy petition, the maximum amount this debtor could dedicate to student loan payments for the year in question is $6,441 ($536.75 per month), or about 11% of his gross income.

A debtor with a gross income of $40,000 and no dependents would have disposable income of $23,665 ($40,000 – $16,335). The applicable student loan debt service threshold is 20% — which means that for purposes of her bankruptcy petition, the maximum amount this debtor could dedicate to student loan payments for the year in question is $4,733 ($394.41 per month), or about 12% of her gross income.

In order to be eligible for discharge, the debtor’s monthly payments (aggregated over the year) must exceed the stipulated maximum amounts for five consecutive years. Calculations would be made for each relevant year to account for changes in salary, poverty thresholds, and payment obligations. The Standard repayment plan would be used to determine payment obligations, even if the debtor’s actual payments are set under an income-based plan. Reliance on the Standard plan is premised on the idea that debtors should not be punished for attempting to avoid delinquency by lowering their payments. Monthly payment obligations are usually highest under the Standard plan.

Lastly, this proposal would apply to federal student loans only. I believe that private student loans should be dischargeable to the same extent as other unsecured debt. Private lenders are able to minimize their exposure to credit risks. Thus, these loans should not be given the same special treatment afforded federal loans, the vast majority for which creditworthiness is not considered.

Americans love (and hate) debt. Our reliance on debt as a means of funding personal consumption and as a tool of macroeconomic growth makes over-indebtedness unavoidable. Thus, our economy requires a bankruptcy system that is fair, efficient, and predictable. The looming rise in bankruptcy filings among student loan debtors adds urgency to an already salient problem. We need a better way to determine the propriety of student loan bankruptcy discharges. Let’s undo undue hardship.

(photo: http://www.flickr.com/photos/uofdenver/3770483632/)

Aaron N. Taylor is a professor at Saint Louis University School of Law. His proposal is explained in full in Undo Undue Hardship: An Objective Approach To Discharging Federal Students Loans In Bankruptcy, which will be published in the Notre Dame Journal of Legislation in May 2012. You can follow him on Twitter at @TheEdLawProf.

  • Frederick Northrop

    One thing I would add would be a prohibition on actions by Health and Human Services for these periods (and after bankruptcy). Med students leave school with heavy debt loads and those who fall behind are subject to reprisals from HHS which effectively render them unemployable in that they and their employer are barred from participating in medicare or any other governmentally funded healthcare program. Most private insurers will also reject anyone on the HHS black list.

  • http://www.coyelaw.com/ Wade Coye

    Student loan debt is creating a bubble. Especially in the legal profession: the debt to education value ratio is becoming more distorted as schools charge more and firms higher less. I was happy to see a sharp drop in LSAT takers in the past few cycles. It seems to be the market correction we have been looking for. This smaller class however won’t be entering the work force for another three years so the anemic demand for new law graduates will likely persist into the foreseeable future. Potential law school applicants should do their due diligence to take it upon themselves to keep their debt low and their networking activity high. My firm has consistently hired former interns and case mangers. We know them and they know us. One of our future attorneys could come from one of these (http://www.coyelaw.com/law-firm-interns.html) talented 19-21 year old’s. No loner does a JD automatically mean a free ride to 6 figures and job security. Even more work is needed to ensure students don’t have to consider bankruptcy because of student loans that could be paid off.

  • http://www.philadelphiadebtclinic.net/ Robert

    I admire the effort, but the results seem equally arbitrary and onerous . The only way a debtor earning $40,000 with two dependents can afford $200 per month is by not having a car. That $200 would be the debtor’s car payment. Realistically, this person earns below median income and with two dependents has no extra money. Reliance upon the federal poverty guidelines or any percentage of them is arbitrary because the federal poverty guidelines are completely arbitrary and grossly inaccurate.

  • http://studentdebtwar.org/ Student Debt War Project

    The 1978 Bankruptcy Reform law used a discharge process that was easy and simple and historically proven 100% successful in stopping “gaming of the system” yet allowing student equal access to fresh start relief. The law was 2-parts and interdependent: 1) Student loan discharge prohibited 5-years post graduation (then discharge at-will thereafter), or 2) Discharge allowed during the 5-year prohibition period if the student debtor was undergoing a legitimate need for bankruptcy / fresh start relief (i.e. that the debtor was not “gaming the system” to get a free education by dumping student loan debt, such as applying for relief right after leaving college. Congress referred to this as “undue hardship” aka “legitimate need for bankruptcy and fresh start relief”. It is very clear in the actual Congressional floor testimony between 1971 and 1978.

    What has happened is that the bankruptcy courts have relied on opinion information found in the BK Commission Report (circa 1971), which was compiled as a “debate starter tool for Congress” and never intended to be used as a document to set forth the final “intent of Congress”—which the BK Courts later applied as intent erroneously. Early case decisions were built on false foundations but built atop one another to lead to the current Draconian interpretation of “undue hardship” used today.

    “Undue hardship” was referred to my members of Congress during debates as a “protection” and “escape clause” designed to ensure student debtors were not barred from fresh start relief. The record is replete with such statements. In fact, there is not a single statement in any record anywhere whereby Congress even hinted at the interpretation of “undue hardship” as it is used today by the courts.

    Today, there are too many exceptions to discharge and bankruptcy has nearly been rendered meaningless to its original intents and purposes, as set forth in the 1898 Bankruptcy Act. We need to clear all exceptions or clear bankruptcy from our midst altogether because the inequity for various debtor groups is now at ridiculous levels.

    Undue hardship and the adversary proceeding requirement represent ‘very bad law” and the piling of discrimination and other harms—the system is completely designed on a foundation of injustice for student debtors.

    For example, the imposition of an adversary proceeding for an undue hardship makes no sense. Today’s adversary proceeding attorneys charge between $10k and $40k to conduct an undue hardship case. If the student debtor has this much money, then they likely would not be an undue hardship. Hence the system ensure injustice by forcing student debtors to act Pro Se—to conduct, on their own, one of the most complicated litigation and “proof sets” and “case law minefields” in the entire legal system. What this shows is Congress did not think when it established such a system (or lenders did all the thinking for them).

    We will be conducting a series of articles that clearly show how the bankruptcy courts as well as the student loan guarantee system are violating the Constitutional Rights (and other Rights) of student debtors and we hope those in the academic and legal communities will read them and lend us a hand in our advocacy to stand up for student debtor rights. As your readers know, law school students are among those hurt the hardest by these Draconian laws and we intend to help them—but we need professionals, experts, and others to lend us a hand once in a while.

    We are planning a series of Constitutional challenges and we need to build a top legal team to lead the effort. We have collected the names of many students who are willing to help financially back the process as best they can and we expect to have over 10,000 participants contributing the project.

    From our standpoint, Congress has made student debt one of the most complicated legal issues and caustic forms of debt in the entire free world. These systems must be revised and highly simplified. Student debtors should not be treated as third class citizens as today’s systems ensure and demand. We are out to fix the problems and we offer some of the most stunning solutions ever devised to help us do it.

    Students are our nation’s future and should be valued and respected, not trampled. We invite concerned legal experts to join us. Lend your expertise and bring others in to help us ensure the kinds of powerful reforms that better serve us all–give us a few hours or a well placed phone call—anything that piles on a bit of help and we will appreciate it, I promise.

    Remember, the point of college is to graduate and pursue the American Dream. It is not to graduate and pursue “life-time debt servitude” only to forfeit that dream (our files are filled with laments of forfeit). Her Majesty America is headed in the wrong direction on this point, so if you agree with statement, we hope you will kindly lend Her a hand.

    Morgan Fisher
    Co-Founder
    Student Debt War Project

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