Chapter 7 and Student Loans

Student loans are not automatically discharged in a bankruptcy. It requires an adversary proceeding, which is a lawsuit within a lawsuit, in order to determine if student loans are discharged. The factors that have to be met make discharge of student loans relatively rare. However, that is not the purpose of this post. Rather, I wanted to explain what does happen to the student loans.

Once the holder of the student loan is notified of the Chapter 7, the loan is recharacterized in their computer system and no action will be taken until the bankruptcy ends. Sometimes the characterization of the student loan as in bankruptcy never gets changes back, which can cause problems later on. However, the debtor can still make payments on the student loan during the Chapter 7, but they will be provided a different address to send the payments. Unfortunately, this notice may take months to be sent out.

If possible, I recommend that the debtor continue to make payments voluntarily during the bankruptcy. This avoids the interest piling up and increasingly the total amount due. It also helps satisfy one of the factors if the debtor later attempts to discharge these loans, even if the payments are less than the full payment due.

Student Debt v Student Loan – viva la difference!

A recent decision out of the Norther District of California Bankruptcy Court bolsters a position I have already been espousing. In re Christoff, 510 BR 876 (N.C. Cal. 2014) looked at 11 USC Sect. 523(a)(8) which makes three types of loans non-discharged unless certain things are proven in an adversary proceeding (a lawsuit within the bankrutpcy). The three types of loans are, in essence: government subsidized loans, IRS qualified education loans, and “an obligation to repay funds received as an educational benefit, scholarship or stipend[.]” 11 USC Sect (a)(8)(A)(ii).

This case involved Meridian University directly funding the debtor’s studies in their Psychology program and whether that constituted the third type of debt above.  The court ruled against Meridian because that statutes says “repay funds” thus requiring that actual funds are distributed. Instead, Meridian simply kept a “tab” of sorts of what the debtor owed them for tuition and fees. There was no third-party lender involved that distributed funds to Meridian or to the debtor.

I expect this would be the same outcome if such a debt discharge were challenged here in the Eastern District of Kentucky. This impacts many technical schools that simply charge the student debtor directly for tuition rather than involving an independent third-party lender. It is very good news for student debtors who went to such schools and then discover their training is not quite as marketable as the school led them to believe. So, the student debtor in the case above had student debt, but not a student loan.

Discharge of Student Loans: The “certainty of hopelessness” test

Student loans have received considerable press coverage in our persistently lagging economy. So many graduates of higher learning institutions find it difficult to secure jobs in their given field of study. Even the fortunate ones who do land a job in their field of training still struggle to pay their student loans because the cost of a degree has skyrocketed in recent years. Colleges and graduate programs have faced cuts in government funding resulting in ever higher tuition.

The legal profession is a prime example of this student loan trap. We now have one lawyer for every 257 persons in America when just a few decades ago it was 1 lawyer for every 750 person. Basically, it really is true that one cannot swing a stick without hitting a lawyer (okay, put the sticks down!). And yet, law school tuition has increased dramatically in recent years. A law student easily rack up $100,000 to $200,000 in student loans, but few obtain high paying jobs. Many other professions are facing this same dilemma.

Even though student loans are unsecured debts, 11 USC Sect. 523(a)(8) precludes their discharge in a Chapter 7 or Chapter 13 unless repayment creates an undue hardship. The Sixth Circuit appellate courts (which set case law for Kentucky bankruptcy courts) adopted the Brunner test:

The Brunner test requires the debtor to prove, by a preponderance of the evidence, (1) that the debtor cannot maintain, based on current income and expenses, a minimal standard of living if forced to pay the loans; (2) that additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment of the student loans; and (3) that the debtor has made good faith efforts to repay the loans.

Many folks meet the first and third prongs of that test, but the second prong is nigh on impossible. As tough as the second prong of Brunner is the way it is written, the Eastern District of Kentucky has interpreted it even more stringently in a decision penned by Judge Joseph Scott, Jr. The case, In re Gibson, issued January of 2010, holds that the debtor must show a “certainty of hopelessness” to satisfy that second, forward looking prong.

Judge Scott states that “…the second prong is not met as Debtor has not shown a certainty of hopelessness as the Debtor may continue to get raises in her current job or find a better paying job as Debtor is only 26 years old with a college degree and her learning disabilities appear to be controlled.” The Debtor did have a teaching degree, but failed twice to obtain a teaching certificate. Such a narrow view of Brunner’s second prong to discharge student loans leaves me scrambling to imagine a situation where a student loan would be discharged short of substantial, irreversible physical impairment. The best hope for debtors crushed by student loans in the Eastern District of Kentucky is for Congress to pass legislation that would bring relief.