Bankruptcy as an Option for Borrowers

As the amount of student loan debt held by Americans continues to rise, the difficulty borrowers face in getting relief, even if they declare bankruptcy, has become increasingly clear. Lawmakers are exploring ways to reform student loan bankruptcy, with a consensus among Democrats, Republicans and experts that Congress should partially reverse actions it took decades ago that made it harder for borrowers to have their student loans discharged.

Student loan debt isn’t treated like most other debts in bankruptcy court. Under current law, discharging federal student loans through bankruptcy is a complex process and requires the courts to determine whether payment of the loans will result in “undue hardship,” a standard that isn’t clearly defined in the bankruptcy code and uses a test that has morphed into “an overly strict and uneven exercise,” said Christopher Chapman, president and CEO of AccessLex Institute, in his written testimony for a Senate Judiciary Committee hearing held Tuesday. Known as the Brunner test, it requires proof that the debtor can’t maintain a minimum standard of living if forced to repay, that this state of affairs is likely to persist for a significant portion of the repayment period and that the borrower has made a good-faith effort to repay their loans.

“This is new in America,” said Senator Dick Durbin, a Democrat from Illinois and chair of the Judiciary Committee. “It didn’t used to be this way. If you were facing financial ruin, you could get relief. We made a mistake in 1998.”

In 1998, Congress eliminated the waiting period -- the number of years a borrower would have to wait after their loans first became due until they could file for bankruptcy -- making the undue hardship standard the only way student loans could be discharged. It’s a notoriously difficult standard to meet -- the Public Law Center in Santa Ana, Calif., has provided 5,000 bankruptcy consultations to debtors since 2012 but has only attempted to discharge federal student loans five times because it knew the other cases would be unsuccessful, said Elizabeth Gonzalez, directing attorney of the consumer law unit.

Durbin said that undue hardship should not be the only path to address student loans in bankruptcy. All five witnesses at the hearing on the subject agreed.

“In the past, I have argued that it would be unnecessary for Congress to reconsider allowing for student loans to be discharged in bankruptcy, due to the more nuanced safety net that [income-driven repayment, known as IDR] provides,” said Beth Akers, senior fellow at the American Enterprise Institute. “However, IDR is in need of serious reform. In the meantime, reinstating the option to have student loans -- both federal and private -- discharged in bankruptcy under certain conditions would create an effective patch to the well-intentioned but inadequate IDR system.”

Durbin and Senator John Cornyn, a Republican from Texas, are proposing the restoration of the waiting period in their legislation, the FRESH START Through Bankruptcy Act, announced at the hearing. The bill would allow borrowers to discharge their federal student loans through bankruptcy after 10 years and would hold institutions with consistently high default rates accountable. Cornyn said he believes it’s necessary for these measures to go hand in hand.

“Some schools have taken advantage of the American taxpayer for too long, and the students are the ones harmed by their excess,” Cornyn said.

Illinois attorney general Kwame Raoul specifically referenced the now-defunct for-profit institutions Westwood College and ITT Technical Institute in his testimony as examples of colleges where borrowers were deceived and could benefit from the ability to discharge their loans in bankruptcy.

“Ironically, a for-profit institution can seek refuge by way of bankruptcy in a way that the students that they prey upon cannot,” Raoul said.

Allowing borrowers to discharge their student loans in bankruptcy had support from committee members on both sides of the aisle. Senator Richard Blumenthal, a Democrat from Connecticut, said he wanted to be a part of the FRESH START Act going forward. Senator Josh Hawley, a Republican from Missouri, said he thought the proposal was sensible.

“While I don’t support cancellation of all student debt for the massive subsidy to wealthy Americans and universities, I can’t think of very many good reasons to keep students with massive amounts of debt as lifelong serfs of banks and universities by not allowing them to discharge in bankruptcy their debt under appropriate circumstances,” Hawley said.

Congress originally changed the way student loan debts are handled under bankruptcy to help curb abuse, though Durbin said those claims of abuse were anecdotal and not based in data. But Gonzalez said that her clients are often ashamed to consider bankruptcy, and if they’ve reached that point to try to discharge a student loan, it’s because they’ve exhausted all other options.

“Despite being so overwhelmed by debt, my clients hesitate to even bring up bankruptcy in a meeting with me,” Gonzalez said. “There seems to be agreement [among witnesses] that not only won’t students rush to file for bankruptcy and discharge their student loans, but that the bankruptcy system has in place protections against the abuse of the bankruptcy process.”

Diane Barta, a former graduate student at the for-profit Ashford University, testified that she had to file for Chapter 13 bankruptcy in 2012 after her husband lost his job. But that excluded the student loan debt she had, which currently sits at more than $120,000 and which she is still struggling to pay.

“If I could have discharged my loans in bankruptcy -- as painful as filing was -- it would ultimately have been a great relief,” Barta said. “I wouldn’t still be having sleepless nights worrying about how I am going to pay and what happens to my children, my husband and me if I cannot.”