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Student Loan Issues Come to the Fore

Karen Cordry, NAAG Bankruptcy Counsel

Prior to the 1978 Bankruptcy Code (“the Code”), student loans could be discharged like other unsecured debts. The Code contained a discharge exception applicable to student loans made by a “nonprofit institution of higher education,” or under a government-funded program to protect the National Defense Student Loan Program (NDSL), the predecessor to the Perkins Loan Program. Initially, loans could be discharged after five years or upon a showing of undue hardship. In 1979, the law was amended to except any period during which payments had been deferred from counting into the five-year calculation. After the law went into effect, concerns were raised that loans were being too easily discharged by those who sought to abuse the Code, and that the failure to repay the loans threaten the financial integrity of the financial aid system.

The Bankruptcy Amendments and Federal Judgeship Act of 1984 excepted from discharge private student loans from all nonprofit lenders (not just colleges). In 1990, the law was amended to extend the time period for discharge from five years to seven. In 1991, a change was made to allow for wage garnishment to repay those loans, and in 1993, the first “income- contingent” payment schedule was adopted for payment of direct federal loans. This addition would often serve to reduce or eliminate the possibility of showing undue hardship by allowing payments to be reduced where the student had little or no income. In 1998, the Code was amended again to remove the time-related basis for discharge; leaving only the undue hardship provision. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) expanded these provisions to apply to all “qualified education loans,” regardless of whether a non-profit institution or governmental entity was involved at all in making the loan.

In the last few years, though, there have been increasing concerns about whether changes need to be made to the overall system of student loans and bankruptcy discharges. The amount of student loan debt is rising quickly, driven by the rapid inflation in the tuition costs for college (caused at least in part by the lower amounts that governments have been able to contribute to the support of the schools in their current economic straits). The financial downturn has, in turn, strained family budgets and resources to pay those expenses without taking out loans. Reduced home mortgage values have also greatly reduced the ability of families to use low-cost secured home equity debt to pay for education costs, leaving students to face ever greater amounts of unsecured student loans, with a higher interest price tag. While that interest rate has been legislatively reduced for the last few years and efforts are underway to retain that reduction, the rate will inevitably rebound. At the same time, principal balances on loans continue to escalate. At $1 trillion in current loans, the total exceeds that for credit cards and auto loans – both of which can generally be discharged in bankruptcy (at least to the extent the loan exceeds the value of the automobile if used as collateral).

Federal Legislation

Current law, though, makes it very difficult to discharge student loans and the impending “debt bomb” as some have called it has impelled legislative efforts to defuse the crisis by relaxing the standards for bankruptcy discharges. The U.S. Senate Judiciary Committee’s Subcommittee on Administrative Oversight and the Courts held a March 20 hearing on “The

Looming Student Debt Crisis: Providing Fairness for Struggling Students,” which examined the bill introduced by U.S. Sen. Richard Durbin (D-IL) last year, S.1102, “The Fairness to Struggling Students Act of 2011.” That bill would amend 11 U.S.C. 523(a)(8) to make all private student loans unconditionally dischargeable in bankruptcy. Federal Direct Student Loans currently total over $124 billion. Private sector lenders will make about another $8 billion in loans or about 6 percent of the overall total. It is only the latter amount that would be discharged under S. 1102.

Among those testifying in support of the bill were Attorneys General Jack Conway of Kentucky and Lisa Madigan of Illinois. Both indicated that their concerns with the private loans was tied up with their investigations of abuses in “for-profit” schools that often failed to provide the education promised while encouraging students to take out private loans to cover the costs of the programs. Such loans are not covered by many of the protections for federal loans so that, if a school goes out of business without providing the courses that had been paid for, students still end up owing the tuition debt with nothing to show for it, unlike the result if the loans had been made under the federal programs.

Multistate Working Group

Consumer protection issues relating to for-profit colleges are the focus of a 25-member Attorney General multistate working group, chaired by Todd Leatherman, Consumer Protection Division director for the Kentucky Attorney General. Michele Casey, from the Illinois Attorney General’s Office and Mr. Leatherman participated in a “Negotiated Rulemaking” committee convened by the U.S. Department of Education from January through March of this year dealing with a variety of issues arising out of the intersection of private, for-profit colleges and private, for-profit loans. Some of those issues included how to determine if efforts were being made to manipulate the “Cohort Default Rate” of borrowers at such schools (to make it appear that the students were more successful after graduation than was actually the fact), analysis of what a “reasonable and affordable” payment structure might entail, and provisions dealing with discharge of loans owed by students who attended a school that closed without allowing them to complete their program of study.

Other March 20 hearing testimony, such as by Danielle Loonin from the National Consumer Law Center, argued that the “undue hardship” standard was applied too harshly and too inconsistently, and that private lenders were eager to grant risky loans but not willing to work with borrowers later when they ran into trouble. Based on those concerns, they argued that targeted relief for borrowers with such loans was appropriate and the situation should be returned to that which existed prior to the 2005 BAPCPA amendments which had extended the Section 523(a)(8) provisions to private student loans for the first time.

Sen. Charles E. Grassley (R-IA) on the other hand testified against the bill. He argued that the real issues were why students couldn’t find jobs and why tuition was increasing. Reducing student loan debt, he asserted, would not solve those problems, it would only reward those who sought a “bailout at the expense of others.” Sen. Grassley argued that the 2005 changes had been made to treat all loans alike and to eliminate problems that had been noticed after the 1978 Code was enacted where debtors had “strategically file[d] bankruptcy just to get their student loans discharged.” The result of limiting such discharges, he asserted, was to make interest rates on loans more affordable than they otherwise would be. Instead of encouraging bankruptcy discharges, he argued, efforts should be made to address the root causes of rapidly rising tuition costs.

This is an area that is likely to continue to engender interest at all levels of government. While it is certainly true that there is a potential for abuse by students receiving loans and the benefit of an education without wishing to pay for it, it is also true that the burden of student loans has grown to the point where it creates serious problems for students and their families, as well as for those providing the loans. Thus, any final solution may need to adopt both approaches – finding better ways to relieve the burden of repayment from students once incurred, while simultaneously searching for ways to reduce the tuition burdens in the first place. The special problems found by Attorneys General with respect to for-profit loans and schools raise additional issues that they will need to continue to address.

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