Corporations, including, among others, Hertz, J. Crew, and Neiman Marcus, discard billions of dollars of debt every year through bankruptcy. In addition, individuals, households, farms, states, cities, and school districts all have the right to file for bankruptcy if they can’t pay their bills. However, one group severely affected by outsized debt has never had access to the legal process: student debt-holders.
45 million Americans owe more than $1.5 trillion in student debt, but unlike mortgage or credit card debt, these loans are “nearly impossible” to shed by bankruptcy. This trend could soon change.
Currently, the only way for student borrowers to discharge loans through bankruptcy to prove they’re facing an “undue hardship” in paying loans back. Of course, the courts have a very narrow view of which hardships are “undue.” The process requires borrowers to essentially countersue their lenders through an adversary proceeding. Debtors present evidence that they have long-lasting extenuating circumstances (beyond “these loans are way too much money”) and have made every good faith effort to pay, while their lenders present opposing evidence. According to Forbes, this process is so invasive and expensive when it comes to legal fees that many borrowers don’t even bother trying.
Until 2005, private student loans were eligible for bankruptcy and this tough process only applied to government loans. The bankruptcy reform bill passed that year — led by Republicans but supported by 18 Democrats including presidential hopeful and newly minted champion of student debt relief Joe Biden — stripped millions of students of bankruptcy protection, contributing to the tripling of student debt that’s taken place over the last decade.
Without bankruptcy, student loan holders’ only option is to default, which happens when a debtor hasn’t made payments on their loans for 270 days. At that point, their debt is transferred to a third party collector who can take them to court for their wages and Federal payments like tax returns, report their debt to credit agencies, and cut their access to forbearance and deferment. More than a million people default on their student loans each year.
Two recent events show the changing tides of bankruptcy policy, which could present a way out of a life governed by loans for some of those 45 million people.
A new loophole for certain kinds of private loans
In September, Byron and Laura McDaniel, a Colorado couple, got $200,000 in private student debt cancelled. They did so, notably without, going through the messy, expensive process of proving undue hardship. The case rested on the categorization of their loans. When they filed for Chapter 13 bankruptcy (the ind for individuals with regular income), their private student loan lender Navient Solutions LLC argued that McDaniel’s loans couldn't be dropped because of the bankruptcy code’s rule, that even in bankruptcy, borrowers are obligated to “repay funds received as an educational benefit.”
The court rejected this claim partially because the McDaniels’ loans were taken out to fund living expenses, not tuition, so they didn’t count as loans “received as an educational benefit” which borrowers are obligated to pay back no matter what. While federal loans, as well as qualified private loans, are always ineligible for bankruptcy, the McDaniels’ private loans counted as “unqualified” by the IRS, meaning they paid for an unaccredited or for-profit university, exceeded the cost of attendance, or were borrowed while the debtor was studying part-time. This made them a rare type loan where bankruptcy isn’t completely ruled out.
The chunk of student debt-holders who stand to benefit from the McDaniels’ ruling is small but not insignificant. Their case doesn’t touch federal loans, which represent over 90% of American student debt. When you account for the McDaniel’s niche circumstances (that their private loans were “unqualified” and funded non-tuition expenses) and the fact that the ruling only holds in the 10th Circuit AKA Colorado, New Mexico, Oklahoma, Utah, and Wyoming, approximately 5 million out of America’s 45 million debt-holders become newly eligible for bankruptcy relief thanks to their case.
The figure is a small portion of Americans,but the Wall Street Journal says the judge that cancelled the McDaniel’s debt is one of “a few” that signals the courts are becoming more flexible. In addition to making a new category of borrower eligible for bankruptcy, Austin Smith, the McDaniels’ lawyer, suggests to the outlet that his clients’ ruling “has a broader import” in that it will force courts to be more deliberate in general, when in the past, they might have written off a student debt bankruptcy.
Some in congress want to undo what they did in 2005
During the COVID-19 pandemic, calls for student debt reform have grown louder in congress, including those related to bankruptcy. Last month, House Democrats debated a bill called the “Student Borrower Bankruptcy Relief Act,” which would make student loans easily discharged via bankruptcy by simply striking the passage of the bankruptcy code that currently makes it so difficult. House Judiciary Committee Chairman Jerry Nadler, who introduced the the bill in 2019, said this while re-introducing it for mark-upon September 29:
“The reality is that Americans across the nation are facing crushing student loan debt… The bankruptcy process is made for just this kind of crisis. It is an option of last resort, and the consequences of filing for bankruptcy are severe. But it also promises a fresh start so that people can get back up and keep working and providing for their families. That promise rings hollow for many people, however, because student loans—the single largest type of consumer debt—are effectively immune from the bankruptcy process.”
Forbes points out that if the bill passes the House where it’s awaiting a vote, it’s unlikely to pass the current Senate. It’s one of at least six student debt relief proposals currently floating around congress to no avail. However, serious momentum has been building across the aisle over the past few years and in recent months as the student debt movement has argued that relief is more necessary than ever during the COVID-19 pandemic and could help stimulate the economy.
Both presidential candidates know they have to do something. Despite his contributions to the roadblocks around student loan bankruptcy, Joe Biden has made student loan bankruptcy reform a part of his official platform, as well indicating he’d support Senators Elizabeth Warren and Chuck Schumer’s Senate resolution to cancel $50,000 for all borrowers. Even President Trump, whose Republican supporters in congress have blocked every proposal for student relief, included student debt forgiveness in the latest Covid-19 stimulus package proposal, though he hasn’t specified how much or who would qualify. On the brink of an upcoming November election that flips the Senate, student debt bankruptcy protection, as well as a number of other forms of relief, could become a reality.
Student debt-holders who live in the 10th Circuit or share the McDaniel’s circumstances can certainly take advantage of the new ruling. For those who don’t, borrowers can take advantage of changing tides in Washington D.C. and the judicial system by putting pressure on their representatives to support bills like the “Student Borrower Bankruptcy Relief Act” and — hate to say it’s as simple as that — voting.