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Guest Post: A Dose of Common Sense in the Treatment of Private Loans in Bankruptcy

Published:  May 20, 2010

By Melissa B. Jacoby

Momentum appears to be growing in Congress for changing federal law to allow individuals to borrow money for education without undue risk to their financial futures. Specifically, Sen. Dick Durbin (D-IL) and Rep. Steve Cohen (D-TN) have offered standalone legislation, S. 3219, and H.R. 5043, respectively, that would restore the common-sense treatment of private student loans in personal bankruptcy. Sen. Al Franken (D-MN) has submitted an amendment to the Senate financial regulatory overhaul bill that would do the same, although it is unclear whether it will be considered.

To see the issue, imagine that Chris owes $10,000 to Bank One and $10,000 to Bank Two. Both banks conducted the same credit checks and charged the same interest rate. Now imagine that Chris suffers severe financial hardship and files for bankruptcy. If Chris is an honest debtor with few assets, he will emerge from bankruptcy with no legal liability to Bank One, but, under current bankruptcy law, likely will continue to owe $10,000 to Bank Two. Why the different treatment? Chris used the Bank One loan for medical care, food, and other basic necessities, but used the Bank Two loan for trade school tuition.

In the 1970s, for-profit consumer lenders publicly criticized the establishment of such a distinction. Their representatives noted, “If the social utility of what is exchanged for the debt is to be determinative of dischargeability then the question can be raised of whether it is proper to discharge medical bills, food bills, etc. This proposed [legislation] simply suggests that if sufficient political pressure can be generated, a special interest group can obtain special treatment under the bankruptcy law.”

Singing a different tune today, however, the Consumer Bankers Association now endorses treating student loans differently from debts incurred for food or medical bills. Why the shift? In 2005, Congress expanded the nondischargeability of private student loans, allowing for-profit lenders to become beneficiaries of the law they opposed decades earlier.

Relief of personal liability is the centerpiece of the bankruptcy system, which plays a critical role in a healthy economy. Exceptions to discharge are to be narrowly drawn on one of two grounds.

The first relates to the debtor’s honesty and “clean hands;” people should not get relief if they have committed fraud or other misdeeds. Appropriately, this principle protects for-profit lenders as much as any other creditor, and it applies whether the money has been borrowed for education or anything else. A special student loan provision was not necessary to reflect this idea because it already was in the Bankruptcy Code.

The second relates to the identity of the creditor, particularly if the creditor is vulnerable and has special needs that may not be met if the debt is discharged. Debts owed for child support are a classic example. The contours of this category can be contested. For example, it is possible that governmental units have obtained too much protection in bankruptcy for themselves on this basis. Whatever the resolution of the debate about government obligations, however, private parties in the business of extending credit for a profit clearly do not fit the special needs category. When Congress expanded the student loan exception to discharge to include debts owed to for-profit lenders, it deviated significantly from longstanding bankruptcy policy.

Perhaps private lenders are trying to squeeze into the special needs category when they allege – as they routinely do – that other borrowers will be hurt if the law presumptively permits discharge. This argument is made in a variety of contexts, not limited to student loans. But this line of argument is as problematic as it is popular.

First, the existence and nature of these costs warrant more critical examination. Restrictions on consumer protections and bankruptcy relief do not automatically translate into benefits for consumers or the economy as a whole. Particularly after the mortgage crisis, some believe the opposite to be true, namely that restrictions on consumer protections incentivize lenders to make particularly costly and irresponsible loans (an example of such a study is here). With respect to the student loan amendment, only since 2005 have for-profit student loans received the preferential treatment that lenders now identify as critical to maintain loan access. Lawmakers should not take the lenders’ cost assertion on faith; if it is to be given credence, lenders must demonstrate affirmative and concrete benefits to borrowers. Evidence largely to the contrary already has been aired, including in Congressional testimony of the American Association of Collegiate Registrars and Admissions Officers, the American Association of State Colleges and Universities, and the National Association for College Admission Counseling, in a detailed report of the National Consumer Law Center, and in a study by Mark Kantrowitz, the publisher of finaid.org, a website about financial aid.

Second, taken to its logical conclusion, the lenders’ point seems to be that borrowers are inherently better off without consumer protections. The possibility that consumer protections are associated with costs, however, can hardly be grounds for rejection.   Social insurance is not free. To encourage opposition to laws that help financially distressed families, lenders would like people to believe that they are subsidizing the protection of less responsible borrowers and will never need the protection themselves. But this is not the case. Empirical research on bankruptcy makes clear that the people who seek protection are a subset of the very borrowers who bear the alleged costs.

Opponents to a presumptive discharge of for-profit student loans also contend that debtors’ needs should be assessed on a case-by-case basis. However reasonable this may sound in theory, conditioning the loans’ discharge on a separate litigation process substantially increases the likelihood that debtors will remain saddled with high-cost student loans after bankruptcy. The test of consumer protection is not the protections it lists on paper, but whether, as a practical matter, financially struggling families can access relief at a reasonable cost. Requiring special litigation to discharge for-profit student loans not only imposes another barrier to debt relief, but is unnecessary. 

Allegations of abusive discharge of student loans that led to the special treatment of student loans in bankruptcy in the first instance were not supported by empirical data. For those who continue to worry, the bankruptcy system already prevents filers from receiving relief in the absence of financial distress, and thus prevents the hypothetical student from dashing from graduation to bankruptcy on the brink of a successful career.  And because private lenders are free to deny credit or to make credit more expensive for former bankruptcy filers, they are in a good position to impose market-based penalties on those who discharge student loans. Thus again, the legal process for discharging private debts incurred for tuition should be the same as discharging private debts incurred for medical bills and food.

Thus, as lawmakers consider changing the treatment of private loans in bankruptcy, they should keep two additional points in mind. First, the creditor equality principle that has long been fundamental to bankruptcy policy favors presumptive dischargeability of for-profit student loans, not the reverse.  Second, implementing this idea is best accomplished by a clean and complete rollback of the application of 11 U.S.C. 523(a)(8) to for-profit student loans -- without waiting periods (which require litigation no matter how they are drafted) and without proof of undue hardship, which, as others have illustrated, is a problematic standard. If special litigation is required to discharge for-profit student loans, lawmakers will deter relief for the very individuals they seek to help.

Melissa Jacoby is the George R. Ward Professor of Law at the University of North Carolina at Chapel Hill. She is a member of the National Bankruptcy Conference and, in the 1990s, was a senior staff attorney for the National Bankruptcy Review Commission. Her views are her own and do not necessarily reflect those of the New America Foundation.

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