A Chapter 7 bankruptcy discharge releases the debtor from personal liability for certain specified types of debts, relieving the debtor of the responsibility to repay the discharged debts and preventing the creditor owed that debt from taking any collection actions against the debtor. The discharge is one of the main benefits of filing for bankruptcy. It also advances the primary goal of the federal bankruptcy laws, namely providing debtors with a “fresh start” from burdensome debts. While most types of debt (such as credit card charges, medical bills, business debts, etc.) can be discharged by filing a chapter 7 bankruptcy case, some other types cannot. Student loan is one of the debt types which Congress has made non-dischargeable through bankruptcy proceedings, except under limited circumstances.
It is interesting to note that prior to 1976, student loans were dischargeable in bankruptcy. Subsequent legislation in 1978 and 1998 respectively limited and disallowed the bankruptcy discharge of student loans made or guaranteed by the government. The most recent round of legislation amending the federal bankruptcy laws took place in 2005, when Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (P.L. 109-8, effective October 17, 2005). The new law extended the non-dischargeability of student loans in bankruptcy to most private student loans.
The Exception to the Non-Dischargeability of Student Loans in Bankruptcy
The Bankruptcy Code allows the discharge of student loans provided that the debtor can demonstrate that it would be an “undue hardship” for him or her to pay them. The test for determining undue hardship varies between courts but most courts, including all California courts, use the three-pronged Brunner test. This test is based on a U.S. Court of Appeals decision (Brunner v. New York State Higher Education Services Corp., 831 F.2d 395 (2d Cir. 1987)), requiring a debtor to prove:
(1) That the debtor cannot maintain, based on current income and expenses, a minimal standard of living for the debtor and dependents if forced to pay off student loans; (2) that additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period of the student loans; and (3) that the debtor has made good faith efforts to repay the loans.
The “Good Faith” Requirement
The Ninth Circuit Court of Appeals, whose decisions on legal issues are binding on all lower California courts, recently decided a case (Hedlund v. the Educational Resources Instutute, No. 12-35258 (9th Cir. 2013)) that turned on the third prong of the Brunner test, namely the “good faith” requirement. In that case, the debtor was not successful in obtaining gainful employment within a few years after graduating from university, when his student loans went into repayment. The debtor negotiated with the lender, who gave him two options that were not financially feasible for him to undertake. The lender then began garnishing the debtor’s wages and the debtor filed a Chapter 7 bankruptcy petition. The bankruptcy court applied the Brunner test and determined the debtor met his burden of demonstrating that it would be an undue hardship for him if he were to repay his loan. The lender appealed the bankruptcy court’s decision to the Bankruptcy Appellate Panel, which found that the bankruptcy court erred in finding that the debtor had made good faith efforts to repay the loan. The debtor, in turn, appealed that decision to the Ninth Circuit Court of Appeals, which upheld the bankruptcy court’s finding of good faith and undue hardship. The Ninth Circuit reiterated the factors that bankruptcy courts must consider before making a good faith determination. These factors include: the debtor’s efforts to obtain employment, maximize income, and minimize expenses, and the debtor’s efforts to negotiate a payment plan with the lender.
What is important about the Ninth Circuit’s decision is its holding that a determination of “good faith” is a factual inquiry and therefore a court of appeals should review a bankruptcy court’s finding of “good faith” under the deferential standard of review of “clear error.” What this means is that bankruptcy courts will have a great deal of discretion in deciding this issue and unless there is a “clearly erroneous” decision, higher courts will not second guess a bankruptcy court’s “good faith” determination. Therefore, it will be difficult for both debtors and lenders to successfully appeal a bankruptcy court’s decision that the debtor has made or failed to make good faith efforts to repay his or her student loans.
An example of a bankruptcy court’s wide latitude in determining whether the debtor has made good faith efforts to repay his or her student loans is the Hedlund case itself. In Hedlund, the debtor’s wife worked only one day per week. In addition, the debtor’s personal expenses for things such as clothing, entertainment, and childcare exceeded what was reasonably necessary to maintain a minimal standard of living. The debtor also did not take any of the several payment options proposed by the lender. Still, the bankruptcy court held that, taken together, these failures did not “tip the balance away from a good faith finding.”
The Ninth Circuit Court’s decision will leave debtors seeking to discharge their student loans in bankruptcy due to undue hardship at the mercy of bankruptcy court judges, who will have much discretion in deciding whether the debtor acted in good faith before initiating bankruptcy proceedings. Debtors seeking to discharge their student loans in bankruptcy must therefore err on the side of caution and do whatever they can to delay the bankruptcy petition, minimize their expenses, and maximize their earnings, while making serious efforts to successfully negotiate a feasible payment plan or reach a settlement with the lender.
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