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Second Circuit Holds Many Private Student Loans Are Dischargeable in Bankruptcy

posted by Adam Levitin

The 2d Circuit this week joined the 5th and 10th Circuits in holding that the discharge exception in 11 U.S.C. § 523(a)(8)(A)(ii) for "an obligation to repay funds received as an educational benefit, scholarship, or stipend" doesn’t cover private student loans, only things like conditional grants (e.g., a ROTC grant that has to be repaid if the student doesn't enlist). It's another important student loan decision. At this point ever circuit to weigh in on the issue has said that private student loans aren't covered under 523(a)(8)(A)(ii).  Instead, a private student loan, if it's going to be non-dischargeable, would have to fit under 523(a)(8)(B), but that provision doesn't cover all private student loans. It only covers "qualified educational loans," which are loans solely for qualified higher education expenses (itself a defined term).

In this case, the debtor alleged that the loan was not made solely to cover his cost of attending college, and the loan was disbursed to him directly. The creditor, Navient, did not claim that the loan qualified as a "qualified educational loan," and instead relied on the 523(a)(8)(A)(ii) exception.The Second Circuit wasn't having any of it.

So what does this mean big picture?

It's not clear to me what percentage of existing private student loans do not qualify as "qualified educational loans," but this decision might be quite problematic for many of those loans, particularly if disbursement went solely to the student and the loan did not require the proceeds to be used solely for qualified educational expenses. Those loans might be dischargeable, but remember that they are unlikely to be the entirety of a debtor's student loan debt. Federal student loans will remain non-dischargeable. That might complicate the calculation for some borrowers of whether it's worthwhile filing for bankruptcy to try to discharge the private student loan debt. I would expect an uptick in filings seeking a discharge, especially in the 2nd Circuit, but I wouldn't expect a sudden stampede of debtors. As word of mouth gets around, however, I think we'll see more interest in bankruptcy as a partial solution to student loan debt.

Going forward, I suspect the private student loan industry can structure around a lot of the risk. I would expect future loans to contain a range of representations about being used only for qualified educational expenses. Whether such representations will matter if the loans are not in fact so used, is an open question, but one way to limit exposure would be splitting the loans in two.  One loan cover tuition and room and board and would be disbursed directly to the educational institutions. That loan should probably be safe from Homaidan exposure. The other (smaller) loan would be disbursed directly to the student and would cover other educational expenses (e.g., books). That loan would still have Homaidan risk, but the dollars involved would be much smaller.  Another approach would be to disburse everything to the school and have the school cover books, etc., but that would require cooperation from the school. This will be interesting to watch.  My prediction:  we see little change in pricing or availability.

(For an interesting profile of one of the attorneys in the suit, and his unsuccessful involuntary bankruptcy petition against Navient, see here.)

Comments

Seems like most private loans make use of 523(a)(8)(a)(i), as guaranteed by a nonprofit, usually the now-defunct TERI.

I’m curious to see the effect on the student loan refinance industry. Companies like SoFi, which has its name on the LA Rama’ stadium, offers to refinance student loans for marginally lower interest rates and allegedly better repayment terms. When they started bombarding my mailbox with offers maybe 10-15 years ago, I assumed that their business model was predicated on the non-dischargibility of student loans.

If the borrower is refinancing a student loan, then it doesn’t sound like they are getting an educational benefit. The refinance comes after the education, and does nothing to help the student acquire the education.

There are several cases that hold that using an otherwise dischargeable line of credit to pay off non-dischargeable tax debt makes the line of credit non-dischargeable. The reasoning is that even if the line of credit was not fraudulently acquired, the non-dischargeable nature of the tax debt still applies to protect private lenders from assuming their borrowers non-dischargeable debt. *It’s been a while since I practiced, so the details are a little murky.

The distinction is that SoFi is soliciting student borrowers, rather than student borrowers using SoFi as a side road to the bankruptcy discharge. At any rate, it seems like the student loan refinance industry is a little riskier.

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