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Smart Summary

• Student loan debt is crippling for many Americans and is generally presumed to be non-dischargeable in a bankruptcy.
• The recent Homaidan v. Sallie Mae case in the Second Circuit has spotlighted at least one circumstance in which this presumption has been successfully challenged thus far in the courts.
• Legislation has also been introduced that would make government-backed loans dischargeable in bankruptcy after 10 years, among other proposed changes.

According to recent statistics from sources like Forbes, EducationData.org, and Nerd Wallet, approximately 12.5% of Americans (~43M) carry an average student debt load of roughly $39,000. In fact, there is approximately $1.6 trillion in total outstanding student loan debt, which is more than credit card and car loan debt combined, and second only to mortgage debt. While slightly more than half of this debt is currently in forbearance due to the regulations tied to COVID-19, sooner or later these forbearance measures will dissipate and loans will be called. So the question is not whether it will happen, but when. Given the financial hardship caused by the pandemic, we may assume that not all borrowers will be in a position to immediately pick up their repayment obligations come time to do so, and it is likely that some borrowers will be filing bankruptcy as a result.

It has long been an absolute that when a borrower files for bankruptcy, student loan debt is presumptively non-dischargeable. As outlined in 11 U.S.C. § 523(a)(8), to be dischargeable, most debtors (including those filing in the Sixth Circuit where Ohio is situated) must show that continued repayment imposes an “undue hardship,” which is a very high standard to meet, and must also show that the obligation does not fall within one of three categories of non-dischargeable educational debts.

[Notably, the law was not always this way. Prior to 1976, student loans were dischargeable just like any other unsecured debt. Between 1976 and 2005, the dischargeability of student loans continued to narrow to the current status, in which it is quite rare for student loan debt to be dischargeable.]

To add extra complexity to the process, a borrower must initiate an “adversary proceeding”—a separate lawsuit within the bankruptcy case—seeking a court determination on whether such debt could be discharged. Nevertheless, in narrow circumstances, some student loan debts may ultimately be determined to be at least partially, if not fully, discharged.

Homaidan v. Sallie Mae Inc., Case No. 20-1981 (2d Cir. July 15, 2021)

In recent news, the Second Circuit, joining the Fifth Circuit ( See Navient Solutions LLC v. Crocker [In re Crocker], 941 F.3d 206 [5th Cir. Oct. 21, 2019 ]) and Tenth Circuit ( See Navient Solutions LLC v. McDaniel [In re McDaniel], 973 F.3d 1083 [10th Cir. 2020]) , spotlighted one such circumstance in the Homaidan case when it concluded that private student loans are not excepted from discharge under § 523(a)(8)(A)(ii).

Homaidan, the borrower in the Second Circuit case, had received two Tuition Answer Loans while attending college between 2003 and 2007 totaling $12,567 from Sallie Mae (now known as Navient). In this case, Sallie Mae deposited the loan proceeds into the student’s bank account. While the borrower used the some of the proceeds to cover educational expenses in part (but not exclusively), the loan proceeds exceeded the cost of tuition. Shortly after graduating from college, the borrower filed bankruptcy and later received a generic discharge in 2009 with no mention of her student loans. After the bankruptcy case closed, Navient, believing that the generic discharge did not include the debtor’s student loan obligations, resumed collection efforts. Assuming the lender was right, the debtor paid the debt back in full.

Thereafter, Homaidan (the debtor) moved to reopen the bankruptcy case in 2017, seeking a determination that the student loan debt was in fact discharged and the debtor should not have been required to repay the debt. According to the debtor, Navient schemed to issue dischargeable loans to student borrowers and then demanded repayment even after the loans were discharged in bankruptcy. Navient moved to dismiss, arguing that the two loans were non-dischargeable under § 523(a)(8)(A)(ii), which excepts from discharge “an obligation to repay funds received as an educational benefit, scholarship, or stipend.”

The bankruptcy court denied the motion to dismiss and an interlocutory appeal followed. Ultimately, the Second Circuit affirmed the bankruptcy court’s decision and joined two other Circuit Courts of Appeals in holding that § 523(a)(8)(A)(ii) discharges only “scholarships, stipends and conditional education grants,” not loans.

The issue turned on statutory interpretation: whether the two loans constituted “an obligation to repay funds received as an educational benefit” under § 523(a)(8)(A)(ii). Navient conceded that the two loans at issue did not fall within the first or third categories of non-dischargeable student loan debts, which except from discharge loans and benefit overpayments backed by the government or a non-profit (§ 523(a)(8)(A)(ii)) and qualified private educational loans (§ 523(a)(8)(B)), respectively. Navient also conceded that the two loans were not “scholarships” or “stipends” under § 523(a)(8)(A)(ii). Thus, the outcome turned on the meaning of “educational benefit.”

The Second Circuit held that the loans were not an “educational benefit” as Navient argued. The Court reasoned that the term must be narrowly read in the context of the series in which it is placed—both scholarships and stipends are akin to conditional grants that students are typically not obligated to repay.

“The defining characteristic of a loan, by contrast, is an unconditional obligation to pay it back.” Because the debtor’s obligations to Navient were clearly loans, and not conditional educational benefits, scholarships, or stipends, the Second Circuit affirmed the bankruptcy court’s denial of Navient’s motion to dismiss. While the case continues to move through the Court, this decision is significant for debtors who believed that their private student loans could never be discharged in bankruptcy.

Is Bankruptcy Reform Legislation on the Horizon?

While the Second Circuit’s decision is narrow, it underscores the risk run by lenders and borrowers alike in assuming that the student loans are automatically non-dischargeable in bankruptcy. Moreover, like most areas of the law, the dischargeability of student loans is constantly evolving.

This is in part due to Congress, which recently heard testimony on student loan debt and bankruptcy reform at a Senate Judiciary Committee hearing on August 3. At that hearing, Senators Durbin and Cornyn introduced new legislation entitled “The FRESH START Through Bankruptcy Act of 2021” that would rewrite student loan dischargeability in bankruptcy. Notably, the bill proposes to, among other things:

1. make government-backed student loans dischargeable in bankruptcy 10 years after the first loan payment is due;
2. keep the current “undue hardship” framework in place for private and federal student loans that have been due for fewer than 10 years; and
3. require colleges with more than 1/3 of their students receiving federal student loans to, under certain circumstances, partially refund the government if a student’s loan is later discharged in bankruptcy.

Our Creditors’ Rights team is keeping a watchful eye on these developments and will continue to share updates, best practices and critical insights as they become available.