In the recent circuit court case of Homaidan v. Sallie Mae, Inc., a federal circuit court held that a ruling by a New York bankruptcy court that private loans to pay for college education are not exempt from being discharged under the Bankruptcy Code’s Section 523. This section of the Bankruptcy Code excludes from discharge a duty to pay back funds obtained as part of a scholarship, strident, or other amount used to advance one’s education. 

Tests Utilized to Discharge Student Loans in Bankruptcy 

To discharge a student loan in bankruptcy, a person must show that it would create an undue hardship for them to repay this loan. The test for assessing an undue hardship changes between courts. Many courts view the test for undue hardship as a nothing or everything proposition. This means that a person either has the entire amount discharged or none of it. Some courts, however, discharge a portion of student loans. 

Despite the test utilized, courts are often hesitant to discharge student loans in bankruptcy. 

In deciding whether to discharge a student loan in bankruptcy, some courts apply the Brunner test. Under this test, a person can discharge a student loan if the individual meets three elements: (1) based on the individual’s income as well as expenses, the person cannot maintain a minimal standard of living if forced to repay a loan, (2) the financial hardship is likely to continue for a significant amount of time, and (3) the individual has made a good faith effort to repay the amount owed. 

Another group of courts uses a totality of circumstances test, while some other courts use other tests including a unique test for Health Education Assistance Loans. 

How the Case Arose

The student loan recipient in this case received loans to pay for college education in the amount of $12,597 from the federal Sallie Mae organization. The recipient used this amount to pay for the education he received at a college in Massachusetts

The loans helped to underwrite the recipient’s secondary education but were not made through Emerson College’s financial aid office. The recipient alleges that these funds went straight to his bank account and the funds were greater than the cost of Emerson’s tuition.

On graduating, the recipient filed the appropriate paperwork in a New York court to begin Chapter 7 bankruptcy. The court’s subsequent order addressing discharge of debts was not clear in regards if the amount received from Sallie Mae could be discharged in bankruptcy. 

Following the bankruptcy proceedings’s closure, the debtor reimbursed the amount received from Sallie Mae, which led the recipient to assume the amount received from Sallie Mae was not discharged and resulted in the recipient paying the loans. The recipient then re-initiated the bankruptcy filing and began legal proceedings against the debtor seeking damages for the debtor’s potential violation of the discharge order. 

A New York bankruptcy court then assessed that the loans are not exempt from discharge in accordance with the Bankruptcy Code’s Section 523. 

The Federal Circuit Court’s Opinion

As part of its opinion, the federal circuit court addresses three kinds of debt associated with education that are incapable of being charged in bankruptcy. These three categories benefit overpayments and loans backed by nonprofits or the government, requirements to reimburse funds that are received as part of a stipend or scholarship for educational gain, and certain private educational loans. 

The debtor claimed that the loans it granted fall into the second group because the loan agreement represents a duty to reimburse funds which the recipient received to advance his education.

The circuit court ruled that the debtor’s interpretation went against several principles of legislative writing. The debtor claimed that the ordinary public meaning of a duty to reimburse funds received to benefit an education includes student loans. The bankruptcy court, however, explained that this is an unconventional method of discussing a loan. The circuit court held that if legislatures meant to exclude educational loans from discharge, lawmakers would have not performed this exclusion in such a restricted manner. The court also rejected the debtor’s efforts to interpret a “loan” into Bankruptcy Code section 523 and found that the word “loan” is not included in section even though it does appear in section and section.  

Additionally, the circuit court rejected the debtor’s interpretation of Section 523. The court rationalized that this interpretation drew all loans used to pay for secondary education into its reach and left other parts of the Bankruptcy Code unnecessary. Instead, the court found that the phrase, “educational benefit” should be read to include payments resembling scholarships and stipends. 

As a result of its interpretation of the Bankruptcy Code, the Secondary Circuit agreed with the New York bankruptcy court’s decision and classified the debtor’s private student loan as dischargeable under the Bankruptcy Code’s Section 523.

The Potential Influence of the Case

The circuit court’s opinion is a significant one because it might now be much less challenging for the borrowers of student loans to discharge loans secured to pay for secondary education by declaring bankruptcy. 

This opinion might counteract the pervasive but simplistic view that private loans used to pay for education are not capable of being discharged without an “undue hardship.” The court’s ruling conforms with an earlier decision by the Tenth and Fifth Circuits, which held that educational loans do not represent a duty to reimburse funds taken in as a benefit to education. 

The Second Circuit Court of Appeals joined the Fifth and Tenth Circuits in ruling that certain private loans are dischargeable in Chapter 7 bankruptcy. Subsequently, the circuit court held in Homaidan that the loans involved do not qualify as “student loans” under the Bankruptcy Code’s Section 523, which excludes from discharge a duty to reimburse funds received as a benefit to education.  

Earlier in 2021, the Senate’s Majority Whip Dick Durbin, as well as John Coryn, introduced the Fresh Start through Bankruptcy Act of 2021. This legislation would permit borrowers to obtain a bankruptcy discharge for federal student loans after waiting ten years. The bill would retain the existing undue hardship discharge choice for private student loans as well as for federal student loans that have been due less than a decade. 

Speak With a Knowledgeable Bankruptcy Attorney 

The bankruptcy process is nuanced and can be challenging to navigate. If you have questions or concerns about bankruptcy, one of the best things that you can do is to speak with an experienced attorney. Contact attorney Melanie Tavare today for assistance.