The House Judiciary Committee yesterday held a hearing on bankruptcy law as it applies to private student loans. The hearing, "An Undue Hardship? Discharging Educational Debt in Bankruptcy," was held by the Chairman of the Subcommittee on Commercial and Administrative Law, Steve Cohen (D-TN).

Bankruptcy is a very visible issue for Cohen's district -- Memphis/Shelby County. Memphis was dubbed "the bankruptcy capital of the nation" for having the greatest number of bankruptcy cases filed. Memphis was also the home of the U.S. representative who sponsored the original Chapter 13 bankruptcy legislation back in 1938.

Before the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, private student loans were unconditionally dischargeable in bankruptcy. However, the 2005 law gave private loans the same preferred treatment as government-guaranteed student loans so they are now not dischargeable except under very extreme circumstances.

During yesterday's hearing, Cohen signaled his intention to sponsor legislation to revise the bankruptcy provisions for private student loans to make them dischargeable again.

"Hopefully it will be bipartisan, but if not -- we're going to do the right thing," he said, suggesting that Democrats would pass the bill even without Republican support.

Joan Crissman, NASFAA Interim President and CEO, voiced support for the restoration of dischargeability provisions for private student loans.

"Private educational loans are no different than any other consumer debt and should be dischargeable through bankruptcy," Crissman said. "Unlike federal student loans, private loans do not have numerous consumer protections and benefits to help borrowers avoid default."

NASFAA is particularly concerned about students who borrow loans marketed directly to them. This process bypasses financial aid office certification and counseling, which can keep students from borrowing more than they need to and ensure they understand the terms and conditions of private loans. NASFAA has been actively advocating for legislation to require that all private loans be certified by the financial aid office to ensure that all students take advantage of federal loans first.

Witnesses testifying at yesterday's hearing were:

• Hon. Danny K. Davis, U.S. House of Representatives, 7th District, IL

• Lauren Asher, President, The Institute for College Access and Success

• Rafael I. Pardo, Associate Professor, Seattle University School of Law

• J. Douglas Cuthbertson, Miles & Stockbridge P.C., McLean, VA

• Brett Weiss, Joseph, Greenwald & Laake, P.A., Greenbelt, MD, testifying for the National Consumer Law Center, sponsor of the Student Loan Borrower Assistance Project

"Students and families should be able to count on their college financial aid office to provide impartial advice about loans and lenders, and many of them can," She said. "However, over the past few years, federal, state and independent investigations have exposed numerous conflicts of interest between student loan companies and universities or their employees, raising questions about the integrity of the advice they give students about loans ... Congress passed legislation in 2008 aimed at curbing such abuses, but that did nothing to help the unsuspecting students who were [already] saddled with unnecessarily costly loans."

Asher noted that some colleges go out of their way to help students avoid or minimize private loans and maximize federal loans and other aid, but she was disturbed by for-profit colleges that make private loans directly to high-risk students. She said such loan programs are motivated by a desire to get around market corrections that have appropriately reduced access to subprime private loans for very high risk borrowers and to justify prices for-profit education and training programs that may exceed federal aid limits.

Pardo recommended that Congress restore the automatic discharge provision for private loans and clarify the undue hardship standard for federal loans. The undue hardship standard is undefined by the Bankruptcy Code and open to subjective interpretation by judges.

He noted that the debtors must currently initiate an adversarial proceeding against the creditor--essentially, a full-blown law suit--in order to discharge a loan under undue hardship. Because bringing such a proceeding requires substantial monetary resources, debtors in bankruptcy face additional hurdles in obtaining a discharge of their student loans.

In response to questions from Cohen about an appropriate and more specific definition of undue hardship, Pardo recommended that it be made quantifiable and tied definitively to whether the debtor actually has sufficient income to repay the debt, eliminating unrelated "extra-legal" factors such as experience level of the attorney or disposition of the judge.

Cuthbertson, an attorney who serves as counsel for the National Council of Higher Education Loan Programs (NCHELP)--but who was testifying on his own behalf and not representing a client--said that student loans have unique underwriting standards. Most consumer credit is granted based on a borrower's current ability to repay and the value of collateral, but student loans are granted based on future potential earnings, which should increase over time.

"Removing the exception to discharge would have one of three effects: (1) lenders would decide to no longer make private loans--a real concern in this credit environment; (2) private loan lenders would increase interest rates or insist on a co-borrower; or (3) borrowers could chose to take out private loans rather than FFELP loans with the intent to discharge all of the loans after graduation," he said.

Committee member Trent Franks (R-AZ), said he felt that restoring dischargeability would increase bankruptcies, and Cuthbertson agreed. Both felt that better definition of the undue hardship provision would be an appropriate action.

Weiss testified that private lenders tend to be universally inflexible in granting long-term repayment relief for borrowers who are in difficult circumstances. Unlike the federal programs, the options are particularly limited for borrowers in default, who are most in need of assistance.

"We constantly hear from borrowers who are desperate to work something out with their lenders only to have the door slammed in their faces," Weiss said.

There was considerable discussion about the possibility of students immediately and capriciously filing for bankruptcy after graduation. This would not happen, testified several of the witnesses, because to qualify to file for bankruptcy a petitioner must meet stringent requirements including a seven year waiting period.

Pardo said that before the original dischargeability prohibition was implemented amid a politically charged atmosphere in 1977, a GAO study found that less than 1% of student loans were discharged in bankruptcy.

According to Weiss, it's extremely rare for students to file bankruptcy unless they have no other choice. Most of the borrowers he sees, he said, "would rather have a root canal without anesthesia."

Resources

Changes to Bankruptcy Laws Needed to Protect Student Borrowers, Says Chairman Miller

Media Coverage

Rethinking Bankruptcy and Student Loans Inside Higher Ed

Discharging Student Loans in Bankruptcy Gets House Subcommittee Hearing The Chronicle of Higher Education

Posted 09/24/09 to www.NASFAA.org. Redistribution to non-NASFAA institutions is prohibited. Please submit Web site questions or comments to Web@NASFAA.org.