Are Private Student Loans Dischargeable in Bankruptcy Court? An In-Depth Examination of Each Sub-Section of Section 523 (a)(8) of the Bankruptcy Code—Part I

In the United States, student loans have exceeded $1.6 trillion, making student loans a central focus amongst Chapter 7 and 13 debtors. Student loans facilitated or guaranteed by the U.S. government or a non-profit institution are non-dischargeable in bankruptcy court, pursuant to Section 523 (a)(8) of the Bankruptcy Code. A non-dischargeable debt means that the debtor must still repay the debt even after successful Chapter 13 or 7 bankruptcy. The only exception to this iron-clad rule is if the debtor shows that repayment would “impose an undue hardship on the debtor and the debtor’s dependents.” 11 U.S.C.S. § 528 (a)(8).

A common question is whether private student loans facilitated by private lenders—such as, Sallie Mae and Chase Bank—are afforded the same non-dischargeable protections as federal and non-profit student loans. In other words, do private student loans fall under Section 523 (a)(8) of the Code and require a showing of undue hardship to discharge the student debt? This three-part blog article explores each of the three sub-sections of Section 523 (a)(8) and explains how, under certain circumstances, private student loans are also a non-dischargeable debt, absent a showing of undue hardship by the debtor.

A Quick Primer on Section 523 (a)(8) & The Undue Hardship Test

Section 523(a)(8) of the Code is titled “Exceptions from Discharge” and specifies three types of student loan debts that remain with a debtor after a successful bankruptcy case:

(A)(i) an educational benefit overpayment or loan made, insured, or guaranteed by a governmental unit, or made under any program funded in whole or in part by a governmental unit or nonprofit institution; or

(A) (ii) an obligation to repay funds received as an educational benefit, scholarship, or stipend; or

(B) any other educational loan that is a qualified education loan, as defined in section 221(d)(1) of the Internal Revenue Code of 1986, incurred by a debtor who is an individual.

Whether private or federally backed, bankruptcy courts will not discharge the debt if the student loan fits into one of the three categories described above.  The only exception is if the debtor presents evidence that repaying the debt would result in an “undue hardship on the debtor and the debtor’s dependents.” 11 U.S.C.S. § 523 (a)(8) (emphasis added).

The Second Circuit Court of Appeals developed a legal standard to determine whether a debtor would suffer an undue hardship if required to repay the student debt.  See Brunner v. New York State Higher Educ. Servs.  Corp. 831 F.2d 395, 396 (2d Cir. 1987).  The Brunner Test includes three factors, and the debtor must prove that each factor weighs in their favor.  The three factors are: (1) the debtor cannot maintain, based on current income, a minimal standard of living for herself and her dependents; (2) additional circumstances exist that indicate the debtor’s current living condition will persist for a significant period of time; and (3) the debtor has made a good faith effort to repay the debt.  See Brunner 831 F.2d at 396.  Nearly all bankruptcy courts throughout the U.S. apply some form of the Brunner Test when confronted with a debtor that seeks to discharge student loan debt.

The Ninth Circuit Court of Appeals in United Student Aid Funds v. Pena (In re Pena), 155 F.3d 1108 (9th Cir. 1998) applied the Brunner Test and discharged the student loan debt.  In In re Pena, a middle-aged married couple filed for bankruptcy relief and sought to discharge the student loan debt that the husband incurred to attend trade school.  The debtors presented evidence that the husband’s certificate was useless and did not help him find better employment or increase his salary.  To make matters worse, the wife suffered from depression, bipolar disorder, schizophrenia, and other mental ailments that prevented her from retaining a job for longer than six months.  Further, the debtors’ age and limited education indicated that their living situation would not improve.  The Ninth Circuit found that the debtors—living on a monthly income of approximately $1,700—could not maintain a “minimal standard of living.”  The Circuit Court held that it would be impossible for the debtors to repay the debt without resorting to homelessness.  As a result, the 9th Circuit Court found that the debtors satisfied the “undue hardship test” and discharged the student loan debt.

Bankruptcy Courts throughout the U.S. rarely discharge student loan debt unless the facts of the case are similar—or worse than—In re Pena, which has made the Brunner Test an extremely difficult standard to satisfy.  Commercial lenders often argue that private student loan debts also fall under Section 523 (a)(8) of the Bankruptcy Code and, as a result, are nondischagabe absent a showing of undue hardship by the debtor.

The remaining part of this article focuses on analyzing each of the three sub-sections of 523 (a)(8) in the context of private student loan debts.  The first part of this three-part article focuses on Section 523 (a)(8)(A)(i).  The second and third segments discuss Section 523 (a)(8)(A)(ii) and Section 523 (a)(8)(B), respectively.

Section 523 (a)(8)(A)(i)—What does the term “program funded” mean?

Section 523 (a)(8)(A)(i) (hereinafter “AI”) is the first sub-section of Section 523 (a)(8). The text of AI states that a debt incurred by an “an educational benefit overpayment or loan made, insured, or guaranteed by a governmental unit, or made under any program funded in whole or in part by a governmental unit or non-profit institution” is non-dischargeable. 

The second use of the word “or” separates AI into two clauses.  There are two notable distinctions between the two clauses.  The first distinction is that the first clause is limited to “loans,” whereas “the second clause of AI concerns loan programs, [not] particular loans.” In re O’Brien 318 B.R. 258, 262 (S.D.N.Y. 2004) (emphasis added) (citations omitted). The other notable difference is that the first clause is limited to loans by a “governmental unit,” and the second clause includes governmental units and non-profit institutions.

These two distinctions indicate that private student loans are excepted from discharge under the second clause of AI (and not the first clause) if: (1) the loan was made under a “loan program” and (2) the program is “funded” by a non-profit institution.  See In re Hammarstrom 95 B.R. 160, 165 (Bankr.N.D.Cal. 1989) (“[f]irst, the loan must be made pursuant to a “program” for providing educational loans.  Second, that program must be “funded” at least in part by a non-profit organization”).

Bankruptcy Courts often find that the first element is satisfied if a non-profit entity is part of a program that facilitates the student loan to the debtor.  For example, in Hemar Service Corp., Inc. v. Pilcher 149 B.R. 595 (Bankr.9th Cir. 1993), the debtor received student loans from a loan program funded by multiple non-profit and for-profit entities.  The Bankruptcy Court found that the creditor satisfied the first element because a non-profit entity that was a member of a loan program that provided educational loans to students in need of financial assistance. See Pilcher 149 B.R. at 598.  The first element is very easy to satisfy and, as a result, Bankruptcy Courts often overlook or do not analyze the first prong of the AI analysis.

Turning to the second element, the Bankruptcy Court in In re Hammarstrom held that the term “funded” means a non-profit institution that “plays any meaningful part in providing funds” to the loan program. In re Hammarstrom, 95 B.R. at 165.  Bankruptcy Courts consistently rely on In re Hammarstrom because it was one of the first bankruptcy cases to define the term “funded” as used in the second clause of AI.  However, Bankruptcy Courts are divided on what constitutes “funding” a loan program.  Some Bankruptcy Courts have held that a non-profit institution funds a loan program when it purchases the notes made under the loan program from a private, commercial lender.

For instance, in In re Hammarstrom, the non-profit entity and a private lender entered into an agreement wherein the private lender would execute the notes with the debtors and loan money directly to the students.  After the lender disbursed the loan proceeds, the non-profit entity would immediately purchase the notes from the lender and would become a creditor of the debtors.  The Bankruptcy Court found that the loan program structure made the commercial lender nothing more than an agent for the non-profit entity to help it advance loans for post-secondary education.  The Bankruptcy Court concluded that the non-profit entity funded the loan program because it purchased all of the notes under the program from the original lender and relieved the lender from its duties and obligations under the same.

The Court of Appeals for the Third and Eighth Circuits came to a similar conclusion but required non-profit entities to participate in the loan program.  In the case of Sears v. EduCap, Inc. (In re Sears) 393 B.R. 678 (Bankr.W.D.Mo. 2008) the non-profit entity prepared the loan documents, marketed the loans, processed the loan applications, and facilitated the disbursement of proceeds from the private lender to the student.  The Bankruptcy Court found that the non-profit lender funded the program because it exercised “plenary control” over the loan program and was required to purchase the loans (at one point or another), regardless of whether the loan was current or in default.  See In re Sears, 393 B.R. at 681. Similarly, in Johnson v. Access Grp., Inc. (In re Johnson), Nos.  1:05-bk-00666MDF, 1:05-ap-00162, 2008 Bankr. LEXIS 3325, at *10 (Bankr. M.D. Pa. Dec. 3, 2008), the Bankruptcy Court for the District of Pennsylvania found that the non-profit institution “funded” the loan program because it (1) agreed to purchase the loan prior to the loan being made to the debtor, (2) the non-profit entity administered the program that facilitated the student loans, and (3) the non-profit entity guaranteed the loan while it was held by the private lender.

The Court of Appeals in the First, Second, Seventh, and Ninth Circuits have encountered different loan programs and, as a result, have reached different conclusions from the other Circuit Courts. The Court of Appeals in the First, Second, Seventh, and Ninth Circuits held that a non-profit entity “funds” the loan program if it guarantees the note and repays the debt to the lender upon the debtor’s default.  These Circuit Courts found that without the guarantees from the non-profit entities, private lenders would not participate in the loan programs.

The Second Circuit Court of Appeals in O’Brien v. First Marblehead Educ. Res., Inc. (In re O’Brien), 419 F.3d 104 (2d Cir. 2005) specifically held that a non-profit entity was “clearly devoting some of its financial resources to supporting the program” by guaranteeing all notes made under the loan program.  The Second Circuit Appellate Court was persuaded by the fact that after the debtor defaulted under the note, the non-profit entity fulfilled its obligations and immediately repaid the debt to the private lender, including all interest, fees, and costs.  Bankruptcy Courts throughout the country have reached similar conclusions. See e.g., In re Duits, No. 14-05277-RLM-13, 2020 Bankr. LEXIS 138, at *5 (Bankr. S.D. Ind. Jan. 15, 2020) (“the non-profit’s guaranty helps fund a program because it encourages a lender to extend credit that may not be otherwise available”); see also Educ. Res. Inst. Inc. v. Taratuska (In re Taratuska) (D.Mass. Aug. 25, 2008, No. 07-11938-RCL) 2008 U.S.Dist.LEXIS 93206, at *18 (the non-profit funded the loan program because it guaranteed the loan, paid the loan upon default, and presented evidence that it “maintained money in segregated reserves to support its guaranteed obligations, thus devoting financial resources to the loan program”).

The cases described above signify that the term “funded” takes on many definitions, depending on the non-profit’s obligations and duties in the loan program.  The Court of Appeals for the First, Second, Seventh, and Ninth Circuits found that a non-profit institution “funds” the loan program when it guarantees the loan and repays the loan proceeds to the lender upon the debtor’s default.  On the other hand, a non-profit entity “funds” the loan program when it purchases the note from the lender (see e.g., In re Hammarstrom, 95 B.R. 160) and manages the loan program.  See e.g., In re Sears 393 B.R. 678.

In conclusion, the case law interpreting AI illustrates that Bankruptcy Courts are willing to employ numerous definitions of the term “funded” in order to find that private student loans that are facilitated through loan programs are excepted from discharge under Section 523 (a)(8)(A)(i). 

This is Part I of a three-part blog article. Part II of this three-part blog article can be accessed by clicking on this link. Part III of this blog article can be accessed by clicking on this link.