This month's column is drawn from the "things don't always turn out the way you expect" file. It concerns the discharge of student loans in bankruptcy and efforts by lenders to make those loans less dischargeable.

There has been an alarming trend in bankruptcy law toward making debts more difficult to discharge. When the modern bankruptcy code was first adopted (in the late 1970's), student loans were dischargeable if they were at least 5 years old. In 1990 that period was lengthened to 7 years and in 1998 the Code was changed to make student loans non-dischargeable no matter how old they were.

There have been several reasons behind the changes. The loans are often made by non-profit organizations or the government and there was a sense that those entities should not suffer the losses associated with bankruptcy filings. Too, the powerful banking lobby did an excellent job of leveraging the changes it wanted through Congress.

The current law does leave one escape valve. Recognizing that some parties are in such dire financial straits that it simply is not reasonable to require them to repay debts, the lawmakers included a section which provided that student loans could be discharged in the event of undue hardship. To qualify under this provision the debtor must show, among other things, that his living expenses are reasonable, that he does not have disposable income and that his financial position is not likely to improve.

The determination of whether an undue hardship exists is made by the bankruptcy judge. After a bankruptcy is filed the debtor brings an adversary action - which is similar to filing a lawsuit - asking the court to determine if the debt is dischargeable.

When the law was first changed, some judges believed that they had the authority to modify the loans rather than simply rule "yes" or "no" on dischargeabiltiy. For example, if a debtor was seeking to discharge a $30,000 loan, the court might decide that the full amount was too much to pay but that the debtor could afford to pay $10,000. Such discretion on the part of the judge gave lenders incentive to actually try these cases since it was likely that the lender would at least get something for his effort.

Last year, the bankruptcy appeals court for the Ninth Circuit (the Federal Circuit in which California is located) considered whether courts could modify these loans. The panel concluded that the law did not allow such modifications and that the only proper determination was either that a loan was fully dischargeable, or that it must be paid in full. Not all circuits agree with the Ninth Circuit but this is currently the controlling law in California.

The result of the appellate court's decision has been intriguing. Lenders who decide to take these matters through a full trial face the very real possibility that they will get absolutely nothing for their efforts if the judge finds that the debtor cannot make the full loan payment. In my experience with several of these cases, the lenders have been willing to mediate settlements rather than chance getting nothing. While settlement is good, this is hardly the result those pressing for the non-dischargeability of these debts envisioned. Because of the pressure to settle, lenders may now be accepting lower total payments than they might have received before the law was changed.

February 1999.
Reprinted with permission of the The Orange County Register.