Second Circuit Rules Student Loans Redeemable in Bankruptcy



July 15, 2021 in St. Homaidan[1] According to the opinion, the Second District has joined the Fifth[2] and tenth[3] Decision tree for certain student loans to be repayable in the event of bankruptcy. These three opinions are very important to the student loan industry, but may not be as important as they appear at first glance, as they do not purport to make all student loans potentially repayable.

In these cases, the question is whether the loans issued qualify as “student loans” for the purposes of the Bankruptcy Code. Section 523 (a) (8) states that certain debts, commonly referred to as “student loans”, are not repayable in bankruptcy unless they “create undue hardship for the debtor and his dependents.” (The line of inquiry into “overwhelming hardship” is in itself complex and irrelevant to these cases.) In general, exempt debts include (1) overpayment of education benefits or government-sponsored loans; (2) commitments to “return funds received as an education grant, scholarship or scholarship”; or (3) other educational loans to individuals subject to the IRS tax code as “qualified educational loans”. Until the last five or six years, most courts held that any student loan was non-repayable under the second aspect, because all student loans included an obligation to pay back funds and an education grant.

A significant change is that the courts are now analyzing the second aspect in relation to the other two. Many people decide that if Congress had charted a second track to cover actual loans, it would be easy for Congress to simply include the term “loans,” as it has done in the other two tracks. Also, people do not usually refer to loans as “educational benefits”; the term “grant” is more commonly used in relation to scholarships or grants. These courts consider non-taxable debt in three main categories: (a) loans provided with the participation of the state; (b) requirements for payment of grants and scholarships (for example, arising if a student does not comply with the terms of the scholarship); and (c) private student loans that comply with IRS guidelines, which may make them tax deductible. Private loans that make No meet the criteria of the IRS, thus, more and more risk of being dismissed as part of bankruptcy proceedings.

Some private student loans have been made through programs that may not be in line with the IRS’s preferred tax regime. This makes these judgments very important for the student loan industry, especially as some law firms are seeking to rethink how student loans are handled in bankruptcy cases nearly a decade ago. However, many other loans were made in accordance with IRS guidelines and were therefore not impacted by this revised approach to student loan screening. Still others could potentially qualify for a favorable tax regime, if not for the debtor’s abuse of funds or other bad actions; these loans are generally also non-repayable. So while these district court decisions are important, they are unlikely to revolutionize the student loan industry or resolve the reported student loan crisis.

[1] Homaidan vs. Sally Mae, Inc., ___ F.4th ___, 2021 WL 2964217 (2d Cir. 2019 July 15, 2021).

[2] Crocker v Navient Solutions, LLC (in Crocker case), 941 F.3d 206 (5th District 2019).

[3] McDaniel v Navient Solutions, LLC (In re McDaniel), 973 F.3d 1083 (10 Cir. 2020).

© Miller, Canfield, Paddock & Stone, 2021 Review of National Legislation, Volume XI, Number 218


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