Court opens window of hope for student debtors

(MoneyWatch) It's well known by now that student debt is hard to shake. In the good old days, personal bankruptcy could allow someone to escape a loan burden. Today, thanks to the Bankruptcy Reform Act of 2005, corporations are allowed to restructure their debt, but individuals not so much. As a result, a student borrower can never escape the debt unless he can prove that the loan is impossible to pay, a standard known as "undue hardship." 

For student loan debtors, "bankruptcy relief is now available only through the random, unfair, and costly 'undue hardship' system," Deanne Loonin, an attorney with National Consumer Law Center, told lawmakers in a 2010 congressional hearing on bankruptcy reform. "Effectively, it has become no choice at all for those who most need it."

How undue that hardship must be has been interpreted by different courts in different ways, leading many financial reform advocates to complain about its arbitrary, sometimes cruel application. But a recent federal appeals court ruling may be opening a door to at least creating a uniform standard for assessing what constitutes undue hardship. And for people struggling to repay student loans, the decision also offers hope that they may be able to legally erase such debt.

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The case before the Ninth Circuit Court of Appeals, decided on May 22, presented a colorful, but by no means unique, display of the lengths courts think people should go to re-pay a loan. The plaintiff in the case, one Michael Hedlund, took on about $85,000 in debt to get an undergraduate degree at the University of Oregon and a law degree at Willamette Law School. He also took an internship with the Klamath County district attorney in Oregon and twice took the bar exam, failing both times. On his third try, Hedlund locked his keys in his car and missed the exam. When he couldn't pass the bar, he lost his job and took another one as a counselor. He got married and had a child. When he was 33, he declared bankruptcy .

The bankruptcy court decided that Hedlund had made a good-faith effort to repay his loans, and allowed him partial relief. But a federal district court held on appeal that Hedlund hadn't done all he could do to pay his debts and reinstated them.

What more should he have done? He hadn't minimized his expenses sufficiently, the trial judge said, and hadn't been aggressive enough in trying to negotiate a payment plan. Finally, the trial judge found fault with the fundamental way Hedlund was living his life: He and his wife chose to live as a single-income family, "a lifestyle that few today can afford."

But the appeals court rejected that reasoning and ruled that Hedlund had indeed done his best to pay his debts. The court found that he was entitled to a partial discharge of his law school loans because paying them back in full would impose an undue financial hardship on him and his family.

By reining in the district court, the appeals court also may offer greater freedom to bankruptcy judges to give student loan borrowers and other debtors the benefit of the doubt if they can show that they tried to pay a debt.

"We're delighted with the court's decision," said Derek Foran, a partner with Morrison and Foerster in San Francisco who represented Hedlund on a pro bono basis, in a statement. "The Ninth Circuit's decision is important for other student debtors, because it clarifies the correct standard of review governing undue hardship determinations under the bankruptcy code. It will mean significant relief for student debtors -- who often are unrepresented -- seeking relief in bankruptcy court."

Here's why that's important, especially in an age when more and more students are sinking into debt to pay for college: Until Congress changed the law eight years ago, bankruptcy offered an important way for certain borrowers to seek debt relief.

That right recognized a key -- and often overlooked -- legal aspect to taking out a loan: Just as borrowers are responsible for repaying that debt, so lenders must act responsibly in issuing loans that they know borrowers can repay. But as the subprime crisis showed, lenders are often reckless in their loan practices. And when loans sour, the same lenders often insist on harsh repayment terms that impose onerous financial demands on borrowers.

The Hedlund case sets a limit in the kind of hardships that courts are willing to enforce. That could make it easier for borrowers who have tried in earnest to repay their loans to seek relief -- a right conspicuously granted under the law to businesses.

"Bankruptcy policy should be about the pragmatic need to offer fresh starts to many debtors," Loonin testified. "Bankruptcy is the legal recognition that someone lacks the resources to meet financial obligations. There are many rules in place to ensure that only borrowers who are financially distressed get relief. It is way past time to give financially distressed student borrowers equal access to relief."