Second Circuit Rules Private Student Loans May Be Discharged in Bankruptcy

Troutman Pepper

Troutman Pepper

On July 15, the U.S. Court of Appeals for the Second Circuit ruled that private student loans are not explicitly exempt from a debtor’s Chapter 7 bankruptcy discharge.

In Homadian, the borrower, after graduating from Emerson College, filed for Chapter 7 bankruptcy in 2007 and obtained a discharge in 2009. The discharge order did not specify whether it applied to the borrower’s two private student loans, totaling $12,567. The loan servicer sought repayment of the loans, which the borrower eventually paid off in 2017.

Shortly after, the borrower reopened his bankruptcy case to file a putative class action adversary proceeding against the loan servicer for violating the discharge order. The servicer moved to dismiss, arguing that Section 523(a)(8)(A)(ii) of the Bankruptcy Code prevented the loans from being discharged. In doing so, the servicer argued that the term “educational benefit” encompasses all private student loans. The district court disagreed, finding the text and structure of both Sections 523(a)(8) and § 523(a)(8)(A)(ii) exempt from discharge a far narrower category of debt. The servicer filed an interlocutory appeal, and the Second Circuit affirmed.

The only question on review was “whether the loans at issue constitute ‘an obligation to repay funds received as an educational benefit’ and were therefore excepted from discharge under § 523(a)(8)(A)(ii).”

The Second Circuit found that under Section 523(a)(8), three categories of loans cannot be discharged:

  1. loans and benefit overpayments backed by the government or a nonprofit;
  2. obligations to repay funds received as an educational benefit, scholarship, or stipend; and
  3. qualified private educational loans.

The servicer did not argue the loans fell into the first or third categories. Instead, the servicer contended that the loan agreements created an “obligation to repay funds” and that the funds were obtained for purposes of advancing the borrower’s education, thereby deriving from them an “educational benefit.”

The Second Circuit embarked on an analysis of statutory interpretation of the U.S. Bankruptcy Code to determine the underlying meaning of “education benefit” in the text. In doing so, the court found that the text’s plain meaning does not support the servicer’s interpretation. Instead, finding that if Congress had intended to except all student loans from discharge under Section 523(a)(8)(A)(ii), “it would not have done so in such stilted terms.” Moreover, the court found that the term “educational benefit” is best read to refer to conditional grant payments like scholarships and stipends and does not cover all private student loans. Essentially, the Second Circuit determined that under the servicer’s reading, “the term ‘educational benefit’ would encompass virtually all private student loans,” which the court flatly rejected.

The court’s decision puts it in line with the Fifth and Tenth circuits, which have also issued similar rulings on private student loans.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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