The decision highlights the evolving and uncertain landscape of student loan discharge in bankruptcy, particularly regarding courts' use of equitable powers to grant partial relief rather than an all-or-nothing outcome.

Background

In the bankruptcy case of In re Newman, Case No. 25-13508, U.S. Bankruptcy Court Judge Patricia M. Meyer of the Eastern District of Pennsylvania (the court) recently issued a decision that clarifies the elements necessary to obtain a discharge of student loan debt pursuant to Section 523(a)(8) of the Bankruptcy Code. In the absence of a ruling on the issue by the U.S. Court of Appeals for the Third Circuit, and in contrast to decisions by other bankruptcy courts within the circuit, the court held that the debtor had presented sufficient evidence that repayment of the full amount of his loans would present an undue hardship.However, the Court also found that some portion of the loans would remain nondischargeable.

In this case, the debtor, prior to his bankruptcy case, borrowed more than $222,000 in private student loans. Alleging that his current and projected income would not allow him to repay the loans without the imposition of an undue hardship, the debtor filed an adversary proceeding seeking to discharge the private loans pursuant to Section 523(a)(8) of the Bankruptcy Code.

The Court’s Decision

Bankruptcy Code and Legal Standard

Section 523(a)(8) of the Bankruptcy Code provides, in relevant part, that a discharge pursuant to a bankruptcy plan “does not discharge an individual debtor from any debt ... unless excepting such debt from discharge ... would impose an undue hardship on the debtor and the debtor's dependents.” Courts within the Third Circuit have noted that this section of the bankruptcy code was intended to further twin policy goals: “rescuing the student loan program from fiscal doom and preventing abuse of the bankruptcy process by undeserving debtors.”Consequently, courts have interpreted Section 523(a)(8)’s “undue hardship” standard as imposing a “heavy burden” on a debtor requesting discharge of student loans.

At the outset, the court noted that the Third Circuit has adopted the three-prong test to determine “undue hardship” established by the Second Circuit in the case of Brunner v. New York State Higher Education Services, 831 F.2d 395 (2d Cir. 1987). Under the Brunner test, a debtor must show: that a debtor cannot maintain, based on current income and expenses, a minimal standard of living for herself and her dependents if forced to repay the loans; that additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period for student loans; and that a debtor has made good faith efforts to repay the loans. If a debtor fails to satisfy any of these three prongs by a preponderance of the evidence, student loan debt will not be discharged.

Here, the court found that the debtor presented evidence sufficient to satisfy all three elements of the Brunner test.

With respect to the first prong—the “minimal standard of living” determination—the court explained that the “upper limit” of this “minimal standard” generally allows for a debtor to purchase basic necessities such as food, closing, housing and medical treatment. A debtor may not, however, use his or her financial resources for discretionary spending in lieu of repaying student loans. A mere showing of “tight finances” is insufficient to meet a debtor’s high burden, but a debtor is not expected to live in “abject poverty.” Further, a court must analyze whether a debtor has taken efforts to maximize his or her income.

In this case, the court found that debtor’s living expenses were minimal and that any amount of “belt tightening” would not allow for monthly loan payments of $1,652. Although the debtor claimed to spend about $200 monthly for “entertainment expenses,” the court noted that under decisions of other courts, allowance for some “small diversion or source of recreation” was acceptable under the Brunner test. With respect to the debtor’s efforts to maximize his income, the court found that the record was insufficient as to whether he could have obtained a higher-paying job or taken a second part-time job. Instead, the court held that it was not the court’s job to impose an “employment plan on the debtor” and that the relevant inquiry was instead whether the debtor had shown an inability to pay in the present and a likely inability to pay in the future, which the court found that the debtor had.

With respect to the second Brunner element—that a debtor’s inability to pay will likely persist through the loan term—the court explained that the debtor need not prove that his future was “bleak” but, rather, that his future income will not allow the maintenance of a minimal standard of living and to repay the loan. Here, the court found that, although the debtor would likely be employed for the duration of the loan and that his income will likely rise across that nearly two-decade period, any such increase in salary would likely be offset by increases in his “already minimal budget.”

Finally, the third-element requires a factual finding as to a debtor’s good faith. The court noted that the debtor’s student loans essentially constituted his only debt and were the sole reason for his filing a Chapter 13 case. Contrary to the decisions of other courts within this Circuit, the court concluded that the debtor’s lack of other debt did not weigh against a “good faith” finding; rather, it demonstrated the contrary; namely, that the debtor was not “merely careless with money” but rather suggested that he had failed to understanding the practical ramifications of incurring large amounts of student loan debt for a job that had limited financial upside. The court noted that “the evidence presented shows that the debtor takes his debt seriously and that he has proceeded cautiously and honestly.”

Order of Partial Discharge

Notwithstanding the court’s findings that the debtor satisfied the Brunner test and that repayment of his loans would present an “undue hardship,” the court found that the “debtor can afford to make some payments on the loan” and ordered that all but $40,000 of the loans would be discharged. In reaching this determination, the court calculated the amount that was exempt from discharge based on the debtor’s representation of the funds available monthly for repayment (approximately $900) across the remaining loan term.

Recognizing that Section 523(a)(8) does not expressly provide for partial discharge of student loan debt, the court noted, however, that multiple bankruptcy courts have held that this relief is permitted pursuant to an exercise of a bankruptcy court’s equitable powers under Section 105 of the Bankruptcy Code. The court also noted that such rulings have been upheld in the Sixth, Ninth and Tenth Circuits. Whether Section 523(a)(8) allows for partial discharge, however, has not been decided by the Third Circuit, and the court noted that at least one of decision from another court within the Third Circuit reached the contrary conclusion. The court declined to follow this nonbinding precedent, specifically rejecting the “principal that Section 523(a)(8) mandates a draconian ‘all or nothing’ approach.”

The court concluded that, although it acknowledged the argument that partial discharge of student loans contravenes the purpose of Section 523(a)(8) of the Bankruptcy Code, the law also acknowledges that some student loan debtors, including the debtor here, may be in “true need of bankruptcy relief.” Indeed, the court expressly concluded that its decision was reached “based not on policy concerns but on the specific facts presented.”

Conclusion

Given the fact-driven analysis of the Brunner standard, whether a bankruptcy court will or will not discharge student loan debt is not readily subject to generalization or predictability. The court’s decision here highlights a further level of uncertainty facing student loan borrowers considering bankruptcy relief—whether a court may conclude that partial but not full discharge is warranted by the facts presented. Moreover, this decision highlights the evolving nature of court analysis of student loan debt held by individual debtors and the changing landscape of whether “partial” relief is available across the circuit courts. Time will tell whether the Third Circuit will join with its sister circuits in affirming this “third way” forward.

With reforms to income-driven repayment plans for federal student loan debt ushered in by recent legislation and growing concerns regarding levels of student loan defaults, more bankruptcy courts may be faced with determining whether partial, and not all-or-none discharge is appropriate. Although partial discharge is likely not satisfactory to either borrowers or lenders, given the flexible nature of the “undue hardship” standard and the inherent equitable powers granted to bankruptcy courts, this area of the law should be watched closely in the coming years.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.