Thursday, July 26, 2012

Student Loan Debt Discharged Under the Brunner "Undue Hardship" Test

In the case of In re Smith, 442 B.R. 550 (Bkrtcy. S.D.Tex. 2010), the bankruptcy court addressed (i)whether Bankruptcy Code § 542(c) applies to a consolidated loan and, (ii) whether it is too late, after execution of a consolidation loan, to determine “undue hardship” under § 523(a)(8). In Smith, debtor borrowed money to send her daughter to Austin Business College for an Associates Degree in Business Technology. That degree has not enabled her daughter, a single mother, to get a job that would support debtor’s daughter and debtor’s grandchild. Debtor's daughter lives in debtor's home and works at Walmart. In 2005, debtor filed a voluntary Chapter 7 bankruptcy petition, but instead of seeking to discharge the student loan debt, debtor attempted to combine the three existing loans into a single loan for ease of payment. Debtor did not seek discharge of the consolidated loan while her bankruptcy case was pending or for several years afterwards. Instead, she tried to pay the loan. Debtor now alleges that she is unable to pay the consolidated student loan, and filed this case seeking a court ruling that the student loan is dischargeable.

The court ruled in favor of the debtor. The court began its analysis by asking whether the consolidated loan was a new loan. The creditor argued that the consolidated loan was a new loan and therefore could not be discharged because it was a post-petition debt. The court found against the creditor on this issue, and held that the consolidated loan was nothing more than a “reaffirmation agreement.”The consideration for the consolidated loan predated the current bankruptcy case. Because no additional advances were made, no new lender advanced funds to pay off the prepetition lender, and no material modifications were made to the loan, the court held that there was no reason to treat the new note as a “loan made.” “The financial effect of a bookkeeping entry on Wells Fargo’s books is not the creation of a new loan, it is a bookkeeping entry that (in this case) has no effect to make the loan dischargeable. Treating this bookkeeping entry as a new loan would elevate form over substance.”

The court then turned its attention to whether a prior discharge under Chapter 7 bars a subsequent determination of dischargeability under § 523(a)(8). Under FED. RULE BANKR.P. 4007(b), a pre-petition student loan is not automatically discharged, but there is no deadline for seeking a determination that § 523(a)(8) applies, and there is no deadline to discharging the debt after the bankruptcy case is closed. “Both the Seventh and Second Circuits have held that debtors are permitted to reopen their cases to seek a discharge of their student loans based on a post-discharge change in circumstances.” In re Walker, 427 B.R. 471, 480 (8th Cir. BAP Minn., 2010).

In this case, debtor testified that she is able to pay her bills as they come due, however, she can only do so by regularly postponing other necessary expenses, such as medical care, home repairs, and car repairs. Also, as a result of debtor's age (56 years old), her income will decline when she reaches retirement. Based on these facts, the court concluded that debtor's financial condition would only worsen over time. Based on facts related to a finding of “undue hardship,” the court concluded that debtor's post-discharge change in circumstances permitted her to reopen her case and seek a discharge of her student loan debt. The court ruled in favor of the debtor and found “undue hardship.”

Apply the law to the facts, the Smith court held to prove that the discharge of student loan debt under 523(a)(8) is possible…albeit, the court construed this case through a very narrow lens, focusing on debtor's extreme financial hardships and low quality of life. However, this case is a twinkle of the “light that’s at the end of the tunnel” for those debtors with extreme circumstances who are deserving of student loan debt discharge.

Austin J. Pollak

Summer Associate

Blog By:  Austin J. Pollak (Austin's bio) of the Schaller Law Firm

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