Bankruptcy as Consumer Protection: The Case of Student Loans

Abstract

Over 300,000 student loan borrowers have applied to the Department of Education for administrative relief from federal student loans on the ground that they were deceived or otherwise victimized by their schools. The Department adopted relatively borrower-friendly rules for this process in 2016. But under the new administration, the Department changed course and adopted new rules that make it “nearly impossible” for student borrowers to prevail. After a presidential veto of a resolution that would have stopped the new rules, they went into effect on July 1, 2020.

With victimized students effectively deprived of administrative relief, bankruptcy provides at least a partial solution. Many such borrowers will be candidates for bankruptcy: The median loan default rate at for-profit colleges sued or investigated for wrongdoing against students is estimated at 31 percent.

To get bankruptcy relief, a debtor must show that repayment would cause “undue hardship.” Courts currently do not consider school wrongdoing in assessing undue hardship; this article argues that they should. When repayment will entail some hardship and the borrower’s decision to incur the student loan was induced by the school’s deceptive representations or unfair, abusive, or unconscionable practices, bankruptcy courts should provide relief. They should discharge at least the amount of the loan corresponding to the difference between the cost of the schooling and any value the loan holder can prove the education actually had.

Considering school misconduct is consistent with the policies underlying non-discharge-ability of student loan debt because victimized students are not abusing the system when they seek relief and because collection from them is unlikely to be cost-effective. Moreover, discharge advances the goals of the student loan program.

It might be objected that the federal government is not itself a wrongdoer in school-misconduct cases, so it should not bear losses arising from bankruptcy discharge of federal student loans. But the FTC’s Holder Rule has provided since 1976 that consumer lenders are responsible for sellers’ misconduct in analogous situations. The assumptions underlying the Holder Rule are met in student-loan cases. As between the two innocent parties, government and student, the government is both better able to absorb school-misconduct losses. The government is also better situated to prevent such losses due to its extensive supervisory powers over schools.

Keywords: Student Loans, Bankruptcy, Consumer Protection, Borrower Defense Rule, FTC Holder Rule

JEL Classification: K35, I22