When Colleges Fail – Bankruptcy and Higher Education

Higher education is amid the most significant upheaval since the Second World War. Fitch, a principal United States bond rating firm, downgraded the sector to “negative” and noted that “Consolidation is likely to accelerate in 2019 and beyond, which may take multiple forms. Smaller private institutions remain most susceptible to consolidation either through a merger, affiliation with another larger institution or outright closure in the most serious scenario” (Wadhwani, 2018). Wadhwani, the report’s author, also cited operational expense pressure, limits to tuition increases, and increasing competition as headwinds for higher education.

As a result of these pressures, 176 higher learning institutions have closed or announced they will close or consolidate with another institution since 2016 (Busta, 2018). And while most of the students impacted were at for-profit institutions, most of the institutions themselves (101 of the 176) are not-for-profit. Each of these institutions has a story leading to their loss of independence; however, one element is common – financial exigency. That exigency extends to the university and the staff, students, faculty, and communities impacted by the closure or consolidation.

Often, the university and those impacted are forced to turn to the United States Bankruptcy Court for relief. Bankruptcy allows a debtor to stop collection actions while reorganizing their finances. That reorganization generally takes two forms – a reorganization, where the person or business retains their assets and works out a repayment plan, and a liquidation – where the person or business sells their assets in partial or complete satisfaction of their debts. Actions in bankruptcy court are governed by a combination of state law and federal statutes. The federal law governing bankruptcy is Title 11 of the United States Code. (U.S. Bankruptcy Code, n.d.)

The impacts of the bankruptcy code are different for each group of impacted stakeholders. This research paper will focus on two stakeholders – the university and the students the university serves.

The ability of a college to file bankruptcy is limited by its reliance on Title IV federal funds. If a school receives funding under Title IV of the Higher Education Act, the institution’s eligibility to participate in these programs terminates automatically at the time of filing because the institution no longer meets the definition of “eligible financial institution” under 20 U.S. Code § 1002.  Thus, while most other businesses and organizations could be afforded the opportunity to restructure and reorganize their finances under provisions of the bankruptcy code, colleges are stuck in a difficult position of attempting to maintain adequate liquidity while not being able to utilize the protections afforded by the bankruptcy code due to statutory limitations and the heavy reliance by schools and students on federal student loans and aid under Title IV.

Under the Bankruptcy Code §109, a university participating in financial aid programs may be a debtor in bankruptcy. However, the inability of the university to access Title IV funds effectively limits the university to a bankruptcy filing if they intend to liquidate quickly under provisions of Chapter 7 of the bankruptcy code. Any attempt to reorganize under Chapter 11 of the bankruptcy code would immediately trigger ineligibility under 20 U.S. Code § 1002, resulting in the freezing of federal funds and the inevitable inability to reorganize. This position was confirmed by the Southern District of New York in 1996 when Betty Owen Schools, Inc. argued that the revocation of Title IV funds under the HEA violated their rights under 11 U.S. Code to reorganize. The court found that “In this instant case, the general policy goals of the two statutes — the Bankruptcy Code and section 1088(a)(4) of the HEA — will be furthered if this Court finds for the Department. First, Congress’s desire to conserve scarce resources under HEA programs will be furthered. Second, conflicting provisions in the Bankruptcy Code will be reconciled.” (In re: Betty Owen Schools, Inc.,1996)

Bankruptcy may be filed voluntarily, by the institution, or involuntarily by a creditor. According to Norberg (2015, p.387), it is unclear whether an involuntary bankruptcy filing would trigger ineligibility under 20 U.S. Code § 1002. An enterprising university may skirt the bankruptcy rules by having a “friendly” creditor make an involuntary filing, though there is no case law on point. Effectively, the university is faced with a choice of liquidation or attempting to find a buyer, merger partner, or another white knight to bail it out. Under Chapter 11 of the bankruptcy code, restructuring is effectively precluded by 20 U.S. Code § 1002.

Bankruptcy Law Impacts on Students

While it is a legal fallacy that federal student loans are not dischargeable in bankruptcy, the fact remains that it requires an adversary proceeding in bankruptcy court, that the burden of proof is high. To receive a bankruptcy discharge for federal student loans, the debtor must bring an adversary proceeding in the bankruptcy court.  An adversary proceeding is a trial before the bankruptcy judge where the sides present their arguments for or against a position.  In the case of federal student loans, the test for whether a loan is dischargeable in bankruptcy is known as the “Brunner Test” (Brunner v. New York State Higher Educ. Servs. Corp., 1987). This test has three prongs:

  1. If the debtor continues to make payments on their student loans, they will not maintain a minimal standard of living.
  2. Additional circumstances indicate that these conditions are likely to persist for a significant portion of the repayment term of the loans.
  3. The debtor made a reasonable faith effort to repay the loans.

This test was accepted by most bankruptcy courts and is generally accepted by most courts of appeal.

In a chapter 13 case, the student debtor submits a plan to repay all their creditors over a fixed period – usually three to five years. Following the Bankruptcy Reform Act of 2005, the debtor’s ability to choose their bankruptcy plan is limited by a means test – so only those debtors with low income can file a Chapter 7 discharge.  Thus, student loan debtors with incomes above the state median income and assets are generally forced to file for Chapter 13 bankruptcy. In a Chapter 13 bankruptcy, the bankruptcy plan determines what the student loan payments will be – and it will be based on what the debtor makes and what they owe – not the original student loan note.  The student loan debtor will still owe the remainder of your student loans when they exit bankruptcy.

In general, students can take steps to relieve themselves of crushing student debt under severe circumstances through bankruptcy courts. Additionally, other remedies are available to students who suffer significant harm when a school closes.

Students from failed institutions may be left without a degree, the credits they earned, the reputation of the degree they earned, and the ability to engage and network with future alums from the school. The Brunner test provides little relief to those students and alums. However, outside the bankruptcy arena, the United States Department of Education offers a “Closed School Discharge” of student loans (United States Department of Education, 2018).

This program allows for the complete discharge of student loan obligations if you were enrolled at the school when it closed, you were on approved leave when the school closed, or the school closed within 120 days of your withdrawal. Meet the eligibility requirements for a closed school discharge of your loans obtained to attend a school that closed on or after Nov. 1, 2013, and you have not enrolled at another school that participates in the federal student aid programs within three years of the date your primary school closed. You will receive an automatically closed school discharge. Interestingly, this program does not extend to students who recently graduated or who choose to follow the same program at another school through teach-out or where the credits are transferrable. If the student transfers their credits but changes programs, they may remain eligible for a loan discharge under this program.

If a student took out a student loan and is due for a refund for expenses from their institution when they close, they are a creditor of the institution. In this case, they would need to understand the priority and legal approach to the school closing. If the school is liquidating under Chapter 7 of the Bankruptcy Code, the student would claim bankruptcy and apply for discharge relief from the Department of Education.             

Conclusion

 

The Bankruptcy Code largely fails both colleges and students as currently written. Higher education institutions largely cannot restructure under provisions of the code due to the limitations placed on them by the Higher Education Act – limiting access to Title IV student aid and loan funds when a college files for bankruptcy.

Students are frozen out when colleges fail – especially if they have student loans and recent graduates. While students who are forced out of a university and a program when they shut down have some recourse under the Closed School Discharge program administered by the Department of Education, recent graduates and those who transfer to other schools in the same course of study are often left with significant student loan debt. However, the Bankruptcy Code offers little in the way of relief to the student who suffers economically from the cost of higher education. The Brunner Test is a high hurdle to pass. While some relief is available, the student must meet almost abject poverty standards to be eligible for student loan relief in bankruptcy.

As bankruptcy is an equity court, and Congress regulates the parameters, there is the ability to make law. The courts provide a more equitable outcome to affected students and institutions.  Like Chapters 12 and 15, which are for farmers and international businesses, Congress could create a chapter for colleges and universities where the Federal Government becomes the highest priority creditor in the equivalent of a liquidating Chapter 11. This would provide those schools with an approved reorganization plan to continue to access Title IV funds and maintain operations during the reorganization.

On the student front, as a policy matter, the courts or Congress could create a more equitable test for students impacted by a college closure for bankruptcy debt relief. Whether through enhanced means testing or cram down provisions in Chapter 13, or partial or complete discharge in Chapter 7, the impact of a closed school on the earning potential of a current or former student should be addressable in the bankruptcy court. Reliance on programs like the Closed School Discharge program is exceptionally limiting and may be inconsistently applied.

 

References

 

20 U.S. Code § 1002 – Definition of the institution of higher education for purposes of student assistance programs. In: Legal Information Institute. https://www.law.cornell.edu/uscode/text/20/1002. Accessed 31 Mar 2019

Brunner v. New York State Higher Educ. Servs. Corp., 831 F. 2d 395 (2d Cir. 1987)

Busta H (2018) How many colleges and universities have closed since 2016? In: Education Dive. https://www.educationdive.com/news/how-many-colleges-and-universities-have-closed-since-2016/539379/ . Accessed 31 Mar 2019.

Carlson S (2014) Rising Tuition Discounts and Flat Tuition Revenues Squeeze Colleges Even Harder. In: The Chronicle of Higher Education. https://www.chronicle.com/article/Rising-Tuition-Discounts-and/147465 . Accessed 31 Mar 2019

In re: Betty Owen Schools, Inc., 195 B.R. 23 (Bankr. S.D.N.Y. 1996)

Norberg SF (2015) Bankruptcy and Higher Education Institutions, St. John’s University School of Law Symposium. American Bankruptcy Institute Law Review 23:385–399.

Student Loan Bankruptcy. (n.d.) In: Student Loan Borrowers Assistance. https://www.studentloanborrowerassistance.org/bankruptcy/ . Accessed 31 Mar 2019

Unglesbee B (2018) Higher ed consolidation could pick up in 2019, Fitch says. In: Education Dive. https://www.educationdive.com/news/higher-ed-consolidation-could-pick-up-in-2019-fitch-says/543798/ . Accessed 31 Mar 2019

U.S. Bankruptcy Code – 2019 Official Edition. (n.d.) In: United States Bankruptcy Code. https://www.usbankruptcycode.org /. Accessed 31 Mar 2019

United States Department of Education (2018) Closed School Discharge. In: Federal Student Aid. https://studentaid.ed.gov/sa/repay-loans/forgiveness-cancellation/closed-school . Accessed 31 Mar 2019

Wadhwani E (2018) Press Release. In: Fitch Ratings Revises U.S. Higher Education Sector Outlook to Negative for 2019. https://www.fitchratings.com/site/pr/10054235. Accessed 31 Mar 2019.

Wootton W (2016) The Real Reason Small Colleges Fail. In: chronicle.com. https://www.chronicle.com/article/The-Real-Reason-Small-Colleges/236732 . Accessed 31 Mar 2019.