The U.S. Court of Appeals for the Second Circuit in Manhattan, N.Y. ruled that a collection agency working to collect loans backed by the Education Department misled debtors by telling them their loans were not dischargeable in bankruptcy.

The decision reverses a lower-court ruling and allowed a lawsuit brought against the agency, Collecto, to proceed in Federal District Court.

Collecto officials gave incorrect legal advice in an effort to coerce money out of the borrowers, said Brian L. Bromberg, appellate lawyer for the plaintiff, a Buffalo, N.Y. woman. Bromberg said that while debt collectors often tell borrowers they cannot discharge students loans in bankruptcy, Collecto put that in writing.

Collecto officials and Education Department officials declined to comment late last week.

For borrowers try to pay off student loans, getting rid of the debt in bankruptcy is difficult because they must convince a judge that it constitutes an "undue hardship," essentially showing that they cannot maintain a minimal living standard, that their state of affairs is likely to continue and that they have made a good-faith effort to repay.

The appellate case dates back to 2001, when the Buffalo woman, Berlincia Easterling, filed a bankruptcy petition. At that time, she owed the Education Department $2,460 for a student loan.  
In her petition, Easterling did not try to pursue an undue hardship claim and listed her student loan debt as “not dischargeable.”

Seven years later, she received a letter from Collecto stating her student loan balance had grown to $3,359.76 with accrued interest. “Account ineligible for bankruptcy discharge,” the letter said. “Your account is NOT eligible for bankruptcy discharge and must be resolved.”

According to the appellate opinion, when Collecto learned that a debtor had filed for bankruptcy, it stopped collection activity until it could determine if the student debt was discharged. In the unlikely event that it was, Collecto would send the debt back to the Education Department as uncollectable.

If the debt was not discharged, Collecto would resume trying to collect it by sending a letter like the one Easterling received. Easterling brought the lawsuit on behalf of herself and 181 other debtors in New York State who received the same collection letter.

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