U.S. must face lawsuit over beauty school student loans

* Wilfred Academy students sued over improper loans

* U.S. is said to collect on loans that should be discharged

* Lawsuit is revived against U.S. Department of Education

NEW YORK, May 12 (Reuters) - A U.S. appeals court in New York revived a lawsuit seeking to stop the government from collecting on loans made to students of a nationwide beauty school chain, since it knew the now-defunct company routinely falsified student eligibility for those loans.

Thursday’s 3-0 decision by the 2nd U.S. Circuit Court of Appeals in New York may make it easier for struggling borrowers to press the U.S. Department of Education to discharge federally guaranteed student loans that should never have been made.

It is a victory for thousands of former students who said Wilfred American Educational Corp victimized them into obtaining loans to attend its roughly 60 for-profit trade schools, popularly known as the Wilfred Academy. The last closed in 1994.

Neither the Education Department nor lawyers for the plaintiffs immediately responded to requests for comment.

The plaintiffs said Wilfred targeted immigrants and lower-income people for enrollment and improperly certified loan eligibility for borrowers who lacked high school diplomas and had not taken tests to show they could “benefit” from enrolling.

They said this enabled Wilfred to receive $405 million in federal student aid during the 1980s, and resulted in more than 61,300 loans going to Wilfred students from 1986 to 1994.

By 1996, long after Wilfred was convicted of financial aid fraud, the Education Department concluded that the misconduct widespread, and that many student loans should be discharged.

But the plaintiffs said the agency continued to collect on the loans, in part by seizing former students’ income tax refunds, garnishing their wages, and destroying their credit.

In January 2015, U.S. District Judge Robert Sweet dismissed the lawsuit. He said that despite “the reality and credibility of plaintiffs’ grievances” the Education Department acted within its discretion.

But in Thursday’s decision, Circuit Judge Gerard Lynch said that discretion is not “unbridled,” and that the law requires the agency to temporarily suspend collections and tell borrowers they may be eligible for discharges when problems surface.

He also said that while the named plaintiffs’ loans had been discharged, the case was not moot because a “large number” of other borrowers with outstanding loans might still be victims.

The appeals court returned the case to Sweet, including to decide whether the case should proceed as a class action.

The case is Salazar et al v. King, 2nd U.S. Circuit Court of Appeals, No. 15-832. (Reporting by Jonathan Stempel in New York; Editing by Alan Crosby)