Department of Education to Revisit Borrower Defense Regulations

The Department of Education recently proposed new rules for relieving student borrowers of their federal debt if their schools have closed or misled them.

These proposed rules are set to replace the 2016 package of proposed higher education regulations, which have not yet gone into effect. The borrower defense rules were originally created in response to the sudden closure of Corinthian Colleges, a for-profit institution, which left thousands of students with federal student loan debt for degrees they could no longer complete.

ED’s new proposed rules differ significantly from the 2016 proposal in certain key areas. They would establish a uniform federal standard for a borrower’s defense to repayment, replacing the state law-based standard currently in effect. While this approach would streamline claims, it is expected to provide weaker protections to students in most states.

Other changes include:

• Affirmative Defenses and Claim Timelines
• Eligibility of Borrower Defense Claims
• Group Claims and Arbitration Agreements
• Triggering Events
• Financial Responsibility Calculations

Affirmative Defenses and Claim Timelines

Notably, ED’s primary proposal would also limit who can file a defense against repayment claim exclusively to students who have already defaulted on their loans, potentially incentivizing some borrowers to strategically default despite the severe financial consequences. While ED maintains that this position is consistent with its longstanding practice, Harvard’s Project on Predatory Student Lending has collected documentation showing that even during the Clinton and George W. Bush administrations, the department approved loan discharges for “affirmative” claims made by borrowers who had not yet entered collections proceedings. Additionally, multiple student veterans’ groups have raised serious concerns with this proposal, as any type of loan defaults can interfere with servicemembers’ abilities to obtain or maintain security clearances.

Recognizing the potential negative consequences of accepting defensive claims exclusively, ED has also floated a secondary proposal that would extend relief to students with affirmative claims but with higher evidentiary standards for all borrowers. Under current rules, borrowers must provide a preponderance of the evidence to successfully have their federal loans discharged. The department’s primary proposal, which accepts only defensive claims, would maintain this standard. However, the secondary proposal which allows both defensive and affirmative claims, would require all borrowers to provide clear and convincing evidence, a significantly higher bar to clear.

Under the primary proposal, defaulted borrowers will be given a 30- to 65-day window to apply for a claim following the start of collection proceedings. However, if ED also accepts affirmative claims, borrowers who have not yet defaulted on their loans will have three years from when they left school to file a claim, regardless of when they became aware of any misrepresentation. In either of these instances, the proposed rules do not permit borrowers to appeal a denied claim, even in light of new evidence.

In the case of school closures, the new proposal extends the window to file a closed school discharge from 120 days to 180 days, naturally increasing the number of borrowers who qualify for this kind of relief. However, the new rules disqualify students for a closed school discharge if they decline an orderly teach-out plan when offered one. This is a marked shift from the 2016 proposed regulations, which gave students the option to accept a teach-out plan or have their loans discharged, with the understanding that students who did not re-enroll in another institution or transfer credits within three years would automatically have their federal loans forgiven.

Eligibility of Borrower Defense Claims

The newly proposed regulations also establish a higher standard for school actions that make students eligible for borrower defense. According to the new rules, borrowers would have to show that an institution intentionally misled a student or acted with reckless disregard for the truth. Claimants would also have to demonstrate that this misrepresentation caused them financial harm, without consideration of the borrower’s opportunity cost or the quality of the education received. Furthermore, final state law judgement and breach of contract will no longer be considered grounds for relief, although they can be submitted as supporting evidence when filing a claim.

Group Claims and Arbitration Agreements

Unlike the 2016 proposed rules, the new proposal will only consider individual claims, even when there is evidence that entire groups of borrowers were misled, because individual students experience different degrees of financial harm.

The new provisions also walk back regulations in the 2016 proposed rules that prohibit colleges from requiring mandatory pre-dispute arbitration agreements and class-action waivers as a condition of enrollment. Instead, the newly proposed rules merely require schools to explain these legal agreements in plain language. Under the new rules, schools will also be permitted to deny transcripts to students with successful defense claims.

Triggering Events

Regarding triggering events, those events that may call into question an institution’s financial responsibility, the latest proposed rules differ from their 2016 counterparts in a number of ways. Most notably, there are fewer triggers overall and the ones that remain are rooted in what ED calls “events whose consequences are known and quantified.”

Mandatory Triggering Events

While there are three potential mandatory triggering events under the new proposal, only one is applicable to nonprofit institutions. This event would be triggered if, at the end of a fiscal year, an institution has incurred a liability arising from borrower defense claims owed that would cause the institution’s composite score to fall below 1.0. (liabilities arising from borrower defense claims adjust the numerator and denominator of all composite score ratios by the amount of the liability) Unlike a similar trigger proposed in the 2016 rules, this is not related to pending or potential borrower defense claims against an institution and only the actual final liability owed, treated as an expense in the composite score recalculation, is used to determine if the triggering event occurred.

Discretionary Triggering Events

Similar to the mandatory events, some of the newly proposed discretionary triggering events are applicable only to proprietary institutions. Unlike the mandatory events that would render a clear determination that an institution is no longer financially responsible, the discretionary triggers would prompt ED to work with an institution to look more holistically at the nature and outcome of the triggering events to determine whether the violation has or could have material financial consequences before determining whether the institution is financially responsible.

Discretionary triggering events include:

• Actions taken against an institution by an accrediting agency, including unsatisfied show-cause orders that could lead to the withdrawal, revocation, or suspension of institutional accreditation.
• Various types of violation of loan agreements with creditors.
• Citations by state licensing or authorizing agencies for violations of state or agency agreements that may prompt the withdrawal or termination of licensure or authorization.
• When an institution’s two most recent cohort default rates are 30 percent or greater.

Another proposal would require a school to notify ED no later than 10 days after any of these mandatory or discretionary triggering events occur. For discretionary triggers, an institution may also explain either in this notice or in follow-up communications with ED why the event is either already resolved or will fail to have a “material adverse effect on the institution.”

Financial Responsibility—Ratios: Proposed Terminology and Definitional Changes

Section 498(c)(1) of the HEA authorizes the Secretary to establish ratios and other criteria for determining whether an institution has sufficient financial responsibility. Financial responsibility relates to an institution’s capacity to provide mission related services, comply with Title IV requirements, and meet its financial obligations. Section 668.172 of the current regulation defines three key financial ratios that are calculated, weighted and combined into a composite score that is used to assess financial responsibility within a numeric scale ranging from negative one (-1) to positive 3 (+3). The three ratios are Primary Reserve, Equity, and Net Income. Appendices A and B of the current regulation illustrate how the composite score is calculated using sample financial statements from proprietary and private non-profit institutions.

The proposal provides a methodology for calculating the three key composite score ratios that aligns with accounting standards issued by the Financial Accounting Standards Board (FASB) since the current regulation went into effect and specifically addresses sweeping accounting changes reflected in FASB Accounting Standards Update (ASU) 2016–02, (Leases) and ASU 2016-14 (Financial Statements of Not-for-Profit Entities). The specific overarching changes in the proposal are:

• Updates to appendices A (for-profit institutions) and B (nonprofit institutions) of the financial responsibility standards found in 34 CFR 668 Subpart L that contain ratio terminology revisions and definitions. New terminology and definitions are most prevalent for non-profit institutions and are needed to conform to FASB’s non-profit financial statement changes in ASU 2016-14.
• A new supplemental schedule that institutions must provide with their annual financial statement submission as part of ED’s EZ Audit requirement. The supplemental schedule must contain all financial elements needed to calculate the composite score ratios, reference where the information can be found in the financial statements, and be reviewed by the institution’s independent auditors.
• A transition period for institutions whose composite scores are negatively impacted by the adoption of FASB's lease standard (ASU 2016-02). Negatively impacted institutions will include the result of capitalizing their former operating leases on the new supplemental schedule so that ratios can be calculated without the impact of FASB ASU 2016-02. (Capitalized “right-of-use” assets are considered part of an institution’s property, plant and equipment (PP&E); the equity ratio can be negatively affected by material additions to the balance sheet that represent leased “right-of-use assets.”). Lease transition calculations will be allowed for a period of six years.
• A new definition of “debt obtained for long-term purposes.”  (emphasis added)
• The new definition changes the meaning of the term ‘‘debt obtained for long-term purposes’’, to include lease liabilities for lease right of- use assets and the short-term portion of the debt, up to the amount of net PP&E. However, all debt obtained for long term purposes used in the calculation of expendable net assets (in the primary reserve ratio) would have to be used to fund capitalized assets (PP&E or other per Generally Accepted Accounting Principles). Further, a required debt disclosure, (on the supplemental schedule or in the financial statements and referenced in the supplemental schedule) must include the issue date, term, nature of capitalized amounts and amounts capitalized.
• This final overarching requirement to relate all debt obtained for long-term purposes to capitalized assets was not recommended by the financial responsibility subcommittee during negotiations. Therefore, there was no discussion or opportunity for consensus.

ED acknowledges that the ratios are not routinely adjusted for accounting changes and that the methodology was developed over 20 years ago. Consequently, within the context of the recommended lease transition guidance, the proposal discusses the need for a future negotiation related to financial responsibility.

All newly proposed non-profit ratio terminology and definition changes are outlined in an accompanying illustration to this article.

All told, given the proposed changes to closed school discharge and borrower’s defense to repayment regulations, the department estimates that costs associated with borrower defense activity will decrease by $12.7 billion between 2019 and 2028, when compared to the 2016 proposal.