The U.S. Department of Education has issued a final rule that broadly addresses the ability of a student to assert a school's misconduct as a defense to repayment of a federal student loan. The final rule includes a ban on all pre-dispute arbitration agreements for borrower defense claims by schools receiving Title IV assistance under the Higher Education Act (HEA) and a new federal standard for evaluating borrower defenses to repayment of Direct Loans. The final rule is effective on July 1, 2017.

A Direct Loan is a federal student loan made by the Department. Highlights of the final rule, which amend the regulations for the Direct Loan and other student loan programs, include the following:

• A new federal standard and limitations period is created for a "borrower defense" asserted with respect to a Direct Loan disbursed on or after July 1, 2017. A "borrower defense" is an act or omission by a school relating to the making of a Direct Loan for enrollment or the provision of educational services for which the Direct Loan was provided. It includes a defense to repayment of amounts owed on such loans and a right to recover amounts previously collected on such loans. Under current HEA regulations that continue to apply to loans disbursed before July 1, 2017, a borrower defense can only be asserted based on an act or omission of a school that would give rise to a cause of action against the school under applicable state law.

Under the new federal standard, a borrower defense can be a "nondefault, favorable contested judgment [against the school] based on State or Federal law in a court or administrative tribunal of competent jurisdiction;" a school's failure "to perform its obligations under the terms of a contract with the student;" or "a substantial misrepresentation [made by a school or any of its representatives if the borrower can demonstrate] in accordance with [HEA regulations that establish the types of activities that constitute substantial misrepresentation by a school] that the borrower reasonably relied on [the misrepresentation] to the borrower's detriment when the borrower decided to attend, or to continue attending, the school or decided to take a Direct Loan."

For purposes of the Department's enforcement authority and a borrower defense involving a Direct Loan disbursed on or after July 1, 2017, the final rule amends the definition of "misrepresentation" to provide that a misleading statement includes any statement that "has the likelihood or tendency to mislead under the circumstances" or "omits information in such a way as to make the statement false, erroneous, or misleading."

A borrower defense based on a judgment can be asserted at any time. A borrower defense asserted as a defense to payment that is based on breach of contract or a substantial misrepresentation can also be asserted at any time but to recover amounts previously collected on a Direct Loan, it must be asserted not later than six years after the school’s breach of contract or the borrower discovers, or reasonably could have discovered, the information constituting the substantial misrepresentation. The final rule establishes new processes for an individual borrower or a group of borrowers to file claims with the Department asserting borrower defenses involving Direct Loans disbursed before or after the final rule’s effective date.

• The Direct Loan Program Participation Agreement requirements with which a school must comply as a condition of receiving Title IV assistance are amended to prohibit a participating school from entering into a pre-dispute arbitration agreement on or after July 1, 2017, to arbitrate a borrower defense claim or from enforcing such an agreement that was entered into before July 1, 2017. Unlike the Department's proposal, the final rule prohibits both mandatory and voluntary pre-dispute arbitration agreements, whether or not they contain opt-out clauses. In the supplementary information accompanying the final rule, the Department stated that its decision to extend the ban to voluntary agreements was based on its conclusion that a borrower cannot make an informed decision whether to arbitrate a dispute before the dispute arises.

The Department also indicated in the supplementary information that it reached that conclusion in part by relying on the Consumer Financial Protection Bureau's (CFPB) finding in its arbitration study that consumers were generally unaware of provisions in credit card agreements allowing them to opt-out of arbitration agreements. The CFPB has issued a proposed rule that would prohibit covered providers of certain consumer financial products and services from using an agreement with a consumer that provides for arbitration of any future dispute between the parties to bar the consumer from filing or participating in a class action with respect to the covered consumer financial product.

A further amendment to the Program Participation Agreement requirements prohibits a school from relying on any pre-dispute arbitration or other agreement to block a borrower from asserting a borrower defense claim in a class action lawsuit until the court has denied class certification and the time for any interlocutory review has elapsed or the review has been resolved. The prohibition applies retroactively to pre-dispute arbitration or other agreements addressing class actions entered into before July 1, 2017, and unless such agreement contains a specified provision stating that the school will abide by the prohibition, it must be amended to include a specified provision with such a statement or the school must provide a specified notice to the student with such a statement. A school must similarly amend any pre-dispute arbitration agreements entered into before July 1, 2017, that do not contain a specified provision stating that the borrower can bring a lawsuit or be a class member to include a specified provision with such a statement or provide a specified notice to the student with such a statement.

The final rule permits schools to continue to use pre-dispute arbitration agreements for claims other than borrower defense claims (e.g. a claim based on a physical injury sustained on campus by a student) and to use post-dispute arbitration agreements to arbitrate borrower defense claims. A participating school is also prohibited by the final rule from compelling a student to pursue a complaint based on a borrower defense claim through an internal school process before the student presents the complaint to an accrediting agency or government agency authorized to hear the complaint. A school that uses arbitration agreements must provide certain arbitral records to the Department in connection with any claim filed in arbitration by or against the school concerning a borrower defense.

As it did in its proposal, the Department rejected the argument that the Federal Arbitration Act (FAA) barred the Department from adopting a rule that bans class action waivers or mandatory pre-dispute arbitration agreements. For the reasons detailed in the linked discussion (which we previously detailed in connection with the proposal), it is our view that the Department's position is incorrect and the final rule's arbitration provisions are preempted by the FAA.

• Actions and events are added that can trigger a requirement for a school to provide a letter of credit or other financial protection to the Department to insure against future borrower defense claims and other liabilities to the Department. A school that is required to provide financial protection to the Department must disclose the requirement on its website and to prospective and enrolled students. A proprietary school at which the median borrower has not either repaid in full or reduced the borrower's outstanding loan balance by at least one dollar must provide a specified warning in advertising and promotional material. The final rule also amends the closed school and other discharge provisions in the Federal Perkins Loan, Direct Loan, Federal Family Education Loan, and Teacher Education Assistance for College and Higher Education Grant programs.