The U.S. Department of Education has issued a proposed rule that includes a ban on mandatory pre-dispute arbitration agreements by schools receiving Title IV assistance under the Higher Education Act (HEA) and a new federal standard for borrower defenses to repayment of Direct Loans. A Direct Loan is a federal student loan made by the Department. Comments on the proposal must be received on or before August 1, 2016. In the proposal, the Department indicates that it expects a final rule to become effective on July 1, 2017.

Highlights of the proposed rule include the following:

• A new federal standard and limitations period would be created for a borrower defense asserted with respect to a Direct Loan disbursed after the effective date of a final rule. A borrower defense is based on 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, a borrower defense can 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. The Department believes the current standard presents a significant burden for borrowers and Department officials in determining the applicability of and interpreting state law, and creates the risk of different relief being awarded to students attending schools in different states but affected by similar problematic practices.
  
  Under the proposed federal standard, a borrower defense can be a “nondefault, favorable contested judgment 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] that the borrower reasonably relied on when the borrower decided to attend, or to continue attending, the school.”
  
  For purposes of the Department’s enforcement authority and a borrower defense claim involving a Direct Loan disbursed after July 1, 2017, the proposal amends the definition of “misrepresentation” to clarify that a misleading statement includes any statement that has the likelihood or tendency to deceive. A “substantial misrepresentation” is defined as “any misrepresentation on which the person to whom it was made could reasonably be expected to rely, or has reasonably relied, to that person’s detriment.”
  
  A borrower defense based on a judgment could 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 could be asserted at any time or, if asserted to recover amounts previously collected on a Direct Loan, not later than six years after the contract breach or after the borrower discovers, or reasonably could have discovered, the information constituting the substantial misrepresentation. The proposal would establish new processes for an individual borrower or a group of borrowers to file claims with the Department asserting borrower defenses involving Direct Loans made either before or after the effective date of a final rule.
• The Direct Loan Program Participation Agreement requirements with which a school must comply as a condition of receiving Title IV assistance would be amended to prohibit a participating school from requiring a student to agree to pre-dispute arbitration of a borrower defense claim as part of the enrollment agreement or any other document that must be executed by the student as a condition of enrollment (but would allow a borrower to choose to pursue a defense claim through arbitration). The Program Participation Agreement would also prohibit 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 or dismissed the claim and the time for any interlocutory review has elapsed or the review has been resolved. The prohibitions would apply retroactively to pre-dispute arbitration or other agreements entered into before the effective date of a final rule, and such agreements would have to be amended to include specified notices indicating the school’s agreement to abide by the proposal’s prohibitions. A participating school would also be prohibited 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 would be required to provide certain arbitral records to the Department.
  
  In the supplementary information accompanying the proposal, the Department claimed that its proposed limits on arbitration agreements were supported by the “findings and reasoning” of the Consumer Financial Protection Bureau (CFPB) in its arbitration study and recent proposed rule. The CFPB’s proposed rule 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 or service. The CFPB's proposed rule would also require a covered provider that is involved in an individual arbitration pursuant to a pre-dispute arbitration agreement to submit specified arbitral records to the CFPB.
  
  Also in the supplementary information, the Department rejected the argument that the Federal Arbitration Act (FAA) barred the Department from adopting a rule that would ban class action waivers or mandatory pre-dispute arbitration agreements. For the reasons detailed in the linked discussion, it is our view that the Department’s position is incorrect and the proposal’s arbitration provisions are preempted by the FAA.
• Actions and events 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 would be added, and if a school is required to provide financial protection to the Department, it would have to disclose the requirement on its website and to prospective and enrolled students. The proposal would also require proprietary schools with a student loan repayment rate less than or equal to zero percent to provide a specified warning to prospective and enrolled students and place the warning on its website and in all promotional materials and advertisements. The proposal also includes amendments to the discharge provisions for the Federal Perkins Loan, Direct Loan, Federal Family Education Loan, and Higher Education Grant programs.