On June 13, the Department of Education (DOE) proposed new rules relating to effective discharges of student loans. The proposed rules should be of note and concern to all schools, nonprofit and for-profit alike, because of significant new provisions and the broadening of defense to repayment rules.

Since 1995, DOE regulations have permitted borrowers to seek a defense to repayment, which currently requires a showing that the student has a state law cause of action against the school. In accompanying commentary to the proposed rules, DOE observes that the existing provisions have been relatively rarely used, and it acknowledges both that the standard is difficult to apply consistently and that there is no existing process for obtaining a defense to repayment. DOE justified the need for the new rules in the fallout from the bankruptcy of Corinthian Colleges, which resulted in thousands of former students seeking student loan relief. In that process, DOE concluded that new borrower defense rules were necessary.

The DOE rulemaking process began last year, with the publication of a notice that it intended to establish a negotiated rulemaking committee. After public hearings and an opportunity for the public to nominate committee members, a committee of approximately 30 members and alternates was established. The members of the committee represented a number of interests including states regulators, lenders, students, consumer advocates, two-year colleges, public schools, four-year public and private schools, and for-profit schools. The committee met in February and March of this year, but did not reach a unanimous consensus on any language for proposed rules. DOE’s press release states that it took into account the recommendations of the committee.

Although the rule changes were motivated by the Corinthian bankruptcy, the majority of the proposals apply equally to for-profit and not-for-profit schools. Among the provisions that apply to all schools are the following:

• A requirement that private schools identified as financial risks, including those with high levels of borrower defense claims or an ongoing suit by state or federal regulators, must in some circumstances provide DOE a letter of credit equal to, in the case of ongoing suits, at least 10 percent of all federal loan funds received by the school in the most recent year. If the requirement for a letter of credit is triggered, it is mandatory. If the letter of credit is not provided within 30 days of a request by DOE, DOE may offset loan funds due to the school and hold them in an escrow account for the same purpose. Schools that are required by DOE to provide this financial protection must notify both enrolled and prospective students.
• A provision prohibiting the use of all arbitration clauses and class action waivers between students and schools going forward, and rendering unenforceable any existing ones.
• A provision forbidding schools from requiring students to first use an internal complaint process before making complaints to accreditors and government agencies.
• Language clarifying that DOE can recover its losses from discharged loans from schools, including loans discharged because of borrower defenses.

One of the most significant aspects of the proposed rules is the new set of standards established for borrower defense, which would become effective for all loans first disbursed after July 1, 2017. Under the new rules, a borrower would have a defense to repayment and a claim for previously repaid amounts when (a) the school breached the terms of a contract with the student; (b) the student, a class of which the student was a member, or a government entity on behalf of the student won a favorable contested judgment against the school in court or before an administrative tribunal; or (c) the school or its agents made a substantial misrepresentation that the borrower reasonably relied on in deciding to attend the school.

Under the proposed rules, a student may submit an application to DOE seeking a defense to repayment on any of these bases. The student’s loans are automatically placed into forbearance while DOE considers the application. A DOE official decides whether the student is entitled to a defense to repayment, under a preponderance-of-evidence standard. The school must be notified and may submit a response. The rules do not provide for an appeal process for either students or schools. There are also procedures for DOE to initiate a consideration of potential defenses to repayment for an entire class of students.

The criteria allowing for a defense to repayment may potentially be implicated in many situations, for both for-profit and not-for-profit schools. In particular, the “substantial misrepresentation” prong could potentially be used against schools that are accused of misrepresenting the opportunities available to students, graduation rates, job placement rates, or graduate salary data. DOE has provided some factors that may be evidence of the reasonableness of the borrower’s reliance, but little guidance on what is a substantial misrepresentation. The proposed rules do alter the existing definition of misrepresentation to clarify that it encompasses any communication that has the likelihood or tendency to mislead under the circumstances.

Given recent news regarding allegations that nonprofit schools, including law schools, have misrepresented information that caused students to attend, many schools have reason to examine the proposed rules closely. Any allegation or suit against a school, particularly a putative class suit, poses additional risks that students may seek to use the suit as a defense to repayment.

In addition, the potential implications of settled cases are unclear. Even under the current standard, the Massachusetts Attorney General has said it will use admissions in a recent consent judgment to urge DOE to cancel loans that were taken out to attend certain programs at American Career Institute. Under the new regulations, a settlement does not qualify as a favorable judgment automatically entitling the student to a defense to repayment, but it is not clear whether a consent judgment would qualify as a favorable judgment. Further, the DOE discussion of the proposed rules expressly states that a settlement can be used as evidence establishing one of the other defenses to repayment criteria, such as a substantial misrepresentation. It is also not clear whether language in the settlement disclaiming liability or denying the allegations would have its intended effect or whether the DOE official could look beyond such language and find a substantial misrepresentation on the basis of a settlement. At a minimum, schools should be aware that if the proposed rule goes into effect as written, the language of any related settlements are likely to be scrutinized for potential support for a defense to repayment claim.

The proposed new rules are open to public comment until August 1, and DOE intends to publish the final rule by November 1.