The “borrower defense” final rule (Final Rule) issued by the Dept. of Education in November 2016 took effect at noon yesterday after Judge Randolph D. Moss of the D.C. federal district court refused to grant the renewed motion for a preliminary injunction filed by the California Association of Private Postsecondary Schools (CAPPS) seeking to preliminary enjoin the arbitration ban and class action waiver provisions in the Final Rule.  CAPPS had sought to block the provisions from taking effect pending the resolution of the lawsuit filed by CAPPS against the ED and Education Secretary Betsy DeVos to overturn the Final Rule.  Judge Moss found that CAPPS had filed to show that any of its members was likely to suffer an irreparable injury in the absence of an injunction.

Shortly before the Final Rule’s initial July 1, 2017 effective date, CAPPS filed a motion for a preliminary injunction to which the ED responded by issuing a stay of the Final Rule under Section 705 of the Administrative Procedure Act (APA).  The Section 705 stay was followed by the ED’s issuance of an interim final rule delaying the effective date until July 1, 2018 and the promulgation of a final rule further delaying the effective date until July 1, 2019 (Final Rule Delay).

On September 12, 2018, Judge Moss issued an opinion and order in Bauer v. DeVos, another case challenging the Final Rule in which he ruled that the ED’s rationale for issuing the Section 705 stay was arbitrary and capricious and that in issuing the Final Rule Delay, the ED had improperly invoked the good cause exception to the Higher Education Act’s negotiated rulemaking requirement.  The case consolidated two separate lawsuits filed after the ED’s issuance of the Section 705 stay, with one filed by two individual plaintiffs and the other by a coalition of nineteen states and the District of Columbia.  Both lawsuits were subsequently amended to challenge not only the Section 705 stay but also the other actions taken by the ED to delay the Final Rule’s effective date.  While Judge Moss vacated the Section 705 stay, he stayed the vacatur until 5 p.m. on October 12, 2018.

After the ED filed a notice with the court in June 2017 regarding its initial delay of the Final Rule’s effective date until July 1, 2018, CAPPS withdrew its motion for preliminary injunction.  Following the court’s decision in Bauer, CAPPS filed its renewed motion for a preliminary injunction.  In his decision denying CAPPS’ motion, Judge Moss stated that on October 12, the court extended the stay of the vacatur until noon on October 16.

The Final Rule broadly addresses the ability of a student to assert a school’s misconduct as a defense to repayment of a federal student loan.  It does not apply to private loans.  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 (i.e. federal student loans made by the ED).  Both mandatory and voluntary pre-dispute arbitration agreements are prohibited by the rule, whether or not they contain opt-out clauses, and schools are prohibited 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.

It would seem that because the Final Rule is now effective, the new federal standard it establishes for evaluating defenses to repayment would be applicable in actions seeking to collect on Direct Loans disbursed on or after July 1, 2017 or to recover amounts previously collected on such loans.  However, because the arbitration ban and class action provisions of the Final Rule are requirements with which a school must comply as a condition of receiving Title IV assistance, the ED presumably could waive such requirements (as well as other provisions subject to ED enforcement such as the actions and events in the Final Rule that can trigger a requirement for a school to provide a letter of credit or other financial protection to the ED to insure against future borrower defense claims and other liabilities to the ED.)

In addition to the CFPB’s Spring 2018 rulemaking agenda that we have already blogged about, the Spring 2018 rulemaking agendas of several other federal agencies contain some items of interest to consumer financial services providers.

Items of particular interest are:

  • OCC.  The OCC plans to issue an Advance Notice of Proposed Rulemaking “for modernizing the current regulations to carry out the purposes of the Community Reinvestment Act.”  The agenda gives a May 2018 estimated date for the ANPRM.  Last month, the Treasury Department issued a memorandum in which it made recommendations for modernizing the CRA.  The memorandum was directed to the primary CRA regulators, consisting of the OCC, the Federal Reserve, and the FDIC.  Of the three agencies, only the OCC’s Spring 2018 rulemaking agenda included a CRA item.
  • NCUA.  The NCUA is drafting an amendment to its general lending rule to give federal credit unions an additional option for offering Payday Alternative Loans (PALs).  The proposal would be an alternative to the current PALs rule.  It would modify the minimum and maximum loan amounts, eliminate the minimum membership requirement, and increase the maximum loan maturity while incorporating the other features of the current PALs rule.  The NCUA expects to issue a Notice of Proposed Rulemaking in May 2018.
  • Dept. of Education.  In June 2017, the ED announced that it was postponing “until further notice” the July 1, 2017 effective date of various provisions of the “borrower defense” final rule issued by the ED in November 2016, including the rule’s ban on arbitration agreements.  It also made a concurrent announcement that it planned to enter into a negotiated rulemaking to revise the “borrower defense” rule.  In October 2017, the ED published an interim final rule postponing the effective date of such provisions of the “borrower defense” final rule until July 1, 2018, and in February 2018, the ED published a final rule to further postpone the effective date until July 1, 2019.  In its Spring 2018 rulemaking agenda, the ED indicates that it expects to issue a NPRM in May 2018 regarding the “borrower defense” rule.

In response to the wave of new state student loan servicing laws and enforcement activity, the U.S. Department of Education has published an interpretation emphasizing that the Higher Education Act (HEA) preempts state regulation of federal student loan servicers.

Citing Supreme Court and appellate court precedent, ED stresses that the servicing of loans made by the federal government under the Direct Loan Program is an area involving “uniquely federal interests” and that state regulation of servicers of Direct Loans impermissibly conflicts with federal law and is entirely preempted. Further, state regulation of servicers of Federal Family Education Loan (FFEL) Program loans is preempted to the extent that it conflicts with, impedes, or otherwise undermines uniform administration of the program.

The interpretation also reaffirms the preemption of state laws that prohibit (1) misrepresentation or the omission of material information, because the HEA expressly preempts state disclosure requirements; and (2) unfair or deceptive acts or practices, to the extent such laws “proscribe conduct Federal law requires” or “require conduct Federal law prohibits.”

Direct Loan Program Servicers

In the interpretation, ED identifies the following conflicts between state laws that regulate Direct Loan servicers and federal law:

  • The licensing requirements interfere with ED’s power to select contractors for Direct Loan servicing. For example, states require servicers to satisfy certain financial requirements, secure a surety bond, and undergo background checks as a condition of licensure. Such requirements add to, and thereby conflict with, the “responsibility determinations” ED makes in accordance with federal contracting law.
  • State-imposed servicing standards pertaining to loan transfers, payment application, and borrower disputes, for example, would conflict with federal law and regulations and ED’s servicing contracts and “skew the balance the Department has sought in calibrating its enforcement decisions to the objectives of the [Direct Loan] program.”
  • State licensing fees, assessments, minimum net worth requirements, surety bonds, data disclosure requirements, and annual reporting requirements will increase the costs of student loan servicing, “distorting the balance the Department has sought to achieve between costs to servicers and taxpayers and the benefits of services delivered to borrowers.”
  • State laws that restrict the actions a servicer may take to collect on a loan impede ED’s ability to protect federal taxpayers by obtaining repayment of federal loans.
  • State-level regulation cuts against the HEA’s goal of creating a uniform set of rules to govern the federal student loan program and “subjects borrowers to different loan servicing deadlines and processes depending on where the borrower happens to live, and at what point in time.”

As ED correctly notes, U.S. Supreme Court precedent involving federal contractors compels the conclusion that the potential civil liability of student loan servicing contractors for non-compliance with state law is an area of unique federal concern because it would raise the price of servicing contracts and because “servicers stand in the shoes of the Federal government in performing required actions under the Direct Loan Program.” Moreover, federal student loan servicing “requires uniformity because State intervention harms the Federal fisc.”

FFEL Program Servicers

As for the servicing of loans made by private lenders and guaranteed by the federal government through the Federal Family Education Loan (FFEL) Program (which Congress discontinued and replaced with the Direct Loan Program in 2010), ED says that state regulation is preempted “to the extent that it undermines uniform administration of the program.” ED provides several examples of the kinds of state laws that invariably conflict with federal FFEL Program regulations, including deadlines for borrower communications and requirements around the resolution of disputes raised by borrowers. ED also notes that state servicing laws appear to conflict with express preemption provisions applicable to guaranty agencies (34 C.F.R. 682.410(b)(8)) and lender due diligence in collecting guaranty agency loans (34 C.F.R. 682.411(o)(1)).

State Disclosure Requirements

ED also stresses that Section 1098g of the HEA expressly preempts state disclosure requirements for federal student loans. ED interprets this to “encompass informal or non-written communications to borrowers as well as reporting to third parties such as credit reporting bureaus.” ED points out that state servicing laws that attempt to impose new prohibitions on misrepresentation or the omission of material information would likewise be preempted by Section 1098g.

Consistency with Earlier Pronouncements

As ED emphasizes, it is not breaking new ground here. Its interpretation is consistent with earlier U.S. responses to state laws that conflict with ED’s administration of federal student loan programs. For example, in 2009, it intervened in litigation in the Ninth Circuit to demonstrate to the Court that the state consumer protection laws on which the plaintiff relied were preempted by the HEA.

Most recently, the U.S. Department of Justice filed a Statement of Interest in litigation brought by the Commonwealth of Massachusetts against the Pennsylvania Higher Education Assistance Agency (PHEAA) alleging violations of Massachusetts law for allegedly unfair or deceptive acts related to the servicing of Federal student loans and administration of programs under the HEA. That Statement of Interest made clear that Massachusetts “is improperly seeking to impose requirements … that conflict with the HEA, Federal regulations, and Federal contracts that govern the Federal loan programs.” (Ballard Spahr LLP represents PHEAA in that matter.)

In its interpretation, ED reaffirms that such claims are preempted because they seek to “proscribe conduct Federal law requires and to require conduct Federal law prohibits.” ED continues, “We believe that attempts by other States to impose similar requirements will create additional conflicts with Federal law.”

Borrower Protections

ED concludes by describing its efforts to “ensure that borrowers receive exemplary customer service and are protected from substandard practices,” including:

  • Monitoring compliance with regulatory and contractual obligations, including call monitoring, account-level review and remote and on-site auditing;
  • Allocating more loans to servicers with better customer service performance metrics and paying servicers higher rates for loans that are in a non-delinquent status such as income-driven repayment; and
  • Maintaining processes for borrowers to report issues or file complaints about servicers.

We encourage servicers of federal and private student loans to consult with counsel regarding the interpretation as well as other defenses to the application of state student loan servicing laws and state enforcement actions.