Schools' Use of Mandatory Arbitration Now Sharply Curtailed; Loan Discharge Rights Expanded

A federal court has ordered an immediate effective date of an important 2016 Department of Education rule that the current Administration had delayed. Most notably for attorneys, the rule allows students to bring class or individual actions against schools as long as the student has taken out a federal Direct Loan to attend the school and the legal claims concern the school’s acts or omissions regarding the educational services for which the Direct Loan was obtained or the school’s actions in making the loan itself. Pre-dispute arbitration and class waiver provisions are prohibited as to these types of claims. The rule applies even to pre-dispute agreements entered into before the rule’s effective date.

This article explains the reach of these requirements and also other key rule provisions that not only provide students with increased clarity about an administrative avenue for raising school-related claims as a defense to federal student loan repayment, but also provide for an automatic discharge of federal student loans in certain situations where their school has closed, while also expanding discharge rights when a school falsely certifies the student as eligible for a course of study. All these protections are now effective as of October 16, 2018. As described below, the Department is unlikely to undo these provisions before July 1, 2020.

Court Overturns Current Department of Education’s Attempts to Delay the Rule

While the prior Administration had promulgated the rules on November 1, 2016, effective July 1, 2017 (see 81 Fed. Reg. 75,926), a trade school association challenged the rule on May 24, 2017, and the current Department of Education used this as grounds to delay the rule’s effective date. See 82 Fed. Reg. 27,621 (June 16, 2017). On February 14, 2018, the Department issued a rule delaying the effective date until July 1, 2019. See 83 Fed. Reg. 6458 (Feb.14, 2018). The Department of Education’s delay actions were challenged in court by student loan borrowers and state attorneys general.

A federal court on September 12, 2018, held in Bauer v. Devos, 2018 WL 4353656 (D.D.C. Sept. 12, 2018), that these Department of Education actions delaying the rule were unlawful. The initial delay in response to the trade school association lawsuit was found to be arbitrary and capricious, and the subsequent rule further delaying the 2016 rule until July 1, 2019 was found to violate the Higher Education Act’s requirement for negotiated rulemaking. The court therefore vacated the delays of the effective date of the 2016 rule. Bauer v. Devos, 2018 WL 4483783 (D.D.C. Sept 17, 2018). The effective date of this court order was delayed, but the order became effective on October 16—the same day that the same court denied the trade school association’s request for a preliminary injunction in California Association of Private Postsecondary Schools v. Devos, 2018 WL 5017749 (D.D.C. Oct. 16, 2018). As a result, the 2016 rule is in effect as of October 16, 2018.

The Department on July 31, 2018 separately proposed a new rule (see 83 Fed. Reg. 37,242 (July 31, 2018)) that would replace the 2016 rule with a far weaker one, including rescinding entirely the prohibition on forced arbitration and class waivers. Nevertheless, the Department has stated that it will not promulgate a new final rule until after November 1, 2018. See California Association of Private Postsecondary Schools v. Devos, 2018 WL 5017749, at note 1 (D.D.C. Oct. 16, 2018). Because no final rule will be in place by November 1, 2018, the Higher Education Act's "Master Calendar Rule" specifies that the soonest that a replacement rule could go into effect is July 1, 2020. See 20 U.S.C. § 1089(c).

Significantly, even if the arbitration rule is rescinded in July 2020, schools may continue to face difficulty requiring arbitration or waiver of class actions afterwards. For students whose enrollment agreements or amended agreements with schools include language—now required under the 2016 rule—that exempts from arbitration and class waivers any claims regarding the school’s acts or omissions in the making of the Direct Loan or its provision of educational services for which the Direct Loan was obtained, the school cannot require arbitration or a class waiver for such claims unless it obtains the student’s agreement to do so. Obtaining such agreement from students no longer associated with the school on July 1, 2020 would be exceedingly difficult.

Sharp Limits on School Arbitration and Class-Waiver Requirements

The Department’s 2016 rule that now is in effect as of October 16, 2018 prohibits schools participating in the federal student loan program from entering into certain pre-dispute arbitration agreements with students or agreements that purport to waive students’ rights to bring class actions. These limitations apply to agreements with students who have obtained federal Direct Loans or benefited from Direct Parent PLUS Loans and apply to claims regarding the making of the federal Direct Loan or the provision of educational services for which the loan was obtained. In other words, schools cannot enter pre-dispute agreements with students that waive students’ right to go to court or to pursue a class action over any claims that could also give rise to an administrative “borrower defense” claim—as discussed in more detail below. See 34 C.F.R. § 685.300(b), (d), (e), (f), as added by 81 Fed. Reg. 75,926, 76,087–76,088 (Nov. 1, 2016).

Claims that could give rise to a borrower defense include a school’s substantial misrepresentation, breach of contract, or a non-default judgment against the school, or violation of a student’s rights under state law—all as relate to the making of a Direct Loan or provision of educational services for which the loan was obtained. See 34 C.F.R. § 685.206(c) and 34 C.F.R. § 685.222 as added by 81 Fed. Reg. 75,926, 76,083 (Nov. 1, 2016).

Nor can the school rely on an existing arbitration agreement to force an individual or class action out of court, even if the agreement was entered into prior to the rule’s effective date. The school must either amend the agreement or notify the students that they will not enforce the agreement. See 34 C.F.R. § 685.300(e)(3), (f)(3), as added by 81 Fed. Reg. 75,926, 76,088 (Nov. 1, 2016). Again, this limitation applies to agreements with students who have obtained or benefited from Direct Loans and whose claims relate to the making of the loan or the provision of educational services for which the loan was obtained.

Arbitration Limits Should Withstand Legal Challenge

Although industry’s request for a preliminary injunction was denied in California Association of Private Postsecondary Schools v. Devos, the court has not ruled on the merits as to the rule’s limitation on arbitration and class waivers. In promulgating the 2016 rule, the Department acknowledged that the Federal Arbitration Act might protect schools’ rights to insist on arbitration as a condition of becoming a student. However, the Department’s rule does not prohibit schools from doing so, but only provides that schools that wish to participate in the federal Direct Loan program must agree as a condition of such participation not to enter into or seek to rely on pre-dispute arbitration agreements as they relate to claims that could give rise to a borrower defense to repayment with students offered federal Direct Loans through that school.

This restriction not only benefits consumers, but also the Department of Education, protecting it from the risk that schools’ illegal conduct will jeopardize students’ ability to repay loans or will render the loans subject to government discharges that might not be necessary if students could bring their claims directly against their schools in court and through class actions. As the Department explained in promulgating the 2016 rule, these targeted limits on forced arbitration and class bans protect the Direct Loan program by preventing schools from insulating themselves from liability for misconduct, from avoiding publicity of wrongdoing that could trigger timely oversight and enforcement action, and ultimately from shifting the risk of loss for misconduct from schools to taxpayers. 81 Fed. Reg. 75,926, 76,022 (Nov. 1, 2016). In this way, the rule is tied to the Department’s statutory authority to require Direct Loan participants to comply with conditions “as the Secretary determines are necessary to protect the interests of the United States and to promote the purposes of” the Direct Loan program.” 20 U.S.C. § 1087d(a)(6).

Rule Clarifies Administrative Process to Raise School-Related Borrower Defenses to Loan Repayment

The law has long allowed students to raise-school related defenses to repayment of their federal student loans, often called “borrower defense” claims. But for over twenty years there has been little clarity as to the process to raise those defenses with the Department or the way such defenses would be evaluated. The existing 1994 rules concerning these borrower defenses are analyzed in NCLC’s Student Loan Law § 13.8.2.2. The newly effective 2016 rules are analyzed at id. § 13.8.2.3.

The 2016 rules are intended to clarify and codify borrower defense procedures, including important borrower protections. The rules set forth a process by which individual borrowers may submit applications to have their Direct Loans fully or partially discharged based on school misconduct, and clarify that a Department official will evaluate the claim using a preponderance of the evidence standard and decide on relief. See 34 C.F.R. § 685.222, as added by 81 Fed. Reg. 75,926, 76,083–76,086 (Nov. 1, 2016). The current application form is available on the Department of Education’s website (with separate applications for former students of Everest, Heald, and Wyotech); advocates should check for any updates to the form in the coming months. Attorneys may also wish to supplement applications with letter briefs or supporting evidence.

Following submission of the application, the borrower will have a number of important procedural rights—including rights related to evidentiary submission and review, written decisions, reconsideration and appeals, as well as rights to forbearance and suspension of collection of defaulted loans while borrowers’ applications are pending or being reconsidered. These rights and the individual process are described in more detail in NCLC’s Student Loan Law § 13.8.2.3.

The rules also set forth a group process through which the Department may provide class-wide relief, without requiring individual applications, where widespread school misconduct is found. Only the Secretary of Education may initiate a group process under the rules, and the Department has discretion as to whether and when to pursue group relief.

Since the current Administration has consistently opposed the 2016 rule (seeking to delay it and initiating a rulemaking to overturn it), and is litigating challenges to its attempts to use new processes to reduce relief to borrowers with approved borrower defense claims (see Calvillo-Manriquez v. DeVos), it bears watching how the Department will administer borrower defense claims and whether it will ever pursue group relief in cases of a school’s pattern of fraud. As of the latest borrower defense report, there is a backlog of over 100,000 applications that await resolution.

New Standards for When the Department Should Acknowledge a Borrower Defense

The newly effective borrower defense process applies to both current and new Direct Loan borrowers. In contrast, the new substantive standards in the rules, which define what type of misconduct will support a borrower defense claim, will only apply to newly disbursed loans. For new loans, students have a borrower defense if: (a) a school breached a contractual promise; (b) a school made a substantial misrepresentation that the borrower reasonably relied on to his or her detriment in deciding to attend—or deciding to continue attending—the school or in deciding to take out a Direct Loan; or (c) there is a nondefault, contested court judgment against the school in the borrower’s favor.

For previously disbursed loans, the prior standard will remain, allowing borrowers to assert a defense to repayment based on any act or omission of the school that relates to the making of the Direct Loan or the provision of educational services for which the loan was provided that would give rise to a cause of action against the school under applicable state law.

Time Limits on Borrower Defenses

The new rule imposes time limits on the recovery of amounts already paid or collected from the borrower. For newly disbursed loans, a six-year limitations period will apply to refunds if the borrower’s defense is based on a breach of contract or a substantial misrepresentation, with the limitations period for substantial misrepresentation claims running from the time the borrower discovered or could have reasonably discovered the information constituting the misrepresentation. There is no limitation period for raising these borrower defenses to offset the remaining amount due on a loan or where there is a court judgment against the school. No time limits apply to discharge of outstanding balances.

For previously disbursed loans, the Department will use the “limitation period under the law applicable to the claim on which relief was granted.” Although state law generally permits borrowers to raise defenses to offset outstanding amounts due on loans so long as the loan is collectable, the Department may interpret this new rule to allow it to limit refunds of amounts already paid on outstanding loans. Equity should counsel against penalizing current borrowers for not “timely” asserting borrower defenses before there was even a process to do so, and such equity-based arguments may be available under applicable state law.

New Borrower Defense Rules Apply Only to Direct Loans

The new borrower defense rights apply to students and parents with Direct Loans. Borrowers with Federal Family Education Loans (FFELs) and Perkins Loans may access relief through this process if they agree to consolidate their loans into a new Direct Consolidation Loan (for those eligible to so consolidate), though they will not be eligible to recover amounts already paid on their FFEL and Perkins Loans through this process. This consolidation path is discussed at NCLC’s Student Loan Law § 13.8.2.4. Borrowers with FFEL Loans may alternatively assert a defense under existing FFEL borrower defense regulations and the terms of their promissory notes, but the new regulations do not clarify the process for FFEL borrowers to assert borrower defenses. Raising school-related defenses to FFEL Loans is discussed at NCLC’s Student Loan Law § 13.8.4.

Private student loans are not eligible to participate in a Department of Education administrative process to raise school-related defenses. But whenever a school originates a private student loan, refers the student to the lender, or otherwise has a business relationship with the lender, federal law requires private student loans to include language stating that that student can raise all school-related claims and defenses against the note holder. Students should have similar rights even if this notice, while required, is missing from the credit agreement. See NCLC’s Federal Deception Law Chapter 4 for a detailed analysis of this FTC Holder Rule.

New Rights for Closed School and False Certification Discharges

Existing law allows students to obtain a complete discharge of their loan obligation and a refund of all loan payments where the school closed while the student was in attendance or the school falsely certified the student’s eligibility for federal student loans. See NCLC’s Student Loan Law § 10.3. Effective October 16, 2018, the new rules strengthen these protections.

Most importantly of the closed school amendments, the new rules require the Department to provide closed school discharges automatically without the student going through the current application process for certain eligible borrowers. The closed school discharge should automatically be provided to eligible borrowers whose schools closed before they could complete their program on or after November 1, 2013 and who did not re-enroll in another school within three years of their school’s closure. This automatic discharge without application should occur three years after the date of school closure, though it is yet to be seen how quickly the Department will implement this provision, and borrowers may continue to apply for a discharge sooner. See 34 C.F.R. § 685.214(c)(2), (f)(4), (f)(5), as added by 81 Fed. Reg. 75,926, 76,081–76,082 (Nov. 1, 2016).

False certification discharges are clarified, so that it is clear borrowers qualify for such discharges where the school falsified the borrower’s high school graduation or diploma or referred the student to a third party to obtain a falsified high school diploma. Additionally, if the Department finds that a school falsified the satisfactory academic progress of its students and a student is thus eligible for discharge on that basis, the Department will grant a false certification discharge without a student application. See 34 C.F.R. § 685.215, as amended by 81 Fed. Reg. 75,926, 76,082–76,083(Nov. 1, 2016). For more on false certification discharges, that completely eliminate a loan obligation and provide the student with a refund on amounts already paid, see NCLC’s Student Loan Law § 10.4.

Other Protections Under Existing Law

These new protections are now added to a number of other student borrower protections under existing law, such as disability and refund discharges, deferments, forbearances, income contingent repayments, loan consolidations, and loan rehabilitations. These are described in detail in NCLC’s Student Loan Law, updated online at www.nclc.org/library.