As we previously reported, in June the Department of Education (DOE) proposed new rules relating to when students could assert a borrower defense to repayment, effectively a discharge of student loans. On November 1, DOE adopted the rules in substantially the same form they were proposed.

In commentary, DOE observes that the former borrower defense provisions, which require showing that the student has a state law cause of action against the school, have been relatively rarely used. DOE justified the need for the new rules in the wake of the bankruptcy of Corinthian Colleges. DOE has approved the discharge of more than 15,000 loans for former Corinthian students, totaling almost $250 million.

The new borrower defense standards are effective for loans first disbursed after July 1, 2017 for both for-profit and non-profit schools (loans disbursed before that date continue to use the former state-law-claim standard). Borrowers have a defense to repayment and a claim for previously repaid amounts when (a) the school breached the terms of a contract (such as an enrollment agreement) 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 or continue attending the school.

Under the new rules, a student may submit an application to DOE seeking a defense to repayment. The student’s loans are automatically placed into forbearance, or collection activity is halted if the student is in default, 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 schools, but students can request reconsideration on the basis of new evidence and the DOE may reopen applications on its own. If a student is successful, DOE may seek repayment from the school of the loan amount. Schools cannot compel students to pursue borrower defense claims through any internal dispute process before seeking relief from DOE.

The rules do not include any limitations period for a student seeking to avoid further payment on loans, but do limit the ability of the student to seek repayment from DOE to six years in the case of the breach of contract and substantial misrepresentation standards. DOE may seek repayment from schools related to successful borrower defense claims for six years in the case of the breach of contract and substantial misrepresentation standards. All DOE must do to comply with this limitations period, however, is provide notice of the borrower defense claim to the school, which will be done routinely under other provisions of the rules. There is no express limitations period on either students or the DOE in the case of borrower defenses based upon the judgment standard; presumably the DOE has concluded that there is no need for a separate limitations period when the borrower’s ability to win a judgment would be constrained by the limitations period applicable in the underlying action.

The rules also contain a provision under which DOE staff can initiate a process to determine whether an entire group of students has a borrower defense. These provisions are similar to a class action; students receive notice and may opt out, but do not need to file a separate application to receive relief. Nor are students directly involved in seeking relief. If this group process finds a substantial misrepresentation by the school, there is a rebuttable presumption that each student in the group relied on the misrepresentation. For open schools, but not closed schools, group determinations by the DOE can be appealed to the Secretary of Education by either the DOE staff or the school.

The criteria for asserting a defense to repayment may be broad and potentially applicable to a wide-range of school actions. For example, 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 salary data. Commentary to the final rule further illustrates the relative ease with which students can claim a defense to repayment. Students need not show intent on the part of the school to demonstrate either the breach of contract or substantial misrepresentation criteria. DOE comments state that, in the case of substantial misrepresentation, students need not show intent because all evidence of intent is likely to be under the control of the school. Further, while a borrower’s state or federal court or administrative judgment against a school is grounds for borrower defense, a judgment in favor of the school does not automatically bar a student from seeking a borrower defense from DOE (although DOE asserts that it will follow collateral estoppel principles with regard to individual issues).

The new DOE rules will also affect the desirability of settling claims brought by students and state or federal authorities. Settlements do not automatically entitle affected students to a borrower defense under the judgment prong of the borrower defense rules. DOE, however, has stated it will consider settlements as evidence and give them “the weight to which they are entitled” in evaluating the appropriateness of a borrower defense under the breach of contract or substantial misrepresentation criteria. DOE will also consider other court filings and orders as evidence. Such consideration may affect the decisions of schools regarding whether to settle claims. Importantly, however, DOE has stated it will not consider any settlement entered prior to July 1, 2017, potentially providing an incentive to resolve current claims before that deadline.

The newly adopted rules present significant risks to non-profit and for-profit schools alike. In addition to the direct financial risk that DOE may seek repayment from the school in successful borrower defense cases, there may also be significant costs to the school to defend against borrower claims. Although under the rules no particular form of response from schools is required, and schools need not respond at all, schools may well decide that it is in their best interest to mitigate the risk of successful claims by fully investigating the allegations in applications and responding with detailed briefs and supporting evidence. The rules require DOE to consider the school’s response.

Finally, pending or even anticipated borrower defense applications can be used as a factor by DOE in determining that a private school is not financially responsible, which can endanger the school’s ability to receive federal loan funds and in some circumstances may require the school to provide DOE with a letter of credit for ten percent of the federal funds received by the school in the previous fiscal year. Such a letter of credit suffices for at most three years, after which the private school must be financially responsible again or potentially provide an even larger letter of credit.