Final Rule on Borrower Defense and Financial Responsibility Published by U.S. Department of Education

On September 23, 2019, the U.S. Department of Education (ED or the Department) published in the Federal Register final regulations on Institutional Accountability, which revise its current regulations on borrower defenses to repayment (BDR), financial responsibility and certain other matters (the 2019 Final Rule). The Department had previously released an unofficial version of the final rule on August 30, 2019. The 2019 Final Rule generally applies to all higher education institutions that participate in the federal student financial aid programs under Title IV of the Higher Education Act, whether public, private nonprofit, or proprietary.

The 2019 Final Rule becomes effective on July 1, 2020, except for certain financial responsibility provisions that ED has designated for early implementation if an institution wishes to do so. Importantly, the revised BDR provisions in the Final Rule will apply only to Title IV federal student loans disbursed on or after July 1, 2020. Any Title IV federal student loans disbursed between July 1, 2017 and June 30, 2020 will remain subject to the BDR provisions of the Department’s 2016 Final Rule, which ED had previously delayed but which were reinstated by federal court order in October 2018, and Title IV loans disbursed before July 1, 2017 remain subject to the Department’s 1994 BDR regulations.

This alert provides a summary of the 2019 Final Rule as related to BDR claims, financial responsibility requirements and composite score matters, closed school discharges, class actions waivers, and pre-dispute arbitration agreements, among other topics. Please note that this summary reflects our initial review of the 2019 Final Rule, which remains subject to our continued review and analysis.

Substantive Framework for BDR Claims

As is true under the 2016 Final Rule, the 2019 Final Rule continues to provide a federal standard by which borrower defense claims will be evaluated by the Department. Under the 2019 Final Rule, a borrower may assert a defense to repayment if he or she can establish, by a preponderance of the evidence, that the participating institution misrepresented a material fact on which the borrower reasonably relied when deciding to undertake the loan, so long as the misrepresentation “clearly and directly” relates to initial or continued enrollment at the institution, concerns the institution’s provision of educational services, and also results in financial harm to the borrower.

This federal standard applies to original or consolidation loans disbursed on or after July 1, 2020, and notably continues the “preponderance of the evidence” standard of proof established by the 2016 Final Rule. It may also be asserted affirmatively or defensively by borrowers, as is true under the 2016 Final Rule. (The standard in the final regulations also differs from the Department’s proposed rule, which had contemplated a structure in which relief would only be granted to borrowers in collection, default, or other proceedings relating to delinquency or nonpayment.)

Notably, the 2019 Final Rule differs from the 2016 Final Rule with respect to definitions of both “misrepresentation” and “financial harm.” Under the 2019 Final Rule, a “misrepresentation” is a false, misleading or deceptive statement, act, or omission made by the institution to the borrower, with reckless disregard for its truth or with knowledge of its misleading, deceptive nature or outright falsity and that is made in clear and direct relation to the borrower’s enrollment, continued enrollment, or the educational services for which a Title IV loan was obtained. The 2019 Final Rule further provides an illustrative list of evidence that a misrepresentation may have occurred, including:

• Actual licensure passage or employment rates that materially differ from institutional marketing materials;
• Actual institutional rankings, admissions profiles, or student selectivity rates that materially differ from institutional representations to students or to national ranking organizations;
• Inclusion of certification, accreditation, or approval in an institution’s marketing materials that is not in fact held, obtained, or removed within a reasonable period of time following revocation or withdrawal;
• Materially different transferability of credits, extent of prerequisites, availability of financial assistance or educational resources, timing or amount of tuition and fees; and
• Representation endorsement by outside organizations, agencies or individuals when no such authorized endorsement in fact exists, among other descriptions of potential misrepresentation.

Similarly, the 2019 Final Rule defines “financial harm” differently from the 2016 Final Rule, and sets out more sharply drawn exclusions. The 2019 Final Rule defines financial harm as “the amount of monetary loss that a borrower incurs as a consequence” of a misrepresentation as defined above, and it explicitly excludes nonmonetary losses. It further notes that the following instances do not constitute financial harm in themselves:

• The act of taking out or consolidating an applicable federal student aid loan;
• Monetary loss predominantly due to local, regional, or national market conditions; or
• Monetary loss due to borrower’s less-than-full-time work or voluntary change in occupation.

Examples of financial harm anticipated by the 2019 Final Rule include but are not limited to periods of unemployment not related to local or national recessions, lack of employment in a field for which the institution “expressly guaranteed” employment, significant differences between actual tuition and fees and those represented by the institution, and the impossibility of completing a program due to the institution’s failure to provide a necessary prerequisite or an acceptable alternative.

The Department also explicitly excludes from the BDR framework any claims arising from the following types of disputes, as they are not “directly and clearly” related to initial or continuing enrollment at the institution, nor to the provision of educational services for which the loan was made: personal injury, sexual harassment, civil rights violations, defamation or slander, property damage, general educational quality, “informal communication” among fellow students, academic disputes, disciplinary matters, and breach of contract (unless such breach independently constitutes a BDR claim).

Procedural Framework and Statutes of Limitations

To submit a BDR claim under the 2019 Final Rule, an aggrieved borrower must submit an application to the Department, signed and acknowledging the penalties of perjury, and including supporting evidence, stating any other claims or sources of tuition recovery, and declaring the amount of alleged financial harm. Notably, and unlike the 2016 Final Rule, the 2019 Final Rule does not provide for group claims. The borrower must also indicate in the application an understanding that, in the event that the claim results in a full and complete discharge of any loan payment obligation, the institution may refuse to verify attendance or provide a transcript in connection with the educational services for which the discharged loan was originally provided.

The Department will notify the institution of the BDR application, including by providing a copy of the application and supporting evidence, and will also provide and may consider any other evidence in its possession. The institution must respond within 60 days, at which point ED will provide the borrower with a copy of the institution’s response, to which the borrower must also respond within 60 days. Upon consideration of each submission, ED will issue a written, final decision regarding the amount and the rationale for relief granted, if any. No timeframe is specified for the Department’s written decision, which may not be appealed.

Under the 2019 Final Rule, a borrower generally must assert his or her defense to repayment within three (3) years from the date on which the student ceased to be enrolled at the institution, whether through graduation or withdrawal. After the date of its final written decision finding that a borrower is entitled to a defense to repayment, the Department has five (5) years in which to seek recovery of the discharged amount from the institution.

Financial Responsibility Triggers

As under the 2016 Final Rule, the 2019 Final Rule specifies certain events, or “triggers,” that ED considers early warning signs of financial difficulty, the occurrence of which may require an institution to provide the Department with a letter of credit or other surety. Unlike the substantive and procedural framework for BDR claims, for which the applicable rules depend on the disbursement date of pertinent Title IV loan, the revised financial responsibility triggers are uniformly effective July 1, 2020. (Until that date, the triggers under the 2016 Final Rule and their related reporting requirements remain in full effect.)

Mandatory Triggers 

The Department will consider an institution not to be financially responsible in any of the following situations:

• For any institution, the incursion of a liability from settlement, final judgment, or other final agency or judicial proceeding that, when applied to the institution’s composite score for its most recently ended fiscal year, results in a recalculated composite score below 1.0;
• For a proprietary institution with a composite score below 1.5, withdrawal of owner’s equity (with limited specified exceptions for intercompany transfers and wage-equivalent distributions), if such withdrawal, when applied to the institution’s composite score for its most recently ended fiscal year, results in a recalculated composite score below 1.0;
• For publicly traded institutions, (1) the SEC suspends or revokes the registration of the institution’s securities, or suspends trading on the institution’s securities; (2) the exchange on which the institution’s securities are traded notifies the institution that it is not in compliance with listing requirements and, as a result, the institution’s securities are delisted, either voluntarily or involuntarily; or (3) the SEC is not in timely receipt of a required report and did not issue an extension to file the report; or
• For all institutions, the occurrence of two or more discretionary triggers enumerated below. 

The mandatory triggers in the 2019 Final Rule are notably narrower than under the 2016 Final Rule, particularly with regard to unresolved lawsuits and similar financial claims against an institution. In its commentary accompanying the 2019 Final Rule, the Department stated that its underlying goal is to adopt an approach to financial warning signs that will identify institutions whose financial condition actually warrants financial protection, rather than applying triggers (as is the case under the 2016 Final Rule) that presumptively result in requiring letters of credit that could in turn have a devastating and unwarranted impact on the institution.

Discretionary Triggers 

The 2019 Final Rule also sets forth the following circumstances where, in its discretion, the Department may consider an institution not to be financially responsible:

• Issuance by the institution’s accrediting agency of an action (including but not limited to show cause or probation) that could lead to withdrawal, revocation or suspension of institutional accreditation;
• Violation of a security or loan agreement provision that then enables the creditor to require or impose an increase in collateral, a change in contractual obligations, an increase in interest rates or payments, or other sanctions, penalties, or fees;
• Violation of a State licensing or authorizing agency requirement, in conjunction with notice that the agency may withdraw or terminate its licensure, authorization, or approval;
• Failure to satisfy the “90/10 rule” for the most recently completed fiscal year;
• Cohort Default Rates of 30 percent or greater in each of the two most recent fiscal years for which ED has determined official rates, unless such rates are successfully challenged or remain on appeal and the result of such challenge or appeal would be to reduce the rate to below 30 percent; or
• Determination by ED that the institution has high annual dropout rates (through a methodology yet to be determined).

Reporting of Triggering Events

As a general matter, an institution must report to the Department the occurrence of any mandatory or discretionary trigger within ten (10) days of its occurrence. One exception to that reporting period is a proprietary institution’s failure to meet the 90/10 rule, which must be reported 45 days after the close of the fiscal year in which the institution failed to satisfy that required ratio.

Composite Score Modifications

Lease Accounting Standards

The 2019 Final Rule modifies the financial responsibility composite score methodology to account for certain recent accounting standards updates (ASUs) by the Financial Accounting Standards Board (FASB). Most significantly, FASB ASU 2016-2 essentially requires that leases be treated as both right-of-use assets and liabilities, whereas GAAP has not historically required such treatment. Under the implementation timeline originally adopted by FASB, public entities (which includes private entities with public debt, e.g. municipal bonds or other public financing) must adopt the new lease accounting standard for fiscal years starting on or after December 15, 2018, and private entities must adopt the new standard starting January 1, 2020 (although FASB recently proposed delaying the private entity implementation date to January 1, 2021).

With the Department’s acknowledgment that changes to accounting standards for leases could have a detrimental impact on an institution’s composite score even in cases where the underlying financial condition of the institution may not have changed, the 2019 Final Rule modifies the composite score methodology to “grandfather” leases that were entered into before December 15, 2018. In short, if an institution properly discloses the effects of the new lease accounting standard on such “grandfathered” leases, in both the notes to its annual audited financial statements and in a supplemental schedule to those financial statements as required by the 2019 Final Rule, the Department will calculate a composite score that excludes the effects of the new lease accounting standard.

For leases entered into on or after December 15, 2018 – including the exercise of any option to extend a lease that was entered into before the grandfathering date – the 2019 Final Rule requires that an institution’s composite score calculation reflect the requirements of FASB ASU 2016-2. Because FASB ASU 2016-2 does not subject most private entities to the new lease accounting standards until at least January 1, 2020, we have requested that ED issue guidance to confirm our understanding that, for leases entered after December 15, 2018, it does not intend to have an institution’s composite score calculation reflect the new lease accounting standards until such time as required under GAAP. Once further information on this topic is received from ED, we will update this alert accordingly.

Long-Term Debt

The 2019 Final Rule substantially alters the permissible composite score treatment of an institution’s long-term debt. Pursuant to Dear Colleague Letter (DCL) GEN-03-08, institutions have been permitted to include in the primary reserve ratio of the composite score all long-term debt obtained for institutional purposes, up to the total amount of the institution’s net property, plant, and equipment (PP&E). That July 2003 guidance replaced earlier ED guidance that had required association of particular debt amounts with the acquisition of identified PP&E.

Reflecting concerns by the Department that DCL GEN-03-08 has fostered manipulation of the composite score through inclusion of long-term debt that is not actually associated with capitalized assets, the 2019 Final Rule repeals DCL GEN-03-08 and effectively reverts to the former requirements. Thus, under the 2019 Final Rule, in order to include long-term debt (including long-term lines of credit) in the primary reserve ratio of the composite score, the notes to an institution’s financial statements must clearly identify that the debt exceeded 12 months and that it was used to fund capitalized assets. Since institutions have not been required under DCL GEN-03-08 to associate long-term debt with specific capitalized assets and thus may not have relevant accounting records, the Department has adopted provisions that serve to “grandfather” the composite score treatment of certain existing long-term debt from the more-restrictive requirements. Institutions should review the long-term debt provisions of the 2019 Final Rule with their accounting firms to ensure a proper understanding of any impacts resulting from this ED policy change.

Early Implementation

The above-described modifications to the composite score methodology are the only aspects of the 2019 Final Rule available for institutions to “early implement” before the otherwise effective date of July 1, 2020, if they choose to do so. We note, however, that the Department appears to require simultaneous implementation of the lease-related provisions and the long-term debt provisions. Thus, institutions should consult with both accountants and legal counsel in order to determine whether early implementation is advisable.

Revised Availability of Closed School and False Certification Discharges

Under the 2019 Final Rule, “closed school” discharges continue to be available to students whose institution—or institutional location—closes, or whose institution has offered a teach-out opportunity that the student has declined. Unlike the 2016 Final Rule, students must choose between pursuing a closed-school discharge and completing their program though the teach-out opportunity approved by the institution’s accreditor. In another change from the currently effective regulations, no “automatic” closed school discharges will be undertaken by the Department; affected borrowers must apply for the discharge individually. However, the closed school discharge period will expand from 120 to 180 days under the 2019 Final Rule, and even that period may be further expanded under “exceptional circumstances,” which are enumerated by ED to be:

• revocation or withdrawal of institutional accreditation;
• revocation or withdrawal of state authorization or licensure;
• termination of the institution’s Title IV participation; or
• the approved teach-out explicitly exceeds 180 days. 

Similarly, false certification discharges are only available to individual applicants under the 2019 Final Rule, and only if it was the school, rather than the borrower, who falsely certified the borrower’s eligibility. The regulations also make explicit provision for alleged instances of authorized document signatures, loan payments, and identity theft.

Removal of Prohibition on Mandatory Arbitration Clauses and Class Action Waivers

The 2019 Final Rule permits institutions (after July 1, 2020) to again include mandatory pre-dispute arbitration clauses and class-action waivers as part of the enrollment process, but only under certain conditions. If an institution wishes to use such agreements, it must provide a clear, plain-text disclosure of each provision and its import to students, and additionally must make such disclosure available on a public-facing website (i.e., not solely in a school intranet setting). Institutions requiring these agreements or waivers must also provide students with a written description of when and how the agreement or waiver applies, including that it does not waive the opportunity to file a BDR claim, and what processes are available to seek redress. Schools must also provide such information regarding their institution’s internal dispute resolution process during the entrance counseling period, and note that a student does not have to participate in an internal grievance procedure or arbitration prior to submitting a BDR claim to ED. Finally, institutions must clearly provide a point of contact in the event that the student has any questions regarding these and other matters.

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This summary should not be construed to constitute legal advice with respect to the Department’s borrower defense or financial responsibility regulations, or with respect to any other education regulatory matters. Please do not hesitate to contact the authors or any member of our Education Law Team if you have any questions regarding the BDR regulations, Title IV financial responsibility requirements, this alert, or any other educational regulatory matters.