| DCLPublicationDate: 1/1/95 DCLID: GEN-95-8 AwardYear: Summary: Direct Loan Program schools will not face greater potential liabilities than FFELP Schools January 1995 GEN-95-8 Summary: Direct Loan Program schools will not face greater potential liabilities than FFELP Schools Dear Colleague: Various lending industry sources are now warning schools that if they participate in the Direct Loan Program, they will face greater potential liabilities than if they remained in the Federal Family Education Loan (FFEL) Program. The purpose of this letter is to explain why these warnings are misplaced. The Department recognizes that proper development of the Direct Loan and FFEL Programs requires thoughtful and critical analysis, and has actively solicited a wide range of views on both programs from participants and interested members of the public. The Department welcomes comments received in this process, and it intends to carefully consider any information provided to continuously evaluate the operation and performance of this new lending program. In that spirit, the Department in particular appreciates the concerns voiced about potential Direct Loan liabilities; however, after careful consideration of the grounds for these fears it is apparent that they rest on misconceptions about the roles and responsibilities of schools under the FFEL and Direct Loan Programs. It is important that schools evaluate accurately the benefits of the Direct Loan Program, and understand the Department's view of the law relating to potential school liabilities on which the Department's implementation of the Direct Loan Program will be based. These concerns are based on the premise that Direct Loan schools face greater potential liabilities than FFEL schools due to (1) administrative responsibilities, (2) Federal and state lender regulations, and (3) borrower defenses to repayment of Direct Loans. For the reasons explained here, the administrative and financial responsibilities of schools in the two loan programs are so similar that there is no significant difference in potential legal liabilities that may arise from performing those duties; Federal and state lender regulations either do not apply, or are unlikely to affect Direct Loan schools; and the treatment of borrower defenses by the Department will not result in greater liability for Direct Loan schools than for FFEL schools. FFEL and Direct Loan schools have similar administrative responsibilities Obviously, the Direct Loan Program has its own responsibilities for schools, but these duties are neither unfamiliar to schools participating in the FFEL, the Federal Pell Grant, and campus- based programs, nor likely to cause liability different than that posed by duties under these familiar programs. The responsibilities of schools in the Direct Loan Program are so similar to those duties that there is little reason to imagine that even Direct Loan originating schools will face greater liability than schools that remain with the FFELP. In the FFEL Program, schools must accurately complete and process the Common Loan Application and Promissory Note, determine the borrower's eligibility and financial need, recommend the loan amount, certify the borrower's eligibility for the loan, receive disbursements of loan funds by check or electronic funds transfer from lenders, and properly disburse loan funds to the borrower. The Department currently holds the FFEL school financially liable for losses caused by school errors in performing these duties. The fact that a guaranty agency or lender might also have a duty to review some of the same determinations does not relieve the school of its own responsibility and potential liability. Similarly, schools that originate Direct Loans must determine the borrower's financial need, eligibility status, and loan amount; secure the completion of the promissory note; and have various recordkeeping duties comparable to those in the FFEL Program. Direct Loan schools, like FFEL schools, will be financially liable for erroneous determinations of borrower need or eligibility, and failure to secure and keep required documentation and records. Fears that these duties will pose either larger or different risks to Direct Loan schools than those faced by FFEL schools are therefore not realistic. Schools also now have extensive cash management and reporting responsibilities in the Federal Pell Grant Program and the campus-based programs, and face potential financial liability for failure to perform these duties properly. FFEL schools face these duties and attendant risks only with respect to Federal funds they received under the Pell and campus-based programs, while Direct Loan schools will also face these same duties and risk for funds received under the Direct Loan Program. To the extent that more funds are involved, the amount of potential risk for mismanagement of Federal funds may be larger for Direct Loan schools than for FFEL schools, but the duty and the risk are neither new nor unfamiliar to schools participating in the Pell and other programs. While the potential risk may be theoretically larger, there is little basis for speculation that schools that have been meeting their cash management duties under the Pell and campus-based programs will actually experience any greater risk in managing, in addition, those new funds they will draw under the Direct Loan program. Federal and State lender regulations have little or no affect on Direct Loan schools Federal and State laws regulate various aspects of consumer loan transactions, and some parties speculate that these laws may pose risk to Direct Loan schools that FFEL schools do not face. There is little basis for this speculation. The Federal Truth in Lending Act does not apply to FFEL, Direct, or Federal Perkins Loans, and State disclosure laws cannot, by virtue of specific provisions of Federal law, apply to these loans. Similarly, State usury laws limit the interest rate that a lender may charge, but even if the Direct Loan rate were to exceed the rate permitted by a particular State law, that unlikely event would not pose risk to the Direct Loan school for two reasons. First, the party making the loan is the Department, not the school itself; second, because Direct Loan interest rates are mandated by Federal law, State laws that would conflict with the use of that Federally-mandated rate are superseded by Federal law. Therefore, Federal and State lender regulations will not create any new liabilities for schools participating in the Direct Loan Program. Borrower defenses will raise the same potential for liability for both FFEL and Direct Loan schools Finally, some parties warn that Direct Loan schools will face potential liability from claims raised by borrowers that FFEL schools will not face. This speculation rests on assumptions taken from the Direct Loan statute and regulations that address borrower defenses and is bolstered by public awareness of recent lawsuits brought by borrowers to avoid repayment of FFEL loans received to attend defunct trade schools.*1* The liability of any school - whether a Direct Loan or FFEL participant - for conduct that breaches a duty owed to its students is already established under law other than the HEA - usually state law. In fact, borrowers will have no legal claims against Direct Loan schools that FFEL borrowers do not already have against FFEL schools. The potential legal liability of schools under both programs for those claims is the same, and the Department proposes to develop procedures and standards to ensure that in the future schools in both programs will face identical actual responsibility for borrower claims based on grievances against schools. The Direct Loan statute creates NO NEW LIABILITIES for schools; the statute permits the Department to recognize particular claims students have against schools as defenses to the repayment of Direct Loans held by the Department. Current Direct Loan regulations allow a borrower to assert as a defense any claim that would stand as a valid claim against the school under State law.*2* The Department intends to develop procedures to ensure that where a Direct Loan borrower avoids repayment by proving a meritorious claim, the Department will, after fair notice and opportunity for the school to rebut the claim, recoup that financial loss from the school that caused the grievance, rather than leaving that loss to the taxpayer and the student. This proposal will not, however, mean less risk for FFEL Program schools. To properly compare liability under Direct Loans with that under FFEL, it is essential to recognize that the Department plans to develop substantially similar loss-shifting procedures for FFEL schools.*3* Congress intended that schools participating in either FFEL or Direct Loan programs should receive parallel treatment on important issues, and the Department has already committed during negotiated rulemaking to apply the same borrower defense provisions to BOTH the Direct Loan and FFEL programs. Therefore, schools that cause injury to student borrowers that give rise to legitimate claims should and, under these proposals, will bear the risk of loss, regardless of whether the loans are from the Direct Loan or FFEL Program. For these reasons, schools participating in the Direct Loan program will, under the proposals being developed by the Department, face no significantly different legal liabilities than those that remain in the FFEL program. I urge school officials that have more questions about these issues to contact me directly at (202) 708-8391; I will be pleased to provide a more detailed legal analysis of these concerns prepared by our counsel's office. Sincerely, Leo L. Kornfeld Senior Advisor to the Secretary *1* In those FFEL cases all parties usually conceded that the borrowers could have sued the schools on their claims, and in none of these cases did courts rule or even suggest that Federal law protected the schools from these claims. However, the schools were invariably defunct, and the only real issue in the lawsuits was whether and when Federal law permitted these borrowers to use these school claims as defenses to repayment of FFEL loans held by a lender, guarantor, or the Department. *2* The scope of this provision can be modified through the rulemaking process as experience dictates. Moreover, as explained earlier, State loan disclosure laws cannot apply to either FFEL or Direct Loans, and no claim based on non-compliance with such a disclosure law can arise and therefore be recognized as a defense even under the current regulation. *3* Federal law already authorizes this same claim procedure against the school, whether public, private non-profit, or for profit, where the Department sues to collect an FFEL program loan. |