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(GEN-95-08) (GEN-95-08) Direct Loan Program schools will not face greater potential liabilities than FFELP Schools

DCLPublicationDate: 1/1/95
Summary: Direct Loan Program schools will not face greater potential liabilities than FFELP Schools

January 1995

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

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

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

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.


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.

Last Modified: 12/31/1994