Coordinating, Not Preempting, State Accountability for Federal Student Loan Servicers

In a legal interpretation published yesterday, the U.S. Department of Education contends that state governments broadly lack the authority to regulate companies responsible for servicing federal student loans. But the Department’s message won’t stand without a fight. In predictable defiance given the sweeping nature of the notice, which carries no formal regulatory authority, several state policymakers have announced their intention to proceed with efforts already underway to protect borrowers from servicers’ shady practices.

States’ interest in maintaining their authority is well-placed. Several student loan servicers have been accused of gross negligence and of actively misguiding borrowers in recent years. Responding to these widespread issues, a number of state lawmakers have stepped in where they believe the Department of Education has fallen short with holding servicers accountable for their actions. This has prompted the servicers to argue they shouldn’t be subject to any non-federal oversight (or even to oversight by another federal agency). As of today, six states have brought federal servicers under their routine regulatory purview. Laws passed in these states give agencies the all-clear to enforce servicing requirements through a combination of licensure, investigation, and fees. Among the six states with student loan servicing laws in place, three have already promulgated regulations, and at least 11 others have a bill up for consideration. What’s more, an October 2017 letter signed by 26 Attorneys General on the topic and a letter from the coordinating association for all 50 state banking agencies released earlier this month suggests plenty more are watching closely.

The main thrust of the Department’s argument hinges on the notion that this rapid rise in state regulations will necessarily lead to disparities in the administration of the loan program. Since Congress intended the loan programs to be uniform across jurisdictions, the Department has argued that there is an exclusive federal interest in governing the contractors carrying out this work. Furthermore, since any additional work or fees required from servicers will require more money, the Department has argued that federal requirements preempt states' authority to oversee federal contractors. Aside from a valid question about the impact additional state requirements may have on costs, the Department seems to have overreacted and overplayed its hand. The Department can establish its own requirements for servicers that may trump certain state requirements, but it doesn’t have the blanket authority to cut off states’ rights to govern activities within their borders.

While a knotty legal debate will likely ensue around what elements states can regulate, the Education Department’s notice is also bad policy, and as such, it should rein in its recent interpretation. Instead of preempting all state oversight, the federal government ought to make clear which types of requirements on its servicers it considers a step too far. Likewise, states should be cautious not to move outside their bounds and must coordinate with each other to create a common blueprint instead of a complicated regulatory “patchwork.”

Those kinds of coordinated efforts could have legs among servicers’ defenders; on top of a strictly legal interpretation, servicers argue that lawmakers should act for policy reasons related to the consistency of servicing, too. As the National Council of Higher Education Resources (NCHER), the main trade association for servicers, has argued differences between state requirements could drive up compliance costs, which will inevitably come out of the federal government’s coffers. Plus, these differences could introduce unnecessary confusion for millions of borrowers if they’re not carefully orchestrated.

If states want to maintain the authority to oversee student loan servicers and protect borrowers, proactively addressing any contradictions between their provisions and federal requirements could prevent a justification for wide congressional action that might definitively box states out of this valuable oversight role. Fortunately, at their core, existing state laws and regulations have focused on brightline efforts to hold servicers accountable for best practices and to prevent fraudulent behavior, generally opting to codify only a few specifications. For example, existing state laws have commonly prohibited servicers from misapplying payments, which is already illegal. But states should proceed carefully when requiring any particular deadlines or methods of communication with borrowers that may differ from the terms laid out in federal contracts now or during a future procurement. Similarly, imposing any significant additional costs directly, either through large surety bonds as is the case with California’s regulation or per loan fees as outlined in the regulations promulgated by D.C., could pose issues.      

By and large, existing state statutes, regulations and guidance do not conflict with federal provisions. But to be sure, they are also hardly shaping up to be a patchwork. Only in several instances do the broad borrower protections laid out by Connecticut, California and Washington, DC, states in which specific regulations have already been promulgated, present small differences in approach that should be addressed. Although, they are not totally inconsequential, these slight variations (like requiring records retention in D.C. and California for three years after a loan has been moved off a servicer’s books, versus two years in Connecticut) do not merit a prohibition on all state oversight of servicers.

Unfortunately, the Department has not been acting in isolation, given the loud protests of the servicers and NCHER. Proponents of state oversight are therefore facing challenges on several fronts. Yesterday’s notice of interpretation accompanies at least two other recent federal attempts to protect student loan servicers from state oversight. The first of these was included late last year when House Republicans authored a broad federal preemption clause in their proposed rewrite of the Higher Education Act. And more recently, the U.S. Department of Justice argued in a statement of interest that a case brought by Massachusetts against federal servicer FedLoan Servicing should be dropped on the basis that states do not have standing to sue a federal contractor. It’s worth noting that the judge in that case has since sided with the Massachusetts AG, ruling that she does have authority to sue the servicer.

While there may be some work left to do to ensure that states do not contradict federal requirements in particular, existing state laws and regulations that seek to improve federal student loan servicing and oversee the servicers’ performance generally offer reasonable approaches. While these laws may require tweaks when they go too far, yesterday’s notice from the Department has turned what should have been a cooperative effort to protect borrowers from unethical practices into an adversarial relationship that stymies progress.