Increased Scrutiny On “Auto-Defaults”— Road To Enforcement Or Impetus For Change?

By: David E. Fialkow and Hollee M. Watson

Private student loan companies are at the center of increased scrutiny by the Consumer Financial Protection Bureau (the “CFPB”). Speaking at a recent conference, the CFPB student loan ombudsman Seth Frotman warned attendees that student loan companies are at risk of violating the law for placing borrowers in default when the co-signer of the loan dies or declares bankruptcy. See Danielle Douglas-Gabriel, Federal agency warns student loan companies about automatic defaults, The Washington Post (Mar. 8, 2016). This “auto-default” practice occurs when banks and other financial companies provide student borrowers with education loans that grant lenders or servicers the right to trigger a default upon a co-signer’s death or declaration of bankruptcy, even if the loan is paid on time.

Bureau officials indicated that student loan lenders and servicers may be at risk of engaging in unfair or deceptive practices by invoking the “auto-default” clauses that unfairly overburden borrowers and could damage their credit profiles. The CFPB hinted that it may pursue enforcement actions based on the following issues:

1. The existence of ambiguous clauses within student loan contracts that fail to clearly identify the specific terms of the “auto-default.” Due to these ambiguities, borrowers could discover they are placed in default only when their payments are refused or they are contacted by a debt collector.
2. The inability of the student loan industry to guarantee uniform treatment of “auto-default” clauses. While some lenders and servicers may not enforce “auto-default” clauses, upon the sale of a student loan, there is no guarantee that the subsequent lender or servicer will do the same.
3. The increasing difficulty co-signers have in obtaining releases. Although student loan companies readily require a co-signer for a borrower to obtain educational financing, many lenders and servicers are frequently rejecting requests for a co-signer release or making the process to obtain a co-signer release more difficult. For example, in addition to making consistent, on-time payments, some lenders and servicers require borrowers to provide proof of graduation, transcripts, employment, or salary information, and may conduct credit checks.

Although it is not the practice of many student loan lenders and servicers to enforce “auto-default” clauses, the CFPB continues to monitor the student loan industry. Mr. Frotman highlighted the CFPB’s commitment to this issue by stating, “Simply extending promises to the public that auto-default provisions will not be exercised is hollow and incomplete because future loan holders may decide to enforce these clauses. If the status quo persists, I am afraid we will continue to hear from borrowers who are subject to this practice, and we will be having this same conversation for years to come — a situation I believe none of us want[s].” See Danielle Douglas-Gabriel, Federal agency warns student loan companies about automatic defaults, The Washington Post. In light of Mr. Frotman’s remarks, and the CFPB’s recent attention to the student loan industry, an enforcement action by the CFPB relating to “auto-default” clauses is possible, if not likely.

Notwithstanding the focus on “auto-defaults,” there is some positive news for student loan lenders and servicers. The CFPB has acknowledged that student loan servicers have made improvements to their student loan payment allocation and loan modification practices. Last year, the CFPB reported its conclusions that several servicers had engaged in unfair and deceptive acts relating to payment allocation on student loans. In its Winter 2016 Supervisory Highlights, the CFPB acknowledged that many servicers had adopted payment allocation policies designed to be more beneficial to borrowers. For example, the CFPB lauded servicers that allocated payments exceeding the total monthly payment on an account to the borrower’s loans with the highest interest rate. The agency commended these servicers for clearly explaining the allocation methodology to consumers, advising that consumers can provide instructions on the allocation of overpayments, and providing instructions so borrowers can choose to allocate excess funds in a different manner.

The student loan ombudsman also previously noted that borrowers complained that servicers had not been offering repayment plans or loan modifications when they struggled to make payments. In response to these complaints, the CFPB observed that servicers have responded positively and provided reasonable borrower workout plans. These changes were highly regarded within the CFPB. Therefore, although the CFPB has increased scrutiny on the student loan industry, it has acknowledged policy changes made by lenders and servicers aimed at assisting borrowers in repaying their student loans. The CFPB’s public scrutiny on issues like “auto-defaults” may be the Bureau’s means to obtain additional improvements within the student loan industry, short of enforcement or rulemaking. We will be following developments and providing further analysis as events affecting the industry unfold.