7th Circuit Rules That Federal Student Loan Servicers Must Follow State Law

A recent court decision could potentially play a vital role in the debate over whether, and to what extent, states should be allowed to regulate servicers who manage federal student loans.

In a recent case, the U.S. Court of Appeals for the 7th Circuit ruled in a class action suit that borrowers with federal student loans could sue their loan servicer for allegedly violating state consumer laws. This decision is the latest development in a debate over whether, and to what extent, states should be allowed to regulate servicers who manage federal student loans.

Case Background

In Nelson v. Great Lakes Educational Loan Services Inc., --- F.3d ---, 2019 WL 2636822 (7th Cir., June 27, 2019), Nicole Nelson, a borrower with federal student loans, said that Great Lakes Educational Loan Services, Inc., the servicer of those loans, touted its expertise as a student loan adviser. But, she claimed, the servicer improperly talked her into an expensive repayment option in violation of state consumer laws.

After Nelson changed jobs, her income dropped, and then she subsequently lost her job. When Nelson spoke to Great Lakes about her situation, the representatives told her to postpone making her student loan payments with a loan forbearance, in which interest continues to accrue. No one, she alleged, said to her that she could enroll in a less-costly income-driven repayment plan. (Consumer advocates say that because the enrollment process can be time consuming, servicers often steer borrowers into taking the easier and more lucrative route of forbearance.) Nelson then sued, contending that Great Lakes’ faulty guidance violated the Illinois Consumer Fraud and Deceptive Business Practices Act, as well as amounted to constructive fraud and negligent misrepresentation under Illinois common law.

The United States District Court for the Southern District of Illinois dismissed the case, holding that Great Lakes simply failed to disclose certain details, and that Nelson's state law allegations were preempted by the federal Higher Education Act (HEA). (The HEA says that federal loans aren’t subject to state disclosure requirements, and the court reasoned that Great Lakes was accused only of failing to disclose information.) Nelson then appealed.

The Court of Appeals’ Decision

On appeal, the U.S. Court of Appeals for the 7th Circuit held that the federal HEA did not preempt Nelson's state-law claims. The court said that accusations that the servicer provided false information amounted to more than just a failure to disclose. The court stated, “When a loan servicer holds itself out to a borrower as having experts who work for her, tells her that she does not need to look elsewhere for advice, and tells her that its experts know what options are in her best interest, those statements, when untrue, cannot be treated by courts as mere failures to disclose information. Those are affirmative misrepresentations, not failures to disclose.”

The court noted that the law has long recognized the difference between mere failures to disclose information and affirmative deceptions. Therefore, because Nelson reasonably relied on the servicer's false statements and misrepresentations to her detriment, the HEA did not preempt the borrower’s state-law claims. The court reasoned that imposing liability for those voluntary but deceptive statements doesn't impose additional “disclosure requirements” on Great Lakes.

Accordingly, the court vacated the dismissal and remanded the case to the lower court, which means the case goes back to the district court.

The Effect of the Nelson Decision

Consumer protection advocates have argued that the federal government’s failure to deal with the student loan problem has left the states with no choice but to pass laws that better protect borrowers. The federal government, through the U.S. Department of Education, on the other hand, has issued guidance saying that state regulation of federal student loans "impedes uniquely federal interests” and that the Department believes such regulation is preempted by federal law.

So, the Nelson case could potentially play a key role in the clash between the Trump administration and states regarding state laws that cover federal student loan servicers. Ultimately, the Court of Appeals’ decision in the Nelson case is a victory for student loan borrowers and a powerful criticism of the current administration’s efforts to protect student loan servicers from state oversight.

Effective date: June 27, 2019