Are ISAs the Solution or a New Problem in Student Lending?

Individual stories tend to get lost when stories are told on a massive scale. Reporting on student debt as a $1.5 trillion problem is like watching buildings being crushed by Godzilla in scenes of sweeping destruction – the focus is on the giant monster and not the impact on the individuals caught in the chaos. Now, a new type of education finance option, known as the Income Sharing Agreement (ISA), is putting the focus solely on the individual student, with the promise of changing the student loan crisis narrative one borrower at a time.

What is an ISA?

ISAs allow students to cover the cost of their education today by paying a percentage of their earnings in the future. The basic concept is that a student is to pay a specific percentage of their future income for a set period of time after graduation. Because it is percentage based, if the student earns more money than expected, the monthly payments and total paid out goes up – meaning they could pay significantly more than their school costs – but if the student makes less money, then the total paid could be less.

ISA terms vary depending on the student’s major – the expected earnings of an engineering major might differ from that of an English major and thus, the payments and terms differ as well. Often they are combined with student loans when a student has maxed out their federal student loans and may still need to cover a gap in their school financing.

Growing Usage

While ISAs are already popular in Latin America and a related system exists in the United Kingdom, ISAs have come to the United States, where coding boot camps and vocational programs have already begun using them. ISAs are also spreading to universities, including Purdue University, University of Utah, Clarkson University, Lackawanna College and Norwich University. Colorado Mountain College has specifically used ISAs to help their Deferred Action for Childhood Arrivals (DACA) students who might not otherwise qualify for federal financial aid. The Department of Education itself is considering their usage in federal programs.

Programs Differ

Usually ISAs are structured by the schools themselves, with the school endowment, alumni or individual donors covering the student’s costs upfront. But some schools are beginning to permit outside investment firms to take a stake in students.

ISA terms vary by school. For example, under Purdue University’s ISA program, if a student makes less than $20,000 but is working full-time or seeking work, the student’s payments stop and the ISA repayment term is not extended to make up for it. In essence, they get a pass for a time because of their circumstances. But if the student is only working part-time or not making any money at all because they are in a graduate program or have voluntarily left the workforce, then the ISA goes into the equivalent of a deferment and the term of the agreement keeps extending up to five years. Therefore, the student will have to pay for the same timeframe originally agreed to.

In comparison, the University of Utah will defer repayment if students are getting graduate degrees, participating in volunteer service (including religious mission work), or earning less than $20,000. Additionally, some schools have capped the total payments to limit the total amount the student might be forced to spend. For example, Purdue’s program caps out at 2.5 times what the student borrowed, while Utah is capped at 2 times.

Legal Questions

ISAs are relatively new and do not fit squarely into any legal or regulatory framework. Bills have been proposed in Congress, but none have been passed. Congressional Democrats are asking tough questions of the Department of Education about ISAs. Of course, gaps in regulation lead to open questions and, as the prominence of programs grows and investors (beyond universities) get involved, rules may be necessary to both protect investors and students alike.

Fair questions exist as to whether ISAs should be subject to usury laws, as well as how they might be treated under bankruptcy and tax laws. One proposed Congressional bill specifically exempted ISAs from usury laws, but usury laws apply to loans, something ISAs do not really resemble. They are not absolutely repayable: they lack an unconditional promise to pay a sum certain. Usury laws do not apply where payment or enforcement of a contract depends on an uncertain contingency or where courts view an agreement as reflecting an “investment” rather than a loan.

In New York, courts will look at the nature of a transaction – its true purpose, substance, and character – not the form it takes to determine if it is usurious. Arguments against the application of usury limits have been successfully made for certain kinds of merchant advance agreements and litigation funding agreements, which have similar characteristics to ISAs.

For example, a court declined to apply usury to a “non-recourse advance agreement” under which a law firm received funds in advance to pay for anticipated litigation. Under the agreement, the law firm was to assign to the funding company a portion of their expected fee from litigation, and pay the funding company only as litigation was resolved. If there is no recovery in the case, then no money would be due to the funding company. Accordingly, the court found the agreement created ownership interests in proceeds of claims, contingent on the actual existence of any proceeds. There could be no usury because there would be no contractual right to payment had the law firm been unsuccessful in negotiating settlements or winning judgments.

Looking Ahead

Although the use of ISAs is so far limited to a few schools, there are questions of what might happen to the overall student loan market if they become more prevalent. Is this a solution for overburdened student borrowers, a positive way for schools to get “skin in the game” or a gateway to a future where investor returns decide which majors are most profitable and, thus, worthy of pursuing to the detriment of others?

Further, if the strongest candidates get scooped up by ISA investors, then lenders may be left with a lower credit quality borrower pool, and compensate for these increased risks with higher interest rates, potentially leading to more defaults in federal student loan programs. In addition, certain terms may become subject to greater scrutiny. For example, binding arbitration clauses, such as those found in Purdue’s ISA contracts, could be argued as protective for the university while leaving students more vulnerable and with limited recourse.

Ultimately, if implemented properly and as part of a multi-prong effort to change the educational spending landscape, ISAs may be a helpful tool for schools, investors and students. An effective solution should include putting pressure on college costs, tailoring expenses to specific majors, and informed disclosures and financial counseling for students.

Nicole Serratore, an Attorney, in the Insolvency, Creditors’ Rights & Financial Products Practice Group of Davis & Gilbert, contributed to this post.

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