Protocol | Fintech

California’s coming for fintech’s student loan solution

The Golden State says income share agreements are student loans. But the income-based payback deals still mostly operate in a legal gray area with little oversight and scant clarity about how they work and who benefits.

An illustration of a diploma alluding to criticisms of income share agreements

Who benefits from income share agreements?

Image: Christopher T. Fong/Protocol

A recent order by California regulators classifying income share agreements as student loans could have a wide-ranging impact on how these financial instruments are handled nationwide.

Income share agreements are either a ticket for economic mobility or a deceitful debt trap preying on students, depending on whom you talk to. Most are structured so recipients pay a percentage of their future income rather than a set, interest rate-based payment. But ISAs still operate with little oversight in a legal gray area, with basic questions about how they work and who benefits still unanswered.

That debate has only gotten more complex as regulators start to weigh in. A recent order by the California Department of Financial Protection and Innovation deemed income share agreements as student loans in the latest indication of changes in the evolving world of student loan replacements.

The federal Consumer Financial Protection Bureau has also made moves to take on ISAs. This month, the CFPB issued a consent order against Better Future Forward, an ISA provider, saying it misrepresented its products by saying they're not loans and do not create debt, and did not comply with consumer laws on private student loans.

The state and federal orders come amid a continuing increase in graduates' debt load and a revenue shortfall for many colleges, which has a number of students and educators looking for alternatives to traditional student loans.

ISAs have been growing quickly in popularity for short-term coding bootcamps and traditional colleges, as well as for other training and education programs such as nursing.

Golden State standard

California's order licensed Meratas, a 2-year-old firm, to service ISAs being offered by schools and colleges in California. Now, income share agreements will be regulated as loans under the California Student Loan Servicing Act. That means Meratas will have to communicate "honestly and fairly" with borrowers and submit data to the DFPI, which it didn't have to before, and Meratas' data, complaints, documents and borrower details are now subject to periodic review by the DFPI, said Maria Luisa Cesar, its deputy commissioner.

This new oversight by regulators also means borrowers in California will have protections from deceptive lending practices, usury, unfair credit reporting practices, unfair collection practices and discrimination, said Ben Kaufman, head of investigations and senior policy adviser at the Student Borrower Protection Center.

But the bigger impact of the order could be across the country. Until recently, income share agreements were not regulated much, if at all. The New York Department of Financial Services could follow California's move, said Mike Pierce, policy director and managing counsel at the SBPC.

Recently, Illinois passed the Know Before You Owe Private Education Loan Act, which defines ISAs as loans alongside traditional private student loans and requires disclosures of interest rates on ISAs based on the borrower's income. It also requires lenders to provide detailed statements to borrowers along with additional requirements for ISAs.

And in a recent panel, Rohit Chopra, who's nominated to be head of the CFPB, said companies offering ISAs should compete on price and product, not on "regulatory arbitrage" — a clear critique of ISAs.

"Companies often use these alternative structures to avoid consumer protections and other laws," Chopra said. "I've long been concerned that marketers of income share agreements might claim that their products are a debt-free or interest-free option, and our laws help prevent these types of unsubstantiated claims."

Currently, Meratas is the only company with this California license. Other companies can also apply for licenses using the Nationwide Multistate Licensing System, a registration system used for non-depository financial institutions, Cesar said.

From an industry perspective, California's licensing of ISAs is an improvement, said Tonio DeSorrento, chief executive at ISA company Vemo Education, even if it's not written how he would've liked, because it will provide more certainty for the market.

Vemo focuses on offering ISAs through colleges — it has 65 college customers and non-college clients as well, said DeSorrento. Unlike others, when Vemo works with colleges, the schools cover the students' tuition and the students pay back the colleges, he said. Vemo only handles communication with students, processing and servicing, he added.

In most cases, Vemo's partner schools are subsidizing the cost of tuition that the student is not paying and losing some money since it's part of financial aid, DeSorrento says. But for colleges, this is worth it because it is an attractive feature to draw more students to enroll, as it shows that colleges actually care that their students are successful, he said. "Having financial skin in the game communicates something important to students and parents," he said.

Vemo and its partner coding academy Make School were sued in July by 47 former Make School students, who alleged that the school didn't inform students of the costs of the ISA-powered program. And last year, two nonprofits — the SBPC and the National Consumer Law Center — filed a complaint with the Federal Trade Commission, alleging deceptive marketing that resulted in unexpected costs.

DeSorrento said the FTC case was a complaint filed with the FTC, and the FTC hasn't taken any action. On the Make School case, DeSorrento declined to comment.

Who benefits?

In the regulatory shuffling that's ongoing, there are still some basic questions that haven't been answered:

  • Are students paying more for ISA loans than they would have paid in a traditional student loan or other personal loan?
  • Who's benefiting?
  • Are income share agreements enforceable like loans are?
  • Finally, what exactly is an ISA, and what isn't?

That's hard to know, because many ISAs are packaged and securitized to large investors. It's hard to compare the student cost of typical student loans with income share agreements because it can vary depending on a student's future income, DeSorrento said. But, he added, the majority of the ISA programs Vemo runs are subsidized by colleges, so they compare well with "any loan option."

In Make School's lawsuit, the plaintiffs have argued that the loans were not legally sanctioned loans, so the companies can't force borrowers to pay them back. A ruling in this case could have an enormous impact on the ISA industry.

"The position that we've taken is ... not only can you not sue a borrower if they don't pay you, but attempting to collect a debt that is unenforceable and that you know is unenforceable is also a violation of a number of other California consumer protection laws," said SBPC's Pierce, a former official on student loans at the CFPB.

Some companies, such as coding academy Lambda School, now offer what are known as retail installment contracts in California instead of ISAs. Lambda in August 2020 entered into a settlement with the California Bureau for Private Postsecondary Education where it agreed to only offer installment contracts in the state. But some advocates argue that Lambda has just changed the name of the product and is still essentially offering ISAs.

When you can't even agree on what a financial product is, it's clear that more changes are coming.

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