Suit Alleges Fraud in 'Resolving' Troubled Student Loans

By PAUL BASKEN

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Stretched across the brick wall at the far end of Sallie Mae’s Indiana call center, the hand-drawn banner looked to be a typical tribute to college basketball’s annual March Madness.

Instead of listing the nation’s top 64 college teams, however, Sallie Mae managers had filled out their brackets with the names of the workers in telephone headsets who sat hunched over computers behind long lines of connected desks.

Each week, the operators who “resolved” the greatest dollar volume of delinquent student loans advanced along the brackets, picking up department-store gift certificates worth $10, $20, or more along the way.

Sallie Mae, the nation’s largest student-loan company, proudly shows off the 54,000-square-foot cinderblock barn and its rows of $9-an-hour phone operators. The facility, tucked inside a Muncie industrial park, is evidence, the company says, of Sallie Mae’s commitment to helping borrowers pay off their education loans with a minimum of financial distress to either the students or the government's guaranteed-loan system.

Such work helped prevent more than $16.7-billion in potential student-loan defaults in 2007, according to USA Funds, a guarantee agency that works with Sallie Mae on debt-collection efforts.

“As a result, U.S. taxpayers saved more than $16-billion in potential default costs, and student-loan borrowers avoided an estimated $5.5-billion in additional loan costs,” USA Funds said in its most recent annual report.

But others, including those who have experienced life on opposite sides of the telephone lines, suggest that the Muncie facility is part of a carefully orchestrated system that ensures many student debts are grown as large as possible, ballooning Sallie Mae’s profits, before taxpayers and debtors get stuck with the final bill.

Ballooning Debts

A former Sallie Mae employee, in a "false claims" lawsuit against the loan company recently unsealed in federal court in Indiana, alleges that the student-loan giant used the practice of granting forbearances to systematically balloon student-loan debts.

With a forbearance, struggling borrowers get a temporary break from making payments on their loans. But the interest on the loans continues to accumulate, often leaving borrowers in a worse financial bind over time.

The forbearance, meanwhile, can help the lender, especially in circumstances unique to Sallie Mae. A federal student loan enters default status if it goes unpaid for more than 270 days, and lenders face financial penalties on all their federally guaranteed loans if too many of their customers default. Because a forbearance stops the 270-day clock, it helps a loan company keep its default rate from rising, while also letting the amount of borrower debt increase.

When a loan enters default status under the federal system, its ownership passes to a guarantee agency—one of the 35 nonprofit entities nationwide that use federal money to repay student-loan companies when borrowers default. The guarantee agency is then responsible for trying to collect the loan.

Most guarantee agencies are independent of the lenders they oversee. Sallie Mae, however, has a contractual arrangement with USA Funds, the nation’s largest guarantee agency, that gives Sallie Mae extensive financial and operational control over the guarantor that oversees its work. USA Funds, with only about 75 employees of its own, pays Sallie Mae about $250-million a year to provide hundreds of workers to perform most of its guarantor operations. That effectively has left Sallie Mae since 2000 in the role of overseeing its own lending activities.

Rules Eased

The ability of lenders to offer forbearances grew in 2002, when the Education Department eased rules to permit “verbal” forbearance agreements, in which the lender needs only the borrower’s spoken permission over the telephone.

That change in departmental rules fostered the abuses, said the plaintiff in the Sallie Mae lawsuit, Michael Zahara, who worked from November 2004 through August 2005 at the Las Vegas offices of the Student Assistance Corporation. The Student Assistance Corporation is the division of Sallie Mae that performs certain jobs for USA Funds, including contacting borrowers whose loans have entered default.

In his complaint, Mr. Zahara says telephone agents working for Sallie Mae on behalf of USA Funds routinely falsified borrower requests for forbearances, often just dialing a borrower’s telephone number and letting the line sit open for a few minutes, so that the company’s computers would record an apparent conversation.

The agent would then list the borrower as having approved a forbearance, when no such approval occurred, he alleges. The law requires the lender to send a written confirmation to the borrower by mail, but it doesn’t require any proof that the letter was received.

Mr. Zahara pursued his case under terms of the False Claims Act, in which a plaintiff who successfully identifies fraud against the government can receive a share of the recovery. The case seeks triple the amount of the money lost by the federal government. The suit offers no estimate of the losses in dollars alleged to have been suffered by taxpayers or borrowers, though it states that the call agents falsely claimed to have obtained verbal forbearances in "tens of thousands, and possibly hundreds of thousands" of cases.

He filed the case in November 2005, and it remained under seal while the federal government evaluated whether to participate in it. A federal judge in Indiana, Sarah Evans Barker, ruled on June 20 that the seal could be lifted after federal lawyers said they would not immediately join the case but would allow it to proceed with the potential for joining it later.

Accuser Fired

Mr. Zahara said he was fired from his job in Las Vegas after he reported his concerns about the practice to federal investigators. Sallie Mae moved much of the operations to its new Indiana facility in October 2006, and Jeff Whorley, the executive vice president in charge of the Student Assistance Corporation, left Sallie Mae in January 2007.

A Sallie Mae spokesman, Tom Joyce, said the company had not been served with any legal documents related to the case and could not comment on it. Sallie Mae’s practices, however, “are consistent with all laws and regulations as they relate to verbal forbearance in the guaranteed student-loan program,” Mr. Joyce said.

A USA Funds spokesman, Robert P. Murray, also had no comment on the case but noted that Mr. Zahara was arrested on a charge of extortion in July as part of a dispute with a short-term candidate for the Nevada State Legislature whom Mr. Zahara accused of failing to pay a debt for campaign consulting services.

The federal government distributes some $60-billion in low-interest loans to college students each year. Most of that lending is done by banks and other private lenders through the Federal Family Education Loan, or FFEL, program. The government pays the lenders a subsidy so they can offer student loans at below-market rates, and guarantees that it will repay virtually the entire amount owed in the event a borrower defaults.

The government, however, doesn’t track or publicly report many key statistics involved in the process, leaving it with little ability to discount whistle-blower claims that the system has created clear incentives for multimillion-dollar abuses of both students and taxpayers.

An Education Department spokeswoman, Samara Yudof, said she could not comment on the allegations raised by Mr. Zahara. Ms. Yudof said department regulations governing the FFEL program do require that if a forbearance agreement is verbal, the lender must send a notice to the borrower confirming the terms within 30 days. But the department doesn’t directly enforce that, Ms. Yudof said.

“Guarantee agencies, in their capacity as the entities with primary program oversight responsibility, are responsible for ensuring that lenders in their FFEL programs are in compliance with applicable statutes and regulations and that forbearances are properly requested, made, and documented,” she said.

Sallie Mae’s relationship with USA Funds dates back to 2000, when Sallie Mae acquired the guarantor's parent company, USA Group, a provider of various student loan-related services. The purchase excluded USA Funds, as a lender cannot own a guarantor, though the newly independent USA Funds signed an agreement tightly binding itself to Sallie Mae.

Payments Not Detailed

Both companies have declined to identify the formula that determines the $250-million payment from USA Funds to Sallie Mae. The companies produced a copy of their contract as part of a separate lawsuit earlier this year, but a chart defining the financial terms was omitted.

The Education Department, accepting a 2002 recommendation by its inspector general, declared in March 2004 that the companies were so tightly connected that the relationship should not be permitted. But a former Sallie Mae official, Matteo Fontana, while serving as head of the Education Department office that oversees lenders and guarantee agencies, reversed that ruling in December 2004, one day before Sallie Mae completed its transition from a government-founded lender into an independent corporation.

The allegations described by Mr. Zahara “are precisely the kinds of shenanigans that occur when a lender essentially controls the agency that is supposed to be overseeing them,” said Robert M. Shireman, president of the Institute for College Access & Success. “Unfortunately, the conflicts of interest are having the effects that could have been predicted, leading to added costs for students and taxpayers."

The department granted authority for verbal forbearances out of a legitimate concern that borrowers sometimes backed out if forced to wait for the paperwork, said Larry Zaglaniczny, director of Congressional relations at the National Association of Student Financial Aid Administrators.

Without the ability to agree verbally, borrowers “might procrastinate or some psychological barrier would come into mind,” Mr. Zaglaniczny said.

Forbearances, which can be extended for up to three years, are among several strategies that lenders, such as the Sallie Mae agents working at the Muncie facility on behalf of USA Funds, can suggest to avoid letting a loan reach default status.

The Sallie Mae collectors also can “resolve” a case by persuading the student to transfer the debt into the government’s own direct-lending system.

Political Benefits

Direct lending is generally regarded as a rival to the bank-based FFEL system, as it gives students an opportunity to borrow directly from the Education Department. The direct-lending program can help lenders in the bank-based system, however, by letting them get full repayment on troubled loans.

In addition to sparing the lender from registering a defaulted loan on its record, the transfer gives the lender a 100-percent reimbursement of the amount owed. The government in most cases guarantees only about 95 percent to 98 percent of the borrower's debt. In addition, Sallie Mae and other lenders in the FFEL program can gain a political boost in the eyes of Congress by taking another hard-to-collect loan off the books of the bank-based system and onto the books of the direct-lending program.

The collections agents in Muncie, motivated by tactics such as the March Madness brackets, merely need to persuade a delinquent borrower to accept the transfer. The sales job is helped by the fact that the transfer immediately restores the borrower to good standing. In addition, low-income borrowers could be persuaded by the fact that, until recently, only the direct-lending system offered an income-based repayment plan.

If those potential benefits are not enough to convince borrowers, Sallie Mae agents can resort to pressure. One form letter sent by Sallie Mae to a delinquent borrower in Nevada warned that her payroll check might soon be seized if she did not transfer her debt into the direct-lending system. “Within 45 to 60 days, your loan could be paid off and your wage garnishment stopped,” said the letter, a copy of which was obtained by The Chronicle.

For loans that do go into default, participating companies may have more opportunities to balloon a debt that the borrower—barred by federal rules from discharging in bankruptcy—cannot legally escape.

The guarantor, after purchasing the loan from the original lender, is expected to continue making efforts to collect. That’s because the federal government, if the loan remains unpaid for several more years, is required to purchase the loan from the guarantor. A former employee of Enterprise Recovery Systems, a partner of USA Funds, alleged in a separate lawsuit that the two companies had figured a way to exploit that requirement.

In order for a loan to remain eligible for eventual purchase by the government, the lender and the guarantor must make regular efforts to track down the borrower. USA Funds, which hires collections companies like Enterprise Recovery Systems, or ERS, to help it, routinely audited ERS to ensure it was making those tracking efforts during the time USA Funds held ownership of the loans. However, USA Funds told ERS in advance which loans it would be checking, the former employee, Rhonda Salmeron, said in her complaint, which was thrown out of court for procedural reasons in August after one of her lawyers admitted that he had publicly released a copy of the contract between Sallie Mae and USA Funds.

Audit Notifications

Ms. Salmeron worked as a general manager for ERS from 1998 to 2002. Documents filed with her complaint portrayed that practice of advance notification as having occurred on a regular basis from 1999 to 2006, enabling ERS to alter the records on many loans in a way that falsely indicated attempts to contact the borrower, she contended.

She also contended that an ERS official had learned from a technology vendor how to alter the computerized loan records. The official then began changing the records identified by USA Funds as facing audits to make it appear the borrowers had been contacted at the required intervals, Ms. Salmeron said.

Ms. Salmeron also submitted printed records showing that official's initials alongside a series of altered student-loan accounts. ERS acknowledged that the official was told how to make backdated changes in the computerized loan records, but it denied that he actually made the changes alleged by Ms. Salmeron.

The USA Funds spokesman, Mr. Murray, said the practice of notifying its collections agent of the specific borrower cases facing audit, in advance, does not compromise the integrity of the audit.

Yet the federal government has prosecuted a series of such cases in the past. In one case, in 2001, Sallie Mae agreed to pay $3.4-million in penalties and damages and to forfeit the federal guarantee on $9.5-million in student loans after being accused of submitting claims for government repayment of the loans without having taken the necessary steps to collect from the borrowers.

In that instance, prosecutors credited Sallie Mae with discovering the false reports, firing the employee responsible for filing them, and reporting the matter to the government. Sallie Mae has “taken corrective steps to ensure that similar misconduct cannot occur in the future,” the U.S. attorney overseeing the case, Donald K. Stern, said in a statement at the time.

The failure of loan companies to track former college students may help such borrowers escape their debts for a while. In the long term, however, the debt continues to multiply. Borrowers are unable to escape it, even through bankruptcy proceedings, and taxpayers are committed to covering any unpaid amounts.

Troubled Borrowers

Debtors in such straits include William M. McLaughlin of Plattsburgh, N.Y., who borrowed $37,625 to attend Embry-Riddle Aeronautical University, in Florida, in the early 1990s. He has paid back more than $50,000 and still owes more than $33,000.

A graduate of Embry-Riddle with a dual degree in aircraft management and engineering, Mr. McLaughlin saw his debt grow in part because he was unemployed for more than a year in the late 1990s during a downturn in the aerospace industry.

But his problems in paying back about a dozen separate loans were compounded, Mr. McLaughlin said, by a confusing loan system that barraged him with various billing statements. Mr. McLaughlin said he paid the bills for a period of time, falsely believing he was caught up on payments.

“As far as I knew, I wasn’t in default,” said Mr. McLaughlin, now 49, who worked several years in aviation maintenance at Pratt & Whitney in both Canada and Connecticut. “I was making payments and everything, and the next thing I know, these people are calling me, and there’s a whole other set of loans that I wasn’t even aware of that I’m defaulting on now.”

Most of his loans were held by Sallie Mae, with USA Funds and ERS among the agencies placed in charge of contacting him for payment, Mr. McLaughlin said.

“Lenders don’t care if you default,” said Alan M. Collinge, founder of StudentLoanJustice.org, a grass-roots organization for borrowers. “On balance, it can actually be far more profitable for them when you do.”

And Sallie Mae’s size and importance in the system of federally subsidized student lending gives it protection against the possibility that a federal prosecutor would punish it for further violations, Mr. Stern said.

“That would be a factor that would be taken into account,” said Mr. Stern, who is now a partner in the litigation department at Cooley Godward Kronish LLP. “There are some instances where you maybe do want to put a company out of business. But if Sallie Mae were ever to be put out of business, that would do a number on the processing of student loans.”