oversight

Special Allowance Payments to Sallie Mae's Subsidiary, Nellie Mae, for Loans Funded by Tax-Exempt Obligations.

Published by the Department of Education, Office of Inspector General on 2009-08-03.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

   Special Allowance Payments to Sallie Mae’s Subsidiary,
  Nellie Mae, for Loans Funded by Tax-Exempt Obligations


                                 FINAL AUDIT REPORT




                                    ED-OIG/A03I0006
                                      August 2009


Our mission is to promote the                         U.S. Department of Education
efficiency, effectiveness, and                        Office of Inspector General
integrity of the Department's                         Philadelphia, PA
programs and operations.
                        NOTICE

Statements that managerial practices need improvements, as well as
other conclusions and recommendations in this report, represent the
opinions of the Office of Inspector General. Determinations of
corrective action to be taken will be made by the appropriate
Department of Education officials.

In accordance with the Freedom of Information Act (5 U.S.C. § 552),
reports issued by the Office of Inspector General are available to
members of the press and general public to the extent information
contained therein is not subject to exemptions in the Act.
                                        UNITED STATES DEPARTMENT OF EDUCATION
                                                        OFFICE OF INSPECTOR GENERAL

                                                                                            Audit Services, Region III, Philadelphia


                                                            August 3, 2009

Mark L. Heleen
Executive Vice President and General Counsel
Sallie Mae, Inc.
12061 Bluemont Way
Reston, VA 20190


Dear Mr. Heleen:

Enclosed is our final audit report, Control Number ED-OIG/A03I0006, entitled Special Allowance
Payments to Sallie Mae’s Subsidiary, Nellie Mae, for Loans Funded by Tax-Exempt Obligations. This
report incorporates the comments you provided in response to the draft report. If you have any additional
comments or information that you believe may have a bearing on the resolution of this audit, you should
send them directly to the following Education Department official, who will consider them before taking
final Departmental action on this audit:

                                           William J. Taggart
                                           Chief Operating Officer, Federal Student Aid
                                           US Department of Education
                                           Union Center Plaza III, Room 112G1
                                           830 First Street, NE
                                           Washington, DC 20002

It is the policy of the U. S. Department of Education to expedite the resolution of audits by initiating
timely action on the findings and recommendations contained therein. Therefore, receipt of your
comments within 30 days would be appreciated.

In accordance with the Freedom of Information Act (5 U.S.C. § 552), reports issued by the Office of
Inspector General are available to members of the press and general public to the extent information
contained therein is not subject to exemptions in the Act.

                                                                 Sincerely,

                                                                 /s/
                                                                 Bernard Tadley
                                                                 Regional Inspector General for Audit

Enclosures




 The Department of Education's mission is to promote student achievement and preparation for global competitiveness by fostering educational
                                                   excellence and ensuring equal access.
                                              TABLE OF CONTENTS

                                                                                                                               Page
EXECUTIVE SUMMARY ...........................................................................................................1

BACKGROUND ............................................................................................................................3

AUDIT RESULTS .........................................................................................................................7

          FINDING – SLMA Billed Loans under the 9.5 Percent Floor
                    Calculation after the Eligible Tax-Exempt Bond Matured
                    and after Its Loans Were Refinanced with Ineligible Funds ....................7

OBJECTIVES, SCOPE, AND METHODOLOGY ..................................................................23

Enclosure: SLMA Comments ....................................................................................................29
                      Acronyms/Abbreviations Used in this Report

ADB          Average Daily Balance
CFR          Code of Federal Regulations
DCL          Dear Colleague Letter
Department   U.S. Department of Education
ECFC         Education Credit Finance Corporation
GAO          Government Accountability Office
GAS          Government Auditing Standards, July 2007 Revision
FFEL         Federal Family Education Loan
FSA          Federal Student Aid
HEA          Higher Education Act of 1965, as amended
HERA         Higher Education Reconciliation Act of 2005
LaRS         Lender’s Interest and Special Allowance Request and Report
LID          Lender Identification Number
NLMA         Nellie Mae
OIG          Office of Inspector General
Pub. L.      Public Law
SAP          Special Allowance Payments
SLMA         Sallie Mae, Inc.
TTPA         Taxpayer-Teacher Protection Act of 2004
Final Report
ED-OIG/A03I0006                                                                         Page 1 of 59



                                 EXECUTIVE SUMMARY


The purpose of the audit was to determine if Nellie Mae (NLMA), a subsidiary of Sallie Mae,
Inc. (SLMA), (1) billed loans under the 9.5 percent floor in compliance with the Taxpayer-
Teacher Protection Act of 2004 (TTPA) and the Higher Education Reconciliation Act of 2005
(HERA) and (2) billed loans under the 9.5 percent floor after the eligible tax-exempt bonds from
which the loans derived their eligibility matured or were retired. Our audit period covered
October 1, 2003, through September 30, 2006.

Special allowance payments (SAP) are made to lenders in the Federal Family Education Loan
(FFEL) Program to ensure that lenders receive an equitable return on their loans. In general, the
amount of SAP is the difference between the amount of interest the lender receives from the
borrower or the government and the amount that is provided under requirements in the Higher
Education Act of 1965, as amended (HEA).

The HEA includes a special allowance calculation for loans that are funded by tax-exempt
obligations issued before October 1, 1993. The quarterly SAP for these loans may not be less
than 9.5 percent, minus the interest the lender receives, divided by four. We refer to this
calculation as the “9.5 percent floor.” When interest rates are low, the 9.5 percent floor provides
a significantly greater return than lenders receive for other loans.

We found that SLMA’s billing for its NLMA subsidiary for SAP under the 9.5 percent floor,
complied with the TTPA and HERA. However, SLMA’s billing for NLMA did not comply with
other requirements for the 9.5 percent floor calculation. Specifically, SLMA continued to bill
loans under the 9.5 percent floor after the eligible tax-exempt bonds, from which the loans
derived their eligibility for the 9.5 percent floor, had matured and been retired, and after the
loans were refinanced with funds derived from ineligible sources. We estimate that this
noncompliance resulted in special allowance overpayments of about $22.3 million.

SLMA officials asserted that the date the last bond associated with an indenture matured
determined the eligibility for the 9.5 percent floor calculation of loans financed by, or made
eligible through, the bonds associated with that indenture. SLMA justified its practice based, in
part, upon the position that, because all of the bonds associated with an indenture shared
common characteristics, all of the bonds should be treated as a single obligation for purposes of
applying the 9.5 percent floor calculation. This management control weakness resulted in
noncompliance with regulations and special allowance overpayments.

We recommend that the Chief Operating Officer for Federal Student Aid (FSA) instruct SLMA
to return to the U.S. Department of Education (Department), the special allowance overpayments
we describe in our report, and disclose any other instances, at any of its subsidiaries (i.e., NLMA,
Southwest Student Services Corporation, Student Loan Funding Resources, Student Loan
Finance Association), of loans billed under the 9.5 percent floor calculation after the eligible tax-
exempt bond issue matured and after the loans were refinanced with funds derived from an
ineligible funding source.
Final Report
ED-OIG/A03I0006                                                                   Page 2 of 59

A draft of this report was provided to SLMA for review and comment on March 10, 2009. In its
comments, SLMA agreed with our conclusion that it complied with TTPA and HERA, but
strongly disagreed with our finding and recommendations. SLMA confirmed that it treated loans
it purchased from Nellie Mae that were made with the proceeds of the 1993 Bonds issued under
the 1993 Trust Agreement as eligible for the 9.5 percent floor calculation until the last bond
issued matured on July 1, 2005, but asserted that this practice was based on a reasonable
application of the HEA, regulations, and clear legislative intent. SLMA provided no evidence to
cause us to revise our finding or recommendations. The full text of SLMA’s comments on the
draft report is included as an Enclosure to this report, except for 36 pages of Exhibit B that
shows amortization tables supporting the two Eligible Loan Balance tables on page 56 of this
report. The full Exhibit B will be made available upon request.
Final Report
ED-OIG/A03I0006                                                                         Page 3 of 59



                                                BACKGROUND


Sallie Mae Corporation

SLMA was founded in 1972 as a government-sponsored enterprise and was originally chartered
as a secondary market that purchased student loans. In 2004, SLMA dissolved its charter,
terminating its corporate ties to the federal government. SLMA's primary business was to
originate and hold student loans by providing funding, delivery, and servicing support for
education loans in the U.S. through its participation in the FFEL Program and through offering
private education loans.

SLMA managed the largest portfolio of FFEL Program and private education loans in the student
loan industry, serving nearly 10 million student and parent customers through ownership and
management of $142.1 billion in student loans as of December 31, 2006, of which $119.5 billion
or 84 percent were federally insured. SLMA served clients that included over 6,000 educational
and financial institutions and state agencies. SLMA also marketed student loans, both federal
and private, directly to consumers.

SLMA acquired several companies in the student loan industry that billed loans under the 9.5
percent floor. These include—

       •   Nellie Mae Corporation in July 1999,
       •   Student Loan Funding Resources in July 2000,
       •   Student Loan Finance Association in November 2003, and
       •   Southwest Student Services Corporation in October 2004.

On July 27, 1999, NLMA incorporated NM Education Loan Corporation. On July 22, 2002, NM
Education Loan Corporation's name was changed to SLM Education Credit Management
Corporation. On November 10, 2003, SLM Education Credit Management Corporation's name
was changed to SLM Education Credit Finance Corporation (ECFC). SLMA was 100 percent
owner of ECFC, and ECFC was the sole owner of both Nellie Mae Holding LLC and Nellie Mae
Education Loan LLC.

Special Allowance Payments

A lender participating in the FFEL Program is entitled to a quarterly SAP for loans in its
portfolio. In general, the amount of a special allowance payment is the difference between the
amount of interest the lender receives from the borrower or the government and the amount that
is provided under requirements in the HEA. For example, for Stafford loans, 1 the amount of the
quarterly SAP is calculated in four steps:

       1. Determining the average of the bond equivalent rates of 91-day Treasury bills auctioned
          during the quarter,

1
    The calculation used for other types of FFEL Program loans is slightly different.
Final Report
ED-OIG/A03I0006                                                                               Page 4 of 59

       2. Adding a specified percentage to this amount (the specified percentage varies based on
          the loan type, origination date, and other factors),
       3. Subtracting the applicable interest rate for the loan, and
       4. Dividing the resulting percentage by 4. (34 C.F.R. § 682.302(c)) 2

According to Section 438(a) of the HEA, the purpose of SAP is to ensure—

           . . . that the limitation on interest payments or other conditions (or both) on loans
           made or insured under this part, do not impede or threaten to impede the carrying
           out of the purposes of this part or do not cause the return to holders of loans to be
           less than equitable . . . .

9.5 Percent Floor

The Education Amendments of 1980 (Pub. L. 96-374) created a separate special allowance
calculation for FFEL Program loans made or purchased with proceeds of tax-exempt obligations,
and the Higher Education Amendments of 1992 (Pub. L. 102-325) continued this separate
calculation for loans with variable interest rates.

In general, the quarterly SAP for these loans is one half of the percentage determined under the
method described above, using 3.5 percent as the specified percentage in Step 2. However, the
separate calculation also provides a minimum payment. The SAP for these loans “shall not be
less than 9.5 percent minus the applicable interest rate on such loans, divided by 4.” (Section
438(b)(2)(B)(i) and (ii) of the HEA) In this report, we refer to the separate calculation as the
“9.5 percent floor.”

When interest rates are low, the 9.5 percent floor calculation results in significantly greater SAP
than the lender would otherwise receive. For example, for a FFEL Program Stafford loan made
on January 15, 2000, currently in repayment, and with an average daily balance of $5,000—

       •   For the quarter ending December 31, 2003, a lender would receive $76 under the 9.5
           percent floor calculation (payment rate of 1.52 percent). Under the calculation that
           would be used if the same loan was not eligible for the 9.5 percent floor calculation
           (payment rate of 0.0025 percent), the lender would receive $0.125.
       •   For the quarter ending December 31, 2006, a lender would receive $29.50 under the 9.5
           percent floor calculation (payment rate of 0.59 percent). Under the calculation that
           would be used if the same loan was not eligible for the 9.5 percent floor calculation
           (payment rate of 0.145 percent), the lender would receive $7.25.

The Student Loan Reform Act of 1993, which was included in the Omnibus Budget
Reconciliation Act of 1993 (Pub. L. 103-66), repealed the 9.5 percent floor calculation,
restricting it to loans made or purchased with the proceeds of tax-exempt obligations that were
originally issued before October 1, 1993. In this report, we refer to these obligations as “eligible
tax-exempt” obligations or bond issues. Tax-exempt obligations that were originally issued on
or after October 1, 1993, are referred to as “ineligible tax-exempt” obligations or bond issues.
Other obligations are referred to as “taxable” obligations or bond issues.

2
    All regulatory citations are to the version dated July 1, 2003, unless otherwise noted.
Final Report
ED-OIG/A03I0006                                                                        Page 5 of 59

Taxpayer-Teacher Protection Act of 2004

The TTPA (Pub. L. 108-409), enacted on October 30, 2004, revised Section 438(b)(2)(B) of the
HEA to make certain loans ineligible for the 9.5 percent floor calculation. Loans were ineligible
for the 9.5 percent calculation if they were—

   •   Financed by a tax-exempt obligation that, after September 30, 2004, and before
       January 1, 2006, had matured or been retired or defeased;
   •   Refinanced after September 30, 2004, and before January 1, 2006, with a funding source
       other than the proceeds of an eligible tax-exempt obligation, as described in Section
       438(b)(2)(B)(v)(I) of the HEA; or
   •   Sold or transferred to any other holder after September 30, 2004, and before January 1,
       2006.

Higher Education Reconciliation Act of 2005

The HERA (Pub. L. 109-171), enacted on February 8, 2006, further revised Section 438(b)(2)(B)
of the HEA. First, the HERA made the TTPA provisions permanent by removing the January 1,
2006, sunset date. Second, under the HERA, a loan is ineligible for the 9.5 percent floor
calculation if it was—

   •   Made or purchased on or after February 8, 2006; or
   •   Not earning special allowance at the 9.5 percent floor rate on February 8, 2006.

The HERA provides an exception to these requirements for certain small lenders, but SLMA
does not qualify for that exception.

Eligible Tax-Exempt Bonds

For the period October 1, 2003, through September 30, 2006, NLMA had three outstanding
eligible tax-exempt obligations (bonds outstanding), totaling $159,800,000 (Table 1).


              Table 1 – NLMA Outstanding Eligible Tax-Exempt Obligations from
                           October 1, 2003 – September 30, 2006

                                                                          Original
                                                 Bond       Indenture
             Bond     Indenture   Issue Date                               Bond
                                                Maturity     Maturity
                                                                          Amount
             1992H      1992H     11/19/1992    11/1/2009   11/1/2009    $24,000,000
             1993A      1993A      3/1/1993      7/1/2005    7/1/2005   $103,300,000
             1993F      1993A      7/1/1993      7/1/2004    7/1/2005    $32,500,000
                                                              Total     $159,800,000

On average, NLMA had total average daily balance (ADB) billings of about $399.3 million in
9.5 percent floor loans for each quarter. During this same period, the Department paid special
allowance, totaling about $75.1 million (net) to NLMA for its 9.5 percent floor loans. Although
ECFC did not have any bonds outstanding during this period, ECFC, on average, had total ADB
Final Report
ED-OIG/A03I0006                                                                                  Page 6 of 59

billings of about $221.4 million in 9.5 percent floor loans for each quarter ended September 30,
2004, through June 30, 2005. The Department paid special allowance (net), totaling about $14.5
million (net) to ECFC for its 9.5 percent floor loans. These amounts are provided below in
Tables 2 (for NLMA) and 3 (for ECFC).


         Table 2 - NLMA’s Quarterly 9.5 Percent Floor Loan Balances and Net SAP Paid

                           Current
  Quarterly Period                          Net Adjustments
                        Quarter ADB                                 Total ADB Billed        SAP Paid (Net)
      Ending                                    to ADB
                            Billed
 December 31, 2003      $1,121,419,999           ($22,469,676)          $1,098,950,323           $17,473,409
 March 31, 2004         $1,125,633,637           ($19,523,037)          $1,106,110,600           $17,562,882
 June 30, 2004            $952,198,680           $142,460,841           $1,094,659,521           $17,355,455
 September 30, 2004       $380,389,990           ($12,755,104)            $367,634,886            $5,851,323
 December 31, 2004        $344,424,312            ($9,969,300)            $334,455,012            $5,305,828
 March 31, 2005           $312,379,041               $485,819             $312,864,860            $4,994,624
 June 30, 2005             $58,055,685           $217,469,058             $275,524,743            $4,418,304
 September 30, 2005        $51,413,978               ($31,032)             $51,382,946             $582,964
 December 31, 2005         $45,437,762                ($4,465)             $45,433,297             $512,105
 March 31, 2006            $39,330,356                  $3,575             $39,333,931             $440,244
 June 30, 2006             $35,384,756                  $7,635             $35,392,391             $395,558
 September 30, 2006        $29,494,247                      $0             $29,494,247             $192,335
        Total:                                                                                   $75,085,031
                      Net adjustments are reflected during the quarters for which the adjustments were applied.
                                                              Source: U.S. Department of Education, Datamart



         Table 3 - ECFC’s Quarterly 9.5 Percent Floor Loan Balances and Net SAP Paid

                         Current
  Quarterly Period                      Net Adjustments
                         Quarter                               Total ADB Billed           SAP Paid (Net)
      Ending                                to ADB
                        ADB Billed
 December 31, 2003               $0             ($17,137)               ($17,137)                         $0
 March 31, 2004                  $0             ($15,204)               ($15,204)                         $0
 June 30, 2004                   $0             ($18,766)               ($18,766)                         $0
 September 30, 2004              $0          $353,718,924            $353,718,924                 $5,858,826
 December 31, 2004               $0          $204,754,549            $204,754,549                 $3,335,806
 March 31, 2005         $86,486,254           $91,622,389            $178,108,643                 $2,931,280
 June 30, 2005         $149,046,800                    $0            $149,046,800                 $2,404,179
 September 30, 2005              $0                    $0                      $0                         $0
 December 31, 2005               $0                    $0                      $0                         $0
 March 31, 2006                  $0                    $0                      $0                         $0
 June 30, 2006                   $0                    $0                      $0                         $0
 September 30, 2006              $0                    $0                      $0                         $0
        Total:                                                                                   $14,530,092
                      Net adjustments are reflected during the quarters for which the adjustments were applied.
                                                              Source: U.S. Department of Education, Datamart
Final Report
ED-OIG/A03I0006                                                                                    Page 7 of 59



                                           AUDIT RESULTS


The purpose of the audit was to determine if SLMA’s subsidiary, NLMA, (1) billed loans under
the 9.5 percent floor in compliance with the TTPA and HERA, and (2) billed loans under the 9.5
percent floor, after the eligible tax-exempt bonds from which the loans derived their eligibility,
had matured or been retired. Our audit period covered October 1, 2003, through September 30,
2006.

We found that SLMA’s billing for its NLMA subsidiary for SAP under the 9.5 percent floor
complied with the TTPA and HERA. We also found that SLMA’s NLMA subsidiary continued
to bill loans under the 9.5 percent floor after the eligible tax-exempt bonds, from which the loans
derived their eligibility for the 9.5 percent floor, matured and after the loans were refinanced
with funds derived from ineligible sources. As a result, SLMA’s billing activities for its NLMA
subsidiary did not comply with laws, regulations, and guidance for the 9.5 percent floor
calculation.

In its comments to the draft report, SLMA agreed with our conclusion that it complied with
TTPA and HERA, but did not concur with our finding and recommendations. SLMA’s
comments are summarized at the end of the finding. The full text of SLMA’s comments on the
draft report is included as an Enclosure to this report.

FINDING – SLMA Billed Loans under the 9.5 Percent Floor Calculation after the
         Eligible Tax-Exempt Bond Matured and after Its Loans Were
         Refinanced with Ineligible Funds

SLMA continued to bill loans under the 9.5 percent floor calculation (1) after the eligible tax-
exempt bond, from which the loans derived the 9.5 percent floor eligibility, matured and retired 3
and (2) after the loans were refinanced with funds derived from an ineligible funding source.
Although three of the bonds matured in 2002 and one matured in 2004 (Table 4), SLMA
continued to bill loans that had been financed by these bonds under the 9.5 percent floor
calculation until June 2005. The loans billed were ineligible to receive special allowance under
the 9.5 percent floor calculation. We estimate that this noncompliance resulted in special
allowance overpayments of about $22.3 million.




3
 Bonds 93B, 93F, 93G and 93H were retired (i.e. repaid) upon each bond’s respective maturity, as noted in Tables 4
and 5.
Final Report
ED-OIG/A03I0006                                                                                        Page 8 of 59



                                         Table 4 – NLMA Bond Issues

                                                                                 Bond Amount
                                     Original Bond
                        Bond                               Maturity Date         Outstanding at
                                       Amount
                                                                                   Maturity
                         93B          $48,905,000          June 1, 2002           $10,700,000
                         93F          $32,500,000          July 1, 2004           $32,500,000
                         93G          $107,000,000        August 1, 2002          $47,400,000
                         93H          $71,790,000        December 1, 2002         $14,370,000

Bonds 93B, 93F, 93G and 93H were issued under NLMA’s 93A Indenture, which consisted of
eight bonds totaling $458,095,000. All eight bonds issued under the 93A Indenture were
refunding bonds issued to refund obligations originally issued before October 1, 1993. The last
outstanding bond issued under the indenture matured on July 1, 2005. 4 (Table 5)


                          Table 5 – Bonds Issued under NLMA’s 93A Indenture

                                            Bond          Date            Bond        Original
              Bond or Supplement
                                            Name         Issued          Maturity    Bond Issue
                 Original Bond               93A         3/1/1993          7/1/2005 $103,300,000
                First Supplement             93B         6/1/1993          6/1/2002 $48,905,000
               Second Supplement             93C         7/1/1993          7/1/1998 $26,100,000
               Second Supplement             93D         7/1/1993          7/1/1998 $10,160,000
               Second Supplement             93E         7/1/1993          7/1/1999 $58,340,000
               Second Supplement             93F         7/1/1993          7/1/2004 $32,500,000
                Third Supplement             93G         8/1/1993          8/1/2002 $107,000,000
               Fourth Supplement             93H       11/15/1993         12/1/2002 $71,790,000
                                                                              Total $458,095,000

SLMA’s treatment of 9.5 percent floor loans financed by bonds associated with the 93A
Indenture was not consistent with NLMA’s practice prior to SLMA's acquisition of NLMA in
July 1999. According to SLMA officials, prior to SLMA assuming responsibility for NLMA’s
bonds and 9.5 percent floor loans, NLMA’s practice was to cease billing loans under the 9.5
percent floor calculation upon the maturity of the applicable eligible tax-exempt bond. SLMA
took the position that NLMA was mistaken when it ceased billing on a particular bond prior to


4
  A bond is a valid debt obligation of the issuer. An indenture is a formal agreement between the issuer of the bond
and a trustee bank. Generally, the indenture creates a trust estate administered by the trustee for the benefit of the
bondholders to ensure repayment of the bonds. Loans made or purchased with the bond proceeds and their
associated payments and income are pledged by the issuer to the trust estate to ensure repayment of the bonds.
(NLMA’s 93A Indenture did not include a pledge of collateral to secure the repayment of the bonds.) The indenture
describes the terms and conditions of the bond, such as the type of obligation, bond amount, interest rate and
maturity date. The indenture also specifies administrative tasks to be performed by the trustee, such as the handling
of bond proceeds. A single bond or multiple bonds may be issued under an indenture or additional bonds may be
issued under supplements to an indenture.
Final Report
ED-OIG/A03I0006                                                                                    Page 9 of 59

the maturity of the particular bond indenture (i.e., the date that the last bond in the indenture
matures).

Pursuant to 34 C.F.R. § 682.302(e)(2), certain loans are ineligible for the 9.5 percent floor
calculation: 5

        The Secretary pays a special allowance to an Authority at the rate prescribed in
        paragraph (c)(1) of this section [the usual special allowance rate] on a loan
        described in paragraph (c)(3)(i) of this section [a loan financed by an eligible tax-
        exempt obligation or related eligible financing sources]—
                (i) After the loan is pledged or otherwise transferred in consideration of
        funds derived from sources other than those described in paragraph (c)(3)(i) of
        this section; and
                (ii) If the authority retains a legal or equitable interest in the loan—
                (A) The prior tax-exempt obligation is retired; or
                (B) The prior tax-exempt obligation is defeased . . . .

On March 1, 1996, the Department issued Dear Colleague Letter (DCL) 96-L-186, Clarification
and interpretive guidance on certain provisions in the Federal Family Education Loan (FFEL)
Program regulations published on December 18, 1992. Item 30 of this DCL addressed the 9.5
percent floor calculation and stated—

        Under the regulations, if a loan made or acquired with the proceeds of a [eligible]
        tax-exempt obligation is refinanced with the proceeds of a taxable obligation, the
        loan remains subject to the tax-exempt special allowance provisions if the
        authority retains legal interest in the loan. If, however, the original tax-exempt
        obligation is retired or defeased, special allowance is paid based on the rules
        applicable to the new funding source (taxable or tax-exempt).

SLMA had a long-standing practice of continuing to bill loans under the 9.5 percent floor
calculation until the last bond associated with the indenture matured. In this instance, SLMA
treated loans made eligible for the 9.5 percent floor calculation by each of the bonds, issued
under the 93A Indenture, as remaining eligible for the 9.5 percent floor calculation until Bond
93A matured on July 1, 2005.

SLMA explained that all of the individual bonds issued under the 93A Indenture shared common
characteristics. For example, all of the bonds had identical terms and were payable from the
same source of funds. SLMA considered it reasonable to treat all of the bonds issued under the
93A Indenture as a single “obligation,” and to consider that obligation to mature only when its
last bond matured. SLMA argued that it would be arbitrary to identify a bond series (a group of
bonds issued on the same date and maturing on the same date, as described in Table 5) as the
“obligation,” because the 93A Indenture did not provide for such a distinction.



5
 After amendments were published in the Federal Register on December 18, 1992 (57 FR 60280), the text of 34
C.F.R. § 682.302(e) remained unchanged until September 8, 2006. We cite the text in effect prior to September 8,
2006.
Final Report
ED-OIG/A03I0006                                                                                      Page 10 of 59

We do not agree that SLMA’s position is a reasonable interpretation of the HEA or regulations.
Though all of the bonds issued under the 93A Indenture do share some common characteristics,
they cannot be considered identical. For purposes of determining an obligation’s eligibility for
the 9.5 percent floor calculation, only the following characteristics are material:

    •    The tax treatment of income from the obligation. (HEA §438(b)(2)(B)(i))
    •    The date the obligation was originally issued. (HEA §438(b)(2)(B)(iv))
    •    If applicable, the date the obligation is refunded. (HEA §438(b)(2)(B)(iv))
    •    If the obligation is refunded, the tax treatment of income (i.e., tax-exempt or taxable)
         from refunding obligation(s). (34 C.F.R. §682.302(e)(2), effective September 8, 2006)
    •    The date the obligation matures, is retired or defeased. (HEA §438(b)(2)(B)(v))

Because bonds issued under the 93A Indenture have different maturity dates, it is unreasonable
to ignore that characteristic and continue to bill under the 9.5 percent floor calculation: it is
unreasonable to treat all bonds as eligible when it is clear from the maturity dates of the bond
series that some of the bonds are no longer eligible.

In addition, the term “obligation,” as it is used in the HEA, regulations, and other guidance
issued by the Department, plainly refers to a bond, not to the bond’s indenture:

    •    Pursuant to Section 438(b)(2)(B)(i) of the HEA, SAP is paid under the 9.5 percent floor
         for “loans which were made or purchased with funds obtained by the holder from the
         issuance of obligations.”

    •    Pursuant to 34 C.F.R. § 682.302(c)(3)(i), SAP is paid under the 9.5 percent floor for a
         loan “that was made or purchased with funds obtained by the holder from . . . [t]he
         proceeds of tax-exempt obligations.”

    •    Pursuant to DCL 96-L-186, guidance is provided for a loan “made or acquired with the
         proceeds of a [eligible] tax-exempt obligation [that] is refinanced with the proceeds of a
         taxable obligation.”

All of these requirements assume that the issuance of an “obligation” provides a lender with
funds that can be used to make or purchase loans. The issuance of a bond does provide such
funds; the issuance of an indenture does not. An indenture is a formal agreement between the
issuer of a bond and a trustee bank, and its issuance does not provide a lender with funds that can
be used to make or purchase loans.

Ineligible Loans Funded by Bond 93F

In July 2004, SLMA sold loans with a principal value of about $688.6 million from its NLMA
subsidiary to its ECFC subsidiary, in consideration of funds derived from ineligible sources. The
eligibility of these loans for the 9.5 percent floor was derived from Bond 93F. 6 As a result of the
sale, NLMA ceased billing the loans under the 9.5 percent floor calculation, and classified the
loans as eligible for the usual special allowance rates, as Bond 93F was scheduled to mature on
6
 We did not perform audit procedures to confirm that these loans were in fact eligible for the 9.5 percent floor
calculation.
       Final Report
       ED-OIG/A03I0006                                                                                     Page 11 of 59

       July 1, 2004. According to SLMA officials, the sale was an erroneous early liquidation of Bond
       93F.

       At the time of the sale, SLMA determined that loans financed by, or made eligible through, Bond
       93F would not be eligible for the 9.5 percent floor calculation after the bond matured on July 1,
       2004. Upon maturity, Bond 93F was repaid and, as a result, retired. Upon the sale to ECFC, the
       loans were classified as being financed by holding tanks associated with ECFC. According to
       SLMA, holding tanks are funded with the proceeds of short-term borrowings and long-term
       notes. Holding tanks are not funded with eligible tax-exempt obligations and, therefore, are an
       ineligible funding source for loans billed under the 9.5 percent floor calculation. When Bond
       93F was retired and the loans were transferred in consideration of an ineligible source (the
       holding tanks), the loans lost their eligibility for the 9.5 percent floor calculation.
        In February 2005, SLMA recoded the loans held by ECFC (the loans that previously derived
       their eligibility for the 9.5 percent floor from Bond 93F) and resumed billing their SAP under the
       9.5 percent floor for the quarters ended March 31, 2005, and June 30, 2005. SLMA adjusted
       prior billings for the quarters ended September 30, 2004, and December 31, 2004, to bill the
       loans under the 9.5 percent floor calculation.

       The loans were billed under SLMA’s ECFC subsidiary as detailed in Table 6. On average, for
       each of the quarters ended from September 30, 2004, through June 30, 2005, SLMA billed an
       ADB of about $221 million under the 9.5 percent floor calculation for ineligible loans associated
       with Bond 93F. SLMA received about $14.5 million in improper SAP under the 9.5 percent
       floor calculation for these ineligible loans.

       We estimated the payments SLMA would have received based on the average usual special
       allowance rates for the same quarters. Of the $14.5 million received for quarters ended
       September 30, 2004, through June 30, 2005, SLMA should have received an estimated $2.2
       million under the usual rates, resulting in an estimated overpayment of about $12.3 million
       (Table 6).


                                        Table 6 – ECFC Special Allowance Billings


                           ECFC
                                           ECFC Net
                          Current                           Total ECFC        Estimated SAP       9.5 Percent      Estimated
  Quarter Ended                           Adjustments
                          Quarter                           ADB Billed        at Usual Rates       SAP Paid       Overpayment
                                            to ADB
                         ADB Billed

September 30, 2004                 $0 $353,732,135 $353,732,135                      $429,659 $5,858,826              $5,429,167
December 31, 2004                  $0 $204,767,175 $204,767,175                      $510,871 $3,335,806              $2,824,935
March 31, 2005            $86,486,254 $91,622,389 $178,108,643                       $604,145 $2,931,280              $2,327,135
June 30, 2005            $149,046,800           $0 $149,046,800                      $644,926 $2,404,179              $1,759,253
                                                      Totals                       $2,189,599 $14,530,092            $12,340,492
Note - Details of our estimates are contained in the Objectives, Scope and Methodology section of this report, “Estimate of
Ineligible 9.5 Percent SAP and Usual SAP on Loans Funded by Bond 93F.” For each quarter, the estimated overpayment is the
difference between the special allowance paid under the 9.5 percent floor calculation and the estimated special allowance amount at
the usual special allowance rates.
Final Report
ED-OIG/A03I0006                                                                              Page 12 of 59

Ineligible Loans Funded by Bonds 93B, 93G and 93H

Upon the maturity of Bonds 93B, 93G, and 93H (in June, August, and December 2002,
respectively), the loans financed by, or made eligible through, these bonds were treated by
SLMA in a manner similar to the loans associated with Bond 93F. According to SLMA
officials, loans funded by Bonds 93B, 93G, and 93H continued to be billed under the 9.5 percent
floor calculation until July 1, 2005, which was the maturation date of the last bond (Bond 93A)
associated with the 93A Indenture. According to SLMA officials, the loans associated with
Bonds 93B, 93G, and 93H were transferred to and maintained in holding tanks, associated with
NLMA, immediately after each bond matured. Holding tanks are not funded with eligible tax-
exempt obligations and represent an ineligible funding source for loans billed under the 9.5
percent floor calculation. As a result, the loans associated with Bonds 93B, 93G, and 93H
became ineligible for the 9.5 percent floor calculation when they were refinanced with the
ineligible funds in the holding tanks and the bonds matured. Upon each bond’s respective
maturity, Bonds 93B, 93G, and 93H were repaid and, as a result, retired.

Within four holding tanks, the loans were commingled with loans associated with other eligible
bonds from the 93A Indenture (i.e., Bonds 93A, 93B, 93F, 93G and 93H). 7 The four holding
tanks, which commingled both eligible and ineligible loans funded by the bonds under the 93A
Indenture, had special allowance billings under the 9.5 percent floor calculation for the audit
period as detailed in Table 7.




7
 The loans were billed under LID 833691 for NLMA. SLMA’s internal systems associated these loans with
holding tanks 4402/5402 and 4421/5421. These holding tanks were associated with the 93A Indenture.
Final Report
ED-OIG/A03I0006                                                                                   Page 13 of 59



                                Table 7 – NLMA Holding Tank Billings for
                               Eligible and Ineligible Loans Associated with
                                    Bonds 93A, 93B, 93F, 93G, and 93H

                                                                        Estimate of 9.5
                                                   Average Daily
                            Quarter Ended                                Percent SAP
                                                     Balance
                                                                             Paid
                         December 31, 2003           $818,752,786           $13,003,077
                         March 31, 2004              $802,965,117           $12,737,214
                         June 30, 2004               $792,198,634           $12,559,635
                         September 30, 2004          $225,306,698            $3,586,004
                         December 31, 2004           $216,111,835            $3,427,641
                         March 31, 2005              $170,380,802            $2,724,468
                         June 30, 2005               $123,819,876            $1,985,496
                                                        Total               $50,023,535
                         Note- We estimated the amount of SAP paid under the 9.5
                         percent floor calculation (9.5 Percent SAP Paid) on the ADB
                         associated with the branch codes for the four holding tanks
                         (4402/5402 and 4421/5421). For each quarter, we divided the
                         total ADB billed for the four holding tanks by NLMA’s total
                         ADB billed under the 9.5 percent floor calculation. We then
                         multiplied the resulting percentage by NLMA’s total SAP paid
                         under the 9.5 percent floor calculation to estimate the amount of
                         9.5 percent SAP paid for each respective quarter on the ADBs
                         associated with the four holding tanks.

SLMA was unable to quantify its 9.5 percent floor calculation billings specifically associated
with Bonds 93B, 93G, and 93H, because the loans within the holding tanks were commingled
with loans associated with other eligible bonds associated with the 93A Indenture. We could not
easily identify the ineligible loans and the quarterly ineligible ADBs associated with these loans.
Therefore, we estimated the ineligible quarterly ADBs associated with Bonds 93B, 93G, and
93H that were billed under the 9.5 percent floor calculation. 8 We also estimated the amount of
the overpayments attributed to these ineligible loans.

In Table 8, we estimated that, on average, for each of the quarters ended June 30, 2002, through
June 30, 2005, SLMA billed an ADB of about $54 million under the 9.5 percent floor calculation
for loans that were no longer eligible for the 9.5 percent floor calculation following the maturity
of the associated eligible tax-exempt bond and after the loans were refinanced with funds derived
from an ineligible funding source.

In Table 9, we estimated that SLMA would have received about $10.7 million in improper SAP
under the 9.5 percent floor calculation for the estimated ineligible ADBs. We also estimated the
payments SLMA would have received based on the average usual special allowance rates for the

8
  We estimated the quarterly ADBs for the ineligible loans associated with the three matured bonds by amortizing
the loans' estimated outstanding amounts at the time each bond matured resulting in an estimated quarterly ADB
through the July 1, 2005, maturation of Bond 93A (Table 8).
Final Report
ED-OIG/A03I0006                                                                                 Page 14 of 59

same quarters. Of the estimated $10.7 million in improper SAP under the 9.5 percent floor
calculation for quarters ended June 30, 2002, through June 30, 2005, SLMA would have received
an estimated $632,000 under the usual rates, resulting in an estimated overpayment of about $10
million.


         Table 8 – Estimate of Ineligible ADB Billed for NLMA Bonds 93B, 93G and 93H

                                                                                        Quarterly
                                                                                         Balances
         Quarter Ended           Bond 93B        Bond 93G          Bond 93H
                                                                                        (Ineligible
                                                                                           ADB)
       June 30, 2002             $3,566,667                                                $3,566,667
       September 30, 2002       $10,490,196      $31,445,098                              $41,935,294
       December 31, 2002        $10,175,490      $46,005,882        $4,790,000            $60,971,372
       March 31, 2003            $9,860,784      $44,611,765       $14,088,235            $68,560,784
       June 30, 2003             $9,546,078      $43,217,647       $13,665,588            $66,429,314
       September 30, 2003        $9,231,373      $41,823,529       $13,242,941            $64,297,843
       December 31, 2003         $8,916,667      $40,429,412       $12,820,294            $62,166,373
       March 31, 2004            $8,601,961      $39,035,294       $12,397,647            $60,034,902
       June 30, 2004             $8,287,255      $37,641,177       $11,975,000            $57,903,431
       September 30, 2004        $7,972,549      $36,247,059       $11,552,353            $55,771,961
       December 31, 2004         $7,657,843      $34,852,941       $11,129,706            $53,640,490
       March 31, 2005            $7,343,137      $33,458,824       $10,707,059            $51,509,020
       June 30, 2005             $7,028,431      $32,064,706       $10,284,412            $49,377,549
                                                                  Average ADB             $53,551,154
       Note – Details of our estimates are contained in the Objectives, Scope and Methodology section
       in this report, “Estimate of Loans Billed After Bonds 93B, 93G, and 93H Matured.” Our
       estimate did not include a consideration for any loans that may have been transferred to the
       holding tank(s) before each bond matured.
Final Report
ED-OIG/A03I0006                                                                                  Page 15 of 59



               Table 9 – Estimated SAP Overpayment for Bonds 93B, 93G, and 93H

                                 Estimated
                                                                        Estimated
                                   NLMA            Estimated SAP                         Estimated
        Quarter Ended                                                   9.5 Percent
                                  Ineligible       at Usual Rates                       Overpayment
                                                                         SAP Paid
                                 ADB Billed
      June 30, 2002                $3,566,667                    $0         $34,534            $34,534
      September 30, 2002          $41,935,294                $7,590        $603,320           $595,730
      December 31, 2002           $60,971,372                $7,012        $871,757           $864,745
      March 31, 2003              $68,560,784                $6,788        $977,831           $971,043
      June 30, 2003               $66,429,314                $4,783        $948,382           $943,599
      September 30, 2003          $64,297,843                $6,816      $1,023,225         $1,016,410
      December 31, 2003           $62,166,373                $8,890        $987,299           $978,410
      March 31, 2004              $60,034,902                $6,184        $952,317           $946,133
      June 30, 2004               $57,903,431               $60,162        $918,010           $857,848
      September 30, 2004          $55,771,961               $35,415        $887,672           $852,257
      December 31, 2004           $53,640,490               $58,146        $850,765           $792,619
      March 31, 2005              $51,509,020              $152,209        $823,653           $671,444
      June 30, 2005               $49,377,549              $278,144        $791,787           $513,643
                                    Totals                 $632,137     $10,670,551        $10,038,413
      Note - Details of our estimates are contained in the Objectives, Scope and Methodology section in
      this report, “Estimate of Ineligible 9.5 Percent SAP and Usual SAP on Loans Funded by Bonds
      93B, 93G, and 93H.”

Recommendations

We recommend that the Chief Operating Officer for Federal Student Aid instruct SLMA to—

1.1   Adjust its special allowance billings for loans associated with Bond 93F that became
      ineligible for the 9.5 percent floor calculation, as described in the finding, and return all
      overpayments to the Department (for which we estimate to be about $12.3 million).

1.2   Identify the loans associated with Bonds 93B, 93G, and 93H that became ineligible for
      the 9.5 percent floor calculation, as described in the finding, and adjust its special
      allowance billings for the affected loans in the quarters ended June 30, 2002, through
      June 30, 2005, and return all overpayments to the Department (for which we estimate to
      be about $10 million).

1.3   Disclose any other instances, at any of its subsidiaries (e.g., NLMA, Southwest Student
      Services Corporation, Student Loan Funding Resources, Student Loan Finance
      Association), of loans billed under the 9.5 percent floor calculation after the eligible tax-
      exempt bond issue matured and after the loans were refinanced with funds derived from
      an ineligible funding source and, if necessary, adjust its special allowance billings for all
      affected loans and return all overpayments to the Department.
Final Report
ED-OIG/A03I0006                                                                          Page 16 of 59

SLMA Comments and OIG Responses

Introduction and Summary of Arguments
• SLMA Comment. SLMA agreed with our conclusion that it complied with TTPA and HERA,
    but strongly disagreed with our finding and recommendations. In its comments, SLMA
    confirmed that it treated loans it purchased from Nellie Mae that were made with the
    proceeds of the 1993 Bonds issued under the 1993 Trust Agreement as eligible for the 9.5
    percent floor calculation until the last bond issued matured on July 1, 2005, but asserted that
    this practice was based on a reasonable interpretation of the HEA, regulations, and clear
    legislative intent.

•   OIG Response. We have made some minor revisions to our report, for clarity, but we have
    not made the substantive revisions requested in SLMA’s comments. We do not agree that
    SLMA’s practice was based on a reasonable application of the HEA, regulations, and
    Departmental guidance.

Definition of “Obligation”
• SLMA Comment. SLMA disagreed with our understanding of the term “obligation,” and
   stated “. . . the OIG adopted a new narrow legal interpretation of the term obligation. An
   interpretation that, to the best of our knowledge, does not appear in the [HEA] . . . or in any
   legislative history and has never been published or communicated to the student lending
   community in any manner.”

•   OIG Response. Our report does not advance a new or unusual definition of “obligation.”
    Our understanding of the term “obligation” is consistent with the term’s use in the HEA,
    regulations, and Departmental guidance. Though the HEA, regulations, and Departmental
    guidance do not include a specific definition of “obligation,” their context indicates that the
    term means the particular debt or borrowing that was the source of the funds used to acquire
    or maintain ownership of a loan: the term is used to tie the 9.5 percent floor rate on a loan to
    the source of the funds used to acquire that loan.

    For example, 34 C.F.R. § 682.302(c)(3)(i)(A) states that a loan is eligible for the 9.5 percent
    rate if it “was made or purchased with funds obtained by the holder from . . . [t]he proceeds
    of tax-exempt obligations originally issued prior to October 1, 1993 . . ..” As such, the
    “obligation” is the funding source for the eligible loan. Contrary to this usage, SLMA’s
    definition of “obligation” would tie the eligibility of a loan for the 9.5 percent rate to a group
    of bonds, none of which may have been its funding source. This is not a reasonable
    application of the HEA’s and regulations’ use of “obligation.”

Congressional Intent
• SLMA Comment. SLMA stated that the finding is not consistent with the intent of Congress
   because the OIG’s understanding of the requirements for the 9.5 percent floor—

       . . . is inconsistent with the original federal legislative intent that the 9.5% rate act
       as a floor and thus a limitation on the yield lenders could obtain. Therefore, the
       federal government encouraged maximizing loans within the 9.5% floor. In the
       past, the Department insisted that lenders not be permitted to turn loans originally
Final Report
ED-OIG/A03I0006                                                                              Page 17 of 59

        financed through tax-exempt obligations, for which special allowance was one
        half the normal special allowance [i.e., subject to the 9.5% floor rate], into loans
        that yielded full special allowance [i.e., subject to the usual rates] by refinancing
        the loans through taxable financings. Sallie Mae’s interpretation is the only
        interpretation consistent with that Congressional intent.

    SLMA also stated that the finding is not consistent with the history of requirements for the
    9.5 percent floor, as reflected in an audit report issued by the Government Accountability
    Office (GAO) in 2004. 9 SLMA stated, “The Department amended 34 C.F.R. § 682.302(e)(2)
    in 1992 to prevent holders from avoiding the Half-SAP cap through refinancing into non-
    floor eligible loans, by adding a provision that if the authority retained a legal interest in
    those loans and the original tax-exempt obligation remained outstanding, floor loan treatment
    must continue.”

•   OIG Response. SLMA’s general appeal to “congressional intent” is unsupported by specific
    evidence and does not address the particular circumstances of SLMA’s billing activity. The
    structure of the HEA provisions evidences Congress’ intent was to align a loan’s special
    allowance payments with the tax-exempt status of the bonds that were used to make or
    purchase it. The Department described this intent specifically, in its preamble to final
    regulations it published in the Federal Register on February 8, 1985:

        The rule implements the Congressional intention in section 438(b)(2) of the HEA
        to reduce special allowances to parties whose lower cost of borrowing does not
        justify Federal subsidy at the rate paid commercial lenders. These regulations
        therefore tie the rate of special allowance to the source of the funds used to
        acquire or maintain the Authority’s interest in a loan, and more particularly, to
        the financing costs incurred in securing those funds. Congress recognized that a
        party raising loan acquisition funds by means of tax-exempt borrowings had a
        financing cost well below that incurred by parties using other sources of funds,
        and the 1980 amendments to section 438 of the HEA which reduced the special
        allowance to tax-exempt borrowers reflect a Congressional judgment of the
        subsidy appropriate to their reduced borrowing costs. (50 FR 5512, emphasis
        added)

    SLMA’s definition of “obligation” is contrary to Congress’ intent to “tie the rate of special
    allowance to the source of the funds.” Its definition would continue special allowance
    payments on a loan at the 9.5 percent rate long after its funding source was retired. For
    example, if a lender made or purchased $200 million in loans with the proceeds of $200
    million in eligible tax-exempt bonds, and if $100 million of those bonds were retired within
    five years, and the remaining bonds continued until a 30-year maturity, these initial
    retirements, in SLMA’s view, would have no impact on the special allowance payments on
    the loans. The entire $200 million in loans would continue to receive special allowance
    payments at the 9.5 percent rate, until the remaining $100 million in bonds were retired.



9
 “Federal Family Education Loan Program: Statutory and Regulatory Changes Could Avert Billions in Unnecessary
Federal Subsidy Payments,” GAO-04-1070, issued September 2004.
Final Report
ED-OIG/A03I0006                                                                      Page 18 of 59

    In addition to the reasons cited in the report’s finding, ECFC’s billings at the 9.5 percent
    floor calculation were also ineligible for 9.5 percent floor treatment because they did not
    comply with § 438(b)(2)(B)(i) of the HEA. § 438(b)(2)(B)(i) authorizes payment under the
    9.5 percent floor calculation only “. . . for holders of loans which were made or purchased
    with funds obtained by the holder from the issuance of [eligible tax-exempt] obligations . . .”
    As such, if the entity that issued the eligible tax-exempt obligation and used the proceeds to
    finance 9.5 percent floor loans no longer has title to, or interest in the loans, following the
    change in ownership of the loans, the loans can only qualify for the 9.5 percent floor
    calculation if the new holder used an eligible tax-exempt funding source to acquire the loan.
    ECFC was not eligible to bill loans under the 9.5 percent floor calculation because (1) ECFC
    did not use an eligible tax-exempt funding source to acquire the loans – it used holding tank
    funds, (2) NLMA did not retain an ownership interest in the loans sold to ECFC, and (3)
    NLMA and ECFC presented themselves as distinct and separate holders of loans for special
    allowance purposes.

SLMA’s Interpretation was Reasonable
• SLMA Comment. SLMA stated, “. . . neither the statute nor regulations currently specifically
  define ‘obligation’ and the precise issue raised in the OIG’s audit is one of first impression.”
  In addition, “SLMA reasonably interpreted the term ‘obligation’ . . . to include multiple
  bonds issued in the same calendar year under a single trust agreement where the bonds
  shared important characteristics.”

    SLMA also stated “. . . the OIG should not use an audit to advance a particular construction
    of an undefined term in a statutory provision that has long perplexed lenders, Congress, the
    Department and the press.” In addition, “If the Department takes the new position that
    ‘obligation’ for purposes of Section 438(b) and [34 CFR 682.302] should be interpreted more
    narrowly as an individual tax-exempt bond, it should publish public guidance for industry
    participants.”

•   OIG Response. As stated in our previous responses, our understanding of the term
    “obligation” is consistent with the HEA, regulations and Departmental guidance. SLMA
    provided no evidence that such a definition “has long perplexed lenders, Congress, the
    Department and the press.”

The OIG’s Estimate is Incorrect and Overstated
• SLMA Comment. SLMA declared that the estimate of a $10 million overpayment of special
   allowance for loans associated with Bonds 93B, 93G, and 93H is overstated, because it is
   “based on a flawed assumption of the average life of non-consolidated FFELP loans, and
   should be removed from any final audit report.” Our report assumes that—

       o The average life of a loan associated with Bonds 93B, 93G, and 93H was 8.5 years,
         but according to SLMA, the average life of these loans ranged from 3.7 years to 4.6
         years; and
       o The loans were newly originated at the time of the bond maturity, but according to
         SLMA, the loans had been in repayment for several years.
Final Report
ED-OIG/A03I0006                                                                      Page 19 of 59

    In addition, SLMA noted that a significant percentage of the loans would have been
    consolidated before the end of their expected lives. The correction of these assumptions
    would reduce the alleged $10 million estimated SAP overpayment.

•   OIG Response. We believe that our estimate is reasonable and accurate. Our choice of 8.5
    years as the average life of a loan was not arbitrary; it was consistent with the assumption
    made by the Department in its guidance for identifying loans that qualify for the 9.5 percent
    floor rate (DCL FP-07-06). We assumed that the loans were newly originated at the time of
    the bond maturity, and SLMA has not provided evidence to the contrary. Pursuant to 34
    C.F.R. § 682.414(a)(4)(ii)(L), SLMA is required to document the accuracy of its billing, and
    it has not provided evidence to contradict our assumption.

    Regardless, our audit report does not recommend recovery of the estimated amount; instead,
    it recommends that SLMA be instructed to “[i]dentify the loans associated with Bonds 93B,
    93G, and 93H that became ineligible” and to adjust its billing and return overpayments for
    those loans. The Department may consider additional information provided by SLMA,
    including information on the specific life of the loans in its portfolio, when determining the
    corrective action for this audit.

The Issues Addressed Have No Application to Other Sallie Mae Subsidiaries
• SLMA Comment. SLMA disagreed with our Recommendation 1.3. It stated “. . . none of
   Sallie Mae’s other subsidiaries with 9.5 percent floor loans: (1) issued tax-exempt bonds
   under similar indentures or trust agreements with similar structures; (2) issued general
   obligation or unsecured bonds; or (3) had similar trust structures that lacked a defined pool of
   loans.”

•   OIG Response. We have not removed Recommendation 1.3. During the audit’s survey
    phase, we noted that, in addition to NLMA, both Southwest Student Services Corporation
    and Student Loan Funding Resources had indentures under which more than one eligible tax-
    exempt bond had been issued. Our audit did not review the tax-exempt obligations and 9.5
    percent floor rate SAP billings of SLMA’s other subsidiaries, and the information provided
    with SLMA’s response was not sufficient to confirm that SLMA’s statements are accurate.
    The Department may consider additional information provided by SLMA when determining
    the corrective action for this audit.

Sallie Mae’s Legal Interpretation is Not a Management Control Weakness
• SLMA Comment. SLMA stated “A difference in legal interpretation of an undefined
    statutory provision is not a management weakness in internal controls.” SLMA cites three
    authorities:

       1. The Public Company Accounting Oversight Board’s (PCAOB) Auditing Standard
          No. 2, “An Audit of Internal Control over Financial Reporting Performed in
          Conjunction with an Audit of Financial Statements,” does not include anything to
          suggest that a company’s process of formulating a legal interpretation of a statute
          constitutes an internal control.
       2. The Securities and Exchange Commission’s (SEC) “Management’s Report on
          Internal Control Over Financial Reporting and Certification of Disclosure in
Final Report
ED-OIG/A03I0006                                                                       Page 20 of 59

          Exchange Act Periodic Reports: Frequently Asked Questions (revised October 6,
          2004)” concludes that “[t]he definition of the term ‘internal control over financial
          reporting’ does not encompass a registrant’s compliance with applicable laws and
          regulations . . . .”
       3. An unspecified, prior version of the Office of Management and Budget’s (OMB)
          Circular A-123, “Management Accountability and Control,” which SLMA quotes as
          stating, “[I]nternal control does not encompass such matters as statutory development
          or interpretation.”

•   OIG Response. The authorities on internal control that SLMA cited were not applicable to
    our audit. The PCAOB and SEC authorities cited pertain to internal controls over financial
    reporting. Our audit was a performance audit, not a financial audit. The OMB circular cited
    pertains to Federal agencies’ internal controls; SLMA is not a Federal agency. In addition,
    the current (December 21, 2004) OMB Circular A-123 does not contain the language cited
    by SLMA. As we state in the Objectives, Scope, and Methodology section of this report, our
    audit was conducted in compliance with standards issued by the Comptroller General of the
    United States, in Government Auditing Standards, July 2007 Revision (GAS). Section 1.30
    of GAS states, “Internal control audit objectives relate to an assessment of the component of
    an organization’s system of internal control that is designed to provide reasonable assurance
    of . . . compliance with applicable laws and regulations.” As such, GAS does not exclude an
    entity’s ability to arrive at a reasonable understanding of statutory and regulatory
    requirements from its definition of “internal controls.”

Common Characteristics
• SLMA Comment. SLMA stated “. . . all of the 1993 bonds were governed by terms of the
  same 1993 Trust Agreement, were issued in the same calendar year, were payable from the
  same sources of funds and because they were unsecured, had no claim or security interest on
  a specific pool of loans.” In addition, “Per the terms of the 1993 trust Agreement, each 1993
  Bond was treated collectively and on a parity basis with the other 1993 Bonds in terms of the
  bondholders’ right to payments, default provisions, and remedies.” Consequently, SLMA
  concluded that, for purposes of applying the 9.5 percent floor provisions, it was reasonable to
  treat all of the 1993 Bonds as a single obligation because they shared common
  characteristics.

    SLMA also stated, “The OIG’s separate consideration of each series relies on arguing
    that each series is unique only because of its issue date. However, the 1993 Bonds
    were not organized in such a way. For example, within certain of the series there
    were multiple interim maturity dates reflecting the maturity of some, but not all of the
    1993 Bonds of an individual series.” In addition, “The OIG’s Draft Report would
    rely on the final maturity date of a bond series to determine eligibility for the 9.5
    percent floor rate and ignore any interim maturity dates within the series. Sallie
    Mae’s practice just as reasonably relies on the final maturity date of the 1993 Bonds
    of July 1, 2005 as the appropriate end date for the 9.5 percent floor rate.”

•   OIG Response. Whether the 1993 bonds had the same terms for right to payment,
    events of default, remedies, amendments, proceeds, and loan servicing has no bearing
    on their eligibility for special allowance payments at the 9.5 percent rate. As we state
Final Report
ED-OIG/A03I0006                                                                         Page 21 of 59

    in the finding, it is unreasonable to ignore attributes of obligations that are material in
    determining their eligibility for the 9.5 percent floor. SLMA’s comments did not
    address this explanation of our position. In regards to the bonds’ interim maturity
    dates, the interim maturities occurred prior to our audit period. As a result, our
    finding does not address SLMA’s treatment of the interim maturities and their impact
    on its 9.5 percent floor billings. Had we expanded the scope of our audit, other
    matters may have come to our attention that we could have included in our report.

Other Statutory Guidance
• SLMA Comment. SLMA asserted, “In the absence of clear statutory, regulatory, or
   Dear Colleague Guidance it was reasonable for SLMA to look to other statutory
   guidance or definition. Treasury’s regulations that permit a series of bonds to be
   treated as one obligation support Sallie Mae’s practice of treating the 1993 Bonds as a
   single financial obligation. Under Treasury’s regulations governing student loan
   bonds during the lifespan of the 1993 Bonds, Sallie Mae was permitted to calculate a
   single yield for all of the 1993 Bonds because of their significant relationship to each
   other under the 1993 Trust Agreement.” Furthermore, “The courts have consistently
   held that undefined terms in a statute be placed beside other statutes relevant to the
   subject and given a meaning and effect derived from the combined whole.” In
   addition, “The original provision of the HEA that established the Half-SAP program
   explicitly incorporated the Internal Revenue Code provisions to determine which
   obligations are tax-exempt. To this day, the Internal Revenue Code provisions
   establish and govern those obligations entitled to receive tax-exempt treatment.”

•   OIG Response. SLMA’s response provided no evidence that it in fact relied on the Treasury
    regulations to determine its FFEL billing practices. Though the HEA, regulations, and
    Departmental guidance do not include a specific definition of “obligation,” the meaning of
    the term is neither ambiguous nor unclear as used for Title IV purposes. The tax rule cited
    by SLMA offers no insight into the definition of “obligation” for purposes of the FFEL
    Program, because that tax rule relates to a limited issue on tax-exempt qualification. Tax law
    provides little support for SLMA’s argument that “obligation” means a group of bonds.
    Section 150 of the Internal Revenue Code, which addresses whether student loan bonds can
    qualify as tax-exempt, defines the term “obligation” as synonymous with “bond”: “The term
    ‘bond’ includes any obligation.” (26 U.S.C. § 150(a)(1))

Inconsistent Practices
• SLMA Comment. SLMA asserted that our report’s allegation of inconsistencies in SLMA’s
   practices is not accurate. SLMA acknowledged inconsistencies with NLMA’s 9.5 percent
   billing practices prior to its acquisition, and stated its billing procedure for 9.5 percent floor
   special allowance payments did not change. Our audit report states that the result of the July
   2004 sale of loans associated with Bond 93F ceased billing the loans under the 9.5 percent
   floor rate and classified the loans as eligible for the usual special allowance rates. SLMA
   stated, “This sentence mischaracterizes the events associated with the July 2004 sale of loans
   associated with the 93F bond series”. In addition, “. . . the July 2004 sale was an erroneous
   early liquidation of bond series 93F.”
Final Report
ED-OIG/A03I0006                                                                     Page 22 of 59

•   OIG Response. Our audit report does not state that SLMA applied its practices
    inconsistently; it states that SLMA’s practices were inconsistent with NLMA’s practices.
    Our report accurately states that as a result of the July 2004 sale to ECFC, NLMA ceased
    billing the loans under the 9.5 percent floor rate. SLMA’s comments do not propose any
    other results from this transaction, and an SLMA memorandum documenting the transaction,
    dated February 1, 2005, supports our statement: “The Half SAP flag was switched to Full
    SAP for these loans. . . . This was an isolated transaction that was being evaluated for the
    first time. Accordingly, this change did not arise from a control gap, but rather from
    adopting a legal conclusion on an issue that had not been previously researched.” However,
    we have revised our report to more clearly state that SLMA considered the sale to be an
    error.

Eligible Loans
• SLMA Comment. SLMA stated in several places that the draft audit report acknowledged
    “the loans that were refinanced with the proceeds of the 1993 Bonds qualified to be billed
    under the 9.5 percent special allowance floor rate.”

•   OIG Response. Our audit report does not acknowledge that “the loans that were refinanced
    with the proceeds of the 1993 Bonds qualified to be billed under the 9.5 percent special
    allowance floor rate.” The objectives of our audit were limited to (1) the requirements of the
    TTPA and HERA, and (2) loans billed under the 9.5 percent floor after the eligible tax-
    exempt bonds from which the loans derived their eligibility matured or were retired. Our
    report makes no assertions about the eligibility of the loans under any other requirements.
Final Report
ED-OIG/A03I0006                                                                                    Page 23 of 59



                    OBJECTIVES, SCOPE, AND METHODOLOGY


The original purpose of the audit was to determine if SLMA billed for SAP, under the 9.5
percent floor calculation, in compliance with requirements in the HEA, regulations, and guidance
issued by the Department. 10 Our audit was to cover the period January 1, 2005, through
December 31, 2006. Based on our initial audit work, the audit’s objective and period of review
were revised. The revised objectives of the audit were to determine if SLMA’s subsidiary,
NLMA, (1) billed loans under the 9.5 percent floor in compliance with the TTPA and HERA,
and (2) billed loans under the 9.5 percent floor, after the eligible tax-exempt bonds from which
the loans derived their eligibility, had matured or been retired. The revised audit period covered
October 1, 2003, through September 30, 2006.

To achieve the audit objectives, we—

•    Reviewed information on SLMA’s four subsidiaries with 9.5 percent floor billings and
     eligible tax-exempt obligations: Southwest Student Services Finance Corporation, Student
     Loan Finance Association, Student Loans Funding Resources, and NLMA.

•    Reviewed the Department’s Datamart
     system for 9.5 percent floor billings for                  Table 10 - NLMA and ECFC Significant Billing
                                                                               Adjustments
     SLMA’s four subsidiaries (listed above)
     and ECFC.                                                                            Significant       Significant
                                                                                          NLMA Net          ECFC Net
•    Reviewed NLMA’s current billings and                      Applied Quarterly
                                                                                            Billing           Billing
     billing adjustments applicable to the                      Period Ending
                                                                                         Adjustments       Adjustments
     audit period, and identified the                                                       (ADB)             (ADB)
     significant billing adjustments by the                   December 31, 2003          ($21,175,628)                $0
     quarter the adjustments were entered by                  March 31, 2004             ($18,439,959)                $0
     SLMA. Billing adjustments less than                      June 30, 2004              $142,497,264                 $0
     $500,000 were excluded from our                          September 30, 2004         ($12,759,720)     $353,732,135
     analysis, resulting in the net applied 11                December 31, 2004           ($9,894,223)     $204,767,175
     significant billing adjustments displayed in             March 31, 2005                        $0      $91,622,389
     Table 10.                                                June 30, 2005              $217,480,127                 $0
                                                              September 30, 2005                    $0                $0
                                                              December 31, 2005                     $0                $0
•    Reviewed applicable laws, regulations and
                                                              March 31, 2006                        $0                $0
     guidance issued by the Department,
                                                              June 30, 2006                         $0                $0
     including the HEA, TTPA, HERA, 34
                                                              September 30, 2006                    $0                $0
     C.F.R. Part 682, and Dear Colleague Letters.



10
   We did not determine if SLMA's special allowance billings under the 9.5 percent floor calculation included only
eligible first-generation and second-generation loans, as those terms are explained in DCL FP-07-01, issued on
January 23, 2007, and in DCL FP-07-06, issued on April 27, 2007.
11
   Adjustments are shown in their applied quarters, and not the quarters in which they were entered.
Final Report
ED-OIG/A03I0006                                                                    Page 24 of 59

•   Reviewed SLMA’s Form 10-K reports for the fiscal years ended December 31, 2005 and
    2006; Compliance Audits (Attestation Examinations), for Lenders and Lender Servicers
    participating in the FFEL Program for the years ended December 31, 2003, 2004, 2005, and
    2006, and for the period from July 1, 2004, through September 30, 2005 (for Southwest
    Student Servicers Corporation).

•   Held discussions with SLMA officials, including the Vice President of Loan Accounting and
    Reporting, Director of Service Accounting, Deputy General Counsel, Senior Vice-President
    of Corporate Finance, Senior Director and Accountant for Financial Reconciliation, and
    SLMA’s Information Technology Group.

•   Reviewed documentation provided by SLMA, including—
    - A written explanation, created and provided at our request, of SLMA’s position,
       understanding, policy, and implementation of SAP billing under the 9.5 percent floor
       calculation;
    - A written description of how SLMA’s CLASS loan servicing system identified loans
       eligible for the 9.5 percent floor calculation;
    - SLMA’s policies and procedures explaining SLMA’s administration of its 9.5 percent
       portfolio to reflect changes in laws and regulations applicable to 9.5 percent floor
       calculation loans;
    - SLMA’s internal systems coding to segregate and identify loans as 9.5 percent eligible
       using Lender Identification Number (LID) -Branch combinations;
    - Transaction documentation regarding the liquidation and subsequent recapture of loans
       funded by Bond 93F;
    - Bond Prospectus Cover Sheets, Internal Revenue Service Form 8038s, Information
       Return for Tax-Exempt Private Activity Bond Issues, and other bond documentation for
       SLMA’s tax-exempt obligations originally issued prior to October 1, 1993;
    - A listing of SLMA’s bonds funding 9.5 percent floor calculation loans, along with
       information related to each bond, including its taxable or tax-exempt status, the amount
       outstanding, and the average daily balance of 9.5 percent floor calculation loans funded
       in each quarter;
    - SLMA’s bond genealogy for outstanding bonds during the audit period;
    - A written description of holding tanks’ funding sources; and
    - An explanation of ECFC’s relationship to NLMA.

•   Obtained from the Department’s Datamart system the amount of 9.5 percent floor SAP, the
    ADB, and ending principal balances included on NLMA’s and ECFC’s Lender’s Interest and
    Special Allowance Request and Report (LaRS) billings for the audit period.

Initial Selection and Review of Loans for TTPA and HERA Compliance

We judgmentally selected and reviewed 2 of the 12 quarterly special allowance billings during
the audit period. We selected the quarter ending March 31, 2005 (because it was the first full
quarter billed following the enactment of the TTPA) and the quarter ending June 30, 2006
(because it was the first full quarter billed following the enactment of the HERA).
Final Report
ED-OIG/A03I0006                                                                                      Page 25 of 59

Using an attribute sample, we randomly selected 120 unique loan records 12 from each of these
two quarters (240 loans in total) from NLMA’s and ECFC’s LaRS data files. The March 31,
2005, universe contained a population of 278,139 unique loan records. 13 The June 30, 2006,
universe contained a population of 12,605 unique loan records.

We tested for compliance to the TTPA by using the following criteria for the loans sampled in
the quarter ended March 31, 2005: 14
• The loan must have been classified in an eligible LID-Branch combination (i.e., eligible tax-
    exempt bond) prior to or during the billing quarter.
• The loan could not be refinanced after September 30, 2004.

We tested for compliance to the HERA and the TTPA by using the following criteria for the
loans sampled in the quarter ended June 30, 2006: 15
• The loan must have been classified in an eligible LID-Branch combination (i.e., eligible tax-
    exempt bond) prior to or during the billing quarter.
• The loan must be originated prior to February 8, 2006.
• The loan could not be refinanced after September 30, 2004.

Identification of Loans Billed After Bond 93F Maturity

When we were performing the audit’s survey phase, SLMA officials notified us that SLMA had
continued to bill loans associated with Bond 93F under the 9.5 percent floor past the bond’s
maturity date. We identified these ineligible loans using the documentation provided to us by
SLMA in its summary of the NLMA bond maturity transactions. In the summary, SLMA
outlined the amount of loans funded by Bond 93F that were sold to ECFC when the bond
matured on July 1, 2004, and then billed under the usual special allowance rates. Subsequent to
the sale of loans to ECFC, SLMA’s documentation detailed its process of recapturing the 9.5
percent SAP rate through current billings and billing adjustments during the quarters ended
March 31, 2005, and June 30, 2005 (the adjustments were applicable to the quarters ended
September 30, 2004, and December 31, 2004).

Estimate of Ineligible 9.5 Percent SAP and Usual SAP on Loans Funded by Bond 93F

To estimate the SAP overpayment on the loans funded by Bond 93F, we—

•    Reviewed the Datamart database and ECFC’s quarterly LaRS data files of loans billed under
     the 9.5 percent floor calculation for the quarters ending September 30, 2004, through

12
   For each universe, a unique loan record was created by combining the borrowers’ SSN together with the loan
Suffix and Loan Sequence Number fields.
13
   The quarter ending March 31, 2005, also included the LaRS adjustments made in subsequent quarters that applied
to the March 31, 2005 quarter.
14
   SLMA was unable to provide documentation to show that 2 of the 120 loans in the March 31, 2005, sample were
eligible for the 9.5% floor calculation. Based upon the two errors in the sample, we are 90 percent confident that the
overall error rate for this sampled quarter is no more than 4.4%. (We considered these two errors to be materially
insignificant.)
15
   We noted no errors in the June 30, 2006, sample of 120 loans. Based upon the results of the sample, we are 90
percent confident that the overall error rate for this sampled quarter is no more than 1.9%.
Final Report
ED-OIG/A03I0006                                                                      Page 26 of 59

    June 30, 2005, to determine the amount of loans billed under the 9.5 percent floor calculation
    that were funded with ineligible funding sources after Bond 93F matured on July 1, 2004,
    and the amount of SAP paid on those loans.

•   Queried the Datamart database for ECFC, LID 834071, for the quarterly LaRS data files of
    special allowance current billings, and the quarterly LaRS data files of the special allowance
    summary of tax-exempt current billings, billing adjustments for the quarters ended
    September 30, 2004, through June 30, 2005.

•   Obtained ECFC’s LaRS data files for the quarters ended September 30, 2004, December 31,
    2004, March 31, 2005, and June 30, 2005.

•   Used data analysis software to reconcile the LaRS/799 Lender Reports with the Datamart
    data to identify the amount of loans billed under the 9.5 percent floor calculation funded by
    Bond 93F.

•   Estimated the SAP that should have been paid on the ineligible loans for each quarter by—
    - Based on the LaRS reports, identifying the ADB for loans that were billed under the
        usual SAP rates and the amount of SAP paid on those loans;
    - Dividing the SAP paid on the loans by their ADB; and
    - Multiplying the resulting percentages by the ADB for the ineligible loans.

•   Subtracted the estimated usual SAP that should have been paid on the ineligible loans
    associated with Bond 93F from the 9.5 percent SAP that was actually paid.

Estimate of Loans Billed After Bonds 93B, 93G, and 93H Matured

SLMA was unable to provide documentation that quantified the loans associated with the
matured Bonds 93B, 93G, and 93H that were maintained in a holding tank and billed under the
9.5 percent floor until the maturity of Bond 93A in July 2005. We could not easily identify the
ineligible loans and the quarterly ineligible ADBs associated with these loans. Therefore, we
performed calculations to estimate the ineligible loan amounts associated with Bonds 93B, 93G,
and 93H by amortizing the final amount of bonds outstanding at the time each bond matured,
starting with the month of the bond’s maturity (Table 11).


                        Table 11 – Bond Amounts Outstanding at Maturity

                                                            Outstanding Bond
                   Bond Name          Bond Maturity
                                                           Amount at Maturity
                       93B                6/1/2002            $10,700,000
                       93G                8/1/2002            $47,400,000
                       93H               12/1/2002            $14,370,000

The estimate was based on the assumptions that (1) the amount of loans transferred to the
holding tank equaled the bond’s outstanding amount for each bond at the time at which the bond
Final Report
ED-OIG/A03I0006                                                                                   Page 27 of 59

matured; (2) each loan was paid off over an 8.5 year period; 16and (3) zero percent interest
accrued on the loans. Our estimate excluded any loans associated with Bonds 93B, 93G, and
93H that were transferred to the holding tank prior to the respective bonds’ maturity date because
we could not reliably estimate amounts associated with these ineligible loans. The ADBs were
prorated, between amounts eligible and ineligible for the 9.5 percent floor calculation, based
upon periods in each quarter in which the bonds were outstanding. The prorated ADBs were for
Bond 93B for the quarter ended June 30, 2002; Bond 93G for the quarter ended September 30,
2002; and Bond 93H for the quarter ended December 31, 2002. The result of the amortization
for each bond was an estimated quarterly ADB for the loans associated with the matured Bonds
93B, 93G, and 93H for which we could estimate the 9.5 percent SAP paid (see Table 8).

Estimate of Ineligible 9.5 Percent SAP and Usual SAP on Loans Funded by Bonds 93B,
93G, and 93H

We estimated the 9.5 percent SAP paid on the estimated quarterly ADB for loans associated with
the matured Bonds 93B, 93G, and 93H by calculating the percentage of 9.5 percent SAP paid as
compared to the ADB billed by NLMA (LID 833691). We divided the net 9.5 percent SAP paid
by the total ADB billed by NLMA for each quarter ended June 30, 2002, through June 30, 2005.
We multiplied the resulting percentage by the estimated quarterly ADB (based on the
amortization results) to estimate the amount of 9.5 percent SAP paid to NLMA on the loans
associated with the matured Bonds 93B, 93G, and 93H.

We calculated the percentage of usual SAP paid by quantifying the ADB and SAP paid on loans
billed by NLMA under usual SAP rates. We divided the SAP paid for these loans by their ADB
to identify the percentage of estimated usual SAP rates for each quarter described above. We
multiplied the resulting percentage of estimated usual SAP rates by the ADB of the loans
associated with the matured Bonds 93B, 93G, and 93H in the quarters ended June 30, 2002,
through June 30, 2005, to achieve the amount of usual SAP that should have been paid to SLMA.
Finally, we subtracted this amount of usual SAP from the 9.5 percent SAP to estimate the
overpayment made to SLMA for the ineligible loans associated with the matured Bonds 93B,
93G, and 93H.

Computer-Processed Data

To accomplish the audit’s objective, we relied, in part, on computer-processed data provided by
SLMA. We obtained SLMA’s LaRS data files for the quarters ended December 31, 2003,
through September 30, 2006. To determine the reliability of the data, we performed limited data
testing. These tests included comparing the files’ average and ending principal balances against
the Department’s FSA Datamart files, comparing information for the 240 randomly selected
loans (described under “Initial Selection and Review of Loans for TTPA and HERA
Compliance”) to SLMA’s CLASS loan servicing system, and applying logical tests to the data

16
  The Department has determined the average life span of non-consolidated FFELP loans to be 8.5 years. The
Department made this determination as part of its obligation under the Federal Credit Reform Act of 1990, 2 U.S.C.
§ 661 et seq., to calculate the subsidy cost for FFELP loans. NLMA’s 9.5 percent floor billings for the quarters
ended June 30, 2002, through June 30, 2005, contained only non-consolidated loans. In comments submitted to a
draft of this finding, SLMA stated that the weighted average life of a loan on its FFELP Stafford portfolio ranges
from 3.7 to 4.6 years, and asked us to revise our assumption from 8.5 years to 4.0 years. We have not made this
revision; our estimate relies on the average life span calculated by the Department.
Final Report
ED-OIG/A03I0006                                                                       Page 28 of 59

files for the two quarters we selected. Based upon our preliminary assessment of the data, we
concluded that the data were sufficiently reliable for use in achieving the audit’s objective.

Internal Controls

As part of our audit, we assessed SLMA’s system of internal control significant to the audit
objective and applicable to its billing for SAP under the 9.5 percent floor calculation, the process
used to identify loans eligible for special allowance billing under the 9.5 percent floor
calculation. Our assessment disclosed a significant management control weakness that adversely
affected SLMA’s ability to accurately identify loans eligible for special allowance billing under
the 9.5 percent floor calculation. Specifically, SLMA continued to bill loans under the 9.5
percent floor calculation after the maturity of the eligible tax-exempt bonds and after the loans
were refinanced with funds derived from ineligible sources. As a result of its management
control weakness, SLMA’s billing activities did not comply with laws, regulations, and guidance
for the 9.5 percent floor calculation. The weakness and its effects are fully discussed in the
Audit Results section of this report.

We conducted on-site fieldwork at SLMA’s office in Reston, Virginia, during the period
October 16, 2007, through May 14, 2008. On January 22, 2009, we held an exit conference with
SLMA. We conducted this performance audit in accordance with generally accepted
government auditing standards. Those standards require that we plan and perform the audit to
obtain sufficient, appropriate evidence to provide a reasonable basis for our finding and
conclusions based on our audit objectives. We believe that the evidence obtained provides a
reasonable basis for our finding and conclusions based on our audit objectives.
Final Report
ED-OIG/A03I0006                                                                    Page 29 of 59

                           Enclosure: SLMA Comments
SLMA provided three exhibits with its cover letter. The enclosed Exhibit B excludes 36 pages
of the amortization tables supporting the two Eligible Loan Balance tables on page 56. The full
Exhibit B will be made available upon request.
Final Report
ED-OIG/A03I0006                                                                                                    Page 30 of 59




        SALLIE MAE, INC-
        12061 Bu/I::!dow WAY
        REsToN, YIRG!NlA 20190
        703-984-S677. hl< 7fJ3 -984-6!!!7

        MARK L. HElEEN
        EXECUTIVti VICE PRESIOENT AND GE)''F-''Al COUNs~L


                                                                May 6, 2009

        VIA OVERNIGIIT MAlL Ai"l) E-MAlL

       Mr. Be rnard Tadley
       Regional Inspector Gcneral for Audit
       Audit Services, Region III
       Office of Inspector General
       U.S. Department of Education
       The Wanamaker Building
       100 Penn Square East, Suite 502
       Philadelphia, PA 19107
       bemard.tadley@ed.gov

                Re:       Sallie Moe - ED-OIG/A0310006

       Dear Mr. Tadley:

                r am pleased to enclose Sallie Mae, Inc.'s ("Sallie Mae") response to the above-referenced draft
       report received under your cover letter dated March 10. 2009. Pursuant 10 Mr. Howard Sorensen's April
       13,2009 e-mail message lind April 28, 2009 c-mail mes.~agll to Mr. Stan Freeman of Powers Pyles Sutter
       & Vervile P.C., Ihis responsc is timcly.

               Please do nOI hcsitate to COnt1cl me with any questions you may havc regarding the enclosed
       response, including the accompanying attachments and exhibits. I    be reached at (703) 984-5677.




                                                                                                                              I
                                                                                                                              ~
      cc:      Stan Freeman, Esq., Powers Pyles Sutter & Vervilc P.C.
               Anne Gish, Esq., Kutak Rock
               Patricia Smitson, Esq., 'rltompson Hine LLC
               Howard Sorensen, Esq., U.S. Department of Education


      Enclosures
Final Report
ED-OIG/A03I0006                                                               Page 31 of 59




                  RESPONSE TO OFFICE OF INSPECTOR GENERAL
                  UNITED STATES DEPARTMENT OF EDUCATION
                            DRAFT AUDIT REPORT

                                           FOR
                                    SALLIE MAE, INC.
                                     ED-OIG/A03I0006
Special Allowance Payments to Sallie Mae’s Subsidiary, Nellie Mae, for Loans Funded by Tax-
                                    Exempt Obligations.

                                       May 6, 2009
Final Report
ED-OIG/A03I0006                                                                          Page 32 of 59

I.      Introduction and Summary of Arguments

        The U.S. Department of Education’s Office of Inspector General (“OIG”) conducted a
review of Sallie Mae’s subsidiary Nellie Mae (defined below). According to the OIG, the
purpose of the audit was to determine if Nellie Mae: (1) billed loans under the 9.5% floor
(defined below) in compliance with the Taxpayer Teacher Protection Act of 2004 (“TTPA”) and
the Higher Education Reconciliation Act of 2005 (“HERA”); and (2) billed loans under the 9.5%
floor after the eligible tax exempt bonds from which the loans derived their eligibility matured or
were retired. The audit covered the period from October 1, 2003 through September 30, 2006.
For purposes of this response, “Sallie Mae” refers to Sallie Mae, Inc., and its affiliates other than
the Student Loan Marketing Association and “Nellie Mae” refers to the New England Education
Loan Marketing Corporation and its successors including SLM Education Credit Finance
Corporation. 17

       With respect to the first audit purpose, the OIG found that Sallie Mae’s billing for its
Nellie Mae subsidiary for special allowance payments (“SAP”) under the 9.5% floor complied
with TTPA and HERA. Sallie Mae agrees with this finding.

        With respect to the second audit purpose, the OIG adopted a new narrow legal
interpretation of the term “obligation.” An interpretation that, to the best of our knowledge, does
not appear in the Higher Education Act of 1965, as amended (“HEA” or “Act”) or in any
legislative history and has never been published or communicated to the student lending
community in any manner. In connection with the second audit purpose, the OIG concluded that
Sallie Mae erred when it took the position that it was entitled to bill the 9.5% floor on loans
funded with the proceeds of bonds issued under such a single master indenture until the last bond
issued under such indenture matured.

       Sallie Mae strongly disagrees with the OIG’s conclusions. We disagree for the following
reasons:

     Sallie Mae’s Interpretation is Correct and Consistent with Congressional Intent

        In a case of first impression, the issue is whether loans financed by the issuance of bonds
in the same calendar year that share common characteristics, and are governed by a single master
indenture or trust agreement, may be treated as an “obligation” for purposes of Section 438(b) of
the Act and 34 C.F.R 682.302(e). Although there have been several OIG Audit Reports and
other Department guidance on the 9.5% floor rate, such guidance has never addressed this
particular issue. Indeed, this particular construction is inconsistent with the original federal
legislative intent that the 9.5% rate act as a floor and thus a limitation on the yield lenders could
obtain. Therefore, the federal government encouraged maximizing loans within the 9.5% floor.
In the past, the Department insisted that lenders not be permitted to turn loans originally financed
through tax-exempt obligations, for which special allowance was one half the normal special
allowance, into loans that yielded full special allowance by refinancing the loans through taxable
financings. Sallie Mae’s interpretation is the only interpretation consistent with that
Congressional intent.

17
  The Student Loan Marketing Association, a government sponsored enterprise that was a subsidiary of SLM
Corporation, was dissolved as of December 31, 2004 pursuant to the terms of its privatization process.
Final Report
ED-OIG/A03I0006                                                                      Page 33 of 59


   Sallie Mae’s Interpretation was Reasonable

        Even if the Department were to now adopt OIG’s new narrow legal interpretation of the
term “obligation”, Sallie Mae’s practice was based on a reasonable application of the Act, the
Department’s regulations, and clear legislative intent. This is particularly true here, where
neither the statute nor regulations currently specifically define “obligation” and the precise issue
raised in the OIG’s audit is one of first impression.

       Sallie Mae reasonably interpreted the term “obligation,” a term that is not specifically
defined in Section 438 (b) of the HEA or Section 682.302 in the regulations, to include multiple
bonds issued in the same calendar year under a single trust agreement where the bonds shared
important characteristics. If the Department takes the new position that “obligation” for
purposes of Section 438(b) and 34 CFR 683.302 should be interpreted more narrowly as an
individual tax-exempt bond, it should publish public guidance for industry participants.
Moreover, the OIG should not use an audit to advance a particular construction of an undefined
term in a statutory provision that has long perplexed lenders, Congress, the Department and the
press.

   The OIG’s Estimate is Incorrect and Overstated

       Apart from question of how the Act and federal regulations should be interpreted, the
OIG’s estimate of the amount of special allowance that it believes Sallie Mae should return is
incorrect, speculative, and based on a flawed assumption of the average life of non-consolidated
FFELP loans and should be removed from any final audit report.

   The Issues Addressed have no Application to Other Sallie Mae Subsidiaries

        The OIG also suggests in its Draft Report that other Sallie Mae subsidiaries should be
reviewed for the same issue. The issue addressed in the Draft Report is limited to Nellie Mae’s
special allowance billings and there is no reason for any final audit report to include the
recommendation to the FSA as to information on Sallie Mae’s other subsidiaries. The issue
addressed in this audit is not relevant to Sallie Mae’s other subsidiaries, since none of Sallie
Mae’s other subsidiaries with 9.5% floor loans: (1) issued tax-exempt bonds under similar
indentures or trust agreements with similar structures; (2) issued general obligation or unsecured
bonds; or (3) had similar trust structures that lacked a defined pool of loans. As such, Sallie Mae
properly treated the Nellie Mae-bonds differently than the bonds of its other subsidiaries and
therefore there is no need to recommend any further review on this issue.
Final Report
ED-OIG/A03I0006                                                                         Page 34 of 59

       Sallie Mae’s Legal Interpretation is not a Management Control Weakness

        Finally, the OIG claims that there was a management control weakness at Sallie Mae.
Even assuming for the sake of argument, that Sallie Mae incorrectly interpreted the 9.5% floor
special allowance provision by continuing to bill 9.5% special allowance until the last bond
issued under a single trust agreement matured, Sallie Mae’s legal reasoning and interpretation on
an issue of first impression is not a management control weakness, and the reference to
management control weaknesses in the Draft Report should be removed from any final audit
report.

        We address each of the Draft Report’s findings in detail below. It is important to note
that the findings in the Draft Report relate to activities that ceased in June 2005, prior to the date
of the Draft Report and prior to September 30, 2006, the end date of the last quarterly period for
which Sallie Mae billed at the 9.5% floor rate.

II.       Factual Background.

        Nellie Mae issued tax-exempt bonds in series from time-to-time during a nine month
period in 1993 (collectively, the “1993 Bonds”) under the terms of the 1993 Trust Agreement
(defined below). The purpose of these 1993 Bonds was to generate proceeds totaling
approximately $458 million that could be used to refund tax-exempt bonds that were previously
issued to purchase eligible student loans. In accordance with the HEA and as acknowledged by
the OIG in its Draft Report, the loans that were refinanced with the proceeds of the 1993 Bonds
qualified to be billed under the 9.5% special allowance floor rate.

III.      9.5% Floor Rate Statutory and Regulatory Provisions.

        The Act provides for the Secretary of Education to make special allowance payments to
eligible lenders. The rates are based on formulas that differ according to the type of the loan; the
date the loan was originally made or insured; and the type of funds used to finance the loan
(taxable or tax-exempt). In 1980, concerned that lender yields for loans financed with tax-exempt
obligations did not adequately reflect the lower costs associated with tax-exempt financing,
Congress reduced the special allowance to be paid on loans financed with tax-exempt obligations
to one-half of that otherwise payable (“Half-SAP”). At the same time, however, Congress
guaranteed that the lender yield for loans financed with tax-exempt obligations would be no less
than 9.5% (the “9.5% floor”). In the Student Loan Reform Act of 1993, included in the Omnibus
Budget Reconciliation Act of 1993, P.L. 103-66, secs. 4105 and 411 (1993), Congress eliminated
the Half-SAP and 9.5% floor for loans financed with tax-exempt obligations issued on or after
October 1, 1993.

        Section 438(b)(2)(B) of the Act, which specifies the criteria for eligible loans to initially
qualify for the 9.5% floor, states in pertinent part:

                 (i) The quarterly rate of the special allowance for holders of loans
                 which were made or purchased with funds obtained by the holder
                 from the issuance of obligations, the income from which is exempt
                 from taxation under Title 26 shall be one-half the quarterly rate of
Final Report
ED-OIG/A03I0006                                                                                        Page 35 of 59

                  the special allowance established under subparagraph (A)[the full
                  special allowance rate], except that… . . . .

                  (ii) The quarterly rate of the special allowance set under division
                  (i) of this subparagraph shall not be less than 9.5 percent minus the
                  applicable interest rate on such loans, divided by 4. 18

        The Department’s regulations at Section 682.302(c)(4) 19 further specify that “[l]oans
made or purchased with funds obtained by the holder from the issuance of tax-exempt
obligations originally issued on or after October 1, 1993, . . . do not qualify for the minimum
special allowance rate [of 9.5%].” As noted above, the OIG acknowledges that the student loans
purchased or refinanced with the proceeds of the 1993 Bonds did properly qualify for the 9.5%
floor rate.

       The regulations also address when such loans lose their eligibility for the 9.5% floor.
Section 682.302(e)(2)(ii) states that such loans lose their entitlement to the 9.5% floor rate when
they are “pledged or otherwise transferred in consideration of funds” that would not have
previously qualified for the 9.5% floor and “the prior tax-exempt obligation [the proceeds of
which were used to purchase the loans] is retired [or defeased].”

IV.      Sallie Mae Correctly Applied the Act and the Regulations in Billing Special
         Allowance on Loans Financed under Nellie Mae’s 1993 Trust Agreement.

        Sallie Mae correctly applied the Act and the regulations in billing Special Allowance on
loans financed under Nellie Mae’s 1993 Trust Agreement. Sallie Mae’s practice was based on a
reasonable application of the Act and the Department’s Regulations. 20 As the OIG stated, Sallie
Mae’s practice was to continue to bill loans that it purchased from Nellie Mae that were floor
loans at the time of acquisition by Sallie Mae at the 9.5% SAP rate until the last serial issue
associated with the 1993 Bond series associated with the 1993 Trust Agreement matured.
Specifically, Sallie Mae treated loans it purchased from Nellie Mae that were made with the
proceeds of the 1993 Bonds issued under the 1993 Trust Agreement as eligible for the 9.5% floor
calculation until the last bond issued matured on July 1, 2005. Sallie Mae never purchased loans




18
   Congress first enacted legislation which established different special allowance for holders of loans “made or
purchased with funds obtained by the holder from the issuance of obligations, the income of which is exempt from
taxation” in 1980, through the Education Amendments of 1980, Pub. L. 96-374, Title IV, § 420(b), Oct. 3, 1980. In
the Omnibus Budget Reconciliation Act of 1993, Pub. L. 103-66, Congress repealed the 9.5% floor for all loans
“financed with funds obtained by the holder from the issuance of obligations originally issued on or after October 1,
1993, the income of which is excluded from gross income under the Internal Revenue Code of 1986.”
19
   The OIG’s Draft Report cites an outdated copy of the Code of Federal Regulations. While the relevant
regulations have been substantially restructured and rewritten, there are no material differences in their application
to this issue.
20
  In its Draft Report, the OIG claims that Sallie Mae’s position is that obligation means indenture. The OIG goes
on to explain why an indenture is not an obligation. The OIG completely misstates Sallie Mae’s position. Sallie
Mae’s position is that obligation refers to all bonds issued under the single master indenture, not the indenture itself.
Final Report
ED-OIG/A03I0006                                                                                 Page 36 of 59

that were made with the proceeds of Bonds 93C-E, thus at issue here is Sallie Mae’s billing of
9.5% floor on loans that were included in Bonds 93B, F, G and H. 21

        Again, Sallie Mae’s practice is based on a reasonable application of the Act and the
Department’s regulations. All of the 1993 Bonds shared common characteristics that support
treating them as a single obligation for purposes of applying the 9.5% floor provisions. The
common characteristics of the 1993 Bonds are based on the specific terms of the 1993 Trust
Agreement with The First National Bank of Boston (the “Trustee”) dated March 1, 1993 (the
“1993 Trust Agreement”) and the relationship between the 1993 Bonds and the collective pool of
loans purchased with the proceeds from the 1993 Bonds. Enclosed as Exhibit A to this
submission is a legal memorandum from experienced bond counsel at Thompson Hine which
agrees with Sallie Mae’s position.

           (a) 1993 Trust Agreement

       Nellie Mae issued the 1993 Bonds in series A through H from time-to-time during a nine-
month period in 1993 under the terms of the 1993 Trust Agreement. The purpose of these 1993
Bonds were to generate proceeds totaling approximately $458 million that could be used to
refund tax-exempt bonds that were previously issued by Nellie Mae to purchase eligible student
loans. In accordance with the Act and as acknowledged by the OIG’s report, the loans that were
refinanced with the proceeds of the 1993 Bonds qualified to be billed under the 9.5% special
allowance floor rate.

        Notably, all of the 1993 Bonds were governed by the terms of the same 1993 Trust
Agreement, were issued in the same calendar year, were payable from the same sources of funds
and because they were unsecured, had no claim or security interest on a specific pool of loans.
Additionally, the rights of each bondholder under each series of 1993 Bonds were identical to the
rights of the bondholders under the other series of 1993 Bonds issued pursuant to the 1993 Trust
Agreement. Per the terms of the 1993 Trust Agreement, each 1993 Bond was treated
collectively and on a parity basis with the other 1993 Bonds in terms of the bondholders’ right to
payments, default provisions, and remedies. The terms of these provisions are discussed below.

           Right to Payment: Article IV of the 1993 Trust Agreement stipulates that on each date
           on which payment on any of the 1993 Bonds is due, the Corporation [Nellie Mae] pays to
           the Trustee and the Trustee pays to the bondholders the requisite amount of interest on or
           principal of the 1993 Bond. Collections on the purchased loans were not dedicated as the
           sole source of repayment of the 1993 Bonds. 22 The provisions make no distinction and
           give no preference to any bondholder of any separate series of the 1993 Bonds.

           Events of Default: Article VIII of the 1993 Trust Agreement states that the failure to
           make a timely payment of the principal of or the interest on any of the 1993 Bonds
           constitutes an Event of Default for all of the 1993 Bonds. Following an Event of Default,
           the 1993 Trust Agreement provides for the acceleration of the principal of all of the
           outstanding 1993 Bonds regardless of the series of 1993 Bonds. In other words, the

21
     See OIG Workpaper G. 4.1. p.2.
22
 This feature was unique to these Nellie Mae 1993 Bonds. These 1993 Bonds were general obligations of Nellie
Mae and were therefore payable from the general revenues of Nellie Mae as opposed to collections from the loans.
Final Report
ED-OIG/A03I0006                                                                   Page 37 of 59

     interests of all of the bondholders under the 1993 Trust Agreement are evenly linked — if
     one bondholder is not paid, the Corporation [Nellie Mae] is in default with regard to all
     bondholders.

     Remedies: Article VIII of the 1993 Trust Agreement also provides for the distribution of
     funds received from the Corporation [Nellie Mae] to remedy an Event of Default or
     following a judgment from a suit filed by the Trustee. The distribution provision causes
     those funds to be shared on a parity basis across all of the 1993 Bonds based on the
     amount of interest, principal, and redemption premium owed. There is no right of the
     holder of an individual 1993 Bond or even the holders of all of the 1993 Bonds of a
     separate series to file suit to enforce the 1993 Trust Agreement without the consent of a
     total of two-thirds (2/3) of the aggregate principal amount of the 1993 Bonds outstanding
     (and not separated by series of 1993 Bonds).

     Amendments: Similar to the remedial rights, the 1993 Bonds also require collective
     action of all bondholders without regard to any separate series of 1993 Bonds to amend
     certain provisions of the 1993 Trust Agreement. Under Section 7.2 of the 1993 Trust
     Agreement, the written consent of the holders of two-thirds (2/3) of the principal amount
     of all of the 1993 Bonds outstanding is required to modify or adopt an amendment to the
     rights and obligations of the Corporation [Nellie Mae] or the holders of the 1993 Bonds.
     In other words, series of 1993 Bonds that matured earlier than other series of 1993 Bonds
     did not control or have greater rights over the administration of all of the 1993 Bonds.
     This provision has the potential effect of an amendment being adopted that modified the
     rights of the bondholders of a particular series of 1993 Bonds even if all of the
     bondholders of that series voted against the amendment.

     Proceeds: In addition to equal treatment of all the bondholders under the 1993 Trust
     Agreement, the terms of the 1993 Trust Agreement do not create a connection between an
     individual 1993 Bond or series and the student loans purchased with the proceeds from
     the 1993 Bonds. Unlike most student loan bond financings, the loans purchased with
     proceeds from the 1993 Bonds are not pledged as collateral in support of a particular
     series of 1993 Bonds. Rather, all unencumbered loans of the Corporation [Nellie Mae],
     along with its general assets and credit, are the source of credit for the entire financing
     under the 1993 Trust Agreement. A more specifically identifiable relationship between
     one series of bonds and one loan portfolio (e.g., where the loans are secured collateral for
     the specific series) did not exist because of the nature and terms of the 1993 Trust
     Agreement.

     Loan Servicing: Section 5.3(b) of the 1993 Trust Agreement requires the Corporation
     [Nellie Mae] to properly service all student loans owned by it regardless of the source of
     the proceeds used to purchase the loan. The 1993 Trust Agreement details the criteria for
     executing a servicing agreement to service the loans and similarly treats each of the
     Corporation’s [Nellie Mae’s] loans equally regardless of which 1993 Bond series’
     proceeds were used to finance the loan.
Final Report
ED-OIG/A03I0006                                                                                      Page 38 of 59

         (b) Application of the Act to the 1993 Bonds

        When Congress first enacted the statutory provision in 1980 that established Half-SAP
treatment for certain loans, it did not specifically define the term “obligation.” Indeed, despite
the fact that Congress has amended the special allowance provisions on numerous occasions
since 1980, Section 438(b)(2) has never included a specific definition of “obligation” for
purposes of applying the 9.5% floor rule. The current regulations that address the 9.5% floor
provision similarly lack any specific definition of the term “obligation.” 23 Indeed, in interim
regulations promulgated in 2006, the Department specifically acknowledged that “current
regulations refer to obligations originally “issued” before or after specified dates, but do not
define that term, derived from Section 438(b)(2)(B) of the Act.” Interim Regulations, 71 Fed.
Reg. 45680, August 9, 2006.

        Because of an ambiguity inherent in the text of the Act and the regulations, Sallie Mae
acted reasonably in relying on a good faith interpretation of the regulations to determine the
appropriate practice for billing 9.5% floor rate loans. The regulations specifically state that an
otherwise eligible student loan loses its 9.5% floor rate status when “the prior tax-exempt
obligation,” the proceeds of which were used to purchase the loan, is retired or defeased. The
ambiguity arises from the use of the word “obligation” in its singular form.

         (c) The Department has Never Addressed the Issue Raised in the Draft Report.

        The Department’s regulations and guidance have not clearly answered the question of
which group of bonds should be used for purposes of applying the 9.5% floor rules. Such bonds
could be grouped based on a multitude of different characteristics to determine which bonds
should be associated with which particular loans. For example, with secured bond issuances, the
relationship between a group of bonds that are secured by a specific group of loans may be easy
to discern. Absent that arrangement, it is reasonable to associate bonds based on their issue date,
maturity date, or some other common term(s), such as the terms of the applicable indenture or
trust agreement.

        Sallie Mae treated the 1993 Bonds as a single obligation because they were all issued
during the same year with identical terms and provisions as discussed above. That application is
arguably consistent with the Department’s interpretation of the regulations. Sallie Mae’s
interpretation recognizes the 1993 Bonds as the group of issuances that has the most common
and significant shared characteristics including issue year, payment rights, collateral and
remedies.

        It is a reasonable approach to treat the 1993 Bonds as a single obligation because of their
common terms and characteristics, rather than arbitrarily identifying each bond series as a
separate obligation. The OIG’s separate consideration of each series relies on arguing that each
series is unique only because of its issue date. However, the 1993 Bonds were not organized in
such a way. For example, within certain of the series there were multiple interim maturity dates

23
  Regulations implementing the Half-SAP provision, promulgated in 1985 broadly defined “obligation” to mean
“any interest-bearing debt or original issue discount debt incurred by an Authority pursuant to its borrowing powers.
[A]s used in this subpart, this term means only an obligation issued to acquire funds for financing or refinancing the
making or purchasing of student loans.” 50 Fed. Reg. 5515, February 8, 1985. The Department removed the
definition of “obligation” from the regulations in December 1992.
Final Report
ED-OIG/A03I0006                                                                     Page 39 of 59

reflecting the maturity of some, but not all of the 1993 Bonds of an individual series.
Additionally, of the eight series of the 1993 Bonds, half of them shared a common issue date.
Instead of being substantively different financings, the use of multiple series for the 1993 Bonds
was based on logistical convenience or investor demands.

        In sum, Sallie Mae had a reasonable basis to treat the collective group of the 1993 Bonds
as the obligation. Sallie Mae’s position that all of the 1993 Bonds issued under the 1993 Trust
Agreement — not the Agreement itself — constitute one obligation with a maturity date of July
1, 2005 is consistent with the intent of Congress in enacting the 9.5% floor provision, namely to
offer less than full special allowance to non-profit lenders with access to tax-exempt financing
and lower cost of funds than for-profit lenders. To address the 1993 Bonds by their separate
series designation is to impart to each series distinct characteristics that do not exist under the
1993 Trust Agreement.

        The OIG’s Draft Report would rely on the final maturity date of a bond series to
determine eligibility for the 9.5% floor rate and ignore any interim maturity dates within the
series. Sallie Mae’s practice just as reasonably relies on the final maturity date of the 1993
Bonds of July 1, 2005 as the appropriate end date for the 9.5% floor rate. The original intent of
Congress in enacting the 9.5% floor provision was to maximize the amount of loans billed at
9.5% to penalize non-profit lenders and minimize any potential windfall they would otherwise
obtain due to their low cost of funds. Sallie Mae’s interpretation is the only interpretation
consistent with that Congressional intent.

       (d) The OIG’s Reliance on Alleged Inconsistencies in Sallie Mae’s Practices is
           Misplaced.

        In its Draft Audit Report, the OIG also attempts to highlight alleged inconsistencies
between Sallie Mae’s treatment of 9.5% floor loans after its acquisition of Nellie Mae and Nellie
Mae’s practice prior to the acquisition, as well as alleged inconsistencies in Sallie Mae’s
treatment of loans funded by Bond 93F. The OIG’s attempt to rely on these alleged inconsistent
interpretations is irrelevant and further misstates the facts.

        Since its acquisition of Nellie Mae in July of 1999, Sallie Mae’s billing procedure for
loans eligible for the 9.5% special allowance floor has been consistent. As noted in the
Overview of Policies Sallie Mae submitted to the OIG, Sallie Mae’s policy for the management
of Nellie Mae’s student loans financed by tax-exempt obligations required that:

   •   Nellie Mae issues tax-exempt obligations under the terms of a trust indenture or trust
       agreement, which established the trust and governed the administration of the trust and
       the assets owned by the trust.
   •   Loans remained 9.5% floor loans if they were transferred to an affiliate of the entity
       issuing the tax-exempt obligations but not refinanced with an ineligible source of funds.
       These affiliates were referred to as “holding tanks” and were funded with general
       corporate funds including equity, cash and taxable, not tax-exempt debt.
Final Report
ED-OIG/A03I0006                                                                                 Page 40 of 59

       •   As the related bond trust was extinguished with the last tax-exempt bond series maturity,
           the eligibility of the related loans in the holding tank for 9.5% special allowance was
           extinguished and the loans had to start receiving full special allowance. 24

         Sallie Mae acknowledges that this interpretation was inconsistent with Nellie Mae’s 9.5%
billing practices in place prior to the acquisition of the company in 1999. 25 However, the Nellie
Mae loans cited in the OIG Draft Report that Sallie Mae purchased under the 1993 Trust
Agreement (loans associated with the 93A, 93B, 93F, 93G, and 93H bond series) were billed at
the 9.5% floor rate under the policy outlined above. 26 The loans associated with the 1993 Bonds
under the 1993 Trust Agreement that matured prior to Sallie Mae’s purchase (bond series 93C,
93D, and 93E) were not loans Sallie Mae purchased and therefore were not billed under this
policy. 27

        The OIG has included statements in the Draft Report and in its workpapers indicating that
the purpose of the July 2004 sale of loans associated with bond series 93F was “to cease billing
the loans under the 9.5% floor calculation, and to classify the loans as eligible for the usual
special allowance rates, as Bond 93F was scheduled to mature on July 1, 2004.” 28 This sentence
mischaracterizes the events associated with the July 2004 sale of loans associated with the 93F
bond series.

        As Sallie Mae has previously explained to the OIG, the July 2004 sale was an erroneous
early liquidation of bond series 93F. 29 As noted in Sallie Mae’s February 1, 2005 memorandum,
the process that had been used by Sallie Mae to “tag” loans qualified to receive 9.5% SAP was
not entirely effective. 30 As part of the monitoring process Sallie Mae initiated in 2004 to
correctly identify and tag all 9.5% loans, Sallie Mae determined that the loans associated with
the 93F 31 bond series had been switched from 9.5% to the full special allowance rate in error.32
Sallie Mae corrected its 799 billings with respect to this error between January, 2005 and June,
2005.



24
     OIG Workpaper H.1.16, D.3.1
25
     See OIG Workpaper D.3.5., p. 2.
26
  OIG Workpaper A.1.1 – July 28, 2008 e-mail communication from J. Wheeler to Robert Janney; OIG Workpaper
G.1.1.
27
     See OIG Workpaper G.4.1, p. 2.
28
     See Draft Report, p. 13; OIG Audit Workpaper D.3.4, D.3.5
29
     See OIG Workpaper H.1.39.
30
     See OIG Workpaper H.1.22, p. 2.
31
   Note, the February 1, 2005 memorandum refers to the loans associated with bond series 93F as bond series 93B,
in error.
32
     See OIG Workpaper H.1.22at p. 3.
Final Report
ED-OIG/A03I0006                                                                                      Page 41 of 59

           (e) The History of the 9.5% Provision Supports Sallie Mae’s Interpretation of
               “Obligation.”

     The historical context of the 9.5% floor loan provisions also provides support for Sallie
Mae’s interpretation of “obligation.” As the Comptroller General recognized in a report issued by
the General Accountability Office (“GAO”) in 2004, 33 in the early 1990s, the Department
expected that interest rates would rise, and that such predicted rise would result in a higher lender
yield for loans not subject to the Half-SAP limitation. The Department was concerned that
holders would transfer loans out of floor loan eligible issuances in order to obtain a higher yield,
“thus resulting in higher special allowance payments for the Government.” GAO Report at p. 5.
The Department amended 34 C.F.R. § 682.302(e)(2) in 1992 to prevent holders from avoiding the
Half-SAP cap through refinancing into non-floor eligible loans, by adding a provision that if the
authority retained a legal interest in those loans and the original tax-exempt obligation remained
outstanding, floor loan treatment must continue. Given this historical context, if interest rates had
been high in 2005, by following the OIG’s interpretation of the word, “obligation,” Sallie Mae
would have subjected itself to accusations of improperly boosting its yield on loans by treating
bonds issued under a single trust agreement as separate obligations for purposes of the 9.5% floor.

           (f) In the Absence of Clear Regulatory or Dear Colleague Letter Guidance, it was
               Reasonable for Sallie Mae to look to other Statutory Guidance or Definitions.

       In the absence of clear statutory, regulatory, or Dear Colleague Letter Guidance, it was
reasonable for Sallie Mae to look to other statutory guidance or definition.

        Treasury’s regulations that permit a series of bonds to be treated as one obligation
support Sallie Mae’s practice of treating the 1993 Bonds as a single financial obligation. Under
the Treasury’s regulations governing student loan bonds during the lifespan of the 1993 Bonds,
Sallie Mae was permitted to calculate a single yield for all of the 1993 Bonds because of their
significant relationship to each other under the 1993 Trust Agreement. Treas. Reg. 1.148-4(a).
This exception to the yield-calculation rules exists because the failure to treat bonds such as the
1993 Bonds as a single obligation can result in discriminatory treatment of the students whose
loans were purchased.

        While the Treasury regulations are tax-based and not derived from the Act, the OIG has
indicated that it may consider economic-related rules and regulations from outside the
Department when addressing billing issues. In the OIG’s Final Audit Report entitled “Special
Allowance Payments to Nelnet for Loans Funded by Tax-Exempt Obligations, 34 the OIG relied
in part on Financial Accounting Standards Board (“FASB”) Accounting Standards, Statements of
Standards FAS 125 and FAS 140 to determine whether certain loan transactions constituted sales
or transfers. Such consideration of other federal regulations supports Sallie Mae’s reliance on
the Treasury’s regulations in its practices with respect to the 1993 Bonds, and in the absence of a
specific definition of “obligation” in the HEA, Sallie Mae’s analogy to the Treasury regulations
was reasonable.

33
     United States Government Accountability               Office,   Report,    GAO-04-1070,      September   2004,
http://www.gao.gov/products/GAO-04-1070.
34
     For a copy of the Nelnet Report see, www.ed.gov/about/offices/list/oig/auditreports/a07f0017.pdf.
Final Report
ED-OIG/A03I0006                                                                                        Page 42 of 59

        The Treasury regulation cited above is relevant to the consideration of the meaning of the
term “obligation” under the HEA. One of the fundamental canons of statutory construction is
that the words of a statute must be read in context with a view to how those provisions fit in the
overall statutory scheme. 35 The courts have consistently held that undefined terms in a statute be
placed beside other statutes relevant to the subject and given a meaning and effect derived from
the combined whole. 36 Generally, where legislation dealing with particular subject consists of
system of related general provisions indicative of settled policy, new enactments of a
fragmentary nature on such subject are to be taken as intended to fit into the existing system and
to be carried into effect conformably thereto, except where a different purpose is clearly
shown. 37

        The original provision of the HEA that established the Half-SAP program explicitly
incorporated the Internal Revenue Code provisions to determine which obligations are tax-
exempt. 38 To this day, the Internal Revenue Code provisions establish and govern those
obligations entitled to receive tax-exempt treatment. 39 In view of these facts, IRS interpretations
establishing the meaning of a tax-exempt obligation; which bonds are entitled to be considered
an ‘obligation’; and the tax-treatment of those obligations, are relevant and appropriate guides to
determine the meaning and treatment of those tax-exempt obligations under the HEA for
purposes of the Half-SAP provision.

        In summary, for all the reasons stated above, Sallie Mae’s billing practices with respect to
the 1993 Bonds issued under the 1993 Trust Agreement were a good faith effort to comply with
the Act and as a reasonable and supported conclusion under the Act and the Department's
regulations.

V.         The OIG’s Estimate of the Alleged Overpayment of SAP is Incorrect.



35
   Food and Drug Admin. v. Brown & Williamson Tobacco Corp., 529 U.S. 120, 120 S.Ct. 1291 (2000) (Tobacco
manufacturers, retailers and advertisers challenged the Food and Drug Administration regulation of tobacco
products. In construing the relevant provisions of Food, Drug and Cosmetic Act, the court considered various
statutes enacted to regulate the use of tobacco products in reaching the conclusion that the FDA did not have
jurisdiction to regulate tobacco products as customarily marketed.)
36
   See e.g., United States v. American Trucking Association, 310 U.S. 534, 543-44 (1940) (Supreme Court
interpreted Motor Carrier Act of 1935 in light of the Hours of Sevice Act, the Motor Vehicle Act, and other statutes
where it was hesitant to interpret clause in question in a way that would deviate from the meaning of other related
statutes); United States v. Abreu, 962 F.2d 1447 (10th Cir. 1992)(noting that in construing ambiguous or undefined
statutory term, Supreme Court has indicated that references to other statutes may may be appropriate as well);
Stribling v. United States, 419 F.2d 1350 (8th Cir. 1969)(where interpretation of particular statute is in doubt, express
language of another statute not strictly in pari material but employing similar language and applying to similar
persons and things may control by force of analogy).
37
  United States v. Arizona, 295 U.S. 174, 55 S.Ct. 666 (1935) (Court considered the statutory history of acts
governing rivers and streams in reaching conclusion that one isolated provision did not evidence intention of
Congress to change its long-standing interpretations).
38
     Education Amendments of 1980, Pub. L. 96-374, Title IV, §420(b), Oct. 3, 1980, 94 Stat. 1427.
39
     20 USC §1087-1 (2008).
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        In its Draft Report, the OIG recommends that the Department require Sallie Mae to return
approximately $12.3 million in SAP billings for loans associated with Bond 93F and
approximately $10 million in SAP billings for loans associated with Bonds 93B, 93G and 93H.
Putting aside the issue of whether the OIG’s interpretation of the term “obligation” for purposes
of the 9.5% floor loans is correct, the OIG’s estimates of alleged SAP overpayments are based on
a flawed assumption about the average life span of loans in the bonds at issue here for purposes
of amortizing the loan balances, and therefore are overstated.

        The OIG based its estimates of the alleged ineligible loan amounts associated with Bonds
93B, 93G and 93H on the assumption that each loan was paid off over an 8.5 year period. Draft
Report, p. 17-18. This 8.5 year average life may in fact be valid for loans originated in 2008.
We submit, however, that it is not valid for loans originated before or during the audit period of
2002-2005. We also submit that OIG incorrectly assumed that the loans were newly originated
at the time of the bond maturity rather than having been in repayment for several years. The
OIG’s faulty assumptions about the average life of the loans, therefore, skewed its estimate of
the alleged SAP overpayment.

         Sallie Mae provided information to the OIG that the average life span on the actual
FFELP Stafford portfolios in question ranges from 3.7 to 4.6 years. These lower average lives
result from two facts.

        First, most of the loans in question were originated before the audit period 2002-2005 and
therefore were well into repayment. Second, frequent loan consolidation during the relevant
period makes the use of a non-consolidation average life span flawed. While these loans were
“non-consolidation” FFELP loans, a significant percentage of these loans would have
consolidated which would significantly speed up the overall pay down of the portfolio.

         As the OIG is familiar, the FFEL Program witnessed a massive amount of loan
consolidation during the 2002-2007 timeframe. In fact, over $40 billion of Sallie Mae’s non-
consolidation FFELP loans (Stafford and PLUS) consolidated between 2002-2005. On an
annual basis, this constituted between 20-40% of Sallie Mae’s entire non-consolidation
portfolio. Because of this high level of prepayment experience, Sallie Mae calculates the
average life of non-consolidation loans to use in determining a number of accounting related
results. These results are included in our publicly disclosed filings with the SEC and are audited
by our independent external auditors. These reports are available on our website
(www.salliemae.com) and on the SEC’s EDGAR system. The affect of these prepayments have
the impact of shortening the overall average life of the portfolio. Our audited weighted average
life information on our FFELP Stafford portfolio disclosed in our 10K report ranged from a high
of 4.6 years to a low of 3.7 years. 40 Sallie Mae previously provided amortization tables (attached
as Exhibit B as a courtesy) which recalculate the impact to the average billed balance using a 4.0
year average life of loan instead of the 8.5 year average used by the OIG. See Exhibit C for
excerpts from relevant Sallie Mae disclosure documents.



40
     SLM Corporation Form 10-K for year ending December 31, 2007, pp.               F-34   and   F-40.
http://www.sec.gov/Archives/edgar/data/1032033/000095013307000881/w30676e10vk.htm
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ED-OIG/A03I0006                                                                                     Page 44 of 59

       The OIG ignored the more specific Sallie Mae data and arbitrarily determined that the
average life span of nonconsolidated FFELP loans is 8.5 years. See Draft Report n.14. 41 If the
OIG had used the data specific to Sallie Mae’s Stafford portfolio, the alleged SAP overpayment
would be reduced.

        For the reasons set forth above, Sallie Mae reaffirms its request that the OIG take this
Sallie Mae specific information on the average life span of Stafford loans into consideration in
calculating its estimate of the alleged SAP overpayments.

VI.     OIG’s Allegation that a Weakness in Sallie Mae’s Internal Controls led to the
        Alleged Improper Billing lacks any Merit.

        The OIG’s finding that a weakness in Sallie Mae’s internal controls led to the alleged
improper billing lacks any merit and should be removed from any final report. A difference in
legal interpretation of an undefined statutory provision is not a management weakness in internal
controls.

         In its Draft Report, the OIG takes issue with Sallie Mae’s interpretation of the 9.5%
special allowance floor provisions in the Act and the regulations. As described in detail above,
the issue raised in the audit report is whether an “obligation” can be all bonds issued under a
single trust agreement with common characteristics, or whether, as the OIG contends, each bond
issued under that trust agreement is a separate “obligation” for purposes of applying the 9.5%
floor calculation. The OIG disputes Sallie Mae’s legal interpretation that all of the 1993 Bonds
issued under the 1993 Trust Agreement with common provisions are a single obligation and
concludes that “[t]his management control weakness resulted in noncompliance with regulations
and special allowance overpayments.” Draft Report at p.1. At the end of its Draft Report, the
OIG again made reference to Sallie Mae’s internal controls as it relates to the 9.5% floor billing.
The Draft Report states:

                 As part of our audit, we assessed SLMA’s system of internal
                 control significant to the audit objective and applicable to its
                 billing for SAP under the 9.5 percent floor calculation, the process
                 used to identify loans eligible for special allowance billing under
                 the 9.5 percent floor calculation. Our assessment disclosed a
                 significant management control weakness that adversely affected
                 SLMA’s ability to accurately identify loans eligible for special
                 allowance billing under the 9.5 percent floor calculation.
                 Specifically, SLMA continued to bill loans under the 9.5 percent
                 floor calculation after the maturity of the eligible tax-exempt bonds
                 and after the loans were refinanced with funds derived from
                 ineligible sources. As a result of its management control

41
   The Draft Report states: “The Department has determined the average life span of non-consolidated FFELP loans
to be 8.5 years. The Department made this determination as part of its obligation under the Federal Credit Reform
Act of 1990,…to calculate the subsidy cost for FFELP loans. NLMA’s 9.5% floor billings for the quarters ended
June 30, 2003, through June 30, 2005, contained only non-consolidated loans. In comments submitted to a draft of
this finding, SLMA stated that the average weighted life of a loan on its FFELP Stafford portfolio ranges from 3.6 to
4.7 years. We have not made this revision; our estimate relies on the average life span calculated by the
Department.” Draft Report n.14.
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               weakness, SLMA’s billing activities did not comply with laws,
               regulations, and guidance for the 9.5 percent floor calculation.

Draft Report at p. 19.
        Whether Sallie Mae’s legal interpretation of the regulatory language relating to what is an
“obligation” ultimately is determined to be the correct interpretation, the OIG’s statement that a
weakness in Sallie Mae’s internal controls led to the alleged improper billing lacks any merit. A
company’s legal interpretation of a statutory provision on an issue of first impression is not an
internal control. None of the Public Company Accounting Oversight Boards, the Securities and
Exchange Commission or the Office of Management and Budget is in line with the OIG’s
position.

         The Public Company Accounting Oversight Board (“PCAOB”) has issued an Auditing
Standard that requires auditors to issue an opinion on the effectiveness of their public company
clients’ internal controls. Auditing Standard 2, “An Audit of Internal Control over Financial
Reporting Performed in Conjunction with an Audit of Financial Statements”, states that an
internal control deficiency exists when the design or operation of a control does not allow for
timely prevention or detection of misstatements. It defines a “material weakness” in internal
controls as” a significant deficiency, or combination of significant deficiencies, that results in
more than a remote likelihood that a material misstatement of the annual or interim financial
statements will not be prevented or detected.” Standard 2 defines “significant deficiency” as
“one that affects the company’s ability to reliably process and report financial data such that
there is more than a remote likelihood that the financial statements will be impacted in a manner
that is consequential but not material.” There is absolutely nothing in Standard 2 to suggest that
a company’s process of formulating a legal interpretation of a statute constitutes an internal
control. Indeed, in a publication of frequently asked questions concerning its Rules on
Management’s Report on Internal Control Over Financial Reporting and Certification of
Disclosure in Exchange Act Periodic Reports (Release No. 34-47986, June 5, 2003), the
Securities and Exchange Commission concluded that “[t]he definition of the term ‘internal
control over financial reporting’ does not encompass a registrant’s compliance with applicable
laws and regulations, with the exception of compliance with the applicable laws and regulations
directly related to the preparation of financial statements, such as the Commission’s financial
reporting requirements.” FAQ, revised October 6, 2004, Question and Answer 10.

        In addition, the Office of Management and Budget (“OMB”) has recognized that, in
determining standards for internal control in government, statutory interpretation is not an
internal control activity. The Federal Managers’ Financial Integrity Act of 1982 (“FMIA”), 31
U.S.C. §3512, requires the General Accounting Office (“GAO”) to issue standards for internal
control in government. These standards are supposed to provide the framework for establishing
and maintaining internal control and for identifying and addressing major performance and
management challenges and areas at greatest risk of fraud, waste, abuse and mismanagement.
OMB Circular A-123, Management Accountability and Control, provides the specific
requirements for assessing and reporting on controls in government. In Circular A-123, Internal
Control Systems, the OMB discussed internal control activities designed to provide reasonable
assurance that government resources are protected against fraud, waste and mismanagement, but
specifically carved out statutory interpretation from the definition of internal controls. Circular
A-123 states “[I]nternal control does not encompass such matters as statutory development or
interpretation.” While OMB Circular A-123 was revised on December 21, 2004, nothing in the
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ED-OIG/A03I0006                                                                     Page 46 of 59

revision suggests that statutory interpretation is an internal control. Indeed, in the revised
Circular, OMB gave examples of control activities as proper segregation of duties, physical
controls over assets, proper authorization, and appropriate documentation and access to that
documentation. Nothing in the revised circular remotely suggests that the method by which a
company comes to a legal interpretation or the resulting legal interpretation itself is a
management control.

        Sallie Mae’s legal reasoning and interpretation of arguably ambiguous statutory and
regulatory provisions is not a management control, and the report’s reference to management
control weaknesses should be deleted.

VII.   The Issues Addressed in the Draft Report have no Application to Other Sallie Mae
       Subsidiaries.

        While the Draft Report focuses on special allowance payments to Nellie Mae for 9.5%
floor loans, the OIG recommends that Federal Student Aid (“FSA”) ask Sallie Mae to disclose
“any other instances, at any of its subsidiaries (i.e., NLMA, Southwest Student Services
Corporation, Student Loan Funding Resources, Student Loan Finance Association) of loans
billed under the 9.5% floor calculation after the eligible tax-exempt bond issue matured and after
the loans were refinanced with funds derived from an ineligible funding source.” Without
conceding that the OIG’s findings as to Nellie Mae’s billings are correct, Sallie Mae can state
that none of its other subsidiaries with 9.5% floor loans issued tax-exempt bonds under similar
indentures or trust agreements with similar structures. No other subsidiaries issued general
obligation or unsecured bonds. No other subsidiaries had similar trust structures that lacked a
defined pool of loans. As such, Sallie Mae treated the Nellie Mae-bonds differently than the
bonds of its subsidiaries. The issue addressed in the Draft Report is limited to Nellie Mae’s
special allowance billings. Thus, there is no reason for any final audit report to include the
recommendation to the FSA as to information on Sallie Mae’s other subsidiaries.

VIII. Conclusion

        Sallie Mae appreciates the opportunity to respond to the OIG’s Draft Report. We believe
our response demonstrates that Sallie Mae did not violate the Act or the applicable regulations in
billing special allowance at the 9.5% floor on certain Nellie Mae loans. As explained in detail
above, there is no definition of the term “obligation” in the statutory or regulatory provisions
addressing the 9.5% floor provisions and Sallie Mae properly treated the 1993 Bonds which have
significant and numerous common terms and conditions as a single obligation for purposes of
determining the date on which to cease billing at the 9.5% floor on loans that were financed with
the proceeds of such 1993 Bonds. In the alternative, even if the Secretary were to adopt the
OIG’s statutory interpretation, this case would be an appropriate one for the Secretary to exercise
his discretion under the regulations to waive any repayment by Sallie Mae of the special
allowance payments at issue.

        Further, even assuming that the OIG has correctly interpreted the Act and the regulations,
its estimate of the alleged overpayment of special allowance is speculative and excessive and
must be reduced. Additionally, since Nellie Mae was the only subsidiary of Sallie Mae with this
particular type of bond structure, there is no reason to recommend any further review of other
Sallie Mae subsidiaries on this issue.
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ED-OIG/A03I0006                                                                    Page 47 of 59


        Finally, the OIG’s finding that the alleged overbilling of special allowance was due to a
weakness of management controls has no merit and must not be included in any final audit
report, as a company’s good faith interpretation of an ambiguous statutory provision is not a
management weakness or a weakness in internal controls.
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