oversight

Special Allowance Payments to Nelnet for Loans Funded by Tax-Exempt Obligations

Published by the Department of Education, Office of Inspector General on 2006-09-29.

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

                Special Allowance Payments to Nelnet 

            for Loans Funded by Tax-Exempt Obligations





                                 FINAL AUDIT REPORT





                                    ED-OIG/A07F0017

                                     September 2006



Our mission is to promote the                          U.S Department of Education
efficiency, effectiveness, and                         Office of Inspector General
integrity of the Department's                          Chicago, Illinois
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 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 

                                                 Chicago/Kansas City Audit Region

                         111 N. Canal St. Ste. 940                            8930 Ward Parkway, Ste 2401
                         Chicago, IL 60606-7297                               Kansas City, MO 64114-3302
                         Phone (312) 886-6503                                 Phone (816) 268-0500
                         Fax (312) 353-0244                                   Fax (816) 823-1398



                                                       September 29, 2006

Michael S. Dunlap
Chairman and Co-CEO
Nelnet, Inc.
121 South 13 th Street, Suite 201
Lincoln, NE 68508

Dear Mr. Dunlap:

Enclosed is our final audit report, Control Number ED-OIG/A07F0017, titled Special Allowance
Payments to Nelnet for Loans Funded by Tax-Exempt Obligations. This report incorporates the
comments you provided in response to the draft report. Because of the voluminous number of
exhibits included in your comments, we did not include the exhibits in the report, but we will make
copies of the attachments available upon request.

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:

                                         Theresa S. Shaw
                                         Chief Operating Officer
                                         Federal Student Aid
                                         U.S. Department of Education
                                         Union Center Plaza
                                         830 First Street NE
                                         Washington, DC 20202

It is the policy ofthe 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 ofInformation 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,

                                                     G~,,~ 

                                                               Richard . ...-:.~~-­
                                                               Regional Inspector General
                                                                  for Audit
Enclosure


            Our mission is to promote the efficiency, effectiveness, and integrity ofthe Department's programs and operations.
                                               TABLE OF CONTENTS


                                                                                                                                         Page

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


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


AUDIT RESULTS .........................................................................................................................6


          FINDING –            The Increase in Nelnet’s Special Allowance Payments 

                              under the 9.5 Percent Floor Was Based on Ineligible 

                              Loans ............................................................................................................6


OBJECTIVE, SCOPE, AND METHODOLOGY ....................................................................16


Enclosure 1: Nelnet’s Written Inquiry and FSA’s Response...................................................18


Enclosure 2: Estimates of Special Allowance Improper Payments.........................................22


Enclosure 3: Nelnet’s Comments................................................................................................26

Final Audit Report
ED-OIG/A07F0017                                                                                    Page 1 of 66



                                     EXECUTIVE SUMMARY



Special allowance payments 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 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 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 special allowance payment for these
loans may not be less than 9.5 percent, minus the interest the lender receives from the borrower
or the government, divided by 4. In this report, 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.

In April 2003, Nelnet implemented a process (“Project 950”) to increase the amount of its loans
receiving special allowance under the 9.5 percent floor. Through Project 950, Nelnet transferred
loans into and out of an eligible tax-exempt obligation from taxable obligations, continuing to
bill under the 9.5 percent floor for those loans after they were transferred to the taxable
obligations. Nelnet repeated this process many times, increasing the amount of loans it billed
under the 9.5 percent floor from about $551 million in March 2003 to about $3.66 billion in June
2004.

The objective of our audit was to determine whether, for the period January 1, 2003, through
June 30, 2005, Nelnet's use of Project 950 to increase the amount of its student loans billed under
the 9.5 percent floor complied with the requirements in the HEA, regulations, and other guidance
issued by the U.S. Department of Education (Department). To accomplish our objective, we
gained an understanding of Project 950, examined Nelnet’s tax-exempt and taxable obligations,
reviewed the criteria used by Nelnet to determine whether a loan qualified for the 9.5 percent
floor, and reviewed other related information.

Nelnet’s Project 950 did not fund loans from an eligible source in compliance with the HEA,
regulations, and other guidance issued by the Department. Therefore, the increased amount of
loans created by Project 950 was ineligible to be billed under the 9.5 percent floor. We estimate
that Nelnet was improperly paid more than $278 million in special allowance for these loans
from the quarter ended March 31, 2003, through the quarter ended June 30, 2005, and that Nelnet
could be improperly paid about $882 million for the ineligible loans after June 2005 if Nelnet’s
billings are not corrected. 1


1
  Our estimates of improper payments to Nelnet include the entire payment to Nelnet for loans billed improperly
under the 9.5 percent floor. We have not reduced our estimates by the amount of the special allowance payments
that Nelnet may have received for the loans if it had billed under the regular special allowance calculation.
However, our analysis of Nelnet’s 9.5 percent loan portfolio indicates that any eligibility for regular special
allowance payments during our audit period would be limited and likely be a small portion of the amount received
under the 9.5 percent floor.
Final Audit Report
ED-OIG/A07F0017                                                                      Page 2 of 66

We recommend that the Chief Operating Officer (COO) for Federal Student Aid (FSA) instruct
Nelnet to exclude all Project 950 loans from its claims for payment under the 9.5 percent floor.
We also recommend that the COO require the return of the overpayments described in this
report.

A draft of this report was provided to Nelnet for review and comment on August 9, 2006. In its
comments dated September 7, 2006, Nelnet strongly disagreed with our finding and
recommendations, stating that its billing under the 9.5 percent floor complies with the HEA,
regulations, and authoritative guidance. Where appropriate, we have incorporated into this
report summaries of Nelnet’s comments and our responses. In response to comments received,
we modified our conclusion that Nelnet’s transactions did not qualify as sales under the
regulations. Because this was an alternative basis for our finding, our basic finding that Nelnet
billed ineligible loans under the 9.5 percent floor did not change. We provide Nelnet’s response
to our draft report as Enclosure 3.
Final Audit Report
ED-OIG/A07F0017                                                                            Page 3 of 66



                                                BACKGROUND



Special Allowance Payments

A lender participating in the FFEL Program is entitled to a quarterly special allowance payment
for loans in its portfolio. In general, for Stafford loans, 2 the amount of the quarterly special
allowance payment is calculated in four steps:

1. 	 Determining the average of the bond equivalent rates of 91-day Treasury bills auctioned
     during the quarter,
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)) 3

According to Section 438(a) of the HEA, the purpose of special allowance payments 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 special allowance payments 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 special
allowance payments 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 results in significantly greater special allowance payments than a
lender would otherwise receive. For example, for the quarter ended December 31, 2003, for a
FFEL Program Stafford loan made on January 15, 2000, with an average daily balance of
$5,000, a lender would receive $76 under the 9.5 percent floor (payment rate of 1.52 percent).


2
    The calculation used for other types of FFEL Program loans is slightly different.
3
    All regulatory citations are to the version dated July 1, 2004.
Final Audit Report
ED-OIG/A07F0017                                                                           Page 4 of 66

Under the calculation that would be used if the same loan were not eligible for the 9.5 percent
floor (payment rate of 0.0025 percent), the lender would receive $0.125.

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, restricting it to loans
made or purchased with the proceeds of tax exempt obligations that were originally issued before
October 1, 1993. The Taxpayer-Teacher Protection Act of 2004 (Pub. L. 108-409) and the
Higher Education Reconciliation Act of 2005 (Pub. L. 109-171) placed further restrictions on
loans’ eligibility for the 9.5 percent floor.

Dear Colleague Letter 96-L-186

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

       Under the regulations, if a loan made or acquired with the proceeds of a 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).

Nelnet and Project 950

Nelnet is headquartered in Lincoln, Nebraska, and makes, purchases, and finances student loans
as part of its activities as a secondary market of student loans. It is the successor in interest to a
qualified scholarship funding corporation which converted to for-profit status in 1998, and as
such, is the issuer of tax exempt obligations pursuant to an Indenture of Trust dated November
15, 1985.

Nelnet officials designed a process so Nelnet could increase the amount of loans it billed as
eligible under the 9.5 percent floor (Project 950). Through Project 950, Nelnet used a series of
internal transactions to increase the amount of loans ostensibly funded by tax-exempt obligations
from approximately $551 million for the quarter ended March 31, 2003, to nearly $3.66 billion
for the quarter ended June 30, 2004. There was no increase in the amount of Nelnet’s
outstanding tax-exempt obligations during this period.

On May 29, 2003, Nelnet sent a letter to the Department requesting guidance on its special
allowance billing process. (Nelnet’s letter and FSA’s response are included as Enclosure 1 to
this report.) In its letter, Nelnet described Project 950 and asked for the Department’s
concurrence:

       As part of [Nelnet’s] overall cash flow management plan, the purchased loans will
       be held within the 1985 Indenture and financed by the tax exempt obligations
       issued by [Nelnet] under that financing for a period of time depending upon case
       management needs and other internal concerns, but in any event for at least one
Final Audit Report
ED-OIG/A07F0017                                                                            Page 5 of 66

           day or longer. Thereafter, loans will be refinanced and placed into financings
           which are taxable on a longer term basis . . . .

           . . . During the time that the loans are held in the 1985 Indenture . . . we intend to
           bill for special allowance at the quarterly rate of one-half the average of the bond
           equivalent rates of 91-day Treasury bill plus 3.5%, divided by 4, subject to a
           minimum of 9.5% minus the applicable interest rate on a loan, divided by 4.
           Since the loans thereafter will be refinanced under a taxable financing, [Nelnet]
           will maintain its 100% beneficial ownership interest in the loans previously
           purchased with proceeds of the 1985 Indenture, and the 1985 Indenture will not
           be retired or defeased, we intend to continue to bill for special allowance at such
           same quarterly rate . . . . We intend to submit billings for special allowance at this
           same rate until such refinanced loans are either no longer beneficially owned by
           [Nelnet] (and are transferred to an unrelated or an affiliated purchaser), or until
           the 1985 Indenture is retired or defeased.

The Department responded to Nelnet’s letter on June 30, 2004. This response provided only
references to other authorities: it neither concurred with nor objected to the process described in
Nelnet’s letter. After receipt of this letter, Nelnet recognized $124.3 million in earnings, citing
“certain clarifying information received in connection with the guidance it had sought, including
written and verbal communications with the Department . . . .” 4

In the year and a quarter after Nelnet sent its letter to the Department, Nelnet’s portfolio of loans
billed under the 9.5 percent floor increased by more than 560 percent:

      • 	 For the last quarter before starting Project 950 (the quarter ended March 31,
          2003), Nelnet reported a tax-exempt average daily principle balance of
          approximately $551 million and received nearly $6.7 million in special allowance
          payments;

      • 	 For the following quarter (ended June 30, 2003), Nelnet reported a tax-exempt 

          average daily principal balance of nearly $856 million and received just over 

          $10.6 million in special allowance payments; and 


      • 	 After more than a year of Project 950 (for the quarter ended June 30, 2004), 

          Nelnet reported a tax-exempt principal balance of nearly $3.66 billion and 

          received approximately $51.4 million in special allowance payments. 


Nelnet terminated Project 950 in May 2004, after the introduction of H.R. 4283, the College
Access and Opportunity Act, which included provisions later enacted under the Taxpayer-
Teacher Protection Act of 2004. Among other requirements, the Taxpayer-Teacher Protection
Act amends the HEA to make loans that are transferred, sold, or refinanced by taxable
obligations after September 30, 2004, ineligible for the 9.5 percent floor.




4
    SEC Filing, Form 10-Q (August 16, 2004).
Final Audit Report
ED-OIG/A07F0017                                                                                         Page 6 of 66



                                             AUDIT RESULTS



Nelnet’s use of Project 950 was not in compliance with requirements in the HEA, regulations,
and the Department’s guidance. The increased amount of loans billed under the 9.5 percent floor
that resulted from Project 950 was not funded by any eligible source listed in 34 C.F.R.
§ 682.302(c)(3)(i). We estimate that Nelnet—

     • 	 Was improperly paid about $278 million in special allowance from the quarter ended
         March 31, 2003, through the quarter ended June 30, 2005; and

     • 	 Could be improperly paid about $882 million in special allowance after the quarter
         ended June 30, 2005, if Nelnet’s billings are not corrected.

FINDING – 	The Increase in Nelnet’s Special Allowance Payments under the 9.5
          Percent Floor Was Based on Ineligible Loans

The amount of loans for which Nelnet received special allowance payments under the 9.5
percent floor increased from about $551 million for the quarter ended March 31, 2003, to about
$3.66 billion for the quarter ended June 30, 2004. This increase is attributable, primarily, to
Nelnet’s use of Project 950 to increase the amount of loans Nelnet billed under the 9.5 percent
floor. However, the loans upon which this increase was based were not funded by eligible
sources.

Project 950

Nelnet implemented Project 950 in April 2003 to increase the amount of loans that it billed for
special allowance payments under the 9.5 percent floor. Under Project 950, Nelnet temporarily
transferred student loans into its NEBHELP 1985A trust estate, which secures repayment of
$143,035,000 in 30-year tax exempt bonds. These bonds are scheduled to be retired in 2015. 5
About 94 percent of the loans transferred into the 1985A trust estate consisted of loans already
held by Nelnet affiliates.

After transferring loans into its 1985A trust estate, Nelnet transferred—as little as one day
later—the loans from the 1985A trust estate to the estates of various Nelnet taxable obligations. 6
Some of these taxable obligations were the same obligations from which Nelnet originally
transferred the loans into the 1985A trust estate. In general, no funds were transferred into the
1985A trust estate from the trust estate receiving the loans from the 1985A trust estate.

5
  Although Nelnet has other pre-1993 tax-exempt bonds outstanding, it used only the bonds secured by the 1985A
trust estate for Project 950, because the 1985A trust indenture has few limitations on the types of loans that can be
financed and no limitations on the geographic origin of the financed loans.
6
 All of these obligations were issued by Nelnet Education Loan Funding, Inc., formerly known as Nebraska Higher
Education Loan Program, Inc.
Final Audit Report
ED-OIG/A07F0017                                                                        Page 7 of 66


For each transaction, Nelnet attempted to match the amount of the loans being transferred into
and from the 1985A trust estate to reduce the need to transfer cash to settle the transaction.
When transferring loans out of the 1985A trust estate, Nelnet received the required concurrence
of the bond trustee to release collateral from the estate. Nelnet, through its subsidiary Nelnet
Education Loan Funding, Inc., remained the 100 percent beneficial owner of the student loans
that were transferred out of the 1985A trust estate.

Nelnet billed all of the loans purchased by or transferred into the 1985A trust estate under the 9.5
percent floor and continued to bill under the 9.5 percent floor for those loans after they were
transferred to the taxable obligations. By repeating this process many times over a 13-month
period, Nelnet increased the amount of loans it billed under the 9.5 percent floor by over $3
billion.

As of March 31, 2005, most of the loans billed under the 9.5 percent floor were identified with
three of Nelnet’s taxable bond issues:

      •    2003-1 issue, $798,753,435 in loans billed ($848,050,000 in outstanding bonds);
      •    2004-1 issue, $928,307,650 in loans billed ($1,010,000,000 in outstanding bonds); and
      •    2004-2 issue, $949,759,185 in loans billed ($969,718,000 in outstanding bonds). 7

As of March 31, 2005, the 1985A trust estate held only $71,411,805 in loans billed under the 9.5
percent floor.

The Project 950 transactions were unrelated to Nelnet’s ability to meet its 1985A bond
obligations. Nelnet sold the 2004-1 and 2004-2 bonds to investors with the express condition
that 9.5 percent special allowance payments would not become part of the trust estates; only an
amount equal to regular special allowance payments would be pledged toward repayment of the
bonds. The excess would be payable to Nelnet for its own purposes.

Department Guidance to Nelnet

In response to our request for information and in interviews we conducted, Nelnet identified
communications with, and guidance received from, the Department related to Project 950. The
only written guidance specific to Project 950 identified by Nelnet was a letter dated June 30,
2004, to the Managing Director, Government and Industry Relations for Nelnet, from the Acting
General Manager, Financial Partner Services, FSA. (See Enclosure 1.) This letter did not
approve or disapprove of Nelnet’s use of Project 950: it only referred Nelnet to existing
authorities.

Nelnet provided its documentation of a conversation with FSA’s former General Manager for
Financial Partners Services on January 3, 2003:

           Based upon the guidance that was issued by ED in 1996, [the Director] agrees that
           there is no legal argument prohibiting a process of passing loans through a tax-

7
    None of these bond issues refunded prior tax-exempt bonds.
Final Audit Report
ED-OIG/A07F0017                                                                           Page 8 of 66

        exempt issuance and into a taxable, while permanently retaining on such loans the
        floor earnings/half-SAP characteristics of the tax-exempts. She also agreed that
        the ED guidance is silent on issues such as how often loans could be passed
        through the tax exempt or how long they had to stay in the tax exempt.

Nelnet also provided its documentation of a verbal statement made by the Chief of Staff,
Financial Partners Services, FSA, on June 30, 2004, concerning the June 30, 2004, letter to
Nelnet. The Chief of Staff allegedly stated that “he thought it was a positive letter.” Nelnet
officials told us that, as a result of the June 30, 2004, letter, the verbal statements, legal opinions
it received, and the fact that the Department paid Nelnet’s billings without objection, they
believed Nelnet’s billing practices for Project 950 were proper. In its comments on the draft of
this report, Nelnet also stated that Department guidance and statements by Department officials
supported its position.

Our review of Nelnet’s documentation did not identify any direct or explicit approval by the
Department of Project 950. Further, the documentation, including Nelnet’s letter of May 29,
2003, to FSA (Enclosure 1), does not appear to reflect a comprehensive disclosure by Nelnet of
the nature or effect of Project 950. For example, Nelnet’s May 29, 2003, letter and its
accompanying flow chart described only the basic process. The letter did not identify the
eligible source of funds that would be used to purchase and qualify loans for the 9.5 percent
floor, did not state directly that the process would be repeated many times, and did not state that
the process would result in a substantial increase in the amount of loans billed under the 9.5
percent floor.

Qualifying Sources of Funds

Pursuant to 34 C.F.R. § 682.302(c)(3)(i), there are five funding sources that qualify loans to be
billed under the 9.5 percent floor. A loan is billed under the 9.5 percent floor if it is—

        . . . a loan made or guaranteed on or after October 1, 1980 that was made or
        purchased with funds obtained by the holder from—
                  (A) The proceeds of tax-exempt obligations originally issued prior to
        October 1, 1993, the income from which is exempt from taxation under the
        Internal Revenue Code of 1986 (26 U.S.C.);
                  (B) Collections or payments by a guarantor on a loan that was made or
        purchased with funds obtained by the holder from obligations described in
        paragraph (c)(3)(i)(A) of this section;
                  (C) Interest benefits or special allowance payments on a loan that was
        made or purchased with funds obtained by the holder from obligations described
        in paragraph (c)(3)(i)(A) of this section;
                  (D) The sale of a loan that was made or purchased with funds obtained by
        the holders from obligations described in paragraph (c)(3)(i)(A) of this section; or
                  (E) The investment of the proceeds of obligations described in paragraph
        (c)(3)(i)(A) of this section.

According to 34 C.F.R. § 682.414(a)(4)(ii)(L), a lender must keep “[a]ny additional records that
are necessary to document the validity of a claim against the guarantee or the accuracy of reports
Final Audit Report
ED-OIG/A07F0017                                                                          Page 9 of 66

submitted under this part.” Also, under 34 C.F.R. § 682.414(a)(1)(i), “[t]he records must be
maintained in a system that allows ready identification of each loan’s current status . . . .”

The loan records we reviewed during our audit did not readily identify the loans’ funding sources
as described in 34 C.F.R. § 682.302(c)(3)(i). Nelnet’s loan records only identified the tax-
exempt obligation with which each loan was associated. Different rules apply to loans that are
funded by different sources, and as such, loan records need to identify their loans’ funding
sources in order to determine whether they should be billed under the 9.5 percent floor.

Loans Funded by Transfers or Sales

The Department’s guidance in DCL 96-L-186 allows a lender to continue to receive special
allowance payments under the 9.5 percent floor after the lender transfers an eligible loan to a
taxable obligation, as long as the original tax-exempt obligation has not been retired or defeased.
However, Project 950 went beyond the scope of the guidance in DCL 96-L-186. The Dear
Colleague Letter did not address the circumstances by which a loan qualified for the 9.5 percent
floor before being transferred.

During Project 950, Nelnet transferred loans from the 1985A trust estate to one of several
trust estates for taxable obligations. Nelnet then transferred loans from the receiving trust
estate to the 1985A trust estate in an amount equal to the principal and accrued interest of
the transferred loans. If these transfers were considered sales, they might result in an
eligible source for 9.5 percent floor funding.

To be considered an eligible source under criteria in 34 C.F.R. § 682.302(c)(3)(i)(D),
“funds [must] be obtained by the holder from . . . [t]he sale of a loan . . . .” As such, to be
considered a sale for the purpose of this requirement, the transaction must be a sale of a
loan by its holder, and funds must be received from the sale.

The evidence we reviewed was mixed as to whether the transactions qualified as sales.
According to Nelnet, each of its trusts is a separate legal entity, and an exchange of loans from
one holder trust to another was sufficient to qualify as a sale. However, Nelnet’s internal
documentation varied in its characterization of the Project 950 transactions as transfers or sales.
Other evidence indicates that the transactions may not qualify as sales under the regulations:

   • 	 Nelnet, in its Form 10-K filed with the SEC on March 16, 2005, stated, “The transfers of
       student loans to the eligible lender trusts do not qualify for sales under the provisions of
       SFAS No. 140 . . . as the trusts continue to be under the effective control of the
       Company.” Under the Financial Accounting Standards Board (FASB) Accounting
       Standards, Statements of Standards FAS 125 and FAS 140, the transfers do not meet the
       criteria to be counted as sales. Nelnet has also acknowledged that for federal income tax
       purposes the transfer of loans to taxable trust estates does not qualify as a sale.

   • 	 The eligible lender and holder for almost all of the Project 950 loans was Wells Fargo
       Bank Minnesota, National Association (Wells Fargo), the trustee for the 1985A trust
       estate and for all of the receiving trust estates. Wells Fargo, as trustee for the 1985A trust
       estate, generally received no funds in exchange for the Project 950 loans transferred out
Final Audit Report
ED-OIG/A07F0017                                                                       Page 10 of 66

        of that trust estate. Wells Fargo received funds only if the amount transferred out did not
        match the loans transferred in on a given day. In those cases, Wells Fargo received only
        the difference between loans transferred out and in. The trustee’s statements for the trust
        accounts designated for the sale or acquisition of loans neither reflect the receipt or
        expenditure of funds corresponding to or commensurate with the Project 950 transactions
        nor do those accounts reflect the acquisition or disposition of loans.

   • 	 Although Wells Fargo was acting as trustee for separate trust estates, the transactions
       were initiated and controlled by the same entity, Nelnet. While the sales may have been
       irrevocable between the trust estates, Nelnet remained the beneficial owner and retained
       the authority to direct Wells Fargo to transfer loans back to their original obligations or to
       other obligations. Nelnet set both the buying and selling price, which was always the
       loan’s principal amount and accrued interest, with no consideration for the loan’s future
       income.

Later Generation Loans Are Ineligible

Regardless of whether the Project 950 transfers qualify as sales, most of the Project 950 loans
would still be ineligible for the 9.5 percent floor. The cycling of loans through the 1985A trust
estate to qualify for the 9.5 percent floor is not permitted under the regulations because funds
received from the proceeds of a loan that is eligible under 34 C.F.R. § 682.302(c)(1)(i)(B)
through (E) cannot be used to make another eligible loan.

The eligible funding sources described in 34 C.F.R. § 682.302(c)(3)(i)(A) through (E) are
summarized below:

   •	   Source A: Proceeds of the eligible tax-exempt obligations.
   •	   Source B: Collections or payments on a loan funded by Source A.
   •	   Source C: Interest benefits or special allowance payments on a loan funded by Source A.
   •	   Source D: Funds obtained from the sale of a loan that was funded by Source A.
   •	   Source E: The investment of funds in Source A.

As such, Sources B through E can only be created with funds that are derived from a loan funded
by Source A. An example is provided below:

   •    Loan 1, funded by the proceeds of the original tax-exempt obligation, is eligible for the
        9.5 percent floor because it is funded by Source A.

   • 	 Loan 2, purchased with funds obtained from the sale of Loan 1, is eligible for the 9.5
       percent floor because it is funded by Source D.

   • 	 Loan 3, purchased with funds obtained from the sale of Loan 2, is not eligible for the 9.5
       percent floor. It is not funded by Source D, because its funds were not obtained from the
       sale of a loan that was funded by Source A.

Project 950 loans transferred into the 1985A trust estate were not “purchased with funds obtained
by the holder from the issuance of tax-exempt obligations,” but were the result of ineligible later
Final Audit Report
ED-OIG/A07F0017                                                                                     Page 11 of 66

generation “sales.” Assuming that at the outset of Project 950 the 1985A trust estate held loans
equal to the face amount of the 1985A bonds, and that those loans were made or purchased with
the original bond proceeds, the maximum amount that Nelnet could have legitimately increased
its 9.5 percent floor portfolio was $143,035,000. 8 However, Project 950 increased Nelnet’s
billing under the 9.5 percent floor about $3.1 billion, which is almost $3 billion more than the
potential maximum increase of $143,035,000.

Estimate of Special Allowance Improper Payments before June 2005

We did not determine the exact amount of the overpayments attributed to these ineligible loans.
However, we estimate a total potential improper payment to Nelnet of about $1,160,000,000.

Table 1 provides our estimates of improper payments to Nelnet before June 2005 (during our
audit period), and our estimate of potential improper payments to Nelnet after June 2005, if
Nelnet’s billings are not corrected. The table includes an estimate based on all Project 950 loans
being ineligible for the 9.5 percent floor and a reduced estimate allowing for possible eligible
loans based on first generation loan sales. 9 The calculation of our estimates is explained and
provided in Enclosure 2.

Table 1

                                         Improper Payment                   Improper Payment
                                        Estimate Based on All              Estimate Allowing for
                                          Project 950 Loans                Possible Eligible First
                                           Being Ineligible                Generation Loan Sales
               Before June 2005              $278,000,000                       $260,000,000
               After June 2005               $882,000,000                       $835,000,000
                                Totals:     $1,160,000,000                     $1,095,000,000


Our estimates of improper payments to Nelnet include the entire payment to Nelnet for loans
billed improperly under the 9.5 percent floor. We have not reduced our estimate by the amount
of the special allowance payments that Nelnet may have received for the loans if it had billed
under the regular special allowance calculation. However, our analysis of Nelnet’s 9.5 percent
loan portfolio indicates that any eligibility for regular special allowance payments during our
audit period would be limited and likely be a small portion of the amount received under the 9.5
percent floor. In its comments, Nelnet estimated that the difference between what it received
under the 9.5 percent floor and the regular special allowance was $322.6 million through June
30, 2006.




8
  An adjustment for possible sales of first generation loans may not be necessary. On page 6 of its comments on our 

draft report, Nelnet stated, “virtually all tax-exempt obligations originally issued prior to October 1, 1993 are, by

now, funding new loan purchases with later generation proceeds.”

9
  See footnote 8, above.

Final Audit Report
ED-OIG/A07F0017                                                                                  Page 12 of 66


Recommendations

We recommend that the COO for FSA—

1.1 	   Require Nelnet to calculate special allowance payments received for Project 950 loans for
        the quarters ended March 31, 2003, through June 30, 2005 (for which we estimate $278
        million in improper payments), and return all overpayments.

1.2 	   Require Nelnet to calculate and return all overpayments it received for special allowance
        after June 30, 2005, and instruct Nelnet to exclude all Project 950 loans from its claims
        for payment under the 9.5 percent floor.

NELNET’S COMMENTS and OIG’S RESPONSE

Nelnet strongly disagrees with our finding and recommendations and requested that our draft
report be withdrawn. Nelnet’s comments are included in Enclosure 3. Nelnet’s comments also
included a memorandum with exhibits from its legal counsel. Because of the voluminous
number of exhibits to the legal memorandum, we have not included the exhibits in Enclosure 3. 10
We summarize and respond to Nelnet’s comments below.

Nelnet’s Comments on Existing Guidance

Nelnet asserted that the draft report was inconsistent with the HEA, regulations, and authoritative
guidance. Nelnet places particular emphasis on a letter from former Secretary Rod Paige to
Senator Edward M. Kennedy, dated November 18, 2004; a press release issued by Secretary
Paige; Dear Colleague Letter 96-L-186; a report issued by the Government Accountability Office
in 2004 (GAO-04-1070); and records of Congressional debate on the Taxpayer-Teacher
Protection Act of 2004. According to Nelnet, implementing the OIG recommendations would
violate established law, which can be modified only through regulatory or statutory change.

OIG Response

Our report acknowledges that Department guidance in Dear Colleague Letter 96-L-186 permits
lenders to continue to bill loans under the 9.5 percent floor after a transfer from a tax-exempt
obligation to a taxable obligation. We do not recommend recovery because of Nelnet’s process
of transferring loans out of the 1985A trust estate disqualified the loans from billing under that
floor. We question whether the Project 950 loans qualified for the 9.5 percent floor prior to
being transferred. We have reviewed the Department guidance and statements cited by Nelnet
and do not agree that they provide authorization for the increase in Nelnet’s billings that resulted
from its Project 950. Neither the guidance nor statements cited specifically addressed whether
the loans qualified for the 9.5 percent floor prior to the transfer.



10
  The legal memorandum includes a document (Ex. 23, a description of Project 950) that the memorandum asserts
was jointly prepared by OIG and Nelnet. An initial draft of that document was prepared by OIG auditors; Ex. 23,
however, includes additional materials and edits not approved by OIG.
Final Audit Report
ED-OIG/A07F0017                                                                        Page 13 of 66

The most immediate and direct guidance provided to Nelnet was in the Department’s response to
Nelnet’s letter dated May 29, 2003. Nelnet’s letter asked the Department to indicate its
“confirmation that our intended billing procedure is compliant with the Higher Education Act of
1965, as amended, and regulations promulgated thereunder, by signing below.” The Department
did not sign or indicate its concurrence, and the Department’s written response to Nelnet did not
provide approval of Nelnet’s billing procedure. The letter from Secretary Paige to Senator
Kennedy, issued less than five months later, confirms this understanding by stating, “The
Department did not approve or disapprove of the methods that Nelnet and other lenders were
using.” As detailed in our report, Nelnet’s Project 950 loans did not qualify for the 9.5 percent
floor under existing law.

Nelnet’s Comments on Transfers

Nelnet disagreed with our conclusion in our draft report that transfers of loans from the 1985A
trust estate did not constitute sales resulting in proceeds that could qualify new loans for the 9.5
percent floor under 34 C.F.R. § 682.302(c)(3)(i)(D). Nelnet asserted that the transfers between
the separate trust estates for reasonable value qualified as sales under commercial and property
law, and that different treatment under accounting standards or federal income tax law did not
preclude the transfers from qualifying as sales under the HEA.

OIG Response

After evaluation of Nelnet’s comments, we modified our conclusion and finding to indicate that
the evidence of whether the transfers qualify as sales is mixed. We have been unable to obtain
the views of responsible Department officials on whether the regulations and the HEA preclude
Nelnet’s Project 950 transactions, as described in our report, from qualifying as sales under 34
C.F.R. § 682.302(c)(3)(i)(D).

Nelnet’s Comments on Later Generation Proceeds

Nelnet disagreed with our finding that proceeds obtained from the sale of later generation loans
cannot be used to qualify a loan for the 9.5 percent floor under 34 C.F.R. § 682.302(c)(3)(i)(D).
Nelnet asserted that it is well-established law that proceeds from later generation proceeds still
constitute proceeds, and as such, the loans qualify for the 9.5 percent floor under 34 C.F.R.
§ 682.302(c)(3)(i)(A), which makes loans eligible for the 9.5 percent floor if they are “obtained
by the holder from . . . [t]he proceeds of tax-exempt obligations originally issued prior to
October 1, 1993 . . . .”

OIG Response

We have not changed our finding. The HEA and implementing regulations explicitly identify
the specific and exclusive funding sources that may be used to qualify loans for the 9.5 percent
floor. Accepting Nelnet’s interpretation of 34 C.F.R. § 682.302(c)(3)(i)(A) would make 34
C.F.R. § 682.302(c)(3)(i)(B) through (E) redundant, because the requirements in those
paragraphs would already be included in Nelnet’s definition of “proceeds.” Any reading of the
HEA or regulations that makes some words redundant or surplusage is not reasonable.
Final Audit Report
ED-OIG/A07F0017                                                                      Page 14 of 66

The language in the HEA makes the limits in the regulations clear. The first sentence of Section
438(b)(2)(B)(i) states, “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 . . . .”
(Emphasis added.) The second sentence of the same paragraph states—

       Such rate shall also apply to holders of loans which were made or purchased with
       funds obtained by the holder from collections or default reimbursements on, or
       interests or other income pertaining to, eligible loans made or purchased with
       funds described in the preceding sentence of this subparagraph or from income
       on the investment of such funds. (Emphasis added.)

As such, the HEA limits eligible funding sources to funds obtained from collections, default
reimbursement, interest, or other income received for loans that are made or purchased with
funds obtained from the issuance of obligations.

Nelnet’s Comments on Sufficiency of Loan Records

Nelnet responded to a statement in our report that Nelnet’s records did not readily identify the
loans’ funding sources as described in 34 C.F.R. § 682.302(c)(3)(i); Nelnet’s loan records only
identified the tax-exempt obligation with which each loan was associated. According to Nelnet,
the requirements in the HEA and regulations do not require a lender to maintain records that
identify the loans’ funding sources. However, since Nelnet’s records identify the trust that sells
the loan and the trust that buys the loan, including each party’s unique bond identification
number, those records clearly reflect each loan’s source of funding and are sufficient to
determine a loan’s eligibility for the 9.5 percent floor.

OIG Response

We did not conclude that Nelnet’s records were legally insufficient. However, as we state in our
report, 34 C.F.R. § 682.414(a)(4)(ii)(L) requires lenders to maintain “records that are necessary
to document the validity of a claim against the guarantee or the accuracy of reports submitted
under this part.” Without records identifying the specific funding source used to make or
purchase loans (whether the loans are funded under paragraph (A), (B), (C), (D), or (E) of 34
C.F.R. § 682.302(c)(3)(i)), a lender cannot readily and accurately determine which of its loans
are eligible for the 9.5 percent floor.

Nelnet’s Comments on Estimates

In a legal analysis provided to Nelnet by Perry, Guthery, Haase & Gessford, P.C., L.L.O.
(Enclosure 3 legal memorandum, page 30), our estimates of overpayments are described as
flawed because the estimates do not represent the difference between what Nelnet received or
will receive under the 9.5 percent floor and the regular special allowance rate. Nelnet estimated
that the difference between what it received under the 9.5 percent floor and the regular special
allowance was $322.6 million through June 30, 2006. Nelnet stated that the estimate of future
payments is speculative due to fluctuating interest rates and reductions of loan volumes due to
payoffs and consolidations. Nelnet reserved the right to challenge the overpayment amount at an
appropriate time.
Final Audit Report
ED-OIG/A07F0017                                                                      Page 15 of 66

OIG Response

We have modified our report to refer to our calculations as estimates of improper payments
rather than overpayments. Although it is appropriate to refer to the amounts received in violation
of program rules as overpayments, we made this change and clarified the recommendations to
avoid confusion between the improper payment amount and the amount Nelnet may have to
return to the Department.

We have annotated the report to indicate that the estimates do not reflect the amount of the
special allowance payments that Nelnet could be eligible to receive under the regular special
allowance calculation. However, based on the low interest rate environment during our audit
period and an analysis of Nelnet’s 9.5 percent portfolio, any eligibility for regular special
allowance payments during our audit period would be limited and likely be a small portion of the
amount received under the 9.5 percent floor.

Nelnet’s own estimate of $322.6 million indicates that the amounts of regular special allowance
payments would be limited and indicates our estimate of improper payments through June 30,
2005, could be reasonable. Regarding future estimates, we acknowledge the possibility of
interest rate fluctuations; our estimate is nevertheless reasonable based on current information.

In any event, we have not recommended that the Department recover the amounts we calculated.
Instead, we have recommended that the Department require Nelnet to calculate and return the
actual overpayments received and exclude ineligible loans from future billings. While loan
volume can fluctuate due to payoffs and consolidation, our future estimate takes payoffs into
account. In addition, 92 percent of Nelnet’s 9.5 percent portfolio consists of consolidation loans,
which have a fixed rate of interest and are less susceptible to payoff through further
consolidation.
Final Audit Report
ED-OIG/A07F0017                                                                         Page 16 of 66



                        OBJECTIVE, SCOPE, AND METHODOLOGY



The objective of our audit was to determine whether, for the period January 1, 2003, through
June 30, 2005, Nelnet's use of Project 950 to increase the amount of student loans billed under
the 9.5 percent floor complied with the requirements in the HEA, regulations, and other guidance
issued by the Department.

To accomplish our audit objective, we—

       • 	 Obtained from the Department the amount of 9.5 percent special allowance payments to
           Nelnet and the average daily loan balances included on Nelnet’s billings on which these
           payments were based, in total, for the period January 1, 2002, through June 30, 2005;
       • 	 Obtained and documented an understanding of the governing law, regulations, and
           guidance applicable to the issuance of tax-exempt and taxable obligations used to fund
           student loans that will be billed at the 9.5 percent allowance rate;
       • 	 Obtained and documented a listing of Nelnet’s bonds issued from October 1, 1993,
           through June 30, 2005, along with information related to each bond, and Nelnet’s use of
           proceeds to fund student loans that would be billed at the 9.5 percent special allowance
           rate;
       • 	 Reviewed and documented Nelnet’s Project 950 procedures and methodologies used to
           fund student loans that would be billed at the 9.5 percent special allowance rate;
       • 	 Reviewed supporting documentation for a randomly selected sample of 30 student loans,
           from the universe of 350,407 student loans that were included in Nelnet’s 9.5 percent
           special allowance billings for the quarter ended March 2005, to determine whether
           Nelnet’s Project 950 methodologies and practices used were in effect;
       • 	 Reviewed supporting documentation for a judgmentally 11 selected sample of 20 student
           loans, from a bond-to-bond listing that documents the student loans transferred between
           Project 950 bonds, dated January 22, 2004, to determine whether Nelnet’s Project 950
           methodologies and practices were in effect;
       • 	 Reviewed supporting documentation for all 120 student loans originated after May 1,
           2004, and associated with a Project 950 bond code, from the universe of 350,407 student
           loans that were included in Nelnet’s 9.5 percent special allowance billings for the quarter
           ended March 2005, to determine whether Nelnet terminated Project 950 after May 1,
           2004;
       • 	 Reviewed supporting documentation for 287 judgmentally 12 selected student loans, from
           bond-to-bond listings that document the student loans transferred between Project 950
           bonds, dated May 28, 2004, to determine whether Nelnet terminated Project 950 after
           May 1, 2004; and
       • 	 Examined the bond transcript and other bond documentation for each bond, associated
           with Project 950, that funded a loan in the sample.

11
     We selected loans with a high principal balance from 14 pages of the listing.
12
     We selected the first loan on each page of the listings.
Final Audit Report
ED-OIG/A07F0017                                                                    Page 17 of 66


We also relied, in part, on computer-processed data provided by Nelnet. To ensure the reliability
of the data, we performed limited data testing. We obtained Nelnet’s Lender Reporting Form
(LaRS) database for the quarter ended March 2005. We validated that the database was
complete and reliable by comparing the ending principal balance against the Department’s
Financial Management Systems Data Mart total and verifying that the dates on the loan history
detail, names, social security numbers, and the loan amounts matched the information in Nelnet's
system.

We conducted our audit in accordance with generally accepted government auditing standards
appropriate to the scope described above. From July 2005 through July 2006, we conducted our
work at Nelnet’s offices in Lincoln, Nebraska, and our offices in Chicago, Illinois, and Kansas
City, Missouri. We discussed the results of our audit with Nelnet officials on June 22, 2006.
Final Audit Report
ED-OIG/A07F0017                                                                                                     Page 18 of 66

     Enclosure 1: Nelnet’s Written Inquiry and FSA’s Response



                                                       Nelnet Education Loan Funding, Inc.
                                                                                   121 Soultl13th
                                                                                       Souttl13th Street, Suite
                                                                                                          Suile 201
                                                                                          Lincoln , Nebraska 68508
                                                                                          Lincoln,
                                                                                                      402.458.2303
                                                                                                      402.456.2303


         May 29, 2003



         Angela Roca·Baker
         United States Department of Education
         Federal Student Aid
         Union Center Plaza
         830 First Street, NE
         Room HE4
         Washington,
         WashingtOD, DC 20202

                  Re::
                  Re           BIiUnal StatelMlit
                          LaRS BllUll  Statellielit Conftrmatlon
                                                    COllftrm atloll

         Dear Ms. Roca-Baker:
                  Roell-Baker:

         This leiter
         "This letter is being written 10to confinn the proper way 10  to submit Lender's Request for Payment of
         Interest and Special Allow~ (LaRS)                     second quarter of2003 by Nelnet Education ~
                                              (laRS) for the sc:oond
         Funding. I.nc. (r-.'ELF).
                          o-.'ELF). Some background information may be helpful in your        ~ur consideration of
                                     IUCCes;;or in interest
         this issue. NELF is the successor
         !his                                      intere&tloto a qualified $Cbolarship
                                                                            sebolarship funding corporation which
         converted to for·profit SiaM
                                    status in 1998 under § ISO(d) of the tax Code. NELF is the issuer  issll« of tax
         exempt obliptions p\lfSuant
                                  pursuant 10to an Indenture of Trust dated November 15, 1985      ]985 (the 19S5
                                                                                                               ]985
         Indenture) with Wells Fargo Bank Minnesota, National Association as trustee. NELF makes,
         purchases and finances student loans as pari     part of ita ordinary activities as a secondary manet
                                                                                                          market of
         student loans in Ihethc stale o fNcbnllib. The trustee holds title to NELF's student
                                 state ofNcbnlib.                                                  loans and NELF
                                                                                           student]oans
         holds 100%                         Interest in itl
                 100"'" beneficial owner iDlereS!       its loans.

                     pun:ha&ins portfolios of FFEL loans with fimds
          NELF is pun:ha&ing                                                funds obtained from proceeds        the tax
                                                                                                   procced!l of thc
          exempt 1985 Indenture in lI,mes              acquisitions . Some of the portfolios will be ~based
                                         I series of acquisitions.                                                 from
                                                                                                        purckased ftom
          third party  nOD-affil iated sellers, and some will be purchased &om.
                part)' non·affiliated                                              from affiliated sellers.
                                                                                                   sellen. Some
                                                                                                            Somc of the
          portfolios will be transferred into the 1985        Indenture from the seller and some will be financed
                                                        ]985 lndenrure
          by a different NELF financing prior 10       to being placed into the 198519S5 Indenture. M pari
                                                                                                        part ofNELF's
                   cash Oow managcmer,t
          overall "ash        managC!nCllt plan, the pUJCba.sed
                                                           purchased loans will he   be held wi!hin
                                                                                             within the 1985 Indenture
                                                                                                              IndCllture
               flIW1ced by the tax eJ(C1l"4't
          and fmanced                 eJl;CJl"4lt obligatiom
                                                  obligaliom issued by NELF under thaI    that fmancing
                                                                                               fmaneing for a period of
          tim e depending upon cash management needs and other internal concerns,      cont:Cm5, but in any event for at
          least one diy
                     day or longer. lliereafter,
                                      Inereaner, loans Wlii          renlllllCed Il!d
                                                           WIll \Ie relIllmced    and placed Into nnanelngs
                                                                                                  nmmc!ngs wlliell    iIIc
                                                                                                              wlticlt ill'c
          ta:uble on
          taxable                                 however, NELF will remain the 100% beneficial owner of the
                   OD aI longer term bas:!; howcver,
          student                      preVlously funded in the
          studen1 loans that were prcVlously                      tile lax
                                                                       tax exempt
                                                                             eJ(cmpt 1985 indenture. A flow chart
                                                                                                                chan is
          beins sent with this
          being                         to Ilelp
                           \his letter 10   help illustrate.

          Wc
          We have  revicwed applicable law, di!ICussed
              hive reviewed                   discussed with officials al
                                                                       at the Departtnent     Education the
                                                                              Department of Educa1ion
          manner in which
                     whi"h hilling
                            billing for         allowiUlCe should be handled in $uch
                                    ror special a1lowilllCc                              circumstances and
                                                                                   such circwnsta.ncu
          considered industry practices. During the time that the loans arcare held in the 1985
                                                                                            ]985 Indenture,
Final Audit Report
ED-OIG/A07F0017                                                                                                   Page 19 of 66




         under 20 U.S.C. § 1087-I(bX2)(B)                               682.302(e)(3), we intend to bill for special
                                i087'!(bX2)(B) and 34 C.F.R. § 682.302(c)(3),
         allowance at the quarterly rate of one-half the average of the bond equivalent rates of 91-day
         Trcas\ll)'
         Treasury bill phu 3.5%, divided by 4, subject to           \0 a minimum of 9.5% minus the applicable
          interest rate on a loan, divided by 4. Since the loans thereafter will be refinanced under I taxable
          interesl
          financing. NELF will mamtam               !OOO/.
                                     maintU:J. its 1000  .4 bemficial
                                                             beneficial ownership interest in the loans previously
         purchased with proceeds of the 1985 1ndcnture.
         pwchased                                       1ndcn~. and the 1985 IndentureInden~ will      not be retired
                                                                                                 wilillOt     retirtd or
         defeased, we intend to                                                    slICb saJm
                                                            special allowance at sucb
                                 \0 continue to bill for spocial                         same quarterly rate (one-half
         ooff 91-day Treasury bill          3.5'1., divided by 4, subjcct
                                 b ill plus 3.5%,                     subject to\0 the minimum of 9.5% minus the
          applicable rate on the loan, divided by 4) fo     following
                                                               llowing such   long lenn refinancing. We have based
                                                                        truch loog
          this upon 34 C.F.R.
                         C .F.R. § 682.302(eX2) l1li    wclllUl Dear Colleague Letter 96-L-186,
                                                    lUI wcllllll                                       96-0-287 (Q&.A
                                                                                            96-L-I86. 96.o-2S7
          No. 30), and our previous discussions with the Department 00           on this maner. We intend to submit
          billings for spocial
                        special allowance al at Ibis          rate until such refinanced loans are either no lonser
                                                      aame rale
                                                this saJm                                                         longer
          beneficially owned by NELF (and an:           transfcrrcod to an unrelated or
                                                   arc IrwlSfcrreod                     01" an affiliated purchaser),
                                                                                                          purchaser). or
          until the 1985 Indenture is retired or defeased.

         We would appreciate                         COll$ider our intended biUing proced\lJC!
                         apprtlCilte if you would cOluidcr                         proeedurt! summarized above
         and verifY thaIthat it confomu
                                conforms to existing applicable lawllaws and regulatory guidance alat your carlielt
                                                                                                           earliest
         convenience,
         convenience. sincesincc we will be calculating the special allowance billings in the upcoming second
         q ... arter LaRS within the DCxt
         quarter                         ncxl few wct:ks.
                                                    wcc:ks. Please indicate your confinnation
                                                                                  confinnatioo that our intended
         billing procedure is complilllt                             Educalion Ad of 1965.
                                     complilVlt with the Higher Education                1965, as amended, and
         reguiatiOll$ promulgated thereunder, by signing below. We intend to proceed under the analysis
         regulations
         described above and assumeassumc itll ccm:dnCM,
                                               com:dnC$S, Wlless
                                                              unless we are
                                                                        arc otherwise directed hy
                                                                                               by you. Thank you
         for your considcn.rion      oflhis
                      considCl1ltion of this mailer.
                                             matter.




         ::'9~
         President ofNelnet
                   ofNelnc!: Education Loan Funding, Inc.




         I concur with the above.                                                    Date

         ce,
                    -
               ,,.........
         "": Tnri Show
             Krim.. iWIocn
                 ....
             Krillie

               Sony
                     H&ao<:n

                    Stroup
               S.Uystroup
                                                                                                                          ED-OIG/A07F0017
                                                                                                                          Final Audit Report
                           Nelnet                                                                         Taxable NElF
                         Education                                                                          Indentures
                                                                     1985 NElF
FFElPlOAN   lDa1 Sales      loan                     FMnc2Ji
                                            T"""""", FMnc"<L        Tax-Exempt                      or
                                                                                                    01          and
 SEllERS                  Funding,           or
                                             01 PuChased
                                                PuCI'<lsed """"                         PuChased
                                                                                        PuCl'<lsed """"    Warehouse
                                                                     Indenture          llong Terml
                             Inc,
                             Inc.                                                                           Flnanclngs
                           (NElF)
                           [NElF)                                                                          [long
                                                                                                           (l ang T
                                                                                                                  Term)
                                                                                                                   erm)

                                                                          Tempo«>y
                                                                          Temporooy
                                                                           AnoncIng
                                                                           Rnonclng
                                                                          r "''''''''''''
                                                                            ""''''''''''''
                                                                             lOcos
                                                                             Loons




                                     ,Tem..="""""'"
                                                 fI'lor'od..n!i
                                                                   NElF Flnanclngs
                                                                  [other
                                                                  (ather than 1985
                                                  Loons
                                     01 Purchased l..oorui
                                     of
                                                                      Indenture)




                                                                                                                          Page 20 of 66
Final Audit Report
ED-OIG/A07F0017                                                                                          Page 21 of 66




          Mr. Paul Tone                                                            JUN 3 0 200\
                                                                                           2001
          Government and Industry Relations
          Neln.t
          Nelnet
          3015 South Park ... Road, Strite
                     Parker         Suite 400
          ~,COBOOI4
          kM"Qra, CO B0014


          Dear Mr. Tone,

          This letter i8 in response to He!oet's
                      ilin              HeJnet's May 29.
                                                      29. 2003 ccwrespondence
                                                               correspondence with regard to
          confirmation of
          cooflrmatlcn      !he proper way for
                         0I1tle            fof a I8ndAr to submit Ike
                                                                  the l.nd  ..... R~ for P:lymont
                                                                      lender'.              P:lymOni of
          Interest and Special AIIowan.::e                      to portfolios funded from the proceeds
                                 A1iowance (laRS) as it relates 10                            proceedI!I of
                                                                                                         01
          the lax- exempt 1985 Indenture.

          34 C.F.R.   Section 682.302(e)
              C .F.R. Sedion  682 .302(e) provides 9uidanoe              to special aJlowance
                                                    guidance with regard 10           allowance payments
                                              lax-exe~
          lor loans financed by proceeds of tax  ...xe~ obligations. Additionally,
                                                                       Additionally, the formulas for tha
                                                                                                      the
          calculations are provided In 34  C.F.R. Section 882.302(c).
                                        J4 C.F.R           682.302(1;). Yotl            refar to Dear
                                                                             can also refer
                                                                        You I:8n
          CoIleagUII
          Colleague Letter 96-L-186 foffor additional information..
                                           additlonallnformatlon

          Please let
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Final Audit Report
ED-OIG/A07F0017                                                                    Page 22 of 66


  Enclosure 2: Estimates of Special Allowance Improper Payments

Estimates of Special Allowance Improper Payments before June 2005

The calculation of our estimate of the special allowance improper payments based on all Project
950 loans being ineligible is provided in Table 2-1:

Table 2-1

                                                                                     Potential
 Quarter          Balance           Special          Revised         Revised         Improper
 Ending           Claimed       Allowance Paid       Balance         Payment         Payment
3/31/2003          $432,168,564      $5,334,343      $432,168,564     $5,334,343                $0
6/30/2003          $736,347,966      $9,293,367      $432,168,564     $5,454,352        $3,839,015
9/30/2003        $1,433,766,618     $19,161,070      $432,168,564     $5,775,565       $13,385,505
12/31/2003       $2,065,372,597     $28,325,817      $432,168,564     $5,927,031       $22,398,786
3/31/2004        $2,949,297,160     $41,223,576      $432,168,564     $6,040,603       $35,182,973
6/30/2004        $3,550,519,779     $50,002,081      $432,168,564     $6,086,243       $43,915,837
9/30/2004        $3,389,308,493     $47,781,542      $432,168,564     $6,092,594       $41,688,948
12/31/2004       $3,291,717,236     $46,399,112      $432,168,564     $6,091,725       $40,307,387
3/31/2005        $3,215,007,716     $45,289,782      $432,168,564     $6,087,954       $39,201,828
6/30/2005        $3,148,631,415     $44,377,891      $432,168,564     $6,091,132       $38,286,759
      Totals:                      $337,188,580                      $58,981,542      $278,207,038

The calculation of our estimate of the special allowance improper payments, based on an
allowance for possible eligible first generation loan sales, is provided in Table 2-2:

Table 2-2

                                                                                     Potential 

 Quarter          Balance           Special          Revised         Revised         Improper

 Ending           Claimed       Allowance Paid       Balance         Payment         Payment 

3/31/2003          $432,168,564      $5,334,343      $432,168,564     $5,334,343                $0
6/30/2003          $736,347,966      $9,293,367      $575,203,564     $7,259,581        $2,033,786
9/30/2003        $1,433,766,618     $19,161,070      $575,203,564     $7,687,106       $11,473,964
12/31/2003       $2,065,372,597     $28,325,817      $575,203,564     $7,888,703       $20,437,114
3/31/2004        $2,949,297,160     $41,223,576      $575,203,564     $8,039,864       $33,183,712
6/30/2004        $3,550,519,779     $50,002,081      $575,203,564     $8,100,610       $41,901,471
9/30/2004        $3,389,308,493     $47,781,542      $575,203,564     $8,109,062       $39,672,480
12/31/2004       $3,291,717,236     $46,399,112      $575,203,564     $8,107,906       $38,291,206
3/31/2005        $3,215,007,716     $45,289,782      $575,203,564     $8,102,887       $37,186,895
6/30/2005        $3,148,631,415     $44,377,891      $575,203,564     $8,107,116       $36,270,775
      Totals:                      $337,188,580                      $76,737,178      $260,451,403
Final Audit Report
ED-OIG/A07F0017                                                                                  Page 23 of 66

In Tables 2-1 and 2-2, the column(s) headed—

• 	 Balance Claimed and Special Allowance Paid contain the actual average daily principle
    balance of the loans reported for Nelnet by its trustee, Wells Fargo Bank, as eligible for the
    9.5 percent floor on its quarterly special allowance billing requests and the actual amount of
    the Department’s special allowance payment on those loans.13

• 	 Revised Balance, in Table 2-1, is the loan amount reported as eligible for the 9.5 percent
    floor for the quarter ended March 31, 2003, before the billed amount was increased with
    ineligible loans created by Project 950. In Table 2-2, amounts for quarters ending June 30,
    2003, and later are increased by $143,035,000, which is the amount of the 1985A trust estate
    and the maximum potential increase of eligible funds. (See our explanation under “Later
    Generation Loans Are Ineligible.”)

• 	 Revised Payment is our estimate of the amount of the Special Allowance Paid that is
    proportional to the revised balance. To calculate the Revised Payment, we determined the
    percentage of the Balance Claimed represented by the Special Allowance Paid, and we
    multiplied the Revised Balance by that percentage: (Special Allowance Paid / Balance
    Claimed) X Revised Balance.

• 	 Potential Improper Payment is the Special Allowance Paid minus the Revised Payment.

Estimates of Special Allowance Improper Payments after June 2005

On December 1, 2015, Nelnet’s 1985A bonds are scheduled to be retired, and Nelnet will no
longer be able to bill under the 9.5 percent floor for loans made or purchased by that trust estate.
We estimate that Nelnet potentially could be improperly paid about $882 million in special
allowance from July 2005 through at least December 1, 2015, if Nelnet’s billings are not
corrected. Requiring Nelnet to correct its post-June 2005 special allowance billings could allow
the Federal government to put the $882 million to better use.

The method we used to calculate our estimates is described below:

     • 	 Determine the date that Project 950 loans will be paid off. For purposes of its
         estimates under the Federal Credit Reform Act of 1990, the Department estimates that a
         student entering repayment on a FFEL Program loan will take approximately 13 years to
         repay his or her loan. Because May 31, 2017, is 13 years after May 31, 2004 (the month
         during which Project 950 ended), we estimate that the ineligible loans will be paid down
         to $0 by May 31, 2017.




13
  Nelnet bills for special allowance payments under three separate lender IDs: Wells Fargo Bank (Lender IDs
821666 and 833500) and Melmac Zions Bank (Lender ID 831300). We have limited the data used to calculate our
estimate to special allowance payments to Lender ID 833500 because virtually all transfers from the 1985A trust
estate to a taxable obligation, under Project 950, were transfers to Lender ID 833500. The sole transfer under
Project 950 to a different Lender ID was a transfer of $463,964 to Melmac Zions Bank, on June 4, 2004.
Final Audit Report
ED-OIG/A07F0017                                                                    Page 24 of 66

    • 	 Calculate potential quarterly special allowance improper payments after June
        2005. There are about 48 quarters between June 30, 2005, and May 31, 2017. As such,
        Nelnet’s potential improper payment estimated in Table 2-1 for the quarter ended June
        30, 2005 ($38,286,759) must be reduced by about $802,588 for each following quarter in
        order to be reduced to $0 on May 31, 2017. Nelnet’s potential improper payment
        estimated in Table 2-2 for the quarter ended June 30, 2005 ($36,270,775) must be
        reduced by about $760,328 for each following quarter in order to be reduced to $0 on
        May 31, 2017.

    • 	 Total quarterly special allowance improper payment estimates. In Table 2-3, we
        estimate special allowance improper payments for each quarter from the quarter ended
        September 30, 2005, through the quarter ending December 31, 2015. Except as noted,
        each quarterly estimate is about $802,588 (for Table 2-1) or $760,328 (for Table 2-2), as
        appropriate, less than the estimate for the previous quarter. Our total estimates of
        potential special allowance improper payments to Nelnet after June 30, 2005, is provided
        in the final row.

Table 2-3

                                                              Potential Improper
                                  Potential Improper        Payment Allowing for
                                 Payment Based on All               Possible
                Quarter               Project 950          Eligible First Generation
                Ending           Loans Being Ineligible           Loan Sales
               9/30/2005             $37,484,171                  $35,510,447
               12/31/2005            $36,681,583                  $34,750,119
               3/31/2006             $35,878,994                  $33,989,791
               6/30/2006             $35,076,406                  $33,229,463
               9/30/2006             $34,273,818                  $32,469,135
               12/31/2006            $33,471,229                  $31,708,806
               3/31/2007             $32,668,641                  $30,948,478
               6/30/2007             $31,866,053                  $30,188,150
               9/30/2007             $31,063,465                  $29,427,822
               12/31/2007            $30,260,876                  $28,667,494
               3/31/2008             $29,458,288                  $27,907,166
               6/30/2008             $28,655,700                  $27,146,838
               9/30/2008             $27,853,112                  $26,386,510
               12/31/2008            $27,050,523                  $25,626,182
               3/31/2009             $26,247,935                  $24,865,854
               6/30/2009             $25,445,347                  $24,105,525
               9/30/2009             $24,642,758                  $23,345,197
               12/31/2009            $23,840,170                  $22,584,869
               3/31/2010             $23,037,582                  $21,824,541
               6/30/2010             $22,234,994                  $21,064,213
               9/30/2010             $21,432,405                  $20,303,885
               12/31/2010            $20,629,817                  $19,543,557
               3/31/2011             $19,827,229                  $18,783,229
               6/30/2011             $19,024,640                  $18,022,901
               9/30/2011             $18,222,052                  $17,262,573
Final Audit Report
ED-OIG/A07F0017                                                                                    Page 25 of 66

                                                                        Potential Improper
                                       Potential Improper             Payment Allowing for
                                      Payment Based on All                    Possible
                  Quarter                  Project 950               Eligible First Generation
                  Ending              Loans Being Ineligible                Loan Sales
                 12/31/2011               $17,419,464                       $16,502,244
                 3/31/2012                $16,616,876                       $15,741,916
                 6/30/2012                $15,814,287                       $14,981,588
                 9/30/2012                $15,011,699                       $14,221,260
                 12/31/2012               $14,209,111                       $13,460,932
                 3/31/2013                $13,406,523                       $12,700,604
                 6/30/2013                $12,603,934                       $11,940,276
                 9/30/2013                $11,801,346                       $11,179,948
                 12/31/2013               $10,998,758                       $10,419,620
                 3/31/2014                $10,196,169                        $9,659,292
                 6/30/2014                 $9,393,581                        $8,898,963
                 9/30/2014                 $8,590,993                        $8,138,635
                 12/31/2014                $7,788,405                        $7,378,307
                 3/31/2015                 $6,985,816                        $6,617,979
                 6/30/2015                 $6,183,228                        $5,857,651
                 9/30/2015                 $5,380,640                        $5,097,323
                 12/31/2015              $3,052,004 (a)                    $2,891,301 (a)
                          Total:          $881,780,622                     $835,350,584
            (a) 	 The estimates for the quarter ending December 31, 2015, are two-thirds the amount
                  that would result from subtracting $802,588 or $760,328 from the amount for the
                  previous quarter, because Nelnet’s loans lose their eligibility for the 9.5 percent
                  floor after two-thirds of this quarter, on December 1, 2015.



Limitation on Estimates

Our estimates of improper payments to Nelnet include the entire payment to Nelnet for loans
billed improperly under the 9.5 percent floor. We have not reduced our estimate by the amount
of the special allowance payments that Nelnet may have received for the loans if it had billed
under the regular special allowance calculation. However, our analysis of Nelnet’s 9.5 percent
loan portfolio indicates that any eligibility for regular special allowance payments during our
audit period would be limited and likely be a small portion of the amount received under the 9.5
percent floor. In its comments, Nelnet estimated that the difference between what it received
under the 9.5 percent floor and the regular special allowance was $322.6 million through June
30, 2006.
Final Audit Report
ED-OIG/A07F0017                                                                      Page 26 of 66


                          Enclosure 3: Nelnet’s Comments
Because of the voluminous number of exhibits included in Nelnet’s comments on the draft
report, we have not included the exhibits in this enclosure. Copies of the exhibits are available
on request.
Final Audit Report
ED-OIG/A07F0017                                                                                             Page 27 of 66


                                      121   SOUTH 13TH STREET, SUITE 301     P 402.458.2370            www.nelnet.net
                                      LINCOLN, NE 68508                      f 402.458.2399            NELNET, INC




                                                     September 7, 2006


          Richard J. Dowd
          Regional Inspector General for Audit
          U.S. Department of Education
          Office of Inspector General
          111 N. Canal Street, Suite 940
          Chicago, IL 60606-7204

                  Re: Control Number ED-OIGIA07F0017
                        Response to Draft Audit Report

          Dear Mr. Dowd:

              This letter is in response to your correspondence dated August 9, 2006 and the Draft Audit
          Report ED-OIG/A07F0017 dated August 2006 (the "Draft Report") issued by the Office of
          Inspector General of the Department of Education (the "OIG"). The Draft Report made the
          preliminary finding that Nelnet, Inc. did not qualify certain of its student loans for the 9.5 percent
          special allowance rate, and recommended that Nelnet repay any amounts billed above the
          ordinary special allowance rate. We have reviewed the Draft Report and strongly disagree with
          its preliminary finding and recommendations. The Draft Report is inconsistent with the Higher
          Education Act, governing regulations and authoritative guidance. This inconsistency is reflected
          in Secretary of Education Paige's statement in 2004 that the regulatory guidance followed by
          Nelnet and other lenders "was specifically endorsed by the prior administration and has been on
          the books for close to a decade." (11/18/04 letter from Sec'y of Education Paige to Sen.
          Kennedy). Since the Draft Report's finding is inconsistent with established precedent, following
          the Draft Report's recommendation would violate established law. A summary of our response
          to the preliminary contentions and finding contained in the Draft Report is set forth below; in
          addition, enclosed please find the legal analysis in support of our response that was provided by
          Perry, Guthery, Haase & Gessford, P .c., L.L.O. (the "Legal Memorandum").

             I.      History and Overview of 9.5 Percent Floor.

              It is important to understand the genesis and context of the 9.5 percent floor. Prior to 1980,
          the government paid the same special allowance rate to student loan lenders who financed their
          loans with tax-exempt obligations and those who financed their loans with taxable obligations.
          In 1980, Congress recognized that lenders who did not enjoy the ability to issue tax-exempt
          bonds had become subject to competitive disadvantage. Thus Congress imposed a statutory
          penalty upon student loan lenders who financed their loans through tax-exempt obligations by
Final Audit Report
ED-OIG/A07F0017                                                                                            Page 28 of 66


    n     September 7, 2006
          U.S. Department of Education
          Office of Inspector General
          Page 2

          reducing their special allowance rate to one-half the rate paid to other lenders. In order to protect
          lenders who used tax-exempt financing (and holders of tax-exempt bonds) from hardships in the
          event interest rates fell precipitously, however, those lenders were given a floor of at least a 9.5
          percent return on their loans.

              Thus in high interest rate environments, tax-exempt issuers would be subject to a
          considerable penalty, and in extremely low interest rate environments, the 9.5 percent floor rate
          could result in special allowance payments being higher than those paid to lenders relying on
          taxable financings. The Department of Education (the "Department") adopted regulations (34
          C.F.R. § 682.302(e)) and in 1996 issued a Dear Colleague Letter (96-L-186), both of which
          prevented tax-exempt issuers from shedding the one-half special allowance rate by merely
          shifting their student loans to taxable financings; those regulations and the Dear Colleague Letter
          made it clear that loans transferred from tax-exempt to taxable financings remain subject to the
          one-half special allowance rate (and the 9.5 percent floor). As a result ofthe Part 682 regulations
          and the regulatory interpretation contained in the Dear Colleague Letter (issued in the previous
          administration), the Department could not lawfully end the 9.5 percent floor without engaging in
          a notice-and-comment rulemaking proceeding, notwithstanding the fact that interest rates hit
          historic lows in 2003 and 2004. Indeed, Department personnel observed on several occasions
          that it would have been required to engage in a negotiated rulemaking proceeding, an even
          lengthier administrative process.

             After carefully reviewing the provisions of the governing statute, the regulations, and the
         regulatory interpretation contained in the Dear Colleague Letter, and after seeking guidance from
         the Department, Nelnet qualified certain loans for the 9.5 percent floor in the manner described
         below. In qualifying those loans for the 9.5 percent floor, Nelnet, in good faith, closely followed
         all of the requirements existing at the time. In implementing this process, Nelnet has
         consistently complied with the law and regulations and has adopted an asset/liability
         management strategy similar to the strategy commonly utilized by many other student loan
         organizations. Concurrently, Nelnet led efforts to eliminate the ability to qualify new loans for
         the 9.5 percent floor by working with Department personnel and Congress beginning in early
         2003. N elnet stopped qualifying any new loans for the 9.5 percent floor when legislation was
         introduced in early 2004 to end the ability to qualify new loans for the 9.5 percent floor, well
         before the new statute was enacted in late 2004.

              II.    The Loans at Issue in the Draft Report Were Purchased with Qualifying Sources
                     of Funds and Are Thus Eligible for the 9.5 Percent Special Allowance.

            Field auditors of the OIG wrapped up their field audit in 2005 and told Nelnet that they had
         found no material exceptions to Nelnet's billings for the 9.5 percent special allowance rate.
         Approximately one year later, however, the OIG's Draft Report now has called into question
         whether the purchases of loans by the 1985A Trust were made with qualifying sources of funds
         under 34 C.F.R. § 682.302(c)(3)(i).
Final Audit Report
ED-OIG/A07F0017                                                                                           Page 29 of 66


    n     September 7, 2006
          U.S. Department of Education
          Office of Inspector General
          Page 3

                 A. The loans at issue are entitled to the 9.5 percent special allowance rate under
                    applicable regulations and authority.

              Loans which are purchased with funds obtained from qualifying sources are eligible for the
          minimum 9.5 percent special allowance rate. These qualifying sources are set forth in 34 C.F.R.
          § 682.302(c)(3)(i)(A) - (E), and are generally funds obtained from proceeds of tax-exempt
          obligations originally issued prior to October 1, 1993. Loans purchased with funds from
          qualifying sources and thus eligible for the 9.5 percent rate remain eligible for that minimum rate
          even if they are subsequently financed with funds derived from taxable obligations or other non­
          qualifying sources. 34 C.F.R. § 682.302(e)(2); Dear Colleague Letter (96-L-186).

              Nelnet's 1985A Trust was created pursuant to an Indenture of Trust in which student loans
          were pledged as collateral on tax-exempt bonds originally issued in 1985, and an indirect Nelnet
          subsidiary was the beneficiary of that trust. The 1985A Trust purchased its first student loans
          with funds obtained from tax-exempt obligations originally issued by the 1985A Trust prior to
          October 1, 1993. The 1985A Trust sold certain of those loans to five different purchasing trusts,
          and the Nelnet subsidiary was beneficiary of each of those purchasing trusts. Thereafter, the
          1985A Trust purchased the new loans at issue in the Draft Report with the proceeds from those
          sales. All of the loan sales transactions were irrevocable, on a non-recourse basis, for which the
          selling trust received reasonably equivalent value, and as a result of which the selling trust
          surrendered all rights and control over the loans being sold to the purchasing trusts.

             Nelnet billed the Department for these new loans at the 9.5 percent special allowance rate
         based on the fact that the funds used to purchase the loans into the 1985A Trust came from
         qualifying sources under 34 C.F.R. § 682.302 (c) (3) (i). Specifically, funds used to purchase
         those loans were obtained from (i) proceeds of the pre-October 1, 1993 tax-exempt obligations
         issued by the 1985A Trust, (ii) the sale of loans that had been purchased with funds obtained
         from the pre-October 1, 1993 tax-exempt obligations issued by the 1985A Trust, and/or (iii)
         investment of proceeds of the pre-October 1, 1993 tax obligations issued by the 1985A Trust.
         The 1985A Trust sold the loans to the purchasing trusts (which were utilizing taxable financing)
         in precisely the manner provided for in 34 C.F.R. § 682.302(e) and the 1996 Dear Colleague
         Letter, resulting in those loans retaining eligibility for the 9.5 percent floor.

                 B. The transfers of loans from the 1985A Trust constituted sales and the proceeds of
                    those sales constitute a qualified source of funds.

            The Draft Report contends that the "transfers" of loans from the 1985A Trust to the
         purchasing trusts did not constitute "sales" under Section 682.302(c)(3)(i)(D), and thus the
         proceeds of those transfers were not a qualifying source of funds with which to purchase loans,
         and in tum the purchased loans were not eligible for the 9.5 percent minimum rate.

              The Draft Report's assertion that transfers from the 1985A Trust were not "sales" is based
         upon faulty premises and is thus wrong. The Draft Report offers five interrelated arguments in
         its contention that the transfers of loans from the 1985A Trust did not constitute sales. First, the
Final Audit Report
ED-OIG/A07F0017                                                                                               Page 30 of 66


  'i'n.·.   September 7, 2006
            U.S. Department of Education
            Office of Inspector General
            Page 4

            Draft Report (at 9) asserts that the 1985A Trust "received no funds" in exchange for the loans
            transferred out of that trust, but instead "received only the difference between the loans
            transferred out and in." The Draft Report fails to acknowledge the fact that in each of the sales,
            the 1985A Trust received a sale price equal to the aggregate outstanding principal balance and
            accrued interest on the loans being sold. Such sale proceeds were applied to and then netted out
            against funds to be paid by the 1985A Trust to purchase new loans in instances where a sale and
            purchase were occurring simultaneously. Such application and netting of funds is commonly
            used in simultaneous purchase and sale transactions, and is similar to other commonly used
            methods of funds delivery such as wire transfers or checks which do not require the physical
            movement of cash. In fact, the Department itself regularly uses the netting method to net special
            allowance to be paid to lenders against amounts to be paid by those lenders, and the Department
            has consistently recognized that loans qualifying for the 9.5 percent rate may be purchased with
            those netted payments. The Draft Report (at 9) does subsequently acknowledge that "[t]he
            purchase price for a loan was always the loan's principal amount and accrued interest." We
            agree with this statement but note that it belies and undermines the Draft Report's earlier
            assertion that the 1985A Trust received no funds in the sales.

                Second, the Draft Report (at 9) asserts that the sales from the 1985A Trust were not at arms
            length for the stated reason that "the transactions were initiated and controlled by the same
            entity, Nelnet." This contention ignores the fact that each sale in question was made from one
            trust to a different and separate trust, and that the 1985A Trust and each of the purchasing trusts
            are separate and distinct legal entities. The Draft Report (at 9) further contends that the sales
            were not at arms length for the stated reason that "[t]he trustee made no attempt to obtain a price
            for the loans that reflected their actual market value." This contention applies an erroneous
            standard which seems to require a selling party to receive "actual market value," whereas the
            existing legal authority on whether a sale has occurred merely looks at whether the sale is made
            for "reasonably equivalent value." The outstanding principal and accrued interest on a loan is
            certainly that loan's reasonably equivalent value. An appraisal of the market value of an asset
            being sold, in order to determine whether precise market value was obtained, has never been a
            condition for treatment of a transfer as a sale, as such a condition would be far too difficult and
            cumbersome to serve as an appropriate standard. Certainly no requirement that the sale be for
            appraised market value is found in 34 C.F.R. § 682.302(c)(3)(i)(D) or anywhere else in the
            regulations or the 1996 Dear Colleague Letter.

                Third, the Draft Report (at 9) asserts that the sales of loans from the 1985 A Trust were "not
            irrevocable," as the authority was retained "to direct Wells Fargo [as trustee] to transfer them
            back." This assertion is flatly wrong. The 1985A Trust did not maintain control over any loans
            after they were sold. Upon sale, the loans sold from the 1985A Trust were all released from the
            indenture and related security interest, thus placing those loans beyond the reach of the 1985A
            Trust and its creditors. Nothing in any agreement between the 1985A Trust and any purchasing
            trust permits revocation of the sale of any of the loans. The purchasing trust has the right to
            pledge the loans purchased, and each of those purchasing trusts do, indeed, pledge the purchased
            loans as collateral and grant security interests in those loans, subject to no other liens or security
            interests. There are no provisions whereby the 1985A Trust can require the repurchase of any of
Final Audit Report
ED-OIG/A07F0017                                                                                           Page 31 of 66


    n     September 7, 2006
          U.S. Department of Education
          Office of Inspector General
          Page 5

          the loans sold. The 1985A Trust has no power to unilaterally cause the return of the loans
          following sale. Thus the sales of the loans by the 1985A Trust were irrevocable.

               Fourth, the Draft Report (at 9) argues that the transfers of loans by the 1985A Trust do not
          constitute sales for the stated reason that Nelnet held beneficial ownership in the loans before
          and after the transfers. Once again, this argument ignores the plain fact that the sale was made
          by one trust to a different trust, each of which is a separate and distinct legal entity. It further
          fails to acknowledge fundamental law providing that separate trusts can not commingle their
          separate trust assets, and that assets are permitted to be properly transferred from one trust to
          another in a sale for reasonably equivalent consideration.

              Fifth, the Draft Report (at 9) asserts that the sales of loans by the 1985A Trust "do not meet
          the criteria to be counted as sales" under FAS 140 or federal income tax law for the stated reason
          that Nelnet "did not surrender control over the transferred assets." Nothing in the Higher
          Education Act, its regulations or any other applicable law warrants the application of accounting
          or tax standards to this issue. The purpose of FAS 140 is strictly for accounting and reporting
          guidance to accountants and was not intended to define the term "sale" or provide a legal
          standard as to whether or not a transfer of loans qualifies as a sale under applicable law.
          Nevertheless, the discussion above in response to the other four arguments put forth by the Draft
          Report clearly establishes that the 1985A Trust did, in fact, surrender control over the loans sold
          out of the trust. Similarly, income tax standards have no relation to whether a transaction is a
          "true" sale under commercial and property law, but instead relate only to how such sales are
          reflected on tax returns.

                 c. Later generation proceeds are a qualifying source of funds for the purchase of loans
                     to be eligible for the 9.5 percent special allowance rate.

              As an alternative to the Draft Report's assertion that the 1985A Trust's transfers ofloans did
          not constitute sales, the Draft Report (at 9) also argues that "[ e]ven if the transfers could be
          characterized as sales," the loans would be ineligible for the 9.5 percent special allowance rate
          for the stated reason that "any funds obtained from later generation sales are not eligible sources"
          under 34 C.F.R. § 682.302(c)(3)(i)(D). The Draft Report appears to be trying to insert a
          requirement to the regulations which would only permit funds "originally" obtained from a pre­
          October 1,1993 tax-exempt obligation to be a qualifying source of funds. No such language or
          requirement exists in the statute or regulations, however. Moreover, the Draft Report focused
          exclusively on whether the funds used to purchase 9.5 percent loans were obtained from the sale
          of loans under § 682.302(c)(3)(i)(D). Since it is well established law that later generation
          proceeds still constitute proceeds, however, the later generation proceeds would constitute a
          qualifying source of funds under § 682.302(c)(3)(i)(A) as funds obtained from "the proceeds of
          tax-exempt obligations originally issued prior to October 1, 1993." Thus, regardless of whether
          the transfers from the 1985A Trust constitute sales, those transfers produced funds obtained from
          proceeds of the pre-October 1, 1993 tax-exempt obligations. Since loans are commonly and
          regularly sold out of and into long term tax-exempt obligations, the Draft Report's assertion is
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  ::n     September 7, 2006
          U.S. Department of Education
          Office of Inspector General
          Page 6

          not rooted in reality, as virtually all tax-exempt obligations originally issued prior to October 1,
          1993 are, by now, funding new loan purchases with later generation proceeds.

                 D. The Draft Report's suggestion that Nelnet's records are insufficient is wrong.

              Finally, the Draft Report (at 8) has indicated that Nelnet's records were insufficient for the
          stated reason that they "did not readily identify the loans' funding sources." Nowhere in the
          regulations of the Higher Education Act is there a requirement to maintain records which identify
          loans' funding sources. Nelnet's records satisfy each of the requirements set forth in 34 C.F.R.
          §§ 682.515 and 682.414(a)(ii), and furnish plentiful additional information beyond the regulatory
          requirements. During the field audit, Nelnet furnished detailed documentation and reports at the
          loan level identifying the selling trust as the "Selling Lender," the purchasing trust as the
          "Buying Lender," referencing each party's unique bond identification number, setting forth the
          sale date, identifying the borrower by name and social security number and providing other
          information. Thus the source of funds is clearly reflected in Nelnet's documentation, whether or
          not such information is required to be maintained by regulation.

             III. Conclusion.

              It is important to remember that the origin of the 9.5 percent minimum rate may be traced to
          Congressional intent to protect lenders who used tax-exempt financing and would thus otherwise
          be subject to the one-half special allowance rate in low interest rate environments. Indeed, when
          the previous administration issued Dear Colleague Letter 96-L-186 in 1996, it made a
          costlbenefit analysis as to whether a lender should be able to shed the half special allowance rate
          by funding loans with taxable obligations. Although critics have placed much focus on the 9.5
          percent floor during recent low interest rate environments, student loan industry participants who
          hold those loans know and understand that interest rates fluctuate greatly over the life of a 30-
          year loan and that the one-half special allowance rate may once again result in significant
          savings for the government in years to come. If prevailing interest rates had been at historic
          highs (rather than historic lows) over the part few years, it is unimaginable that the Draft Report
          would have advanced the same novel interpretations which are contrary to longstanding law and
          guidance, and recommended that N elnet be compensated for underbilling the Department.

              It would be inconsistent (and indeed unlawful) to retroactively change established
          interpretations when interest rates swing one direction, particularly when those interest rates may
          swing in the opposite direction in the future to the lender's detriment. When asked why the
          Department of Education had not sought to recover 9.5 percent floor payments made to Nelnet
          and other lenders, the former Secretary of Education correctly pointed out that the Department
          was bound by "existing Department regulations, and interpretations of those regulations,
          including an interpretation issued by the prior administration expressly permitting" the methods
          that Nelnet and other lenders had used, and could not change existing rules without going
          through lengthy rulemaking procedures. (November 18, 2004 letter from Sec'y of Education
          Paige to Sen. Kennedy). The U.S. Government Accountability Office (GAO) found in its
          September 2004 report that the method used by Nelnet and other lenders to qualify loans for the
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         September 7, 2006
         U.S. Department of Education
         Office of Inspector General
         Page 7

         9.5 percent floor was one of the ways to increase 9.5 percent loan volume, and acknowledged
         that legislation or regulatory change were the only avenues available to prospectively end the
         ability to use that method in the future. Floor debate on the 2004 legislation ending the ability to
         qualify new loans for the 9.5 percent floor demonstrates that members of Congress consistently
         found the practice to be perfectly valid and legitimate, and that legislation or rulemaking was
         required to change the rules and to end future activity.

             Our actions and documentation are consistent with the laws, regulations and guidance
         governing the 9.5 percent special allowance rate on the loans at issue in the Draft Report, and the
         loans for which we have billed and received the 9.5 percent rate were fully eligible for that rate.
         For the reasons set forth above as well as in the enclosed Legal Memorandum, we do not concur
         with the finding in the Draft Report, nor with its recommendations. We thus propose that the
         Draft Report be withdrawn.

             We appreciate your review of the response materials and look forward to working with you
         to complete the audit.
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                                               MEMORANDUM

           TO:            Nelnet, Inc.; Jeffrey R. Noordhoek, President and Terry J. Heimes, .Chief
                          Financial Officer

           FROM:           Daniel F. Kaplan

           DATE:           September 6, 2006

           SUBJECT:        Legal Analysis of Draft Audit Report of Inspector General

           ==================================================================
           1.      INTRODUCTION

                     Nelnet qualified certain student loans for the 9.5% special allowance rate using a process
           . permitted by. the governing statute, implementing regulations, and authoritative departmental
             guidance. In this process, a trust that benefited an indirect N elnet subsidiary used the proceeds
             of a tax-exempt obligation to purchase loans, which it subsequently sold to other trusts. In each
             sales transaction, legal title to the loans passed to the trustee of the purchasing trust and the
             selling trust received valuable consideration. The sales were irrevocable and without recourse.
             Because the loans were acquired with the proceeds of a tax-exempt bond issued before October
             1, 1993 that had not been retired or defeased, they were eligible for billing at the 9.5% special
             allowance rate set forth in 34 C.F.R. § 682.302(c)(3)(i), and, pursuant to· 34 C.F.R.
             § 682.302(e)(2), remained eligible for that rate even after they were subsequently sold.

                    On August 9,2006, the Department's Office of Inspector General ("DIG") issued a Draft
            Audit Report (the "Draft Report") contending (at 5) that "[tlhe increase in Nelnet's special
            allowance payments under the 9.5 percent floor was based on ineligible loans." Recognizing that
            "a lender may continue to receive special allowance payments under the 9.5 percent floor after
            the lender transfers an eligible loan to a taxable obligation," the OIG previously conceded in its
            Exception Report (at '1) that "[t]he basic premise" for Nelnet's process "is in compliance with
            Departmental Guidance." Yet the Draft Report claims (at 5) that the increased amount of loans
            billed under the 9.5% floor that resulted from Nelnet's process were not funded by any eligible
            source listed in 34 C.F.R. § 682.302(c)(3)(i). It therefore recommends (at 13) that Nelnet be
            required to calculate and return the special allowance overpayments it received for the allegedly
            ineligible loans.

                    The Draft Report's finding rests on two faulty premises. First, the Draft Report contends
            (at 8-9) that the transactions among the trusts do not qualify as "sale[~]" of loans, and that the
            trusts did not obtain "funds" from those transactions that could be used to purchase additional
            eligible loans under 34 C.F.R. § 682.302(c)(3)(i)(D). Second, the Draft Report contends (at 9)
            that even if the transactions qualified as sales, "[aJny funds obtained from later generation sales

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           are not eligible sources under 34 C.F.R. § 682.302(c)(3)(i)(D)." As explained more fully below,
           however, the relevant transactions were sales: the loans were sold by one trust and bought by a
           legally distinct trust without any right of revocation or recourse and in return for funds
           representing reasonably equivalent value. See Part III, infra. Furthermore, both the plain text of
           the regulation and the Department's official pronouncements show that a loan funded by
           subsequent generation proceeds of a tax-exempt obligation issued prior to October 1, 1993 is
           eligible for the 9.5% floor. See Part IY.A., infra. Finally, the Draft Report is inconsistent with
           the Department's authoritative interpretation of the regulations as well as guidance and public
           statements by both the previous and current administrations. See Part IV.B., infra. Accordingly,
           the Draft Report's finding is incorrect and the recoIIl1llendations based on it should be
           withdrawn.




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                                                                          TABLE OF CONTENTS

           1.         INTRODUCTION .................................................................................................................. 1

           II.        BACKGROUND ..................................................................................................................... 5

                 A.         Statutory And Regulatory Context...................................................................................... 5

                 B.         The Relevant Entities .......................................................................................................... 6

                 C.         Nelnet's Process .................................................................................................................. 8

                 D.         The OIG Exception Reports And Draft Audit Report ........................................................ 8

           III.             THE LOANS AT ISSUE ARE ELIGIBLE FOR THE 9.5% SPECIAL
                            ALLOWANCE RATE BECAUSE THEY WERE ACQUIRED WITH
                            FUNDS OBTAINED FROM A QUALIFYING SOURCE............................................... 9

                 A.         A "Sale" Is A Transfer Of Property From One Entity To Another For A Price................. 9

                 B.         The Transfers From The 1985A Trust Constitute True Sales ........................................... 11

                 C.         The 1985A Trust And The Purchasing Trusts Are Discrete Legal Entities,
                            Distinct From Each Other And From Their Common Beneficiary.................................. 13

                      1.        The 1985A Trust and the Purchasing Trusts are duly established trusts ...................... 14

                      2.        Trusts are, as a matter oflaw, distinct from their beneficiaries and each other............ 14

                 D.         Consistent With Applicable Trust Law, The Transfers To The Purchasing
                            Trusts Were Via Sales At A Reasonably Equivalent Price in Netted "Funds." ............... 15

                 E.         The Accounting And Tax. Definitions Of "Sale" Do Not Apply...................................... 17

            IV.             LOANS PURCHASED WITH THIRD GENERATION PROCEEDS OF
                            A TAX-EXEMPT OBLIGATION QUALIFY FOR THE 9.5% SPECIAL
                            ALLOWANCE RATE ...................................................................................................... 18

                 A.         Third Generation Proceeds Are A Qualifying Source Of Funds Under
                            34 C.F.R. § 682.302(c)(3)(i) ............................................................................................. 18

                       1.       Third generation proceeds constitute "proceeds" under 34 C.F.R.
                                § 682.302(c)(3)(i){A).................... :............................................................................... 19

                      2.        A loan acquired with third generation proceeds also qualifies for the 9.5%
                                floor under 34 C.F.R. § 682.302(c)(3)(i)(D) ................................................................. 20


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             B.         The Department's Authoritative Interpretation And Public Guidance Confirm
                        That Nelnet's Loans Were Entitled To The Special Allowance Rate.............................. 21

                   1.     The governing regulation and a Dear Colleague Letter established the rules
                          on eligibility for the 9.5% floor.................................................................................... 21

                   2.     The Department is bound by these rules ....................................................................... 22

                   3.      The Department's actions, guidance, and public statements confIrm that
                           these rules allowed Nelnet to qualify additional loans for the 9.5% floor.................... 23

                   4.      The Draft Report's suggestion that Nelnet did not adequately disclose its
                           process is inaccurate..................................................................................................... 27

                   5.      The regulatory history further refutes the Draft Report................................................ 28

              C.        Nelnet's Records Are Sufficient. ...................................................................................... 30

           CONCLUSION ............................................................................................................................. 32




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           ll.     BACKGROUND

                   A.     Statutory And Regulatory Context

                   The federal government pays a special allowance rate on many student loans to private
           student loan lenders. That special allowance rate is based on a formula. The rate rises as interest
           rates rise, and falls as interest rates fall. Prior to 1980, the special allowance rate paid on a
           student loan to a student loan lender did not depend on whether the loan had been financed with
           a taxable or tax-exempt obligation. Congress altered that state of affairs when, having concluded
           that lenders who financed loans through tax-exempt obligations were enjoying an undue
           competitive advantage, it enacted the Education Amendments of 1980. Section 420 of the
           Education Amendments reduced the special allowance rate paid on loans that had been financed
           by tax-exempt obligations to one-half the rate paid on loans financed by taxable obligations. At
           the same time, to protect lenders in the event interest rates fell, lenders were guaranteed at least a
           9.5% return on loans that had been financed by tax-exempt obligations. See Pub. L. No. 96-374
           § 420,94 Stat 1367, codified at 20 U.S.C. § 1087-1(b).

                    By 1992, the D!=lpartment had grown concerned that interest rates might again rise. The
            Department feared that if rates did rise, lenders who held loans that had been financed with tax­
            exempt obligations would transfer such loans to taxa1:>le obligations and then claim the full
            special allowance ·rate rather than the halved special allowance rate applicable to loans financed
            through tax-exempt obligations. To forestall that possibility, the Department' promulgated
            regulations that define which loans are subject to the reduced special allowance rate (and
            corresponding 9.5% floor). Federal Family Education Loan Programs, 57 Fed. Reg. 60280 (Dec.
            18, 1992). The regulations define the loans that are subject to the reduced special allowance rate
            in terms of the sources of fimds used to make or purchase them.. The enumerated sources include
            "funds obtained by the holder from":

                           (A) The proceeds of tax-exempt obligations originally issued prior
                           to October 1, 1993 ... ;


                           (D) The sale of a loan that was made or purchased with funds
                           obtained by the holders from [tax-exempt obligations originally
                           issued prior to October 1, 1993]; or

                           (E) The investment of the proceeds of [tax-exempt obligations
                           originally issued prior to October 1, 1993].

            34 C.F.R. § 682.302(c)(3)(i)(A), (D), (E).

                    To prevent lenders from transferring loans to taxable obligations and subsequently
            claiming the full special allowance rate on such loans, the regulations provided that the reduced
            special allowance rate would continue to apply to a loan that had been funded with one of the
            enumerated sources "[a]fter the loan is pledged or otherwise transferred in consideration of funds
            derived from sources other than those described in [34 C.F.R. § 682.302(c)(3)(i)]," so long as
            "the authority retains a legal or equitable interest in the loan" and the tax-exempt obligation has

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           not been ''retired'' or "defeased." 34 C.F.R. § 682.302(e)(2).          In 1996, the Department
           interpreted § 682.302(e) in a Dear Colleague letter, explaining that:

                          Under the regulations, if a loan made or acquired with the proceeds
                          of a 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).

           U.S. Dep't of Education, Dear Colleague Letter 96-L-186 (Q&A No. 30) (Ex. 1).

                   Rather than rising, interest rates ultimately fell following these regulatory actions. As a
           consequence, rather than having a regulatory incentive to transfer loans from tax-exempt
           obligations (and the corresponding one-half special allowance rate provisions), lenders had a
           regulatory incentive to transfer loans to tax-exempt obligations (thereby securing eligibility for
           the 9.5% floor on su.ch loans).

                   B.     The Relevant Entities

                   Nelnet Education Loan F~ding, Inc. (''NELF''), the successor entity to NEBHELP,
           INC., is a corporation iocated and organized in the State of Nebraska and is an indirect wholly­
           owned ·subsidiary of Nelnet, Inc. NELF is a party to various trust agreements, each of which is
           associated with a particular indenture or credit facility. Pursuant to the Higher Education Act of
           1965, as amended, only an "eligible lender" (as defined therein) may own legal title to certain
           federally guaranteed student loans such as those at issue. Wells Fargo Bank, N.A. ("Wells
           Fargo") is an "eligible lender" under the Higher Education Act. In its capacity as trustee under
           various eligible lender trust agreements with NELF, Wells Fargo acquired legal title to the
           student loans with funds provided pursuant to an indenture or credit facility to which NELF is a
           party.

                   One of these trust arrangements-the 1985A Trust--:-issued tax-exempt obligations called .
           the Series 1985A bonds prior to October 1, 1993<- NELF used proceeds of those bonds to
           purchase or originate student loans. The Series 1985A bonds were issued under an indenture, in . .
           relation to which NELF entered into an eligible lender trust agreement. Documentation relating
           to the 1985A trust was made available to the OIG during its audit. The indenture and the eligible
           lender trust agreement are, by their terms, governed by Nebraska law.

                    NELF is also the beneficiary of several eligible lender trust agreements relating to
            financing programs that issue various taxable obligations. Wells Fargo is the eligible lender
            trustee for each of these "Purchasing Trusts," which include: (i) a securitization program created
            by a Trust Indenture dated as of June 1, 1993, between NELF, as grantor and beneficiary, and
            Wells Fargo, as trustee that relates to a Student Loan Trust and Agency Agreement dated as of
            JW1e 1, 1993 (the "1993A Trust"); (ii) an Eligible Lender Trust Agreement dated as of June 1,
            2003, that relates to a securitization program trust created by an Indenture of Trust dated as of
            June 1,2003, between NELF, as grantor and beneficiary, and Wells Fargo, as trustee (the "NELF

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           2003-1 Trust"); (iii) a Student Loan Trust and Agency Agreement dated as of May 1, 1997 that
           relates to a securitization program trust created by a Trust Indenture dated as of May 1, 1997,
           between NELF, as grantor and beneficiary, and Wells Fargo, as trustee (the "SLM CP Trust");
           (iv) an Eligible Lender Trust Agreement dated as of May 1, 2003, that relates to a securitization
           program trust created by the Warehouse Note Purchase and Security Agreement dated as of May
           1,2003, among NELF as borrower,Wells Fargo, as trustee, and various other parties (the "BofA
           Trust"); and (v) an Eligible Lender Trust Agreement dated as of April 28, 2003, that relates to a
           securitization program trust created by the Amended and Restated Warehouse Loan and Security
           Agreement dated as of April 28, 2003 among NELF, as borrower, Zions First National Bank, as
           trustee, and various other parties (the "RBC Trust"). Most of these trust arrangements are, by
           their tenns, governed by Nebraska law; the remainder are governed by Minnesota law.

                   Although NELF is the grantor and beneficiary of each eligible lender trust, each trust is a
           separate entity, distinct from both NELF and the other trusts. The following attributes of the
           respective trusts are among the many indicia of their separate existence and independence from
           each other:

                          •   Each trust is established pursuant to separate agreements which, in
                              tum, set forth separate and distinct sets of obligations and rights.

                          •   The loans held by each trust are assigned a designation which is
                              distinct from all other assets in which NELF has an interest.

                          •   The loans and other assets held in each trust are segregated and not
                              commingled.

                          •   The bank accounts of each trust are separate and segregated.

                          •   Each trust holds itself out to the public and its creditors under its
                              capacity as a separate and distinct trust.

                          •   None of the trusts have guaranteed or pledged any assets to secure
                              liabilities, obligations, or indebtedness of the other trusts.

                          •   The loans relating· to each respective trust consist of specific,
                              identifiable and segregated assets.

                          •   The loans relating to each trust are pledged under separate security
                              arrangements with different creditors.

                          •   The obligations owed to such different creditors are limited obligations
                              payable solely from a discrete and specific pool of collateral, separate
                              from each other trust.

                          •   No trust will bear any losses or take on the ultimate risk of failure of
                              payment on loans held in any of the other trusts.


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                           •   The loans relating to each trust are serviced under separate servicing
                               agreements.

                           •   The servicing agent under each such servicing agreement has been
                               directed to transmit collections of borrower, guarantor and
                               governmental payments separately to the trustee for deposit in
                               segregated accounts.

                           •   The loans relating to each trust are held under separate custodian
                               agreements proving for the segregated possession ofloans and funds.

                           •   The loans relating to each trust are reported on separately to the
                               creditors relating to such trust and the related trustee.

                           •   No trust pays any of the other trusts' debts.

                           •   The loans held by each trust are assigned a separate and distinct bond
                               identification number and the eligible lender trustee for each such trust
                               is able to readily distinguish which loans belong to which trust at any
                               given time.

                           •   Each trust retains separate books of account and records.

                   C.      Nelnet's Process

                    Nelnet adopted an assetlliability management strategy similar to strategies commonly
            used by many other student loan organizations, and such strategies included use of the 9.5%
            floor provisions. The process that Nelnet used to qualify loans for the 9.5% floor involved a
            series of sale and purchase transactions between the 1985A Trust.and the Purchasing Trusts. The
            1985A Trust sold loans, which had been acquired with funds obtained from the Series 1985A
            bonds, to the Purchasing Trusts at reasonably equivalent value. The proceeds 9f those sales were
            then used to acquire, also at reasonably equivalent value, other loans from the Purchasing Trusts.
            The process of selling loans and buying other loans with the proceeds of those sales is a common
            industry practice called ''netting.'' When a given loan was sold, legal title passed from the trustee
            of the selling trust to the trustee of the purchasing trust. In each instance, the sales were
            irrevocable and without recourse: the seller could not unilaterally reverse the sale, and the buyer
            had no recourse against the seller, even if the borrowers defaulted on the loans.

                   Recognizing that the loans sold by the 1985A Trust had been acquired with "[t]he
            proceeds of tax-exempt obligations originally issued prior to October 1, 1993," 34 C.F.R.
            § 682.302(c)(3)(i)(A), Nelnet billed the Department on loans sold by the 1985A Trust at the
            9.5% special allowance rate, including after their sale to the Purchasing Trusts.

                    D.     The OIG Exception Reports and Draft Audit Report

                   The 010 issued two Exception Reports against Nelnet relating to its audit of Nelnet's
            9.5% loans on April 17, 2006. In its Exception Report relating to the method Nelnet used to


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           qualifY loans for the 9.5% rate, the OIG asserted that loans acquired by the 1985A Trust "did not
           qualifY for the 9.5 percent floor" because the funds with which the loans were acquired
           purportedly fell outside the categories of qualifying funds enumerated in 34 C.F.R.
           § 682.302(c)(3Xi). In particular, the OIG claimed that the funds used to acquire the loans did not
           constitute funds obtained from the "sale" of loans as provided in § 682.302(c)(3)(i)(D).

                   In the Nelnet Loan Records Exception Report, the OIG claimed, as an initial matter, that
           ''Nelnet's loan records might not be adequate to determine a loan's eligibility for the 9.5 percent
           floor." The ~IG's principal contention in this exception report, however, was that funds derived
           from the sale of loans that were themselves acquired with funds derived from the sale of loans
           Oater generation sale proceeds) did not constitute qualifying funds under § 682.302(c)(3)(i).

                  Nelnet expressed its disagreement with the Exception Reports in a letter, attaching a
           lengthy memorandum from outside counsel discussing the legal issues, a legal opinion from
           independent counsel that the trust transactions were true sales for commercial and property law
           purposes, and numerous exhibits.

                  On August 9, 2006, the OIG issued its Draft Audit Report. The core positions set forth in
           the Draft Report are the same as those set forth in the ~IG's Exception Reports.

           III.    THE LOANS AT ISSUE ARE ELIGIBLE FOR THE 9.5% SPECIAL
                   ALLOWANCE RATE BECAUSE THEY WERE ACQUIRED WITH FUNDS
                   OBTAINED FROM A QUALIFYING SOURCE.

                  There is no dispute that a loan is eligible for the 9.5% special allowance rate if it is
           purchased with funds from one (or more) of the five qualifying sources enumerated in 34 C.F.R.
           § 682.302(c)(3)(i). As noted above, the qualifying sources include "funds obtained by the holder
           from" .any one or more of the following: "[tJhe proceeds of tax~exempt obligations originally
           issued prior to October 1, 1993"; "[t]he sale of a loan that was made or purchased with funds
           obtained ... from [such] obligations"; or "[t]he investment of the pro~eds of [such]
           obligations." ld. § 682.302(c)(3)(i)(A), (D), (E).

                  The OIG also appears to agree that the loans initially acquired by the 1985A Trust with
           funds obtained from pre,.October 1, 1993 tax-exempt obligations qualified for the 9.5% special
           allowance rate under § 682.302(c)(3)(i)(A). Thus, the only question presented by the Draft
           Report is whether loans acquired by the 1985A Trust with funds obtained-either directly or
           indirectly-from the disposition of such initially acquired loans also qualified for the 9.5% floor.

                   As framed by the Draft Report, resolution of this question turns on the definition of
            "sale." The Draft Report focuses on 34 C.F.R. § 682.302(c)(3)(i)(D), contending that loans
            acquired by the 1985A Trust with the consideration obtained from the disposition of previously
            held loans do not qualifY for the 9.5% special allowance rate because, according to the Draft
            Report, the antecedent transactions did not constitute "sales" from which "funds" were obtained
            for purposes of § 682.302(c)(3)(i)(D). In those transactions, which were between the 1985A
            Trust and the Purchasing Trusts, the 1985A Trust relinquished legal title to certain loans and, in
            exchange, received consideration of reasonably equivalent value. According to the Draft Report
            (at 8-9), those transactions constituted "internal transfer[s] or barter[s]" rather than "sales"

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           because: (1) the 1985A Trust received "only limited amounts" of cash "funds" in exchange for
           the loans to which it relinquished title; (2) the trustee made no attempt to obtain a price for the
           loans that reflected their actual market value; (3) Nelnet "retained the authority" to revoke the
           transactions by directing the trustee to transfer the loans back to the 1985A Trust; (4) the
           transactions "did not cause a change in the beneficial ownership of the loans"; and (5) the
           transactions did not count as. sales for accounting or tax purposes. Consequently, the Draft
           RejJort concludes, the loans received by the 1985A Trust in these transactions were not funded
           by an eligible source and thus do not qualify for the 9.5% special allowance rate.

                   The Draft Report is mistaken in both its premises and its conclusion. First, by focusing
            exclusively on § 682.302(c)(3)(i)(D), which extends the 9.5% special allowance rate to loans
            purchased with funds obtained from "[t]he sale of a loan that was made or purchased with funds
            obtained" from a tax-exempt obligation originally issued prior to October 1, 1993, the Draft
            Report disregards the fact that the loans at issue also qualify for the 9.5% rate under
            § 682.302(c)(3)(i)(A) and (E)-which do not require a "sale." See Part IV, infra. Second, and
            perhaps more importantly for present purposes, the relevant transactions were indeed "sales" and
            therefore the loans also qualify for the 9.5% floor under § 682.302(c)(3)(i)(D).

                   A.      A "Sale" Is A Transfer Of Property From One Entity To Another For A
                           Price.

                   Neither the Higher Education Act nor its implementing regulations define the term
            "sale." It is a well-established rule of statutory construction that "absent contrary indications,
            Congress intends to adopt the common law definition of statutory terms." United States v.
            Shabani, 513 U.S. 10, 13 (1994). See also NLRB v. Amax Coal Co., 453 U.S. 322, 329 (1981)
            ("Where Congress uses terms that have accumulated settled meaning under either equity or the
            common law, a court must infer, unless the statute otherwise dictates, that Congress means to
            incorporate the established meaning of these terms."); Morissette v. United States, 342 U.S. 246,
            263 (1952) ("[W]here Congress borrows terms of art ill which are accumulated the legal tradition
            and meaning of centuries of practice, it presumably knows and adopts the cluster of ideas that
            were attached to each borrowed word in the body of learning from which it was taken and the
            meaning its use will convey to the judicial mind unless otherwise instructed. In such case,
            absence of contrary direction may be taken as satisfaction with widely accepted definitions, not
            as a departure from them."). It is also well established that courts "construe a regulation in the
            same manner as ... a statute," Tesoro Hawaii Corp. v. United States, 405 F.3d 1339, 1346 (Fed.
            Cir. 2005), and will thus "accord[] words used in the regulations their 'ordinary and common
            meaning' unless a definition is provided." Adair v. United States, 70 Fed. Cl. 65, 70 (Fed. Cl.
            2006).

                    The 1985A Trust, which is governed by Nebraska law, transferred legal title in the loans
            to the Purchasing Trusts. The majority of the Purchasing Trusts are also governed by Nebraska
            law; those that are not are governed by Minnesota law. Not surprisingly, each of the relevant
            states defines the term "sale" similarly. According to the Nebraska Supreme Court, "[t]he term
            'sale' ordinarily means a transmutation of property from one man to another in consideration of
            some price or recompense of value." Dial Realty, Inc. v. Cudahy Co., 254 N.W.2d 421, 423
            (Neb. 1977); see also Lucas v. County Recorder, 106 N.W. 217, 220 (Neb. 1905). The
            Minnesota courts have looked to standard dictionaries to define the term as "the 'exchange of

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           goods or services for an amount of money or its equivalent'" or "an 'exchange of property of any
           kind, or of services, for an agreed sum of money or other valuable consideration. '" Husbands v.
           City of Baudette, 2003 WL 22952754, at *4 (Minn. App. Ct. Dec. 16, 2003) (quoting THE
           AMERICAN HERITAGE DICTIONARY OF THE ENGLISH LANGUAGE 1591 (3d ed. 1992) and
           WEBSTER'S NEW WORLD DICTIONARY 1255-56 (2d College ed. 1980»; Knese v. Heidgerken,.
           358 N.W.2d 177, 179 (Minn. Ct. App. 1984) (defining "sale" as "a bargained-for exchange").
           See also BLACK'S LAW DICTIONARY (8th ed. 2004) (defIning sale as "[t]he transfer of property
           or title for a price"). Under each of these definitions, the transfer of a loan's legal title by the
           1985A Trust to another trust in exchange for value constitutes a "sale."

                     The conclusion that these transfers were sales is confIrmed by the Department's recently
            proposed regulations, which were promulgated to implement the reauthorization of the Higher
             Education Act in 2006. Those regulations clarify that "a loan is purchased" with funds obtained
             from tax-exempt obligations ''when the loan is refinanced in consideration of those funds," and
             explain that a loan is ''refinanced'' when it is released as collateral for one· obligation and pledged
             as collateral for another. 34 C.F.R. § 682.302(c)(5), (f)(3), 71 Fed. Reg. 45666, 45704-05 (Aug.
             9, 2006). The Department explained that the reason for this clarification was that "[c]urrent
             regulations do not incorporate ... the Department's longstanding interpretation of the statute and
             regulations as applicable to the treatment of loans acquired from tax-exempt funding sources
           . listed in the statute and in Sec. 682.302(c)(3)(i)." 71 Fed.Reg. 45680. Under this longstanding
             interpretation and the new regulations, a refinancing is treated as a sale that generates qualifying
             funds for purposes of § 682.302(c)(3)(i)(D). Because the loans at issue here were refinanced
             when they were released to the Purchasing Trusts, which then pledged them as collateral for
             taxable obligations, those transactions constitute sales.

                    B.      The Transfers From The 1985A Trust Constitute True Sales.

                    None of the fIve arguments contained in the Draft Report prevents the sales of loans by
            the 1985A Trust to the Purchasing Trusts from meeting the general requirements of "true sales"
            under ordinary commercial and property law principles. The transfers of loans by the 1985A
            Trust to the Purchasing Trusts were part of "securitization" transactions involving the Purchasing
            Trusts. In a securitization, assets (in this case loans) are pooled and used as collateral for debt or
            other securities issued to third parties .. It is critical for purposes of a securitization that the loans
            be transferred in a sale because the transfers are designed to remove the assets from the potential
            bankruptcy estate of the transferor of the loans.

                    For this reason, the question of what constitutes a sale has been addressed with particular
            rigor in the context of securitizations. Law fInns regularly provide legal opinions to the effect
            that a particular transfer of loans is a sale, and bankruptcy court decisions have affirmed sales
            made in securitization transactions. Courts addressing the "true sale" issue in the securitization
            context typically employ a multi-factor test The factors they consider include the sufficiency of
            the consideration paid in exchange for the assets; the intent of the parties to the transaction; how
            the .parties described the transaction between themselves and to third parties; whether the
            consideration paid changed after the transfer; whether the transferor bore the risk of loss or
            default by the underlying borrower; whether the transferor had the right to reacquire the property
            transferred; and whether the transferor retained the burden of servicing the loans. See generally
            1 Jason H.P. Kravitt, SECURITIZATION OF FINANCIAL ASSETS § 5.03 (2d ed. 2005 Supp.); Thomas

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           E. Plank, The True Sale of Loans and the Role of Recourse, 14 GEO. MASON U. L. REv. 287
           (1992); see also In re Kassuba, 562 F.2d 511 (7th Cir. 1977); Major's Furniture Mart, Inc. v.
           Castle Credit Corp., 602 F.2d 538 (3d Cir. 1979).

                  Applying these well-established standards under existing law, the sales of loans by the
           1985A Trust to the various Purchasing Trusts were true sales for 'commercial and property law
           purposes. The Purchasing Trusts gave reasonably equivalent consideration for the loans, paying
           a purchase price equal to the loans' outstanding principal and accrued interest as of the sale date.
           The sales were recorded as sales at the trust level and documented accordingly in, for example,
           releases from the trustee, funds transfer records, and loan transfer records. See Ex. 2.
           Furthermore, no agreement exists whereby the purchase price may be adjusted if collections on
           the loans exceed or fall below expectations. Thus, neither the form nor the amount of
           consideration paid ever changed after any of these loans was transferred.

                   The Draft Report confuses the sale issue by focusing (at 9) on whether Nelnet had control
           over trust transactions and authority to direct the trustees because its indirect subsidiary NELF is
           the beneficiary of the 1985A Trust and the Purchaser Trusts. The pertinent question for
           determining whether these loan transfers were sales is not whether Nelnet as parent controlled
           the common beneficiary and thus the trusts, but instead whether the 1985A Trust as seller
           controlled the Purchasing Trusts with respect to the transferred loans. Indeed, the Draft Report's
           focus on common parentage cannot· be correct because it is well established that common
           ownership or control does not deprive sales between related entities of commercial effect.

                   Here, the 1985A Trust had no control over the Purchasing Trusts with respect to the
           transferred loans. Contrary to the Draft Report's position (at 9), the 1985A Trust retained no
           right to revoke the transfers after sale of the loans and in fact no rights of any kind in the loans.
           Instead, the Purchasing Trusts gained the rights to all benefits of ownership of the transferred
           loans upon consummation of the transfers, and they then pledged those loans as collateral subject
           to no other liens or security interests. The 1985A Trust was entitled to none of the interest or
           principal payments, special allowance payments, guarantor payments, or any other form of
           income from the transferred loans upon their sale. Following transfer, all future activities with
           respect to a transferred loan were reflected on the books and records of the Purchasing Trust
           effective as of the date of transfer. Nor was there any agreement between the 1985A Trust and
           any of the Purchasing Trusts whereby, in the event of insolvency of the 1985A Trust, the
           relationship between it and any of the Purchasing Trusts would change with respect to any of the
           student loans.

                   Similarly, the 1985A Trust did not retain any liabilities with respect to the transferred
           loans. No recourse rights were granted by the 1985A Trust to the purchasing trusts, and the
           purchasing trusts assumed all risks associated with a borrower's default on the underlying
           transferred loans. No loss arising from default of a borrower on any of the transferred loans was
           ever recognized by the 1985A Trust after transfer.

                   Servicing of the loans purchased from the 1985A Trust was conducted by a servicer
            pursuant to a separate servicing agreement relating to the indenture or credit facility for the
            applicable Purchasing Trusts. Servicing fees for the servicing of such transferred loans were no
            longer paid by the 1985A Trust following transfer, and all such servicing fees from the date of

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           transfer forward were paid pursuant to the indenture or credit facility relating to the applicable
           Purchasing Trust.

                   Finally, in keeping with the other "true sale" indicia, Nelnet, in its internal description of
           the loan transactions, consistently referred to them as sales and treated those transactions as
           sales. See, e.g., Ex. 3, at 1 (internal Nelnet memorandum expressly stating intention that the
           loans "sold" into the 1985A Trust thereafter be "sold" to the taxable bond transaction).
           Moreover, prior to each sale, a "loan list" was prepared that identified the specific loans that.
           were to be sold, the "Selling Lender" trust, the ''Buying Lender" trust, and the "sale date." See,
           e.g., Ex. 4.

                   The internationally recognized law firm of Mayer, Brown, Rowe & Maw LLP, through
           its senior partner Jason H.P. Kravitt, who is widely recognized as the pre-eminent national expert
           on true sales and is editor of SECURITIZATION OF FINANCIAL ASSETS (2d ed.), has undertaken an
           independent examination of the facts and law in this situation. Its opinion, issued as independent
           counsel and attached as Ex. 5, concludes that the transfers in question from the 1985A Trust to
           the five Purchasing Trusts constituted true sales. In reaching that conclusion, the Mayer Brown
           opinion applies a detailed analysis of the law on true sales to the process N elnet used to qualify
           loans for the 9.5% floor. A Mayer Brown opinion concluding that such transfers constituted true
           sales was also submitted previously in response to the DIG Exception Reports.

                   C.      The 1985A Trust And The Purchasing Trusts Are Discrete Legal Entities,
                           Distinct From Each Other And From Their Common Beneficiary.

                   The Draft Report does not dispute that legal title in the loans was transferred by one bona
           fide trust to another in exchange for value. Rather, it maintains (at 9) that a "sale" did not occur
           because the transfers "did not cause a change in the beneficial ownership of the loans." That
            argument appears to be based on a fundamental misunderstanding of trust law.

                    Duly established trusts, such as· those involved in the transactions at issue here, are
           .distinct legal entities. Accordingly, sales between separate trusts are precisely that, sales
            between separate trusts, regardless of the beneficiaries involved. In Nelnet's process, one trust
            gave another trust legal title to certain loans in exchange for reasonably equivalent value. The
            mere fact that the beneficiary of the 1985A Trust, NELF, was also the beneficiary of the trusts to
            which the loans were sold does not render those sales anything other than sales. The trust that
            relinquished legal title, the 1985A Trust, did so irrevocably; the trusts that acquired legal title did
            so without recourse to the 1985A Trust, even if the borrowers defaulted on those loans. Under
            these circumstances, the subject transactions were indeed "sales" within the meaning of
            § 682.302(c)(3)(i)(D). Again, the Draft Report confuses the sale issue by misdirecting its
            "control" analysis to the relationship between Nelnet and NELF rather than to the relationship
            between the transferor and transferee trusts.




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                          1.      The 1985A Trust and the Purchasing Trusts are duly established
                                  trusts.

                   Although the Draft Report does not suggest otherwise, it is worth noting that the 1985A
           Trust and the Purchasing Trusts are bona fide trusts duly established under the laws of their
           respective states.

                   The 1985A Trust is expressly governed by Nebraska law, which generally defines a trust
           as "a fiduciary relationship with respect to property, subjecting the person by whom the property
           is held to equitable duties to deal with the property for the benefit of another person" 0 'Connor
           v. Burns. Potter & Co., 36 N.W.2d 507,517 (Neb. 1949); Parker v. Bourke, 269 N.W. 102, 104
           (Neb. 1936). See also NEB. REv. STAT. § 30-3828 (listing requirements for creation of a trust);
           RESTATEMENT (THIRD) OF TRUSTS § 2 (2003) (defining trust); 1 SCOTT ON TRUSTS § 2.3, at 41
           (4th ed. 1987). In the 1985A Trust, NELF granted property to the named trustee, and set forth
           equitable and fiduciary duties of that trustee in dealing with such property for the benefit of
           NELF. Thus, the 1985A Trust is clearly a trust under Nebraska law.

                     The Purchasing Trusts are likewise duly established Trusts under the relevant state's
            laws. Two of the Purchasing Trusts are governed by Minnesota law; the other Purchasing Trusts
            are governed by Nebraska law. Minnesota defines a trust the same as Nebraska.,-as the grant of
           ·legal title in property to a fiduciary for the benefit of another. See, e.g., Schlug v. Michael, 245
            N.W.2d 587, 590 (Minn. 1976) (defining trust as "a fiduciary relationship with respect to
            property, subjecting the person by whom the title to the property is held to equitable duties to
            deal with the property for the benefit of another person, which arises as a result of a
            manifestation of an intention to create it") (citing RESTATEMENT (SECOND) OF TRUSTS § 2).
            When the Purchasing Trusts were created, NELF granted the trustee of each trust legal title to .
            specified loans to hold as trustee and fiduciary. Thus, the Purchasing Trusts, like the 1985A
            Trust, are properly established and fully cognizable trusts.

                           2.     Trusts are, as a matter of law, distinct from their beneficiaries and
                                  each other.

                   As noted above, the 1985A Trust was created under Nehraska law, as were a majority of
           the Purchasing Trusts, while the. Purchasing Trusts not fonned under Nebraska law were
           established under Minnesota law. It is well settled, in each of these jurisdictions, that a trust
           creates a separate legal entity distinct from its creator, its beneficiary, and all other entities. For
           example, according to the Nebraska Supreme Court:

                           Grantors of trusts create a legal entity separate and apart from
                           themselves. Except as the law may otherwise provide, such
                           grantors are not free to alternately embrace or disown their creation
                           as their individual interests may dictate at a particular moment. As
                           long as the trust exists, its separate nature must be respected.

            Payless Building Center, Inc. v. Wilmoth, 581 N.W.2d 420,423 (Neb. 1998). See also Nebraska
            Attorney General Opinion No. 96087 (December 20, 1996) ("trusts are recognized as separate



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           legal and administrative entities under the law"). 1 Similarly, under Minnesota law, "once a trust
           has been created, it becomes a legal entity unto itself and is subject to judicial supervision and
           scrutiny under established doctrines. of trust administration." Edmondson v. Edmondson, 226
           N.W.2d 615, 617 (Minn. 1975).

                   The 1985A Trust, the Purchasing Trusts, and their beneficiary, NELF, are not only
           distinct as a matter oflaw, but also distinct as a matter of fact. As cataloged above, see pages 7-
           8, supra, the trusts feature numerous indicia of independence, including creation by different
           instruments, maintenance of separate assets that are not commingled, and loans pledged under
           separate security arrangements with different creditors.

                   The fact that the same entity, Wells Fargo, serves as trustee for the transferring and
           purchasing trusts is immaterial. The trustee's powers and duties are defined in the respective
           trust agreements, and the trustee has a separate duty of loyalty and fairness to each trust that it
           serves. The mere fact that the same entity, NELF, is the beneficiary of the transferring and
           purchasing trusts is likewise immaterial. NELF has separate and distIDct rights and duties in
           each of the trusts of which it is a beneficiary. Applicable law provides that two trusts may
           engage in a transaction even where the trustee and the beneficiary of the first trust are,
           respectively, identical to the trustee and the beneficiary of the second trust. See, e.g., Neb. Rev.
           StaL § 30-3867(g)(3) (expressly authorizing "a transaction between a trust and another trust ...
           of which the trustee is· a fiduciary or in which a beneficiary has an interest"); Unifonn Trust
           Code § 802(h).

                   Furthermore, the documents creating the respective trusts provide that the assets of each
           are to be kept separate and apart pursuant to custodian agreements. Independent of the particular
           trust agreements, the law itself imposes upon the trustee the duty "not to mingle property held
           upon one trust with property held upon another trust, whether the two trusts are created by
           separate settlers or by the same settler." RESTATEMENT (SECOND) OF TRUSTS § 179 cmt. (c)
           (emphasis added); see also SCOTT ON TRUSTS § 1179.2, at 502 (4th ed. 1987). Hence,
           notwithstanding the fact that NELF was the beneficiary of each trust, the trustee would have
           violated both the respective trust agreements and its fiduciary duties had it commingled loans
           from the various trusts. Consequently, the only way in: which loans could properly be transferred
           from one trust to another was through a sale.

                   D.      Consistent With Applicable Trust Law, The Transfers To The Purchasing
                           Trusts Were Via Sales At A Reasonably Equivalent Price in Netted "Funds."

                   The law has long recognized the authority of a trustee for two trusts to sell property from
           one trust to the other at a fair or reasonably equivalent price. As noted by a leading treatise:
           "Where the same person is trustee under two separate trusts, a sale of property by himself as
           trustee to himself as trustee under the other trust cannot be set aside if the transaction was fair to
           both trusts." SCOTT ON TRUSTS § 170.16, at 381 (4th ed. 1987). Here, the trustee who engaged
           in the sales was Wells Fargo, a national bank subject to regulation by the Comptroller of the
           Currency. Under regulations promUlgated by the Comptroller, "[a] national bank may sell assets
           held by it as fiduciary in one account to itself as fiduciary in another account if the transaction is


                   Available at http://ago.nol.orgllocaVopinioniindex.html?topic=detailS&id=1929.
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           fair to both accounts and if such transaction is not prohibited by the terms of any governing
           instrument or by local law." 12 C.F.R. § 9.12(d). See also Neb. Rev. Stat. § 30-3867(g)(3)
           (noting that a transaction between trusts with common trustees is permissible if it is "fair to the
           beneficiaries").

                   In Nelnet's process, the Purchasing Trusts bought loans from the 1985A Trust for a
           purchase price consisting of consideration of reasonably equivalent value. The loans were priced
           at their outstanding principal plus accrued interest. Because the transactions at issue were sales
           in exchange for a reasonably equivalent (and therefore fair) value, they comported with the
           applicable trust agreements and governing law discussed above. Nothing in the governing law
           described in Part Ill.A. above required the loans to be priced at their precise market value, or
           indeed at any particular value, for the transaction to constitute a sale. The Draft Report fails to
           acknowledge it is standard in the context of true sales in asset-backed securitization for loans to
           be sold at a purchase price equal to the outstanding principal and accrued interest.

                     Moreover, the purchase price that the 1985A Trust obtained from the sale of its loans was
             paid in "funds" within the meaning of 34 C.F.R. § 682.302(c)(3)(i). Funds to be paid by the
             Purchasing Trusts to (and to be received by) the 1985A Trust in payment of the purchase price
             were simply applied to (and netted against) funds to be paid by the 1985A Trust in its
           . contemporaneous purchase of loans. Thus, although the Purchasing Trusts did not physically
             deliver·cash to the 1985A Trust, the Pur-ehasing Trusts did pay funds over to the 1985A Trust by
             applying such funds to reduce amounts that were to be paid simultaneously by the 1985A Trust
             to the Purchasing Trusts. The fact that the dollar amounts of these purchases and sales were
             netted does not mean that "funds" were not paid by the Purchasing Trusts. As the attached
             Mayer Brown opinion explains, such netting is a common and acceptable means of funding
             purchase and sale transactions. It would be completely unreasonable to insist that offsetting
             funds be physically "moved from one trust estate to the other," as the Draft Report suggests (at
             8), in order to be deemed funds.

                     Even if it were construed that the 1985A Trust received some of the purchase price in the
             form of other loans rather than cash, the common-law meaning of the term "funds" includes
             securities and other evidences of debt. -E.g., Salter v. Salter, 155 N.E.2d 430, 432 (Mass. 1959)
             (funds ordinarily is ''used to describe an accumulation of money or collection of securities set
             apart and held for a definite purpose"); Williams v. Best, 142 S.E. 2, 4 (N.C. 1928) ("money,
             securities, and other· evidences of debt; .. fall[) within the accepted ·definition of the word
             'funds"'); see also BLACK'S LAW DICTIONARY 697 (8th ed. 2004) (plural term funds includes not
             only ''money'' but "other assets, such as stocks, bonds, or working capital, available to pay debts,
             expenses, and the like"). The Deparbnent's new interim final regulations confirm that the
             physical movement of cash is not required in order to purchase a loan with "funds." 34 C.F .R.
           . § 682.302(c)(5) (2006) ("a loan is purchased with funds described in [paragraph (c)(3)] when the
             loan is refinanced in consideration of those funds.").

                    Finally, the Department engages in netting every quarter with holders of loans, as the
            Department nets special allowance payments it owes lenders against amounts that the lenders are
            required to pay the Department. If the Draft Report's novel interpretation were adopted now, it
            would result in lenders being deemed not to have received funds from such netting, and the
            netting payments could not be utilized to purchase or make new loans that would be eligible for

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           the 9.5% floor. Yet netting is a well-established, common student loan industry and finance
           industry practice, recognized as appropriate - and utilized - by the Department.

                   E.      The Accounting And Tax Defmitions Of "Sale" Do Not Apply.

                    The Draft Report also asserts (at 9) that the transfers ofloans by the 1985A Trust to the
           Purchasing Trusts "do not meet the criteria to be accounted for as sales" under FAS 140 or
           federal income tax law. Yet it offers no explanation as to why accounting or income tax
           standards are relevant in the very different property and commercial law context. Nothing in the
           Higher Education Act or its implementing regulations warrants their application to this case.
           The definition of "sale" for purposes of § 682.302(c)(3)(i)(D) is properly determined by
           reference to its plain commercial and property law meaning, not by reference to the specialized
           and complex rules relating to accounting and tax sales. See Shabani, 513 U.S. at 13; Tesoro, 405
           F.3d at1346; Adair, 70 Fed. Cl. at 70. Such accounting and tax rules often relate to balance sheet
           performance and income recognition to gauge the financial health of a company, not to whether
           title to an item has passed from a seller to a buyer under commercial and property law principles.
           In particular, FAS 140 contains provisions unique to accounting standards that are skewed
           toward avoiding the removal of assets from the balance sheet for accounting purposes in
           instances where affiliates transfer assets to each other. In addition, with respect to tax rules, it is
           common in consolidated group tax returns for transfers that otherwise constitute "true sales" for
           legal purposes to be treated as other than sales for tax purposes. .

                  Nevertheless, if Nelnet were to assume that FAS 140 applies in this situation, it would
           consider its application at the trust level. Based on a review of the provisions of FAS 140 and
           preliminary discussions with Nelnet's independent auditors, Nelnet is confident that the loan
           sales would be treated as sales when accounting for and reporting those transactions at the
           individual trust level.

                  The specific issue with respect to FAS 140 raised in the Draft Report concerns whether
           there was a surrender of control, which is governed by paragraph 9(c) ofFAS 140:

                           The transferor has surrendered control over transferred assets if ...
                           the transferor does not maintain effective control over the
                           transferred assets through either (1) an agreement that both entitles
                           and obligates the transferor to repurchase or redeem them before
                           their maturity ... or (2) the ability to unilaterally cause the holder
                           to return specific assets, other than through a cleanup call ....

                   Here, the 1985A Trust (as transferor) did not maintain any control over the loans after
           they were sold from the trust and no longer pledged as collateral for the bonds. Upon sale, the
           loans transferred from the 1985A Trust were all released from the indenture and related security
           interest created under that selling trust, thus placing those loans beyond the reach of the 1985A
           Trust and its creditors. Nothing in any agreement between the 1985A Trust and the Purchasing
           Trusts permits revocation of the sale of any of the loans. There is no contractual restraint on the
           Purchasing Trusts' right to pledge the loans purchased by them; indeed, in each ofthe documents
           creating the Purchasing Trusts, the purchased loans are pledged as collateral and first security
           interests are granted, subject to no other liens or security interests. There are no provisions

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           whereby the 1985A Trust as transferor can require the repurchase of any of the loans sold under
           any terms. Thus, although the standard set forth in FAS 140 is irrelevant to the eligibility of
           Nelnet's portfolio for the 9.5% floor, that standard is nevertheless met at the trust level.

                                                  * * * * *
                   In sum, the transactions characterized by the OIG as mere "internal transfers"-i.e., the
           transfer of loans from the 1985A Trust to the Purchasing Trusts in exchange for the loans'
           reasonably equivalent market value--were in fact "sales" within the meaning of
           § 682.302(c)(3)(i)(D). Thus, even if subsection (D) were the only regulatory provision on which
           Nelnet relies, it would be sufficient to make the loans at issue eligible for the 9.5% floor.

           IV.    LOANS PURCHASED WITH THIRD GENERATION PROCEEDS OF A TAX­
                  EXEMPT OBLIGATION QUALIFY FOR THE 9.5% SPECIAL ALLOWANCE
                  RATE.

                   The Draft Report asserts that even if the loan transfers in question were sales, loans that
           the 1985A Trust purchased with third generation proceeds of a tax-exempt obligation-i.e.,
           funds obtained from the sale of a loan that was itself purchased with funds obtained from the sale
           of a lo.an that had been made Or purchased. with the proceeds of a tax-exempt obligation
           originally issued before October 1, 1993-are.ineligible for the 9.5% floor, .A~rding t9 the
           Draft Report (at 9), funds obtained from later generation sales are not eligible sources under 34
           C.F.R. § 682.302(c)(3)(i)(D) because "eligible funds only result from the sale of a loan that is
           made or purchased with funds obtained by the holder from the issuance of tax-exempt
           obligations." As explained below, the Draft Report's view that third generation proceeds are
           ineligible for the 9.5% floor is incorrect in light of well-established law, departmental
           pronouncements, and the relevant regulatory history.

                   The Draft Report also contends (at 8) that the loan records reviewed by the OIG during
           .its audit "did not readily identify the loans' funding sources as des.cribed in 34 C.F.R.
            § 682.302(c)(3)(i)." In fact, as further explained below, Nelnet's records comply with all
            applicable regulations and allow an auditor to detennine whether a particular loan is eligible for
            the 9.5% floor.

                   A.     Third Generation Proceeds Are A Qualifying Source Of Funds Under 34
                          C.F.R. § 682.302(c)(3)(i).

                   A loan qualifies for the 9.5% floor under § 682.302(c)(3)(i)(A) if it was purchased with
           funds obtained from "[t]he proceeds of tax-exempt obligations originally issued prior to October
           1, 1993." Similarly, a loan qualifies for the 9.5% floor under 34 C.F.R. § 682.302(c)(3)(i)(D) if
           it was purchased with funds obtained from "[t]he sale of a loan that was made or purchased with
           funds obtained ... from" a tax-exempt obligation issued prior to October 1, 1993. In concluding
           that loans purchased with third generation proceeds (or later) do not qualify for the 9.5% floor
           under subsections (A) or (D), the Draft Report makes two errors. First, it misconstrues the term
           "proceeds't of an obligation to exclude proceeds derived from proceeds. Second, it implicitly
           and impermissibly amends subsection (D) to insert the word "originally" so that only loans
           acquired with funds from the sale of a loan "made or purchased with funds originally obtained"

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           from a preMOctober 1, 1993, tax-exempt obligation qualify for the 9.5% special allowance rate.
           These two errors must be corrected, and with such corrections the Draft Report's conclusions
           cannot stand.

                          1.      Third generation proceeds constitute "proceeds" under 34 C.F.R.
                                  § 682.302(c)(3)(i)(A).

                   The Draft Report focused exclusively on whether the funds used to purchase loans billed
           under the 9.5% floor qualified as funds obtained from the sale of loans under 34 C.F.R. §
           682.302(c)(3)(i)(D). Yet § 682.302(c)(3)(i)(A) provides that eligible loans also may be acquired
           with funds obtained from "[t]he proceeds of tax-exempt obligations originally issued prior to
           October I, 1993." Neither the Higher Education Act nor its implementing regulations define the
           term ''proceeds.'' Therefore, the term must be given its ordinary meaning. See, e.g., Martin v.
           Alamo Community College Dist., 353 F.3d 409, 412 (5th Cjr. 2003) ("[w]hen the applicable
           statute or regulation has left a word undefined, 'the most basic principle of statutory construction
           requires us to give that word its ordinary meaning"); Adair, 70 Fed. Cl. at 70 ("the court
           'ascertain[s] the plain meaning' of the regulations by according words used in the regulations
           their 'ordinary and common meaning' unless a definition is provided").

                   In ordinary legal usage, the term ''proceeds'' encompasses proceeds of proceeds. The·
           UCC as adopted in Nebraska makes clear that "proceeds" include ''whatever is acquired upon the
           sale, lease, license, exchange, or other disposition of collateral." Neb. Rev. Stat. V.C.C. § 9-
           102(a)(64)(A). The accompanying commentary makes clear that the idea ''that proceeds of
           proceeds are themselves proceeds" is "expressed in the revised definition of 'collateral' in
           section 9-102." Id. cmt. c. 2 Indeed, numerous courts have expressly recognized that "[t]he term
           'proceeds' includes proceeds of proceeds." Bank of California v. Thornton-Blue Pacific, Inc., 62
           Cal. Rptr. 2d 90,94 nA (Cal. Ct. App. 1997); see, e.g., In re Tri-State Equipment, Inc., 792 F.2d
           967, 969 (10th Cir. 1986) (applying identical VCC provision as that enacted in Nebraska and
           concluding that "[p]roceeds will include proceeds of proceeds.").

                   Because proceeds of proceeds (i.e., second generation proceeds) are "proceeds," proceeds
           of proceeds of proceeds (i.e., third generation proceeds) are·a1so ''proceeds.'' See, e.g., In re
           Placid Oil, 102 B.R. 538, 541-42 (Bankr. N.D. Tex. 1988) (granting lien where creditor claimed
           security interest in "proceeds of proceeds of proceeds"). Indeed, given the ''undeniable fact that
           under the Uniform Commercial Code . . . second generation proceeds of liened proceeds are
           merely 'proceeds of proceeds,'" "'[t]here is no limit on the number of steps through which the
           creditor can follow the collateral as long as it is possible to trace from one step to another.'" In
           re Package Design & Supply Co., 217 B.R. 422, 423 & n.3 (W.D.N.Y. 1998) (quoting 9
           ANDERSON ON THE UNIFORM COMMERCIAL CODE § 9 306:63, at 275 & n.253 (3d ed. 1994». In
                                                                    M




           other words, proceeds of proceeds remain proceeds, no matter how many intervening
           transactions have occurred.

                  Thus, the proceeds that the 1985A Trust received when it sold loans that had been
           purchased with the proceeds of earlier loan sales were just as much proceeds of the trust's tax        M




                  As defined in the Nebraska vee, collateral "means the property subject to a security interest"
           and expressly includes "proceeds to which a security interest attaches." Neb. Rev. Stat. § 9-102(a)(12).
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           exempt bonds as were the proceeds of the initial loan sale. Because they were acquired with
           funds from "the proceeds of tax-exempt obligations originally issued prior to October 1, 1993,"
           loans that were acquired by the 1985A Trust with third and subsequent generation proceeds are
           loans acquired with qualifying funds under 34 C.F.R. § 682.302(c)(3)(i)(A). As such, they are
           entitled to the 9.5% special allowance rate irrespective of whether a sale occmred. under
           subsection (D).

                   In summary, the plain and ordinary meaning of proceeds should be adopted. Indeed,
           prior to the Draft Report, no person in the Department, the student loan industry, or the tax­
           exempt bond markets has ever contemplated that loans financed by a pre-1993 tax-exempt
           obligation would somehow fail to qualify for the 9.5% rate due to some earlier loan sales. It is
           commonly understood that the underlying loan portfolios in a 30-year bond estate may tum over
           several times. If the Draft Report's interpretation were to be adopted, unintended results
           impacting tax-exempt financings all the way back to the 1980s would follow. All the holders
           and lenders that purchased loans with special allowance payments, payoffs; interest paYments,
           guarantee payments, recycled funds, and sale proceeds of later generation loans that had been
           placed into their tax-exempt financings would now be told that their billings for special
           allowance at the 9.5% minimum rate were incorrect over the prior decades. This unprecedented
           interpretation would impermissibly apply on a retroactive basis, notwithstanding the fact that the
           student loan industry had relied upon existing authoritative interpretations which are directly in
           conflict with -the -Draft Report's new position... The Draft Report's interpretation-fails- to
           acknowledge the fact that Congress has already addressed the issue via legislation in the
           Taxpayer-Teacher Protection Act and the Higher Education Reauthorization Act. Adopting the
           Draft Report's unprecedented and unduly restrictive interpretation of qualifying proceeds would
           have significant and far-reaching and industry-wide impact upon student loan providers using
           tax-exempt financing.          .

                  The Department has already furnished guidance on a similar issue raised in the New
           Mexico Educational Assistance Foundation audit, where the OIG found that refundings of pre­
           October 1, 1993 tax-exempt obligations did not qualify as proceeds of those obligations. The
           Department correctly rejected -this finding~ thus confinning that proceeds of proceeds are still
           qualifying sources of funds~                  .

                          2.      A loan acquired with third generation proceeds also qualifies for the
                                  9.5% floor under 34 C.F.R. § 682.302(c)(3)(i)(D).

                   It is black-letter law that a regulation, like a statute, is to be construed as written. See
           Wronke v. Marsh, 787 F.2d 1569, 1574 (Fed.Cir. 1986) ("As in the interpretation of statutes, ...
           we begin, as we must. with the plain language of the regulation"); see also Laird v. Redwood
           Trust LLC, 392 F.3d 661, 668 (4th Cir. 2004) (Duncan, J., dissenting) ("As with the
           interpretation of statutes, our interpretation of regulations begins with their text"); Wilson v. U.S.
           Parole Comm 'n, 193 F.3d 195, 197 (3d Cir. 1999) ("Our starting point on any question
           concerning the application of a regulation is its particular written text"); Sierra Club v. Sigler,
           695 F.2d 957, 973 (5th Cir. 1983) ("interpretation of an administrative regulation must begin
           with its text"). Here, the text of the governing regulation expressly states that loans purchased
           with funds obtained from "[t]he sale of a loan that was made or purchased with funds obtained


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           · .. from" a tax-exempt obligation issued prior to October 1, 1993 are eligible for the 9.5% floor.
           34 C.F.R. § 682.302(c)(3)(i)(D).

                   Nothing in the regulation's plain text suggests that, to qualify under this provision, the
           funds must have been obtained from the sale of a loan that was ''made or purchased with funds
           originally obtained" from a pre·October 1, 1993 tax·exempt obligation. The Department could
           have drafted the regulation that way had it so intended, but it did not. Indeed, a related
           subsection, 682.302(c)(3)(i)(A), shows that the Department affumatively used the word
           "originally" when it wished to limit the range of qualifying funds. See id. (defining qualifying
           funds to include those obtained from "[t]he proceeds oftax·exempt obligations originally issued
           prior to October 1, 1993") (emphasis added). The fact that subsection (D), in contrast to
           subsection (A), specifically omits the limiting term "originally" prohibits reading subsection (D)
           to include that term. See United States v. Hohn, 482 U.S. 64, 71 (1987). Accordingly, the Draft
           Report is mistaken in assuming that only loans acquired with second generation p)."oceeds:-i.e., .
           with funds from the sale of a loan "made or purchased with funds originally obtained" from a
           pre·October 1, 1993, tax-exempt obUgation-qualify for the 9.5% floor under subsection (D).

                     B.   The Department's Authoritative Interpretation And Public Guidance
                          Confrrm That Nelnet's Loans Were Entitled To The Special Allowance Rate.

                           1.     The governing regulation and a Dear Colleague- Letter established the
                                  rules on eligibility for the 9.5% floor.
                  As explained above, under the plain meaning of the applicable statute and regulations,
           Nelnet's loans qualified for the 9.5% floor. The Department's own authoritative interpretation
           and public guidance support that conclusion.

                   In February 1993, 34 C.F.R. § 682.302(e)(2) jnitially established the rule that a loan.
           subject to the 9.5% floor does not lose the minimum special allowance rate even if the loan is
           transferred from a tax-exempt financing to a taxable financing. In March 1996, the Department.
           authoritatively confinned that 9.5% loans could be transferred to taxable vehicles without losing
           their 9.5% status so long as the original tax· exempt obligation with which they were associated
           remained effective. Specifically, the Department interpreted § 682.302(e)(2) in a Dear
           Colleague Letter (DCL 96-1-186) (the "1996 Dear Colleague Letter"), explaining:

                           Under the regulations, if a loan made or acquired with the proceeds
                           of a 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 originaltaxMexempt obligation is
                           retired or defeased, special allowance is paid based on the rules
                           applicable to the new funding source (taxable or tax-exempt).

            Ex. 1.



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                          2.     The Department is bound by these rules.

                   In its regulation and the 1996 Dear Colleague Letter, the previous administration
           unambiguously mandated that a lender following the process used by Nelnet can claim only the
           one-half special allowance rate (subject to the 9.5% floor). If the Department wishes to change
           these rules, it may do so only through. notice and comment rulemaIqng under the Administrative
           Procedure Act and negotiated rulemaking under the Higher Education Act. 5 U.S.C. § 551 et
           seq.; 20 U.S.C. § 1098a; see Alaska Pro!'l Hunters Ass 'n" Inc. v. FFA, 177 F.3d 1030, 1033·34
           (D.C. Cir. 1999) ("Once an agency gives its regulation an interpretation, it can only change that
           interpretation as it would formally modify the regulation itself: through the process of notice and
           comment rulemaking." (quoting Paralyzed Veterans of Am. v. D.C. Arena, 117 F.3d 579, 586
           (D.C. Cir. 1997».

                   No such rulemaking procedure has occurred with respect to the 9.5% floor. Although.
           Congress enacted legislation prospectively eliminating the ability to qualify new loans for the
           9.5% floor in the Taxpayer·Teacher Protection Act of 2004, Congress never passed any
           legislation eliminating pre·existing eligibility for the 9.5% floor. Moreover, the current
           administration has consistently acknowledged that it is bound by the regulation and the 1996
           Dear Colleague Letter, notwithstanding its dislike of the payments those rules require in the
           current low interest rate environment. The then· Assistant Secretary of Education, in .response to
           a draft of a' GAO report on the 9.5% floor, gave a detailed analysis of why the Department could
           not act on the GAO's recommendation to prospectively scale back eligibility for the 9.5% floor
           for Nelnet and other lenders:

                          Th[e] [GAO] study reports the recent increases in the
                          Departriient's Special allowance payments to lenders and other loan
                          holders on student loans financed with tax.exenipt securities, i.e.
                          "9.5 percent loans," and describes three strategies employed by
                          such lenders and loan holders to maintain and even increase their
                          9.5 percent loan portfolios.        The report recommends the
                          Department change, through rulemaking, its current interpretation
                          of the provision in the Higher Education Act of 1965, as amended
                          (HEA), that governs eligibility for the special subsidy for 9.5
                          percent loans.

                          The Department believes that these special allowance payments
                          should be scaled back considerably, and, as you noted, the
                          President proposed this in his fiscal year 2005 budget request. Last
                          year the Department considered undertaking the process to issue
                          new regulations or to reverse the Clinton Administration's
                          regulatory interpretation. However, we quickly realized that doing
                          so would have resulted in the new policy becoming effective no
                          sooner than July 2005-long after we expected the HEA to be
                          amended to address the issue. This is so because of certain
                          requirements in the HEA and other applicable laws.



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           Ex. 6, at 1. The then-Assistant Secretary went on to explain that "the Department
           believes negotiated rulemaking is required for changes of regulatory interpretation, like
           changes to the 1996 interpretation at issue here." Id. at 2.

                   Secretary of Education Rod Paige reiterated that the Department's hands were tied by the
           prior administration's authoritative pronouncements. A joint letter from Secretary Paige and the
           then-Director of the Office of Management and Budget to the Chairman of the House Committee
           on Education and Workforce acknowledged that 9.5% floor payments "to Nelnet and other
           lenders, "which are made pursuant to a regulatory interpretation by the prior administration, have
           increased significantly." Ex. 7. The letter then explained that "[t]he most direct and expeditious
           path" to change the rule was "through legislation." The Secretary further explained that
           "[b]ecause the current Higher Education Act (HEA) provisions that govern rulemaking prevent
           the Secretary of Education from immediately stopping these payments, the administration urges
           the Congress to enact legislation" ending the ability to qualify new loans for the 9.5% minimum
           rate. Ex. 7.

                   In a press release issued by Secretary Paige on October 7, 2004, he stated that "[d]espite
           partisan fmger pointing to the contrary, the [ability to qualify new loans for the 9.5% floor] ...
           was not the making of this administration. It came about 8 years ago when the Clinton
           Administration interpreted an existing Department regulation. Federal courts in the District of
           Columbia have ruled that changes "in regulatory interpretations "reqUire using the standard
           rulemaking process." Ex. 8.

                   In response to questions from Senator Kennedy as to why the Department had not sought
           to recover 9.5% floor payments previously made to Nelnet and other lenders, Secretary Paige
           stated again that "[i]n March 1996, the prior administration issued an authoritative interpretation
           of Department regulations that provided 'if a loan made or acquired with the proceeds of a tax­
           exempt obligation is refinanced with the proceeds of a taxable obligation, the loan remains
           subject to the tax-exempt special allowance provisions.'" Ex. 9. Secretary Paige then explained
           in detail that the" law restricted the Department from reversing such an "authoritative
           interpretation" unless it adhered to the lengthy rulemaking process: "Although we would have
           preferred an even quicker fix" to end the ability to qualify loans for the 9.5% rate, other than new
           legislation, "some actions taken by the administration legally require notice to the public and an
           opportunity to comment pursuant to the Administrative Procedures Act (AP A)." Ex. 9.

                           3.     The Department's actions, guidance, and public statements confirm
                                  that these rules allowed Nelnet to qualify additional loans for the
                                  9.S% floor.

                    Notwithstanding that the Department under the current administration wished to end the
            ability to qualify additional loans for the 9.5% floor, it recognized that the regulations and the
            1996 Dear Colleague letter permitted that practice (at least until passage of the Taxpayer­
            Teacher Protection Act). Relying upon these established rules and the Department's statements,
            Nelnet obtained a series of legal opinions, beginning March 4, 2003, which affirmed that loans
            transferred from tax-exempt to taxable status would remain lawfully eligible for the 9.5% rate so
            long as the original tax-exempt obligation was not retired or defeased. These opinions were

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           authored by John E. Dean of Dean Blakey, a law finn specializing in student loan issues. See
           Ex. 10.

                   Although the Draft Report asserts that Nelnet received no formal approval from the
           Department for the process it followed to qualify loans for the 9.5% floor, the Department's
           actions and its guidance and public statements on the 9.5% floor support the conclusion that
           Nelnet's process would qualify additional loans. The history of the Department's approach to
           this issue is summarized below.

                     •    Nelnet has billed the Department, on a quarterly basis. for the 9.5% loans since
                          2003. The Department has paid all of Nelnet's bills without suggesting any
                          impropriety.

                      •   The Department expressly rejected a suggestion from its auditors that transferred
                          loans of the type at issue were ineligible for the 9.5% floor. The audit in question
                          concerned the Iowa Student Loan Liquidity Corporation ("ISLLC"). As Nelnet
                          would do in conjunction with its process, ISLLC had billed the Department at the
                          9.5% special allowance rate on loans transferred from a tax-exempt obligation to,
                          taxable obligations and on replacement loans subsequently acquired by the tax­
                          exempt obligation. The Department's field auditors objected, stating in their draft
                          report: '''The regulations do not penlrii"unlimited growth of tax-exempt funds by
                          transferring loans from one bond issue to another.... If a lender moves a loan
                          from a qualifying tax-exempt bond to a non-qualifying bond, it may continue to
                          bill the loan as a qualifying tax-exempt issue. However, this diminishes the
                          available qualifying funds in the original bond subject to the minimum special
                          allowance rate." Ex. 11. To our knowledge, the Department never adopted this
                          finding.

                      •   On May 29,2003, Nelnet sent a letter (with an accompanying process flow chart)
                          to the Department describing the entire process utilized by Nelnet to qualify loans
                          for the 9.5% floor-including how··it planned to bill the Department for such
                          loans-and asking for the Department's concurrence. Ex. 12. Specifically,
                          Nelnet's letter described how the 1985A Trust intended to purchase multiple
                          portfolios ofloans and then sell those portfolios into a taxable financing.

                      •   The Department's formal response took the form of a June 30, 2004 letter to
                          Nelnet's Paul Tone. It stated that the Department's regulations, as well as DeL
                          96-L-186, provided the necessary guidance. Ex. 13. The letter contained no
                          indication that Nelnefs treatment of the 1985A loans was in any way invalid and
                          reconfirmed the Department's adherence to the 1996 Dear Colleague Letter.

                      •   Secretary of Education Paige's characterization of the Department's response to
                          Nelnet in his November 18, 2004 letter to Senator Kennedy is enlightening. The
                          Secretary's letter was in response to Senator Kennedy's question why the
                          Department had not sought to recover the 9.5% floor payments from Nelnet. The
                          Secretary responded by explaining that "the Department implemented regulations,
                          and interpretations of those regulations, including an interpretation issued by the

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                         prior administration expressly permitting lenders to extend the excessive special
                         allowance payments indefinitely."

                     •   Meanwhile, Nelnet had voluntarily discontinued qualifying new loans for the
                         9.5% floor in May 2004, after ranking Republicans introduced a bill in the House
                         to prospectively eliminate the 9.5% floor provisions from the Higher Education
                         Act. That legislative initiative followed the acknowledgement that a change in
                         the law was the swiftest way to end the ability to qualify loans for the 9.5% floor
                         as provided in the regulations. See, e.g., Ex. 14 (Kennedy-Kildee letter).

                     •   In the then-Assistant Secretary of Education's September 14,2004 response to the
                         draft GAO report on student loan financing, the Department stated that only "a
                         change in the law" could preclude lenders from taking advantage of the 9.5%
                         opportunity. The letter explained that, under existing regulations, transferred
                         9.5% loans "retain that eligibil~ty as long as the tax-exempt bond whose proceeds
                         were used to make or purchase the loans remains open." Ex. 6.

                     •   On September 21, 2004, the GAO issued its final report. It not~ that, under
                         existing law and the Department's regulations, "loans that are financed with the
                         proceeds oftax-~xeWpt bonds ,issued prior to October 1, 1993 are guaranteed a
                         miniinum 9.5 percent yield." Ex. 15 at 2. The GAO recOgruzed that ''under
                         Education regulations, a lender can significantly increase its 9.5 percent loan
                         volume" by buying and selling loans inthe process utilized by Nelnet. ld. at 4. In
                         fact, the GAO noted "an increase in the volume of9.5 percent loans" due, at least
                         in part, to this process. ld. The diagram on page 32 of the GAO's report fully
                         illustrates the process engaged in by Nelnet and other lenders. The GAO
                         recommended prospectively eliminating the ability to qualify loans for the 9.5%
                         floor using this process and called for changing the law and regulations to do so.
                         ld. at 6 .

                     • ' Secretary of Education Paige also recOgnized the lawfulness of existing 9.5%
                         ,lending practices. He and the then-OMB Director sent a joint letter to the
                          Chairman of the House Committee on Education and the Workforce. The letter '
                          acknowledged that these payments were "made pursuant to a regulatory
                          interpretation by the prior administration," which "expressly permitted lenders to
                          extend these payments indefinitely." The letter urged Congress ''to enact
                          legislation" ending the practice "without delay." Ex. 7 (emphasis added).

                     •   The House approved the requested legislation on October 6, 2004, and the Senate
                         followed suit on October 9. The floor debate consistently recognized that the new
                         legislation was required to end lenders' admittedly lawful practices under the
                         9.5% loan program. As a primary sponsor of the House bill put it, "the loan
                         providers were told by the Clinton administration that it was perfectly legal and
                         legitimate."   Ex. 16 (Cong. Rec. H8320 (Oct. 6, 2004).            Senators also
                         acknowledged that actions had not yet been taken to end the law permitting such
                         practices. Ex. 17 (Cong. Rec. S10918 (Oct. 9, 2004). Hence, both Democratic


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                          and Republican administrations were as one when it came to recognizing that the
                          targeted 9.5% lending practices were legitimate under existing law.

                     •    hnmediately after passage of the House bill, Secretary Paige issued a press release
                          praising the bill and confinning that it would end the process to qualify loans
                          ''that allows lenders to receive special allowance payments on FFEL loans
                          permitting a return of9.5%." Ex. 8 (10/7/04 press release, emphasis added).

                     •    In fact, the Department has recognized that the Taxpayer-Teacher Protection Act
                          of 2004, signed by the President on October 30, 2004, had no retroactive effect.
                          A November 2004 Dear Colleague Letter from the then-Assistant Secretary of
                          Education stated expressly that loans "purchased with funds obtained by the
                          holder from collections or default reimbursements on, or interest or other income
                          pertaining to, eligible loans made or purchased with funds from the original pre­
                          October 1993 tax-exempt obligations or from income on the investment of such
                          funds would still receive a special allowance of not less than 9.5 percent minus
                          the applicable interest rate on such loans." Ex. 18 (emphasis added).

                     •    Following termination of the 9.5% student loan program, the Department
                          continued to recognize that 9.5% loan practices initiated prior to the effective date
                          of the new legislation, such as those utilized by N elnet, were valid. For example,
                          after OIG issued a report contending that 9.5% secondary market loans of the
                          New Mexico Educational Assistance Foundation (''NMEAF'') were unlawful, the
                          NMEAF sued to prevent enforcement of the audit findings, and the Department
                          publicly agreed that the NMEAF was right, leading the NMEAF to dismiss the
                          suit. Exs. 19-20. And in a November 18, 2004 letter to Sen. Kennedy, the
                          Department reaffirmed that, in DCL 96-L-186, "the prior administration issued an
                          authoritative interpretation of Department regulations that provided 'if a loan
                          made or acquired with the proceeds of a tax-exempt obligation is refinanced with
                          the proceeds of a taxable obligation, the loan remains subject to the tax-exempt
                          special allowance provisions!" Ex. 9 (Secretary Paige's 11118/04 letter).

                     .•   In an August 2005 audit, the Department found nothing improper with respect to
                          LoanSTAR Funding Group's 9.5% Loan billings, including its transfers of loans
                          tied to a tax-exempt financing instrument issued before October 1, 1993 to taxable
                          financing instruments, resulting in continued entitlement to the 9.5% floor. Ex.
                          21.

                      •   As recently as December 31, 2005, the Washington Post quoted the following
                          remarks by the then-Assistant Secretary of Education regarding the validity of the
                          9.5% floor payments to Nelnet and other lenders using similar practices: ''The
                          law is the law is the law . . .. What the law says is what you pay people. We
                          didn't make this stuff up. We may not like it, but we can't just unilaterally ignore
                          Congress. "

                      •   The OIG requested information with respect to oral conversations between Nelnet
                          personnel and Department officials, in which Nelnet's plans to qualify loans for

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                           the 9.5% floor and the relationship of the regulations and the 1996 Dear
                           Colleague Letter to those plans were discussed. Nelnet complied with this
                           request.

                    Given this history, most of which the Draft Report disregards, Nelnet had no reason to
            doubt that its practices with respect to 9.5% loans were entirely consistent with the law, the
            Department's regulations, and the Department's interpretation of those regulations. Indeed, there
            is no indication that anyone ever suggested, prior to the change in the law in late 2004, that the
            process followed by Nelnet would result in anything other than loans being eligible for the 9.5%
            floor. The Draft Report contends that the Department's "only written guidance specific" to
            Nelnet's process was its June 30 letter to Nelnet's Paul Tone, which "did not approve or
            disapprove" of Nelnet's practices, and that none of the additional communications referenced in
            Nelnet's June 30, 2004 letter constituted a "direct or explicit approval by the Department."
            Rather, according to the Draft Report, the Department "only referred Nelnet to existing
            authorities." But as explained above, those existing authorities approved 9.5% loan transfers
            from tax-exempt to taxable vehicles without ever suggesting that the Department would deem
            any such transfers, including multi-generational transfers, ineligible for the 9.5% floor.

                      The Draft Report also suggests that Nelnet's process "went beyond the scope of the
          .. "guidance in DCL 96-L-186," which "did not address the circumstances by"which a loan qualified
              for the 9.5 percent floor before being transferred." That is simply not the case. The DCL
              expressly stated that, if two conditions were satisfied, any loan "made or acquired with the
              proceeds of a tax-exempt obligation [that] is refinanced with the proceeds of a taxable
              obligation" would remain eligible for ''the tax-exempt special allowance provisions." Ex. 1. The
              two conditions were that the holder of the 9.5% loan retain a legal or equitable interest in the
              loan and that the original tax-exempt obligation not be retired or defeased. Nelnet's process
              satisfied both conditions, and the Draft Report does not suggest otherwise. There is no legal
             "basis for retroactively imposing new conditions now.

                    The substantial record of recognition by the Department, other Executive Branch
            officials, Congress, and infonned commentators that programs such as N~lnet' s were valid until
            Congress prospectively changed the law in October 2004 refutes any notion that Nelnet's 9.5%
            loan practices were inconsistent with the Department's guidance. The Draft Report not only
            disregards this record, but also fails to suggest any reason why Congress had to pass legislation
            to end these lending practices if such practices were already invalid. Perhaps the former
            Secretary of Education summed it up best when he stated that the process used by Nelnet and
            others to qualify loans for the 9.5% floor "was specifically endorsed by the prior administration
            and has been on the books/or close to a decade." Ex. 9 (emphasis added).

                           4.      The Draft Report's suggestion that Nelnet did not adequately disclose
                                   its process is inaccurate.

                    Implicitly recognizing that the Department did in fact authorize the 9.5% loan practices
            implemented by Nelnet, the Draft Report tries (at 7) to attribute that authorization to a lack of
            "comprehensive disclosure by Ne1net of the nature or effect" of its process. In particular,
            according to the Draft Report, Nelnet's May 29,2003 letter to the Department "did not identify
            the eligible source of funds that would be used to purchase and qualify loans for the 9.5 percent

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           floor, did not state directly that the process would be repeated many times, and did not state that
           the process would result in a substantial increase in the amount of loans billed under the 9.5
           percent floor." ld.

                   The Draft Report's first criticism is flatly inaccurate. Nelnet's May 29 letter did identify
           the eligible source of funds as purchases of "portfolios with funds obtained from proceeds of the
           tax exempt 1985 Indenture in a series of acquisitions." Ex. 12. The Draft Report's second and
           third points also are clearly inaccurate. Nelnet's May 29 letter expressly stated that ''the
           purchased loans will be held within the 1985 Indenture and financed by the tax exempt
           obligations issued by NELF under that financing" and "[t]hereafter ... will be refinanced and
           placed into financings which are taxable on a longer tenn basis." ld. Nelnet's detailed
           description of the 1985A Trust's intent to purchase and then refinance multiple loan ''portfolios''
           in a "series" of transactions disclosed that Nelnet's process contemplated repetition and would
           result in an increase of loans eligible for the 9.5% floor. In fact, Nelnet had reason to believe
           that the Department not only understood that its process would result in growth of 9.5% loans,
           but that it planned to analyze how this development might benefit the Department in the event of
           future interest rate increases. Accordingly, the Draft Report's suggestion that Nelnet was not
           forthcoming about its 9.5% loan program cannot be reconciled with the factual record and should
           be withdrawn.

                   Nelnet is unaware of any other participant in the entire education finance industry who
           proactively contacted the Department and walked through in detail the precise process it would
           use to quality loans for the 9.5% floor. In fact, Nelnet was one of the first in the industry to bring
           the prospect of ending this practice to the attention of the Department and Congressional leaders.
           Nelnet worked with the Department and Congress to draft and pass legislation to eliminate the
           ability of all education finance industry participants to qualify additional loans for the 9.5% floor
           and voluntarily discontinued such activity upon introduction of that legislation. Nelnet could
           have quietly qualified loans and collected the 9.5% floor without attracting attention. Instead, it
           sought guidance so that it would not be placed into its current predicament, and it sought to be a
           responsible industry participant pushing for responsible change.

                           5.      The regulatory history further refutes the Draft Report.

                    By focusing on the fact that the Nelnet transactions were ''repeated many times" (Draft
            Report at 7), the Draft Report may simply be reiterating its position that "later generation sales
            are not eligible sources" of 9.5% loans. That position not only is contrary to the applicable
            regulation's plain meaning (see Part IV.A., supra), but also is inconsistent with the regulation's
            history. The 9.5% floor was enacted in 1980 as part of a statutory reform meant to lower the
            subsidy paid to lenders financing student loans with tax-exempt bonds. In exchange for
            receiving only half of the otherwise applicable special allowance, lenders financing student loans
            with tax-exempt bonds were guaranteed a minimum return of 9.5%. See 20 U.S.C. §1087-
            1(b)(2)(B)(ii). In 1992, out of concern that lenders might transfer loans from tax-exempt to
            taxable obligations in times of rising interest rates and thereby regain the full special allowance,
            the Department issued 34 C.F.R. § 682.302(e). Under that provision, a loan originally financed
            with a tax-exempt obligation would remain subject to the reduced special allowance rate (and the
            9.5% floor) so long as the lender retained a legal or equitable interest in the loan, even if the loan
            were transferred (by sale or otherwise) to a taxable obligation. See DeL 96-L-186 (Ex. 1).

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                   It would have defeated the purpose of § 682.302(e) if a lender could have freed a loan
           from the reduced special allowance rate simply by selling it more than once. Indeed, if interest
           rates had remained high, the Department undoubtedly would have refused to pay more than half
           the regular special allowance on a loan originally financed from the proceeds of a tax-exempt
           obligation no matter how many times it was bought and sold. If the Draft Report's position­
           that a later generation loan is not subject to the provisions of § 682.302(c)-were correct, then
           § 682.302(e) could never have achieved the Department's stated goal; lenders would have been
           able to evade § 682.302(c) simply by reselling previously sold loans. Thus, the Draft Report's
           current view makes no sense in light of the history and purpose of§ 682.302(e).

                   Unintended results flowing from the Draft Report's finding are revealed when one
           considers that if prevailing interest rates had been at historic highs (instead of historic lows) over
           the past few years, such that Nelnet's 9.5% loans would have been subject to the one-half special
           allowapce penalty rate, the OIG would surely not be making the same arguments it makes now,
           and demanding to pay Nelnet the full special allowance rate. In such circumstances, it is
           unimaginable that a Draft Report would advance unprecedented and novel interpretations of the
           law, which are inconsistent with the established regulations and agency guidance that has been
           relied upon by industry participants for over a decade, in order to help a holder of loans receive
           the full special allowance rate rather than the half rate. Interest rates will certainly fluctuate over
           the life of a thirty year tax-exempt bond. The OIG has stepped in after a short peri~d of some of
           the lowest interest rates seen in history, and the OIG may regret its market-timed position if
           interest rates rise in the future. The arguments advanced in the Draft Report may inadvertently
           enable holders of loans to circumvent the one-half special allowance penalty rate as rates
           continue to swing higher. Such an outcome would fly in the face of the clear intent of the 1996
           Dear Colleague Letter.

                    Furthermore, the Department was aware that Nelnet and other lenders that had issued tax­
            exempt obligations· before October 1, ·1993 used third generation proceeds to acquire new loans
            which then became subject to § 682.302(c). The House Budget Committee also recognized the
            propriety of using proceeds to qualify additional generations of 9.5% loans, stating that "[i]n
            1996 the Clinton Administration issued another piece of administrative guidance that permitted
            loans to be transferred in and out of eligible bonds, allowing still more loans to become subject
            to the higher guaranteed rate ofretum." H. Rep. No. 109-276, at 218 (2005) (emphasis added).
            The GAO, too, explained that one of the ways a lender could legitimately increase its volume of
            9.5% loans was ''by issuing a taxable bond," then ''using the proceeds to purchase 9.5 percent
            loans financed by a pre-October 1, 1993 tax-exempt bond," and "then us[ing] the cash available
            from the pre-October 1, 1993 tax-exempt bond to make or buy additional loans, which are
            guaranteed the minimum 9.5 percent yield." GAO, Federal Family Education Loan Program,
            supra, at 4 (emphasis added). The GAO report even provided a circular diagram to portray this
            process, noting that a "[l]ender can continue to transfer so long as the pre 10/1/93 tax-exempt
            bond is not retired or defeased." Id. at 32 (emphasis added).

                    In short, the argument that Nelnet's loan transfers were invalid because such transfers
            were frequent and relied on multiple generations of proceeds is a red herring. Not only was the
            validity of the transactions not lost through repetition, but the regulations in fact contemplated
            that there would be repetition, and policy makers acknowledged that repetition was occurring.


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                                                     * * * * *
                    The preliminary finding of the Draft Report is contrary to existing law, regulation, and
           Departmental guidance. Legal and policy issues, taken in conjunction with the potential
           economic impact on Nelnet (at least according to the Draft Report's calculations),3 as well as the
           rest of the student loan industry, are sufficiently substantial to make "reasoned decisionmaking"
           critical in this matter. Motor Vehicle Mfrs. Ass 'n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29,
           52 (1983); Student Loan Mktg. Ass 'n v. Riley, 907 F. Supp. 464, 474-76 (D.D.C. 1995). It is not
           reasoned decisionmaking for. an agency to construe a statute or regulation inconsistently with its
           prior representations. City of Kansas City v. HUD, 923 F.2d 188, 192 (D.c. Cir. 1991); accord
           State Farm, 463 U.S. at 57. Nor is it reasoned decisionmaking for an agency to authorize (or
           even allow) a lender to make government-subsidized loans under a widely accepted construction
           of the agency's regulations that agency officials repeatedly promulgated, only to reverse course
           years later and say ''we want our subsidies back." The "reasonable decisionmaking" standard
           should be kept in mind as the propriety ofNelnet's 9.5% loans is evaluated.

                   C.      Nelnet's Records Are Sufficient.

                  Finally, the Draft Report intimates that Nelnet's loan records are inadequate under
           regulatory mandates. The oro made a similar finding in its ~udit of the New Mexico
           Educational Assistance Foundation, but its finding was rejected by the Department. Nelnet's
           records fulfill the record-keeping requirements of the applicable regulations and are sufficient to
           determine whether a loan qualifies for the 9.5% floor.

                   Lender recordkeeping requirements are found at 34 C.F.R. § 682.515, which states that
           lenders must maintain "current, complete, and accurate records of each loan that it holds,
           including but not limited to the records described in Section 682.414(a)(3)(ii)." There is no
           subsection (ii) of §' 682.414(a)(3); the cross-reference was apparently intended to be to
           § 682.414(a)(4)(ii), which lists certain records to be maintained by lenders. Nelnet has fully
           complied with the recordkeeping requirements of these provisions, which- do not impose any
           obligation to ''readily identify the loans' funding sources," as the Draft Report alleges (at 8).
           OIG's inference of such a requirement from the general obligation in § 6S2.414(a)(4)(ii)(L) to· .'
           retain records sufficient to "document .' .. the accuracy of reports submitted under this Part" is an
           unduly broad interpretation. But even ifthere were such a requirement, Nelnet has satisfied it, as
           shown below.

                    Section 682.515(a) provides:



                   Nelnet believes the Draft Report's calculations are fundamentally flawed because the asserted
           overpayment does not represent the difference between what Nelnet received and what it would have
           received absent availability of the 9.5% rate. Nelnet calculates that difference to be approximately $322.6
           million through June 30, 2006. Further, any attempt to quantify potential future overpayments is
           speculative in light of fluctuating interest rates and diminishing volumes of 9.5% loans due to payoffs and
           consolidations. Because Nelnet was not overpaid at all as demonstrated in this Memorandum, however, it
           would be premature to detail those flaws at this point. Nelnet reserves its right to challenge the asserted
           overpayment amount if and when it becomes appropriate to do so.
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                        (1) A lender shall maintain current, complete, and accurate records
                        of each loan that it holds, including, but not limited to, the records
                        described in§ 682.414(a)(3)(ii). The records must be maintained in
                        a system that allows ready identification of each loan's current
                        status.

                        (2) A lender shall retain the records required for each loan for not
                        less than five years following the date the loan is repaid in full by
                        the borrower or the lender is reimbursed on a claim. However, in
                        particular cases the Secretary may require the retention of records
                        beyond this minimum period.

                        (3)(i) The lender may store the records specified in
                        § 682.414(a)(3)(ii)(C)-(K) on microfilm, optical disk, or other
                        machine readable format.

                        (ii) The holder of the promissory note shall retain the original note
                        and repayment instrument until the loan is fully repaid. At that
                        time the holder shall return the original note and repayment
                        instrument to the borrower and retain copies for the prescribed
                        period.

                        (iii) The lender shall retain the original or a copy of the loan
                        application.

                 34 C.F.R. § 682.414(a)(4)(ii) provides:

                        (ii) The lender shall keep-

                        (A) A copy of the loan application if a separate application was
                        provided to the lender;

                        (B) A copy of the signed promissory note;

                        (C) The repayment schedule;

                        (D) A record of each disbursement ofloan proceeds;

                        (E) Notices of changes in a borrower's address and status as at least
                        a half-time student;

                        (F) Evidence of the borrower's eligibility for a deferment;

                        (0) The documents required for the exercise of forbearance;

                        (H) Documentation of the assignment of the loan;




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                         (I) A payment history showing the date and amount of each
                         payment received from or on behalf of the borrower, and the
                         amount of each payment that was attributed to principal, interest,
                         late charges, and other costs;

                         (J) A collection history showing the date and subject of each
                         communication between the lender and the borrower or endorser
                         relating to collection of a delinquent loan, each communication
                         other than regular reports by the lender showing that an account is
                         current, between the lender and a credit bureau regarding the loan,
                         each effort to locate a borrower whose address is unknown at any
                         time, and each request by the lender for default aversion assistance
                         on the loan;

                          (K) Documentation of any MPN confirmation process or
                          processes; and

                          (L) Any additional records that are necessary to document the
                          validity of a claim against the guarantee or the accuracy of reports
                          submitted under this part.

                   Nelnet's records satisfy each of these requirements and provide plentiful additional
           information. Whenever a loan was acquired by the 1985A Trust, it was contemporaneously
           recorded on a report listing the acquired loans. That report was furnished to the trustees of the
           1985A Trust and the applicable Purchasing Trusts. Each report expressly identifies the "Selling
           Lender" and references the selling lender's unique bond identification number. The report
           further identifies the "Buying Lender" and its own unique bond identification number. The
           "Sale Date" is also included in each report. The report also identifies each loan by the
           borrower's Social Security Number and includes additional detailed infonnation with respect to
           each loan, such as the principal balance, accrued and unpaid interest, accrued fees, and the
           identity of the loan's servicing agent. See, e.g., Ex. 4 (sample of such a detailed report). In
           addition to maintaining the detailed list of acquired loans, Nelnet generated transfer summaries
           that provided information with respect to ten or more transfers at a time. Those summaries
           identified the origin of the acquired loans, described the placement of the loans into the 1985A
           Trust, and contained aggregated data on outstanding principal and interest. See Ex. 22. Thus,
           Nelnefs records establish the date each loan went into an eligible bond and identify the number
           of that bond.

                   Furthermore, as described both in a summary prepared jointly by the OIG and Nelnet and
           in an internal Nelnet memorandum (see Exs. 23 & 3 ), Nelnet has established internal control
           procedures documented by, inter alia, written sale reports, Bond Transfer Logs, Detailed Trial
           Balance reports, loan sale summaries, preliminary status summary reports, certificates, and
           releases signed by the trustee. See, e.g., Exs. 2, 22, 24, & 25. Additionally, the interest accrual
           income, guarantor payments, special allowance payments, and borrower payments received by
           the 1985A Trust with respect to each eligible loan are documented in servicing reports. These
           control procedures, which adhere to the practices originally described to the Department,
           augment the loan sale documentation discussed above.

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                   Although the record-keeping provisions set forth in 34 C.F.R. § 682.515 do not require
           such information, Nelnet has-notwithstanding the Draft Report's suggestion to the contrary­
           maintained, and made available to the OIG, records identifying each loan's funding source. The
           relevant infonnation is clearly identified in the sales reports described above (Ex.. 26) and in the
           "Detailed Trial Balance," a sample of which is attached as Ex.. 25. The Detailed Trial Balance
           shows that the 1985A Trust bought loans with proceeds from sales of loans previously financed
           by the bonds issued by that Trust, and tracks the flow of funds from such sales. The
           documentation described above further establishes each loan's funding source. In a March 5,
           2005 audit report (at 13), which was issued following the Department's audit of Nelnet, the
           Department stated that Nelnet "currently retains sufficient backup documentation to validate the
           reports submitted to ED ...." Accordingly, the Draft Report's conclusion that Nelnet's loan
           records "did not readily identify the loans' funding sources" is incorrect

                                                    CONCLUSION

                  The loans acquired by the 1985A Trust were acquired with funds obtained from the
           "sale" of loans that had been acquired with the "proceeds" of a tax-exempt obligation.
           Therefore, the loans were obtained with qualifying funds from an eligible source as enumerated
           in 34 C.F.R. § 682.302(c)(3)(i), and, pursuant to 34 C.F.R. § 682.302(e)(2), remained eligible for
           the 9.5% special allowance rate after being sold to the Purchasing Trusts. Accordingly, the Draft
           Audit Report's finding and recommendations should be withdrawn.                          .




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