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There has been a growing literature of late discussing how higher education should be funded and by whom, and Benjamin Leff and Heather Hughes make an important contribution to this conversation. One of the key questions currently being debated is whether equity-based models of higher education funding, such as income share agreements and human capital contracts, are viable and ought to be considered more seriously. It is here that Leff and Hughes interject, proposing a derivative instrument they call an “income-based repayment swap” (IBR swap) as a new equity-based method of funding legal education. The Leff-Hughes proposal is innovative and, though it poses some problems, may in fact be viable. What is more interesting, though, is the fact that they propose it at all and what this tells us about the state of the “human equity” market and its relationship to law and regulation.

Some background is in order: Since Milton Friedman and Simon Kuznets first discussed the notion in 1945, economists and others have floated the idea of the “human capital contract,” an instrument that would allow investors to provide capital to individuals in exchange for a percentage of that individual’s future earnings, in essence allowing individuals to issue a sort of equity interest in themselves. From Yale’s “tuition postponement program” of the 1970s to Portland’s “IPO Man” to athlete-tracking stocks to arrangements between baseball players and the buscones who represent them, the markets have dreamed up a number of variations on the human equity theme.

In recent years, a number of startups and organizations (including Pave, Upstart, 13th Avenue Funding, and Lumni) began to offer funding through such income share agreements. The offerings have occurred both in and outside the higher education context. However, the market for these income share agreements never really seemed to gain traction. More than one of these entities has since backtracked from offering income share agreements and shifted to traditional loans instead. The limited success of offerings of income share agreements may be due in part to competition from the government. Income-driven repayment programs offered by the government sector, which cap repayment amounts, may offer students a better proposition for higher education financing than the instruments being offered by the private sector.

But there are two other possible explanations for the sputtering of the income share agreement market. First, there are limitations in how effectively one can raise large amounts of capital from investors to fund individuals. Second, regulatory uncertainties in the treatment of income share agreements may have created frictions that have dampened the market.

The IBR swap proposed by Leff and Hughes claims to solve these latter two problems. Basically, it works as follows: the student borrows money per usual by taking out a traditional student loan. The student then enters into a contract with a financial institution (the swap counterparty) under which that counterparty agrees to make the student’s loan repayment, while the student agrees to pay the counterparty a percentage of her future income. Leff and Hughes argue that the IBR swap has a number of advantages over regular income share agreements, including curing the two limitations of income share agreements noted above: First, the swap arrangement eliminates the need to raise a large amount of capital from investors upfront, while also reducing default risks and collection costs and coordinating better with current student loan programs. Second, as a derivative, the swap eliminates many regulatory uncertainties currently surrounding income share agreements. This is because derivatives are a well-recognized category of financial instrument and have relatively determinable treatment.  Of course, the IBR swap has problems too, which Leff and Hughes note, including discriminatory pricing, which may or may not be curable by regulation.

Putting these issues aside, however, the most interesting thing about the Leff-Hughes proposal is what it illuminates about the state of the equity-based human financing market. As Diane Ring and I have argued, the regulatory uncertainties for offerings of income share agreements are nontrivial, the instruments themselves are heterogeneous, and they are best regulated on a case-by-case basis, by analogizing to existing instruments that they most closely resemble. This “regulation by analogy” has costs, however, most obviously uncertain regulatory outcomes. Such regulatory uncertainties may have contributed to the decline of the income share agreement market and incentivized some promoters to redesign their products to conform more closely to traditional debt. Leff and Hughes argue that because it is a derivative, the IBR swap eliminates many of those regulatory uncertainties and will better allow equity-based human financing to thrive.

The fact that avoidance of regulatory uncertainties is one of the key motivators of the Leff-Hughes swap proposal is telling about the state of our legal regimes and their application to new economic arrangements that don’t fit well into current categories. Human equity, by virtue of being “not debt” and also not other familiar things, falls into a regulatory gray area that makes offering platforms, investors, and issuers nervous, and this creates an incentive to retreat into familiar boxes (such as debt). Of course, assuming one is a pragmatist, how we feel about this nervousness may depend on whether we like income share agreements and other “human equity” instruments in the first place. While the chilling effects of regulatory uncertainty may seem problematic, uncertainty is not per se a bad thing where it applies the brakes on a potentially problematic transaction. Thus, the big question with respect to regulatory uncertainty and Leff and Hughes’ method of circumventing it may really be a question of one’s priors. If we dislike the idea of income share agreements or human capital contracts, then we are likely to be somewhat comfortable with the chilling effects of regulatory uncertainty and may dislike the IBR swap as a way of getting around it. This is the more fundamental question that needs to be asked.

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Cite as: Shu-Yi Oei, Regulatory Gray Areas, Uncertainty, and “Human Equity”, JOTWELL (January 8, 2016) (reviewing Benjamin M. Leff & Heather Hughes, The Income-Based Repayment Swap: A New Method for Funding Law School Education (2015)),