America's top consumer finance watchdog is taking action against an alternative education finance provider advised by an Obama-era Education Department official for allegedly misleading students about income-share agreements (ISAs).

ISAs are an alternative type of student loan financing where a borrower receives a loan and then pays a percentage of their income after graduation. The terms of an ISA depend on various factors such as their major topic of study and projected future earnings.

ISA providers regularly argue that their product isn't a loan and hence is not affected by consumer protection law, but the Consumer Financial Protection Bureau (CFPB) disagrees.

“The ISA industry has tried to evade oversight by claiming that its products are not loans,” CFPB Acting Director Dave Uejio said in a statement. “But regardless of the name on the label, these products are credit and have to comply with federal consumer protections. The ISA industry cannot pretend that core consumer protection laws do not apply to their products.”

In a consent order made public on Tuesday, the agency alleged that Virginia-based Better Future Forward (BFF) — which lists former U.S. Under Secretary of Education Martha Kanter as an advisor — mischaracterized ISAs and "failed to provide disclosures required by federal law and violated a prepayment penalty prohibition for private education loans."

“I have always advised for transparency and full disclosure for students,” Kanter told Yahoo Finance, adding that BFF is one of the few organizations focused on helping low-income students afford college. (Kanter also leads College Promise, a nonprofit initiative that advocates for tuition-free college.)

Under the CFPB’s order, BFF is required to provide disclosures that comply with federal consumer financial law, eliminate the prepayment penalties, and stop misleading borrowers.

BFF CEO Kevin James stated that the company "has been a leader in advocating for policymakers to adopt clear and protective guardrails for the emerging ISA space." He added that the BFF believe that "CFPB’s oversight role is critical and are eager to work with the Bureau to bring clarity to these questions around how federal disclosures should apply to BFF’s ISAs.”

The Student Borrower Protection Center (SBPC), a D.C.-based advocacy group, stated that the CFPB action was "the first public federal enforcement action against an Income Share Agreement provider and sets the stage for increased regulatory scrutiny of the ISA industry."

Some regulation has occurred on the state level: California's consumer watchdog recently signed a deal with an ISA company to increase oversight over the practice.

“The CFPB’s action shows that no private student lender is above the law," SBPC said in a statement. "Despite industry attempts to evade consumer protections, federal law is clear—income share agreements have always been a form of consumer credit and all borrowers are entitled to the same rights and protections, regardless of whether they took out an ISA engineered by Silicon Valley or a traditional loan from a big bank."

The SBPC further asserted that the ISA model "harms consumers and is illegal: from the discriminatory impact on women and borrowers of color to the predatory interest rates, the tricks and traps designed to lure vulnerable borrowers into high-cost debt. Now is the time for law enforcement officials at all levels of government to act swiftly to hold this rogue industry accountable and provide justice to borrowers.”

ISAs, once hailed as a solution to the student debt crisis, are facing more scrutiny: This year, more than 50 former students of the Make School coding academy filed a lawsuit alleging that the for-profit school misrepresented its ISAs, and students who attended online bootcamp at the Lambda School alleged that the for-profit school misrepresented ISAs and other aspects of the program.

CFPB says ISAs are private student loans

The CFPB's action sheds some light on how the federal agency is thinking of grappling with the growing number of providers offering ISAs as an alternative to traditional student loans.

After taking out an ISA, students sign a document agreeing to make 120 payments back to the creditor when they are earning more than $40,000 (adjusted each year for inflation). Payments are based on a fixed percentage of the student’s income. BFF has provided ISAs to over 170 students since 2017.

According to the CFPB, BFF falsely represented that ISAs are not loan products and operated as though their agreements were not "credit" or "private student loans," leading the company to not provide the right disclosures for private education loans as required by federal consumer financial law.

The company also subjected borrowers to fees or penalties for early repayment or prepayment on its private student loans.

The CFPB's consent order requires BFF to:

• Stop stating that ISAs are not loans, or that they don't create debt for consumers

• Provide disclosures "required by the Truth in Lending Act and its implementing Regulation Z for closed-end credit, including disclosures about the finance charge, the amount financed, and the annual percentage rate, as well as disclosures required for private education loans."

• Continue to not object to any discharge of a student's ISA in bankruptcy, "including not contesting that repaying a student’s ISA would present an undue hardship."

• Not impose a prepayment penalty on a private education loan

CFPB did not impose any fines on BFF.

Update: This post has been updated with comment from Martha Kanter.

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Aarthi is a reporter for Yahoo Finance. She can be reached at [email protected]. Follow her on Twitter @aarthiswami.

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