This reading of the law is at odds with the prevailing opinion of many schools that the student would not have produced work of a particular quality under his or her own resources, and therefore, that faculty have some “ownership rights” in the output of any class. Since that time I have been very careful to ask students first about any public use of their work, even in lectures I give at other schools, and I always credit the work with their names and give students the details on the presentation venues for their resumes. My lawyer friend told me that statements in college catalogs claiming that the institution retains ownership of work produced in a class wouldn’t hold up in court; unless the maker is an employee of the institution/company or has signed away rights through some explicit agreement, ownership is retained by the maker. Other attorneys may have different interpretations, and I don't profess to be a legal expert, but the ownership of work produced by students is certainly something to think about.
Therefore, there are some standard procedures that are advisable when entering into “sponsored projects” and internships that involve current students. First, most universities have something called a “memorandum of agreement,” a document that is less complicated than a formal contract but that lays down the conditions of sponsored collaborations involving students. In many cases, these standard letters have been drafted by legal counsel and intellectual property experts and it is simply a matter of filling in the blanks for the particular project. Although it won't solve problems already in dispute, consulting the legal or grants and contracts offices of the university about such a letter for future projects is recommended. They can help draft one for design services or provide one that is used by other research/outreach units on campus. Student design centers or courses designed to provide work to clients should not operate without one of these letters, even when the work is pro bono. I encourage schools to be consistent in their use, rather than having faculty and students draft their own, project by project (which may leave them outside the protection of the university in the case of disputes).
Second, it is advisable that students always have registration alternatives to a course in which they work for clients and are asked to relinquish ownership of their work to clients or sponsors. That way, a student can meet the requirements of the curriculum without being required to give up ownership of something they produce; they enroll in the sponsored class fully informed of the conditions that apply to the fruits of their labor and make the choice to do so among other viable options. In some cases, projects extend beyond the duration of the sponsored class. In this case, all bets are off on the client/student relationship once the agreed upon course product has been delivered; additional work proceeds under a new freelance arrangement negotiated between the student and the client. This can be made clear to clients before work with the class begins.
If the client comes to the class specifically to engage students, and understands that the students are accountable to another set of evaluation criteria beyond those of service, and proceeds on that basis, it's one thing. But negotiations regarding outcome will be different if the student is working outside the formal academic structure.
For this reason, it is not a good idea to intervene as faculty in negotiations between a student and a client for non-credit freelance work, even when the work is to be conducted with a unit of the same institution. The best practice is to have a standard, published policy regarding how clients access students on a freelance basis and then to leave negotiations to the student and client. For example, saying the department will alert students to freelance opportunities through a website but not get involved in contractual negotiations is a good idea. There are books, such as the Graphic Artists Guild Pricing and Ethical Guidelines to which you can direct students for standard contracts and pricing thresholds (including kill fees), and then step back. And a professional practices class or workshop can identify the issues to consider when entering into an agreement. But as long as all parties know up front that the student is a free agent, there is no damage to the department if a project goes sour and clients will or won't accept the risk of working with a novice. And faculty won't be subject to criticism if student A is paid and student B is not for comparable projects. This practice also makes alumni happier as the resources of the institution (i.e. your explicit professional mentorship) aren't in competition with professionals who can’t possibly win competitive bidding for the same projects.
Imagine you're a teacher directing a student project for a university client (museum, choral society, etc.). The client wants to make changes in the student's design with which both you and the student disagree and has demanded the electronic files. With no prior agreement regarding the nature of responsibilities and risks within the collaboration, you're caught in the middle of a situation with an implied obligation to another unit of your university to deliver services because you agreed to mentor the student, while at the same time siding with the student on the design issues; an untenable position. Had this been a for-credit engagement, you could have outlined a detailed set of conditions that clearly separated the obligation of the educational experience for the student from the delivery of service and allowed the university client to proceed, knowing that it risked a situation in which the student could not sacrifice academic standards in meeting the museum's requirements. But my guess is that the university client proceeded thinking you were there as a professional to ensure a good outcome, whatever they thought that might be. So now you’re caught in a situation in which, legally I suspect, the student cannot be compelled to turn over files for which he/she received no compensation, but which also ethically leaves a worthy non-profit high and dry in executing its project.
There are lessons here for all three parties. There is nothing that prevents a faculty member from informally providing a student with design suggestions on freelance projects, but I suspect this arrangement appears to the university client as an employee-and-her-apprentice business relationship. When disputes arise it is necessary then to negotiate and reach a compromise. The student needs to learn that framing the conditions of work is necessary if he/she is going to withhold delivery at a later date, and the university client needs to understand that if it wants to art direct the solution to the project, it should hire the student as an intern/employee, not as an unpaid freelancer or student scholar.