OIG: U.S. Department of Education Must Do More to Police the Financial Condition of Colleges and Universities

by Hogan Lovells

Hogan Lovells

Last week, The Chronicle of Higher Education reported that it had analyzed data released by the U.S. Department of Education (“ED”) and concluded that 177 private colleges and universities failed ED’s financial responsibility regulations: 112 not-for-profit and 65 for-profit. The Chronicle’s reporting comes on the heels of a February 24, 2017 Office of Inspector General (“OIG”) audit report that urged ED to do more to police institutions’ financial health.

The OIG audit report provides an overview of ED’s financial responsibility regulations, including the requirement that to continue to participate in Title IV programs after failing to satisfy them, an institution must post an irrevocable letter of credit in an amount based on a percentage of the institution’s prior-year Title IV revenue. The letter-of-credit requirement—which in some cases must be in an amount not less than 50% of prior-year Title IV revenue—often exacerbates the financial challenges facing institutions. Key takeaways from the report include:

• OIG urged ED to act to prevent institutions from manipulating composite scores. With respect to for-profit and not-for-profit institutions, ED measures financial responsibility in part by using a “composite score.”  To oversimplify, ED plugs institutions’ audited financial data into a series of financial ratios ED developed in 1997. ED then weights and combines the results to arrive at a “composite score,” which ranges from –1.0 (the worst) to 3.0 (the best). OIG observed that, before its collapse, Corinthian Colleges, Inc. (“Corinthian”) borrowed funds from a credit facility just prior to fiscal year end, reported the funds as long-term debt on its audited financial statements (because the debt could be repaid over longer than twelve months), but then repaid the funds almost immediately after fiscal year end. OIG concluded that by doing so, Corinthian was able to inflate its composite score. OIG recommended and ED agreed to “identify common ways that a school could manipulate its composite score” and to scrutinize institutions that are “at risk of manipulating their composite scores.”

• OIG supported the new, somewhat controversial borrower defense rule. In the twilight of the Obama administration, ED promulgated the “borrower defense” regulations. In addition to providing borrowers with additional grounds to obtain federal student loan forgiveness from ED (and for ED to look to institutions for reimbursement), that rule made significant changes to the financial responsibility regulations. Unless the Trump administration or Congress acts to stop it, the new rule will go into effect on July 1, 2017. Among other changes, the new rule will in certain circumstances permit ED to calculate an institution’s composite score more frequently than once per year and to develop and implement a new financial stress test. The rule will also create new automatic and discretionary triggers for ED to require an irrevocable letter of credit (or equivalent form of financial security) from institutions. OIG emphasized that the rule would improve ED’s ability to obtain “financial protection” from institutions based on better financial information. OIG seems to have added its voice to those calling for the Trump administration to retain the borrower defense rule.

• OIG underscored ED’s existing program review criteria. The report also indicated that ED already performs a “formal school risk assessment each year” for each domestic institution that participates in the federal student financial aid programs. That assessment results in a “risk score,” which is one measure ED uses to select an institution for a program review (other measures include compliance audit results, borrower complaints, accreditor findings, and media coverage). ED aims to conduct 300 program reviews each year.

The traditional higher education financial model is under stress at many institutions, and many institutions face varying degrees of financial challenges. If the OIG report is any indication, and if the Trump administration retains the borrower defense regulations, including the new financial responsibility regulations, institutions can expect additional oversight and potentially new letter of credit requirements from Washington. Many institutions will seek to identify creative paths to address financial challenges, such as new strategic alliances, nonprofit-private partnerships, and reevaluating academic program offerings, to name just a few.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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