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Financially Irresponsible: The History of Federal Rules

Nov 13, 2017 by

The History of Federal Financial Responsibility Rules for Colleges

This blog series was authored by Blake Harden, a former U.S. Department of Education official.

This post is the first in a series about the financial responsibility rules to which institutions of higher education are subject. This post explores the history of the financial responsibility requirements, beginning in the 1970s.

This week, Secretary of Education Betsy DeVos will begin negotiations on the (already recently negotiated) borrower defense to repayment rule – a regulation that created a process for borrowers whose schools misled them and established new requirements to ensure taxpayer funds weren’t lost when financially risky institutions shut down. Within the Department’s plan for letting colleges off the hook for defrauding students is another change that could affect thousands of colleges each year. The Department plans to change its financial responsibility composite score rules—regulations that set standards for the financial condition of universities.

While there’s no question the regulations could benefit from some minor updates to keep up with the times, it’s important to understand what that will mean in practice—and why these rules exist in the first place. To that end, this blog series will revisit the history of the longstanding financial responsibility standards, the origins of which trace back to the 1970s.

A Brief History

The concepts of “fiscal responsibility” and “appropriate institutional capability” first appeared in the 1976 reauthorization of the Higher Education Act (HEA). The 1976 law charged the Commissioner of Education (there wasn’t a Secretary, as the Department of Education didn’t exist yet) to establish “reasonable” standards for fiscal responsibility. And fourteen years later, the 1992 reauthorization of the HEA charged the Secretary of Education with an even more explicit mandate to determine whether an institution had the “financial responsibility” to participate in the federal student aid programs, enumerating three baseline requirements—a school had to be able to provide the services it promised to students, it had to comply with federal laws and regulations, and it had to be able to meet financial obligations like refunds to students and repayment of liabilities and debts to the Department. In addition, the law required the Secretary to promulgate rules to establish additional standards to measure financial wherewithal.

The statutory changes in both the 1970s and the 1990s were a bipartisan response to what had become a routine cycle of closure and abuse of Title IV dollars by for-profit institutions since the 1960s. Students were frequently left in the cold, without the education they had been promised and without the refunds their school owed them; and taxpayers were stuck holding the bag when those students defaulted on their loans. The financial responsibility requirements were meant to catch schools at risk of that kind of closure, and require financial protection from them upfront. In the worst cases, the requirements would prohibit financially risky institutions from participating in the programs altogether.

It took the Department nearly a decade to establish the regulations currently in effect. The first attempt came in 1994. These rules established three independent tests: (1) an “acid-test” ratio measuring the ratio of cash to current liabilities, (2) a test for operating losses showing that an institution had not sustained losses that resulted in a substantial decline of its net worth, and (3) a test of positive tangible net worth showing that its tangible net assets exceeded its liabilities. The thresholds set in these tests were meant to signal that financial failure was imminent. Under the rule, the Department cited an institution for failure if it appeared deficient on any single test. These rules remained in effect for only several years.

Not long after promulgating the 1994 rules, the Department began a dialogue with the higher education community about improving the standards.  In consultation with the accounting firm KPMG, the Department embarked upon a two-year process that resulted in the “financial composite score” still in effect today. While the rule wasn’t subject to negotiated rulemaking due to a quirk of timing (future amendments to the HEA later made it clear that all Title IV activities were subject to negotiated rulemaking), the Department carried out an uncommonly collaborative rulemaking for the time, with an unprecedented 207-day comment period. The 1997 rulemaking served as a model for the negotiated rulemaking that would take place in subsequent decade

The Department argued that the changes were necessary because the old tests (1) didn’t provide a comprehensive measure of financial health, (2) didn’t consider the relative performance of each institution, making it difficult to distinguish between “institutions that are clearly not financially healthy, institutions that are financially sound enough to participate in the title IV…programs, and institutions whose financial health is questionable,” and (3) didn’t address the differential “accounting, financial, and operating characteristics that exist between proprietary and private non-profit institutions.”

The new rules measured the ability of an institution to operate over both the short and long term by plugging information from institutions’ financial statements—reported to the Department annually and certified by an independent auditor—into a weighted equation made up of three ratios. The sum of the three ratios would indicate an institution’s financial health on a scale from -1.0 to 3.0, with scores above 1.5 indicating robust financial health, between 1.0 and 1.4 indicating questionable financial health, and 0.9 or below indicating poor financial health. A failing composite score or a failure to satisfy the three statutory requirements in the HEA marks a college as not financially responsible. If that happens, schools have the opportunity to post a letter of credit (LOC)—a form of financial guarantee that the government can draw from in the case of closure—and continue their participation in the federal financial aid programs.

The three ratios constituting the composite score—the primary reserve ratio, the equity ratio, and the net income ratio—each capture aspects of an institution’s financial condition. The primary reserve ratio is a measure of a school’s viability and liquidity. The equity ratio is a measure of a school’s capital resources and ability to borrow. The net income ratio represents a measure of a school’s profitability or ability to operate within its means. The primary reserve ratio is weighted more heavily for non-profit institutions, while the net income ratio receives more weight in the calculation of proprietary institutions’ scores, owing to their differing financial structures.

The Department heralded the new methodology as a way to account for nuances in institutions’ financial conditions. Previously, an institution wouldn’t be financially responsible if it failed a single ratio test; the new rule gave institutions the ability to make up for deficiencies in one measure with strengths in the other two ratios. From the Department’s perspective, the new rule would finally measure the “total financial circumstances” of an institution.

The Composite Score Illustrated

Take two nonprofit institutions of similar size: Institution A and Institution B. Institution A is highly liquid (i.e., has plenty of cash on hand) and has a moderately-sized endowment with very few restrictions placed upon its use (i.e., no donor-imposed limitations on how the money can be spent). Accordingly, its primary reserve ratio is strong because it has resources on hand to meet expenses. However, it spent far more than it took in in tuition revenue last year due to a precipitous dip in enrollment (Institution A relies heavily on tuition revenue to fund its operations). As such, the institution had to rely on its endowment reserves to fund this year’s operations, and its net income ratio was negative. But Institution A also owns most of its fixed assets outright (i.e., hasn’t used much debt to finance new buildings), resulting in a strong equity ratio. Despite the effects of last year’s enrollment declines on its revenues, Institution A is still passing.

Institution B has an endowment and annual budget equivalent to that of Institution A. Accordingly, its primary reserve ratio is strong. Institution B also experienced a steep decline in tuition revenue in the past year, resulting in a negative net income ratio. But unlike Institution A, Institution B has borrowed considerably to finance capital projects like a new student fitness center and modern dormitory in past years. The institution owes nearly ninety percent of the total value of its new fixed assets to creditors; if the institution were forced to pay off all of its debt, it could only meet a fraction of its obligations using its liquid assets. As a result, the school’s equity ratio is low. Institution B receives a failing score. While the institution’s endowment may provide a buffer for short-term shortfalls, it is unclear whether the institution will remain viable if tuition revenues do not increase and it is unable to pay down all of its debt.

The Rule In Practice

While the financial responsibility rule has been able to identify many financially precarious institutions and protect the government from losses since its inception, the economic conditions of the last decade have proven the composite score hasn’t always been enough to capture likely closures. A recent spate of private nonprofit college closures have proven that nonprofits aren’t immune to financially driven closures, suggesting the need for more effective oversight and underscoring the importance of an effective financial responsibility metric.

The recession took a major toll on nonprofit colleges’ endowments and tuition revenues, resulting in a significant increase in failing scores. From the 2008 to the 2009 school year, the number of private nonprofit institutions failing the financial responsibility test doubled. The uptick in failures mirrored reports in the media. The demise of the small private college has been covered extensively, with stories frequently citing financial institutions’ bleak prognostications on small schools’ long-term viability. Moody’s, a ratings agency, recently predicted that at least 15 private institutions would close in 2017 due to their inability to increase revenues, largely due to enrollment declines. Perhaps most prominently, the institution led by Sen. Bernie Sanders’ wife, Burlington College, suffered closure after a spate of poor financial decisions and questionable conduct by administrators.

But the concern about closure isn’t just emanating from outsiders. Annual NACUBO surveys of university business officers show a sizable share of institutions’ own financial leaders are concerned about the long-term viability of their institutions. Seventy-one percent of college business officers think media reports that higher education is in the midst of a financial crisis are accurate. According to the same survey, just under 50 percent of college business officers believe their own campus is viable over the next decade. Just a few years ago, in 2014, confidence was even lower; only 40 percent of business officers believed their schools were viable over the long-term.

Yet institutional associations are persistent in their criticism of the score, asserting that fundamental change is needed to prevent false positives and reduce institutional burden. For instance, a 2012 report by the NAICU Financial Responsibility Task Force made a series of recommendations (which we will discuss in greater detail in a future post), some of which would likely make it easier for private nonprofit schools to pass financial responsibility standards. They are committed to a less burdensome metric to benefit the few that fail, despite failures abating for the vast majority of the sector as the economy has rebounded and endowment coffers have grown.

On the other hand, the for-profit sector noticed a much smaller uptick in failing composite scores during the recession, presumably due to soaring enrollments financed by federal student loans. But they’ve been less fortunate in recent years, as enrollments have begun to contract and the Department of Education and other oversight bodies have adopted a more aggressive regulatory posture toward the sector. Increasing oversight led to a number of high-profile closures, such as Corinthian Colleges, ITT Tech, and Marinello Schools of Beauty, which left hundreds of thousands of students in the lurch and the taxpayer responsible for hundreds of millions of dollars of loan discharges—with little financial protection on the books at the time of closure. Many smaller institutions have also closed, though the liabilities accrued by the government were far smaller by comparison. Some, but not all, of these institutions had failed the composite score test. Given all this, it is unsurprising that for-profit sector lobbyists have been relatively quiet on the topic of financial responsibility (apart from their opposition to the Borrower Defense to Repayment rule promulgated by the Department in 2016, which expanded the criteria that the Department could consider in its composite score formula between annual audits and included some problem areas for for-profit colleges, like facing a lawsuit or settlement with a state or federal agency or failing the 90-10 revenue ratio of federal to non-federal dollars).

Forecasting the Future

It is the large, high-profile for-profit closures of late that have spurred the most concern from watchdogs and consumer advocates, both for the sheer number of students they affect and for the massive bill laid before taxpayers when they fail. These closures have also drawn attention to the shortcomings of the composite score. The huge taxpayer liabilities accrued in the wake of Corinthian–in excess of $97 million as of June 2016–led many on the left, the Government Accountability Office (GAO), and the Department’s own Inspector General (IG) to advocate for more robust oversight of institutions that allows the Department to collect financial protection in advance of closure. Both GAO and the IG lobbed criticism on the effectiveness of the composite score in particular.

While the composite score is a metric well-equipped to assess the general financial circumstances of an institution, it’s clear that it can’t always keep up with the rapid pace of changes in enrollment and revenue, external circumstances (like lawsuits and investigations) that have reputational and financial implications for a college, and even the existential implications of severe actions taken by accreditors or the Department of Education. And structural changes in the higher education sector are likely to lead to more, not fewer, schools in dire financial straits. Just as it did when the first fiscal responsibility laws were passed in the 1970s, the federal government has a responsibility to taxpayers and students to ensure that students are enrolled in financially sound institutions that aren’t likely to close before students can even earn their degrees. If those institutions do close, policies should be in place to ensure that the taxpayer doesn’t bear the cost of making students whole again. Financial failure may be rare, but when it happens, it can ruin students’ lives—not to mention its deleterious effects on the taxpayers who all too often bear the brunt of the costs.

Stay tuned: In our next several posts, we will dig deeper into the mechanics of the rule, evaluate the criticisms waged against it, and make recommendations for improving the Department’s measures of financial responsibility.

Source: Financially Irresponsible: The History of Federal Rules

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