62830 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

DEPARTMENT OF EDUCATION

34 CFR Part 668

RIN 1840–AC36

Student Assistance General Provisions

AGENCY: Department of Education.

ACTION: Final regulations.

SUMMARY: The Secretary amends the

Student Assistance General Provisions

regulations (34 CFR part 668) to revise

Subparts B and K and add a new

Subpart L. These final regulations

improve the Secretary’s oversight of

institutions participating in programs

authorized by title IV of the Higher

Education Act of 1965, as amended (title

IV, HEA programs), by revising the

standards of financial responsibility to

provide a more accurate and

comprehensive measure of an

institution’s financial condition. The

regulations reflect the Secretary’s

commitment to ensuring institutional

accountability and protecting the

Federal interest while imposing the

least possible burden on participating

institutions.

DATES: Effective dates: These regulations

take effect on July 1, 1998.

Applicability and Compliance Dates:

The Secretary will apply the standards

of financial responsibility established in

these regulations to institutions that

submit audited financial statements to

the Department on or after July 1, 1998.

However, affected parties do not have to

comply with the information collection

requirements in §§ 668.171(c),

668.172(c)(5), 668.174(b)(2)(i),

668.175(d)(2)(ii), 668.175(f)(2)(iii), and

668.175(g)(2)(i) until the Department

publishes in the Federal Register the

control number assigned by the Office of

Management and Budget (OMB) to these

information collection requirements.

FOR FURTHER INFORMATION CONTACT: For

general information contact Mr. John

Kolotos or Mr. Lloyd Horwich, U.S.

Department of Education, 600

Independence Avenue, S.W., Room

3045, ROB–3, Washington, D.C. 20202,

telephone (202) 708–8242. For

information regarding accounting and

compliance issues, an institution should

contact the Department’s Institutional

Participation and Oversight Service

(IPOS) Case Management Team for the

state in which it is located:

IPOS Case Management Team Contacts

Boston Team, (617) 223–9338 (covering

Connecticut, Maine, Massachusetts,

New Hampshire, Rhode Island and

Vermont)

New York City Team, (212) 264–4022

(covering New Jersey, New York,

Puerto Rico and the Virgin Islands)

Philadelphia Team, (215) 596–0247

(covering Delaware, District of

Columbia, Maryland, Pennsylvania,

Virginia and West Virginia)

Atlanta Team, (404) 562–6315 (covering

Alabama, Florida, Georgia,

Mississippi, North Carolina and South

Carolina)

Chicago Team, (312) 886–8767 (covering

Illinois, Indiana, Michigan,

Minnesota, Ohio and Wisconsin)

Dallas Team, (214) 880–3044 (covering

Arkansas, Louisiana, New Mexico,

Oklahoma and Texas)

Kansas City Team (816) 880–4053

(covering Iowa, Kansas, Kentucky,

Missouri, Nebraska and Tennessee)

Denver Team, (303) 844–3677 (covering

Colorado, Montana, North Dakota,

South Dakota, Utah and Wyoming)

San Francisco Team, (415) 437–8276

(covering Arizona, California, Hawaii,

Nevada, American Samoa, Guam,

Federated States of Micronesia, Palau,

Marshall Islands and Northern

Marianas)

Seattle Team, (206) 287–1770 (covering

Alaska, Idaho, Oregon and

Washington).

Individuals who use a

telecommunications device for the deaf

(TDD) may call the Federal Information

Relay Service (FIRS) at 1–800–877–8339

between 8 a.m. and 8 p.m., Eastern

standard time, Monday through Friday.

Individuals with disabilities may

obtain a copy of this document in an

alternate format (e.g. Braille, large print,

audiotape, or computer diskette) by

contacting Mr. John Kolotos or Mr.

Lloyd Horwich.

SUPPLEMENTARY INFORMATION:

The following is an ordered list of the

key topics covered in this preamble:

• Overview of the Standards and

Provisions of Financial Responsibility.

• Community Involvement in the

Regulatory Process.

• The Secretary’s Responsibility for

Assessing the Financial Condition of

Participating Institutions.

• Need for Revising the Rules.

• The Final Rule.

• Provisions for Public Institutions.

• The Ratio Methodology for Private

Non-Profit and Proprietary Institutions.

• Overview of the Methodology.

• Issues Raised in the Notice of

Proposed Rulemaking and other

Department Publications.

• Substantive Changes to the NPRM.

• Analysis of Comments and

Changes.

On September 20, 1996, the Secretary

published in the Federal Register a

Notice of Proposed Rulemaking (NPRM)

addressing a variety of topics, including

a ratio methodology that would be used

in part to determine whether an

institution is financially responsible (61

FR 49552–49574). The NPRM also

included financial responsibility

standards for third-party servicers that

enter into a contract with a lender or

guaranty agency, and provisions for

submitting financial statement and

compliance audits, adding additional

locations, and changes of ownership

that result in a change of control (61 FR

49552–49574). On November 29, 1996,

the Secretary published final regulations

governing submissions of financial

statement and compliance audits and

other aspects of financial responsibility,

but delayed establishing final standards

regarding the ratio methodology and

other proposed provisions (including

changes of ownership and additional

locations), pending further comment,

study, and review (61 FR 60565–60577).

The Secretary provided an extensive

opportunity for public involvement and

comment on these final regulations. On

December 18, 1996, the Secretary

reopened the comment period until

February 18, 1997 for the delayed

standards and provisions (61 FR 66854).

On February 18, 1997, the Secretary

extended that comment period until

March 24, 1997 (62 FR 7333–7334). On

March 20, 1997, the Secretary again

extended the comment period until

April 14, 1997 (62 FR 13520).

These regulations establish under a

new Subpart L the provisions and

standards of financial responsibility that

an institution must satisfy to begin or

continue to participate in the title IV,

HEA programs. Furthermore, these

regulations amend certain sections of

Subparts B and K to harmonize the

requirements under those sections with

the provisions and standards under

Subpart L. As discussed more fully

under Parts 4 and 15 of the Analysis of

Comments and Changes, these

regulations do not establish new

standards of financial responsibility for

lender or guaranty agency third-party

servicers, or new provisions regarding

additional locations and changes of

ownership.

Overview of the Standards and

Provisions of Financial Responsibility

As provided under section 498 of the

HEA, the Secretary determines whether

an institution is financially responsible

based on the extent to which an

institution satisfies three statutory

components, which are illustrated

below.
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62831

STATUTORY COMPONENTS OF FINANCIAL RESPONSIBILITY

Financial obligations (provisions for debt payments, refunds, and repayments)Administration of the title IV, HEA programs

(past performance and program compliance

provisions)

Financial condition (ratio standards)

HEA sections 498(c)(1)(C) HEA sections 498(c)(1)(B) and 498(d)

HEA sections 498(c)(1)(A)

The extent to which an institution:

(1) Satisfies its obligations to students and

to the Secretary, including making refunds

to students in a timely manner and repaying program liabilities to the Secretary;

and

(2) Is current in its debt payments.

The extent to which an institution or the persons or entities that exercise substantial

control over the institution administer properly the title IV, HEA programs.

The extent to which an institution has the resources necessary to:

(1) Provide and to continue to provide the

education and services described in its official publications; and

(2) Continue to satisfy its financial obligations.

The current standards and provisions

under 34 CFR 668.15 relating to an

institution’s financial obligations and

administration of title IV, HEA programs

are detailed in the above chart and

carried forward in these regulations,

under §§ 668.171 and 668.174,

respectively. These regulations focus on

establishing a ratio methodology that

provides a comprehensive measure of

the financial condition of proprietary

and private non-profit institutions.

The current regulations employ three

independent tests for assessing the

financial condition of an institution,

and require an institution to satisfy the

minimum standard established for each

of those separate tests to be considered

financially responsible.

In contrast, these regulations employ

a ratio methodology under which an

institution need only satisfy a single

standard—the composite score standard.

Unlike the current tests that treat

different measures of an institution’s

financial condition without reference to

each other, the ratio methodology takes

into account an institution’s total

financial resources and provides a

combined score of the measures of those

resources along a common scale (from

negative 1.0 to positive 3.0). This new

approach is more informative and

allows a relative strength in one

measure to mitigate a relative weakness

in another measure.

Under these regulations, the Secretary

considers a proprietary or private nonprofit institution to be financially

responsible based on its composite

score. If an institution achieves a

composite score of at least 1.5, it is

financially responsible without further

oversight. An institution with a

composite score in the zone from 1.0 to

1.4 is financially responsible, subject to

additional monitoring, and may

continue to participate as a financially

responsible institution for up to three

years.

An institution that does not satisfy

either the composite score or zone

standards, or that fails to meet its

financial obligations or satisfy other

standards of financial responsibility,

may be allowed to participate in the title

IV, HEA programs by qualifying under

the provisions of an alternative

standard. The alternative standards are

described under § 668.175 of these

regulations and illustrated in the

following table.

ALTERNATIVE STANDARDS

Alternative Used when: Provisions

Letter of credit 1 for a new institution ................ An institution that seeks to participate in the

title IV, HEA programs for the first time does

not satisfy the composite score standard but

satisfies all other applicable standards and

provisions.

The institution may begin to participate by

submitting a letter of credit for at least 50

percent of the title IV, HEA program funds

that the Secretary determines the institution

will receive during its initial year of participation, as provided under § 668.175(b).

Letter of credit for a participating institution ..... A participating institution does not satisfy one

or more of the standards of financial responsibility (including the composite score standard) or the institution’s auditor expresses an

adverse, qualified, or disclaimed opinion, or

the auditor expresses doubt about the continued existence of the institution as a going

concern.

The institution may continue to participate as a

financially responsible institution by submitting a letter of credit for at least 50 percent

of the title IV, HEA program funds the institution received during its last completed fiscal year, as provided under § 668.175(c).

Provisional certification ..................................... A participating institution: .................................

(1) Does not satisfy the composite score

standard or any provision regarding its financial obligations; or

(2) Has or had a program compliance problem as provided under § 668.174 but satisfied or resolved that problem.

The institution may participate under a provisional certification by submitting a letter of

credit for at least 10 percent of the title IV,

HEA program funds the institution received

during its last completed fiscal year and

meeting other provisions described under

§ 668.175(f).

Provisional certification for an institution where

persons or entities owe liabilities.

The persons or entities that exercise substantial control over the institution owe a liability

for a violation of a title IV, HEA program requirement.

The institution may continue to participate

under a provisional certification if it satisfies

the provisions described under § 668.175(g).

1A letter of credit is a financial instrument, typically issued by a commercial bank, whereby the bank guarantees payment to the Secretary for

an amount up to the amount of the letter of credit.
62832 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

A public institution demonstrates that

it is financially responsible under these

regulations by providing a letter from an

official of the State or other government

entity confirming the institution’s status

as a public institution.

Although the Secretary proposed to

treat independent hospital institutions

slightly differently under the ratio

methodology, the Secretary now

believes that any differences between

these institutions and institutions in the

other sectors relate primarily to control.

Under these regulations, therefore, an

independent hospital institution must

satisfy the provisions of the ratio

methodology established for a

proprietary institution if it is a for-profit

entity, or the provisions established for

a private non-profit institution if it is a

non-profit entity. If an independent

hospital institution is a public entity, it

must satisfy the requirements

established for public institutions.

Community Involvement in the

Regulatory Process

The Secretary sought to maximize the

postsecondary education community’s

participation in this regulatory

initiative. In developing the initial study

on which the NPRM was based, the

Department’s contractor, KPMG Peat

Marwick LLP (KPMG), consulted with a

task force representing various sectors of

the community. To ensure that the

community was given sufficient time to

analyze and comment on the proposed

rules, the Secretary reopened the

original comment period and then

extended that comment period twice, so

that the total comment period was 207

days. In response, the Secretary received

approximately 850 comments during the

original and extended comment periods.

Between December 18, 1996 and the

publication of these final regulations,

the Department took the following

actions to supplement the original

empirical work on which the NPRM was

based, and to solicit questions,

suggestions, and other comments

regarding the proposed ratio

methodology:

• The Department again engaged

KPMG to assist the Department in

reexamining the proposed ratio

methodology, considering public

comments and suggestions to change

and improve the methodology, and

conducting additional empirical studies

of financial statements and other

sources of information. Much of this

additional work was based on

suggestions made by the community.

• The Department held meetings with

more than 20 representatives of higher

education associations and institutions

on February 5, 1997 and March 11,

1997, with nine representatives of

proprietary institutions on February 27,

1997, and with four representatives of

higher education associations and

public institutions on April 4, 1997. The

Department also conducted a number of

other meetings with parties representing

individual institutions or groups of

institutions.

• For purposes of public

consideration and comment, the

Department published on the Office of

Postsecondary Education’s World-Wide

Web site, minutes of the meetings with

representatives of postsecondary

education associations, information

regarding possible changes to the

proposed ratio methodology, and the

results of some of the empirical studies.

The Department also made available, for

viewing on-line, the KPMG report on

which the Department based the

proposed ratio methodology.

Many commenters expressed their

appreciation to the Secretary for the

open, collaborative, and cooperative

nature of this rulemaking process and

for the extensive opportunities for

public and community involvement.

The Secretary in turn appreciates the

commenters’ thoughtful and

constructive contributions to this

process.

The Secretary’s Responsibility for

Assessing the Financial Condition of

Participating Institutions

The statute and the legislative record

show that Congress expects the

Secretary to determine whether

institutions participating in the title IV,

HEA programs are financially sound

and administratively capable of

providing the education they advertise

(Higher Education Amendments of

1992, Report of the Committee on

Education and Labor, House of

Representatives, One Hundred Second

Congress, Second Session, p. 74).

Congress authorized the Secretary (at

that time, the Commissioner) to

establish financial responsibility

standards with the passage of the

Education Amendments of 1976 (Pub. L.

94–482), and reinforced that authority

in subsequent amendments to the HEA.

In those amendments, but particularly

in the legislative history leading to the

1992 Amendments, Congress made clear

that the Secretary should scrutinize

closely the financial condition of

institutions with regard to their capacity

to fulfill their educational and

administrative responsibilities, and thus

expected the Department to ‘‘play a

more active role’’ in the gatekeeping

process (i.e., determining whether

institutions should begin to participate

in the title IV, HEA programs and

overseeing participating institutions to

determine whether those institutions

should continue to participate).

In keeping with the statute and

congressional intent, the Secretary

establishes in these regulations the

standards and provisions that a

postsecondary institution must satisfy to

demonstrate that it is financially sound

enough for students to confidently

invest their time and money in

programs offered by the institution, and

for the Federal government, on behalf of

taxpayers, to provide that institution

with access to substantial amounts of

public funds. The Department is

committed to carrying out the

Secretary’s gatekeeping and oversight

responsibilities in a manner that ensures

accountability and program integrity but

that provides as much flexibility to, and

places as little burden on, institutions as

possible.

Need for Revising the Rules

The current regulations have enabled

the Department to identify and take

action against many financially weak

problem institutions that drew the

attention of Congress. The Secretary

nevertheless believes that problems still

exist that call for continued close

scrutiny, and undertook an extensive

process to develop more effective

regulations for the following reasons.

First, the Secretary believes that the

standards need to be revised to provide

a more comprehensive measure of an

institution’s financial condition. As

previously noted, the current standards

provide discrete measures of certain

aspects of an institution’s financial

condition. Those aspects are measured

by three independent tests—an acid test

ratio, a test for operating losses, and a

test of tangible net worth. However,

because each test provides a measure of

financial health without regard to the

other tests or to other resources

available to an institution, the

assessment made under each of these

tests does not always reflect the overall

financial condition of an institution.

Second, because the current standards

do not consider the extent to which an

institution satisfies or fails to satisfy the

tests, the Department cannot readily

make distinctions among (1) institutions

that are clearly not financially healthy,

(2) institutions that are financially

sound enough to participate in the title

IV, HEA programs, and (3) institutions

whose financial health is questionable.

Consequently, a more considered

approach is needed to evaluate the

relative level of financial health of

institutions to more closely tie the

Department’s gatekeeping and oversight

efforts to the corresponding risk to the
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62833

Federal interest posed by institutions at

various levels.

Third, the Secretary believes that the

current standards must be improved to

properly address the different

accounting, financial, and operating

characteristics that exist between

proprietary and private non-profit

institutions.

Finally, based on KPMG’s original

study and the additional analysis

performed during the extended

comment period, the Secretary is

prepared to carry out a commitment

made to representatives of the

postsecondary education community in

the context of the promulgation of the

1994 financial responsibility

regulations, that instead of establishing

independent tests, the Department

would assess the institutions’ financial

responsibility based on blended test

scores.

The Final Rule

Provisions for Public Institutions

The Secretary initially proposed to

apply the ratio methodology to public

institutions, but, based on public

comment, the Secretary has decided not

to use the methodology to determine the

financial responsibility of those

institutions for two primary reasons.

First, these institutions are subject to

more public oversight and scrutiny than

private non-profit and proprietary

institutions. The Secretary believes that

it is the responsibility of the State or

responsible government entity to make

available the resources necessary for

those institutions to provide the

education and services expected by

students who enroll at those institutions

and the residents of the State or locality

whose funds support the institutions.

Second, the legal and financial

relationships between public

institutions and their respective State or

local governments vary widely,

impacting in different ways the assets

and liabilities reported on those

institutions’ financial statements. Thus,

the ratio methodology would not treat

all public institutions equitably.

In view of these and other reasons

noted by the commenters (see Analysis

of Comments and Changes, Part 4), the

Secretary does not establish in these

regulations a composite score standard

for public institutions. Rather, the

Secretary will rely on the statutory

alternative that, in lieu of satisfying the

general standards of financial

responsibility (including the composite

score standard), a public institution is

financially responsible if its debts and

liabilities are backed by the full faith

and credit of the State or other

government entity. The Secretary will

consider that a public institution has

that backing if the institution provides

a letter from the cognizant State or

government entity confirming the

institution’s status as a public

institution. The Secretary takes this

approach in implementing the full faith

and credit provision under section

498(c)(3)(B) of the HEA to eliminate

technical and other problems

experienced by public institutions in

demonstrating their compliance with

this provision under the current

regulations.

The Ratio Methodology for Private NonProfit and Proprietary Institutions

In developing the final regulations,

the Secretary sought to address all of the

needs for revising the current rules by

formulating a ratio methodology, and

provisions relating to the methodology,

that would be fair, easily understood by

institutions, and efficiently

administered by the Department.

Based on the additional analysis

performed by the Department and

KPMG during the extended comment

period, and the many helpful comments

and suggestions made by the

community, the Department establishes

by these final regulations a ratio

methodology for proprietary and private

non-profit institutions that:

(1) Provides a comprehensive measure

of financial health (the composite score)

by using ratios that take into account all

of the resources of an institution and

employing an approach under which

the financial strength demonstrated in

one ratio mitigates a financial weakness

in another ratio;

(2) Provides the Department the

means to assess the relative health of all

institutions along a common scale; and

(3) Takes into account the key

differences between these sectors of

postsecondary institutions.

In so doing, the ratio methodology

enables the Department to use more

effectively the case management system

implemented by IPOS. Under this

system, case teams responsible for

particular institutions have access to all

of the data available to the Department

regarding those institutions, including

financial, compliance, and

programmatic information. The case

teams use this information to identify

institutions whose level of financial

health, or whose conduct in

administering the title IV, HEA

programs, or both, indicates that those

institutions (1) need technical

assistance, (2) must be monitored more

closely, or (3) pose a risk to the Federal

interest that requires the Department to

initiate an adverse action.

Furthermore, in the interest of treating

all institutions fairly and equitably, the

Department will calculate the ratios

under the methodology by using only

the information contained in an

institution’s audited financial

statements that are prepared in

accordance with generally accepted

accounting principles (GAAP) and by

removing the effects of questionable

accounting treatments.

The Secretary is committed to

ensuring a smooth transition and to

helping institutions understand the ratio

methodology and other provisions

established in these regulations by

offering technical assistance, both

initially and as case teams identify

institutions in need of further

assistance.

Overview of the Methodology

The methodology is an arithmetic

means of combining different but

complementary measures (ratios) of

fundamental elements of financial

health that yields a single measure (the

composite score) representing an

institution’s overall financial health.

Under the methodology, the composite

score is calculated by:

(1) Determining the value of each

ratio;

(2) Calculating a strength factor score

for each of the ratios;

(3) Calculating a weighted score by

multiplying the strength factor score by

its corresponding weighting percentage;

and

(4) Adding together the weighted

scores to arrive at the composite score.

In the first step of the methodology,

the values of the Primary Reserve,

Equity, and Net Income ratios are

calculated from information contained

in an institution’s audited financial

statement. These ratios together measure

the five fundamental elements of

financial health: financial viability,

liquidity, ability to borrow, capital

resources, and profitability. The

strength factor scores are calculated

using linear algorithms (equations) and

those scores reflect along a common

scale the degree to which an institution

in a particular sector demonstrates

strength or weakness in the fundamental

elements. The weighting percentages for

each of the ratios make it possible to

compare institutions across sectors by

accounting for the relative importance

that the fundamental elements have for

institutions in each sector. In the final

step of the methodology, the weighted

scores are added together. The resulting

value, the composite score, represents

an overall measure of an institution’s

financial health.
62834 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

Each step of calculating the composite

score under the ratio methodology is

illustrated in Appendices F and G of

these regulations and discussed more

fully in the following sections.

Step 1: Financial Ratios

The methodology employs three ratios

that measure the same elements of

financial health but are customized to

reflect the accounting differences

between the sectors. The values of the

ratios are determined from information

contained in an institution’s audited

financial statement and are generically

defined as follows:

For proprietary institutions:

Primary Reserve ratio = Adjusted Equity

nses

Equity ratio = Modified Equity

ssets

Net Income ratio = Income Before Taxes

nues

Total Expe

Modified A

Total Reve

For private non-profit institutions:

Primary Reserve ratio = Expendable Net Assets

nses

Equity Ratio = Modified Net Assets

ssets

Net Income ratio = Change in Unrestricted Net Assets

Total Unrestricted Revenues

Total Expe

Modified A

A detailed description of the

components of the numerators and

denominators of the ratios is provided

under Appendix F of these regulations

for proprietary institutions and under

Appendix G for private non-profit

institutions.

In view of the public comment and

the empirical work performed by

KPMG, the Secretary selected these

ratios because together they take into

account the total financial resources of

an institution and provide broad

measures of the following fundamental

elements of financial health:

1. Financial viability: The ability of an

institution to continue to achieve its

operating objectives and fulfill its

mission over the long-term;

2. Profitability: Whether an institution

receives more or less than it spends

during its fiscal year;

3. Liquidity: The ability of an

institution to satisfy its short-term

obligations with existing assets;

4. Ability to borrow: The ability of an

institution to assume additional debt;

and

5. Capital resources: An institution’s

financial and physical capital base that

supports its operations.

In identifying these fundamental

elements, the Secretary relied on

KPMG’s extensive experience in

analyzing the financial condition of

postsecondary institutions and the work

of the community task force assembled

to assist the Department and KPMG in

developing the ratio methodology.

The Primary Reserve ratio provides a

measure of an institution’s expendable

or liquid resource base in relation to its

overall operating size. It is, in effect, a

measure of the institution’s margin

against adversity. The Primary Reserve

ratio measures whether an institution

has financial resources sufficient to

support its mission—that is, whether

the institution has (1) sufficient

financial reserves to meet current and

future operating commitments, and (2)

sufficient flexibility in those reserves to

meet changes in its programs,

educational activities, and spending

patterns. Thus, the Primary Reserve

ratio provides a measure of two of the

fundamental elements of financial

health—financial viability and liquidity.

The Equity ratio provides a measure

of the amount of total resources that are

financed by owners’ investments,

contributions or accumulated earnings,

depending on the type of institution, or

stated another way, the amount of an

institution’s assets that are subject to

claims of third parties. Thus, the ratio

captures an institution’s overall

capitalization structure, and by

inference its ability to borrow. With

respect to the fundamental elements of

financial health, the Equity ratio

measures capital resources, ability to

borrow, and financial viability.

The Net Income ratio provides a

direct measure of an institution’s

profitability or ability to operate within

its means and is one of the primary

indicators of the underlying causes of a

change in an institution’s financial

condition.

A more thorough description of the

ratios is provided under part 4 of the

Analysis of Comments and Changes.

Step 2: Strength Factor Scores

The strength factor score reflects the

degree to which an institution

demonstrates strength or weakness in

the fundamental elements as measured

by the ratios. That strength or weakness

is assigned a point value of not less than

negative 1.0 nor more than positive 3.0,

where a negative 1.0 indicates a relative

weakness in the fundamental elements

and a positive 3.0 indicates relative

strength in those elements. The point

values are assigned by a linear algorithm

(equation) developed for each ratio.

For example, the linear algorithm for

calculating the strength factor score for

the Equity ratio of a proprietary

institution is ‘‘6 X Equity ratio result.’’

A proprietary institution with an Equity

ratio equal to ¥0.167 would have a

strength factor score of negative 1.0 (6

X ¥0.167=¥1.002).

The linear algorithms developed for

each ratio are contained in Appendix F

for proprietary institutions and

Appendix G for private non-profit

institutions. The algorithms are

explained in greater detail under Part 6
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62835

of the Analysis of Comments and

Changes.

In developing the algorithms, the

Department, having consulted with

KPMG, determined the value of each

ratio at three critical points along the

scoring scale:

(1) The point at which an institution

begins to demonstrate a minimal level of

strength;

(2) The point at which an institution

demonstrates no strength; and

(3) The point at which an institution

demonstrates relative strength.

The algorithms were then constructed

to yield, at these relative levels of

financial health, strength factor scores of

1.0, zero, and 3.0, respectively. For

example, as calculated under the

algorithms, a strength factor score of 1.0

indicates that an institution has a

minimal level of expendable reserves

(Primary Reserve ratio), is just beginning

to demonstrate equity (its assets are

greater than its liabilities, but not by

much) (Equity ratio), and broke even

(Net Income ratio). A strength factor

score of zero indicates that an

institution has no expendable reserves

or equity, and incurred a small loss. On

the upper end of the scale, a strength

factor score of 3.0 indicates that an

institution has a healthy level of

expendable reserves and equity (its

assets are substantially greater than its

liabilities) and generated operating

surpluses that added to its overall

wealth.

The Secretary considered carefully

the comments made by the community

regarding the proposed scoring scale

and the impact of the proposed

methodology on an institution’s ability

to satisfy its mission objectives. In view

of these comments and the empirical

work performed by KPMG during the

extended comment period, the Secretary

revised the scoring scale to make greater

distinctions among institutions on the

lower end of the scale and to consider

more fairly the actual financial health of

institutions as measured by the

methodology. Since the strength factor

scores reflect the degree to which an

institution demonstrates strength or

weakness in the fundamental elements

as measured by the ratios, these scores

enable the Department to assess the

extent to which an institution has the

financial resources to:

(1) Replace existing technology with

newer technology;

(2) Replace physical capital that wears

out over time;

(3) Recruit, retain, and re-train faculty

and staff (human capital); and

(4) Develop new programs.

A more thorough discussion of the

revisions to the scoring process and

strength factor scores is provided under

Part 6 of the Analysis of Comments and

Changes.

Step 3: Weighting Percentages

The weighting percentages for each of

the ratios make it possible to compare

institutions across sectors by accounting

for the relative importance that the

fundamental elements have for

institutions in each sector. For example,

expendable resources (as measured by

the Primary Reserve ratio) are more

important to private non-profit

institutions than to proprietary

institutions—proprietary institutions

generally have greater access to capital

markets, and owners, unlike trustees,

may invest cash as needed to support

operations, or may increase expendable

resources by leaving earnings in the

institution. On the other hand, nonprofit institutions are generally

dependent on contributions from donors

as their primary source of additional

capital.

In this step of the methodology, the

strength factor score is multiplied by a

weighting percentage. For example, the

weighting percentage for the Primary

Reserve strength factor score of a

proprietary institution is 30 percent. To

determine the weighted score for a

proprietary institution with a Primary

Reserve strength factor score of 1.2, the

institution would multiply 1.2 by 30

percent, for a weighted score of 0.36 (1.2

× 30 percent = 0.36).

The regulations revise the proposed

weighting percentages to account for the

effect of replacing the proposed

Viability ratio with the Equity ratio and

to reflect more accurately the

importance of each ratio. These

revisions, and the rationale for

establishing the weighting percentages,

are discussed more fully under Part 7 of

the Analysis of Comments and Changes.

Step 4: Composite Score

In the final step of the methodology

the weighted scores are added together

to arrive at the composite score. Because

the weighted scores reflect the strengths

and weaknesses represented by the

ratios and take into account the

importance of those strengths and

weaknesses, a strength in the weighted

score of one ratio may compensate for

a weakness in the weighted score of

another ratio. Thus, the composite score

reflects the overall financial health of an

institution and provides a cardinal

ranking of all institutions along a

common scale from negative 1.0 to

positive 3.0.

A sample calculation of a composite

score is illustrated in the following

chart.

CALCULATING A PROPRIETARY INSTITUTION’S COMPOSITE SCORE

Step 1 Step 2 Step 3 Step 4 1

Calculate the ratio results Calculate strength factor

score by use of the appropriate algorithm

Calculate weighted score

(multiply strength factor

score by weighting percentage)

Primary reserve ratio = .06 ........................................................................... .06 × 20 = 1.20 1.20 × 30% = 0.36000

Equity ratio = .27 .......................................................................................... .27 × 6 = 1.620 1.620 × 40% = 0.64800

Net income ratio = .029 ................................................................................ (.029 × 33.3) + 1 = 1.9657 1.9657 × 30% = 0.58971

1Step 4: Add the weighted scores (=1.59771) and round the total of the weighted scores to one digit after the decimal point to arrive at the

composite score = 1.6.

While institutions may achieve the

same composite score in different ways

(by having different ratio results),

institutions with the same scores are

similarly situated with respect to the

resources that they can bring to bear to

satisfy their obligations to students and

to the Secretary.

The Regulatory Standard of Financial

Responsibility

As noted previously, an institution

must satisfy the standards and

provisions under each component of

financial responsibility. With respect to

its financial condition, an institution

must achieve a composite score of at

least 1.5 (the composite score standard).

In determining the minimum

composite score that an institution
62836 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

would need to achieve to demonstrate

that it is financially responsible, the

Department, having consulted with

KPMG, formulated the algorithms to

establish the point along the scoring

scale below which an institution is

clearly not financially healthy, i.e., a

composite score of 1.0. From that point,

the Secretary determined the level of

financial health that indicates that an

institution has the resources necessary

not only to continue operations, but to

fund to some extent its mission

objectives.

An institution with a composite score

of 1.0 should be able to continue

operations but does not have the

financial resources to meet its operating

needs without difficulty, or the financial

reserves necessary to deal with adverse

economic events without having to rely

on additional sources of capital.

Moreover, because it has very limited

resources, the institution will have

difficulty funding its technology, capital

replacement, and program needs. Below

this level, an institution will have even

more difficulties, if not serious

difficulties, in meeting its operating

needs without additional revenue or

support, and in funding any of its

technology, capital replacement, human

capital, or program needs.

A composite score of 1.5 generally

characterizes an institution that has

some margin against adversity, is

funding its historical capital

replacement costs, and has the resources

to provide funding for some investment

in human and physical capital.

However, the institution has no excess

funds to support new program

initiatives or major infrastructure

upgrades.

The composite score reflects the

relative financial health of institutions

along the scoring scale from negative 1.0

to positive 3.0. Stated another way, any

given composite score along this scale

reflects the degree of uncertainty that an

institution will be able to continue

operations and meet its obligations to

students and to the Secretary; the

uncertainty that an institution will be

able to continue operations and meet its

obligations increases as its composite

score decreases. Thus, if the Secretary’s

sole aim for these regulations had been

to accept the lowest level of uncertainty,

only institutions achieving the highest

composite score would be considered

financially responsible. The Secretary

notes that a significant number of

institutions in the samples examined by

the Department and KPMG attained

composite scores of 3.0 (44 percent of

the institutions in the private non-profit

sample, and 13 percent of the

institutions in the proprietary sample).

However, the Secretary believes that a

composite score of 1.5 reflects a level of

financial health that is in keeping with

the statutory requirements and the

Secretary’s goals in determining that

institutions are financially responsible.

This level balances the need to

minimize uncertainty with the need to

minimize regulatory burdens on

institutions that are likely to remain in

business, provide educational services

at a satisfactory level, and administer

properly the title IV, HEA programs.

Institutions With Composite Scores in

the Zone

As noted previously, provided that an

institution satisfies the standards

relating to its debt payments and its

administration of the title IV, HEA

programs, an institution demonstrates

that it is financially responsible by

achieving a composite score of at least

1.5, or by achieving a composite score

in the zone from 1.0 to 1.4 and meeting

certain provisions.

The ratio methodology is designed to

identify the point along the scoring

scale where an institution is financially

sound enough (a composite score of at

least 1.5) to continue to participate in

the title IV, HEA programs without any

additional monitoring arising from a

review of its financial condition, and

the point below which (a composite

score of less than 1.0) there is

considerable uncertainty regarding an

institution’s ability to continue

operations and meet its obligations to

students and to the Secretary. For

institutions scoring below 1.0,

additional monitoring and surety are

required immediately to protect the

Federal interest.

The Secretary considers institutions

with composite scores in the zone

between these two points (i.e., a

composite score of 1.0 to 1.4) to be

financially weak but viable, and

therefore allows these institutions up to

three consecutive years to improve their

financial condition without requiring

surety. The provisions for institutions

scoring in the zone are contained in

§ 668.175(d) of these regulations under

the zone alternative.

Under those provisions, an institution

qualifies initially as a financially

responsible institution by achieving a

composite score between 1.0 and 1.4,

and continues to qualify by achieving a

composite score of at least a 1.0 in each

of its two subsequent fiscal years. If an

institution does not achieve at least a

1.0 in each of its subsequent two fiscal

years or does not sufficiently improve

its financial condition so that it satisfies

the 1.5 composite score standard by the

end of the three-year period, the

institution may continue to participate

in the title IV, HEA programs by

qualifying under another alternative.

Institutions scoring in the zone

should generally be able to continue

operations in the short-term, absent any

adverse economic events. However,

even though the resources of

institutions scoring in the zone are

notably greater than the resources of

institutions scoring below 1.0, those

resources provide only a limited margin

against adversity. Moreover, because

zone institutions have notably less

resources than institutions scoring

above the zone, their ability to fund

necessary mission objectives is similarly

limited. In view of the limited resources

of zone institutions, and the uncertainty

regarding the ability of those

institutions to continue operations and

satisfy their obligations to students and

to the Secretary in times of fiscal

distress, the Secretary believes it is

necessary to monitor more closely the

operations of zone institutions,

including their administration of title

IV, HEA program funds.

Accordingly, the regulations require

an institution in the zone to provide

timely information regarding certain

accrediting agency actions that may

adversely effect the institution’s ability

to satisfy its obligations to students and

to the Secretary, and certain financial

events that may cause or lead to a

deterioration of the institution’s

financial condition. In addition, the

Secretary may require the institution to

submit its compliance and financial

statement audits soon after the end of its

fiscal year.

With regard to the administration of

title IV, HEA program funds, the

Secretary provides those funds to a zone

institution, or to an institution with a

composite score of less than 1.0, under

the reimbursement payment method or

under a new payment method, cash

monitoring. The Secretary establishes as

part of these regulations the cash

monitoring payment method in view of

the public comment that the

reimbursement payment method is

burdensome or that it may be

inappropriate for some institutions.

Under either the reimbursement or cash

monitoring payment method, to help

ensure that title IV, HEA program funds

are used for their intended purposes, an

institution must first make

disbursements to eligible students and

parents before it requests or receives

funds for those disbursements from the

Secretary. However, unlike

reimbursement, where an institution

must provide specific and detailed

documentation for each student to

whom it made a disbursement, before
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62837

the Department provides title IV, HEA

programs funds to the institution, the

Department provides funds to an

institution under the cash monitoring

payment in one of two less burdensome

ways. The Department either requires an

institution to make disbursements to

eligible students or parents before

drawing down title IV, HEA program

funds for the amount of those

disbursements, or requires the

institution to submit some

documentation identifying the eligible

students and parents to whom a

disbursement was made before the

Secretary provides funds to the

institution for those disbursements.

Although the Secretary anticipates that

the documentation requirements under

cash monitoring will be minimal for

most institutions, the Case Teams have

the flexibility under these regulations to

tailor the documentation requirements

on a case-by-case basis. In addition, the

Secretary expects that institutions with

composite scores of less than 1.0 will

continue to receive funds under the

reimbursement payment method if those

institutions are provisionally certified

(in rare instances, however, the

Secretary may provide funds under the

cash monitoring payment method to an

institution based in part on its

compliance history and the amount of

the letter of credit submitted to the

Department).

The Secretary notes that the future

implementation of the just-in-time

payment method—which the Secretary

intends to implement as soon as

possible—may reduce or eliminate the

use of the cash monitoring payment

method. Any changes to the cash

monitoring payment method arising

from the implementation of the just-intime payment method will be addressed

in a future proposed regulation, and the

Secretary will invite public comment on

those changes. (For more information on

Cash Monitoring, see the discussion

under part 9 of the Analysis of

Comments and Changes).

In developing these provisions, the

Secretary intended to achieve three

objectives. First, the Secretary wished to

provide a reasonable amount of time for

institutions to improve their financial

condition without increasing the risks to

the Federal interest. Second, the

Secretary did not wish to interfere

unnecessarily in the operations of

institutions seeking to improve their

financial condition. Third, the Secretary

wished to provide as much flexibility as

possible to the Department’s case teams

in determining the appropriate level of

monitoring and oversight required of

institutions in the zone.

Alternative Ways of Demonstrating

Financial Responsibility

Section 498(c)(3) of the HEA provides

alternatives under which the Secretary

must consider an institution to be

financially responsible if it fails to

satisfy one or more of the components

of financial responsibility. These

alternatives are described under

§ 668.175 of the regulations. This

section also contains alternatives under

which the Secretary will permit an

institution that does not demonstrate

that it is financially responsible under

the statutory provisions to continue to

participate in the title IV, HEA

programs.

An institution that does not achieve a

composite score of 1.5, or qualify under

the zone alternative, may demonstrate

that it is financially responsible by

submitting to the Secretary a letter of

credit for at least 50 percent of the title

IV, HEA program funds the institution

received in its last fiscal year. If the

institution’s composite score is less than

1.0, it may continue to participate as a

financially responsible institution by

submitting the 50 percent letter of

credit, or the institution may submit a

smaller letter of credit (at least 10

percent of the amount of its prior year

title IV, HEA program funds) and

participate under a provisional

certification.

As noted previously, the ratio

methodology is designed to consider all

of an institution’s resources. In

particular, the Primary Reserve and

Equity ratios together reflect all of the

resources accumulated over time by an

institution that are available to the

institution to support its current and

future operations. For this and other

reasons discussed under Part 7 of the

Analysis of Comments and Changes,

these two ratios account for 70 percent

of the composite score for proprietary

institutions and 80 percent for nonprofit institutions.

Institutions that do not satisfy the

composite score standard that would

otherwise participate under the zone

alternative or be required to provide a

letter of credit may find that it is less

costly to take the steps necessary to

improve their financial condition. Based

on an analysis of the data compiled by

KPMG, the Secretary notes that a

number of institutions scoring below the

zone (i.e., have composite scores of less

than 1.0) may qualify under the zone

alternative by making relatively small

capital infusions or increasing modestly

their unrestricted net assets. For some of

these institutions, the amount of the

cash infusion or increase in net assets

that would be necessary to achieve a

composite score of 1.0 is less than five

percent of total revenue because that

infusion or increase is reflected

positively in both the Primary Reserve

and Equity ratios. Alternatively,

institutions may choose to retain more

earnings. In either case, the cost to many

institutions of improving their financial

condition is less, sometimes far less,

than the cost of securing a letter of

credit.

Institutions that qualify under the

zone alternative may find that by taking

similar actions they can improve

sufficiently their financial condition to

achieve a composite score of 1.5. A zone

institution that achieves a composite

score of 1.5 at the end of any year in the

zone or by the end of the three-year

period, avoids the costs that it would

otherwise incur in securing a letter of

credit under the available alternatives.

More importantly, the resources that

would otherwise be used, by a zone

institution or an institution scoring

below the zone, to secure the letter of

credit would now be available to the

institution to support its mission

objectives. The Secretary anticipates

that financially weak institutions will

move into and out of the zone as those

institutions demonstrate a commitment

to improve their financial health.

Furthermore, the Secretary expects that

institutions will seek to improve their

financial health in the manner that most

benefits students.

Collective Guarantees

Several commenters suggested that

the Secretary revise the final regulations

to include an alternative under which a

group of institutions could (under some

type of insurance-pooling arrangement)

collectively provide a letter of credit, or

other financial instrument, that would

serve to cover the potential liabilities of

any institution in the group. The merits

of this alternative are that all of the

institutions in the group could continue

to participate in the title IV, HEA

programs as financially responsible

institutions at a lower cost than if any

one of those institutions posted a letter

of credit on its own. In the meetings

held during the extended comment

period, some participants noted that the

potential interest in such an alternative

would depend on the nature of the final

regulations.

Although the Secretary did not revise

the regulations to include this suggested

alternative (primarily because the

commenters and meeting participants

did not provide any details regarding

insurance-pooling arrangements or

alternative financial instruments, and

because the Secretary is uncertain about

the continued community interest in
62838 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

this alternative), the Secretary will

consider collective guarantee or

insurance-pooling requests on a case-bycase basis.

Issues Raised in the Notice of Proposed

Rulemaking and Other Department

Publications

The September 20, 1996 NPRM

included a discussion of the major

issues surrounding the proposed

regulations (as well as a summary of the

August 1996 report by KPMG) that will

not be repeated here. The following list

summarizes those issues and identifies

the pages of the preamble to the NPRM

(61 FR 49552–49563) on which the

discussion of those issues can be found:

• The scope and purpose statement of

the new subpart L (p. 49556).

• A proposal to modify the

precipitous closure alternative to

demonstrating financial responsibility,

and a clarification of the types of

alternatives to demonstrating financial

responsibility available to new

institutions (pp. 49557–49558).

• Financial responsibility standards

and other requirements for institutions

undergoing a change of ownership (p.

49558).

• Past performance standards (p.

49559).

• An outline of additional

requirements and administrative

actions, including requirements for

institutions that are provisionally

certified, and an outline of

administrative actions taken when an

institution fails to demonstrate financial

responsibility (p. 49559).

• The contents of the proposed

Appendix F (p. 49559).

The following list summarizes the

areas of discussion that were posted on

the Department’s World-Wide Web site.

This site is located at (http://

www.ed.gov/offices/OPE/PPI/

finanrep.html). This web site will

remain active at least until the

regulations are fully effective.

• The possibility of using in the ratio

analysis an Equity ratio either as an

additional ratio, or as a substitute for the

Viability ratio; and a discussion of the

components of, and possible strength

factor scores for, that ratio.

• Possible adjustments to the

threshold factors to take into account

new data of the effects of Financial

Accounting Standards Board (FASB)

Statements 116 and 117 on private nonprofit institutions, and to take into

account additional data on proprietary

institutions.

• Possible modifications to the

weighting percentages of the ratios,

including the weighting for the

proposed Equity ratio.

• Possible modifications to the

calculation of composite scores from the

ratio analysis to eliminate ‘‘cliff effects,’’

including the possible use of a linear

algorithm or the addition of more

strength factor categories to linearize the

composite scores.

• Possible modifications to the

scoring scale, including truncating the

upper end of the scale to eliminate

unnecessary differentiation of

institutions that attain high composite

scores.

• Community suggestions regarding

the treatment of goodwill in the

calculation of the ratios.

• Community suggestions for a

secondary tier of analysis, and suggested

changes to the alternative means of

demonstrating financial responsibility

for those institutions that fail the ratio

test.

• Discussions of the utility of using a

cash flow analysis.

• Discussions of the treatment of

institutional grants and other fullyfunded operations in the calculation of

the ratios.

• Discussions of donor income with

regard to determining the financial

responsibility of non-profit institutions,

and in particular of institutions that

have continued for many years on tight

budgets with a minimal financial

cushion.

• The treatment of debt in the

proposed ratio methodology, including

concerns that the proposed ratio

methodology could penalize institutions

for taking on necessary amounts of debt

to expand or to invest in infrastructure,

and suggestions for the evaluation of

institutions that remain debt-free.

• Community suggestions for altering

the proposed standards for changes of

ownership.

• Discussions of the utility and

practicality of using a trend analysis

rather than a snapshot approach, and

community suggestions that financial

responsibility need not be determined

annually, at least for stronger

institutions.

• Community suggestions for revising

the ‘‘full faith and credit’’ alternative for

public institutions.

Substantive Changes to the NPRM

The following discussion reflects

substantive changes made to the NPRM

in the final regulations.

• The proposed ratio standards for

public institutions have been eliminated

in favor of a revised approach in

implementing the statutory alternative

that an institution is financially

responsible if it is backed by the full

faith and credit of a State or equivalent

government entity.

• The proposed Viability ratio has

been replaced by the Equity ratio.

• The proposed scoring scale has

been modified to range from negative

1.0 to positive 3.0, rather than from 1.0

to 5.0. The low end of the range, below

1.0, indicates the poorest financial

condition. At the high end, a score of

3.0 indicates financial health.

• The proposed strength factor tables

have been replaced by linear algorithms.

• The proposed ratio results

necessary to earn points along the

scoring scale have been lowered to

reflect a time frame of 12-to-18 months

rather than 3-to-4 years.

• As a result of revising the scoring

scale and the strength factor scores, and

the change in focus from 3-to-4 years to

12-to-18 months, the minimum

composite score for establishing

financial responsibility has been

changed from the proposed standard of

1.75 (on a scale of 1.0 to 5.0) to 1.5 (on

a scale of negative 1.0 to positive 3.0).

• The proposed precipitous closure

alternative has been modified and

implemented in these regulations as the

zone alternative. Under the zone

alternative, an institution whose

composite score is less than 1.5 but

equal to at least 1.0 may participate in

title IV, HEA programs as a financially

responsible institution for up to three

consecutive years.

• As part of the modifications to the

proposed precipitous closure

alternative, the provision requiring

owners or persons exercising substantial

control over an institution to provide

personal financial guarantees is

eliminated. Instead, an institution

whose composite score is less than 1.5

is required to provide information

regarding certain oversight and financial

events, and the Department provides

title IV, HEA program funds to that

institution under the reimbursement

payment method or under a new, less

burdensome payment method, Cash

Monitoring (discussed above and under

part 9 of the Analysis of Comments and

Changes).

• The proposal to apply the ratio

methodology to third-party servicers

entering into a contact with lenders and

guaranty agencies has been withdrawn.

The financial standards currently under

§ 668.15 continue to apply to those

entities.

• The proposed revisions to the

procedures relating to changes of

ownership have been withheld pending

further review and comment.

Executive Order 12866

These final regulations have been

reviewed as significant in accordance

with Executive Order 12866. Under the
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62839

terms of the order, the Secretary has

assessed the potential costs and benefits

of this regulatory action.

The potential costs associated with

the final regulations are those resulting

from statutory requirements and those

determined by the Secretary to be

necessary for administering the title IV,

HEA programs effectively and

efficiently.

In assessing the potential costs and

benefits—both quantitative and

qualitative—of these regulations, the

Secretary has determined that the

benefits of the regulations justify the

costs.

The Secretary has also determined

that this regulatory action does not

unduly interfere with State, local, and

tribal governments in the exercise of

their governmental functions.

Summary of Potential Costs and

Benefits

The potential costs and benefits of

these final regulations are discussed

elsewhere in this preamble under the

heading Final Regulatory Flexibility

Analysis (FRFA), and in the information

previously stated under Supplementary

Information and in the following

Analysis of Comments and Changes.

Analysis of Comments and Changes

In response to the Secretary’s

invitation to comment on the NPRM,

approximately 850 parties submitted

comments. An analysis of the comments

and of the changes in the regulations

since the publication of the NPRM

follows.

The Department received comments

on these regulations from September 20,

1996 through April 14, 1997. Although

the Department received and considered

comments on all of the topics included

in the NPRM, the comments discussed

here are primarily those which address

the changes to the NPRM made by these

final regulations.

Major issues are discussed under the

section of the regulations to which they

pertain. Comments concerning the new

Subpart L are grouped by topic or issue.

Technical and other minor changes—

and suggested changes the Secretary is

not legally authorized to make under

applicable statutory authority—are not

addressed. An analysis of the comments

received regarding the Initial Regulatory

Flexibility Analysis (IRFA) can be found

elsewhere in this preamble under the

heading Final Regulatory Flexibility

Analysis (FRFA).

Section 668.23—Compliance Audits

and Audited Financial Statements

Comments: Several commenters noted

that the requirements under

§ 668.23(f)(3) (previously codified under

§ 668.24), are not always possible to

meet. Under this section, an

institution’s or servicer’s response to the

Secretary regarding notification of

questioned expenditures must be based

on an attestation engagement performed

by the institution’s or servicer’s auditor.

The commenters maintained that an

attestation engagement is proper only

when the subject of the attestation is

capable of being evaluated based on

reasonable, objective criteria, and that

some responses to notifications of

questioned expenditures may be based

on grounds that could not be so

evaluated, i.e., the contention that an

auditor misinterpreted or misapplied a

regulatory requirement when the

auditor questioned the institution’s or

servicer’s compliance or expenditure.

Discussion: The Secretary agrees that

there are cases in which the institution’s

response to an audit does not have to be

based on an attestation engagement.

This provision was intended to inform

institutions that new information or

documentation that was not available

during the original audit should be

accompanied by the auditor’s attestation

report, when that report is submitted to

the Secretary. Without the auditor’s

report, the resolution of the audit may

be delayed or the data may not be

considered reliable. However, the

Secretary agrees that the necessity for

the attestation engagement is

determined by the nature of the

response being made, and may not be

required in all cases.

The Secretary also has determined

that the procedures described in

§ 668.23(f)(1)–(3) are redundant with

requirements under OMB Circulars A–

128 and A–133 and the Office of

Inspector General Audit Guide, and that

redundancy may cause confusion for

some institutions. The OMB Circulars

and the Audit Guide each contain

requirements that a Corrective Action

Plan, which includes the institution’s

responses to the audit findings and

questioned costs, be submitted with the

audit. If the institution disagrees with

the findings or believes corrective action

is not needed, it provides the rationale

for that belief in the Corrective Action

Plan.

Normally, an institution submits

information in its Corrective Action

Plan, in response to a specific request

from the Secretary, or as part of an

appeal under 34 CFR 668 subpart H.

The Secretary establishes whether an

attestation report is required as part of

the Secretary’s request for information;

the Hearing Official evaluates the

reliability of information submitted with

an appeal. To avoid duplication and

unnecessary audit work and because

few institutions submit additional data

as described in paragraph (f), the

Secretary removes this paragraph.

Changes: The Secretary removes

paragraph (f) under § 668.23.

Subpart L—Financial Responsibility

Part 1. General Comments Regarding the

Proposed Ratio Methodology

Comments: Many participants

involved in the discussions conducted

by the Secretary during the extended

comment period expressed the view that

the manner in which those discussions

were conducted demonstrated the

Department’s commitment to public and

community involvement in the

rulemaking process and should serve as

a model for future rulemaking.

Several commenters maintained that

the Secretary cannot change the current

standards of financial responsibility

without first convening regional

meetings to obtain public involvement

in the development of proposed

regulations as provided under the

negotiated rulemaking process

described in section 492 of the HEA.

One commenter opined that absent a

negotiated rulemaking process the

Secretary could not promulgate

regulations that would have legal force

and effect.

Several commenters argued that the

proposed ratio methodology is contrary

to statutory provisions under section

498 of the HEA because the proposed

ratios do not include the type of ratios

specified by the HEA.

Other commenters maintained that

any attempt by the Secretary to

promulgate financial responsibility

standards was duplicative, and that for

reasons of efficiency and regulatory

relief the Secretary should rely upon

standards used by financial institutions

and accrediting agencies.

Discussion: The Secretary appreciates

the participants’ remarks and thanks

those persons for their valuable input

regarding the direction and

development of these rules. The

Secretary disagrees that negotiated

rulemaking is required under the HEA

to implement these regulations. In

accordance with section 492 of the HEA,

the Secretary conducted regional

meetings to obtain public involvement

in the preparation of draft regulations

for parts B, G and H of the HEA as

amended by the Higher Education

Amendments of 1992. As required

under section 492, those draft

regulations were then used in a

negotiated rulemaking process that was

subject to specific time limits connected

with the enactment of the 1992
62840 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

Amendments. The negotiated

rulemaking requirement was therefore

anchored at one end by the statutorily

required regional meetings that followed

the enactment of the 1992 Amendments,

and at the other end by fixed time limits

for the final regulations created by that

process. Subsequent regulatory changes

to these sections cannot be tied to those

requirements for negotiated rulemaking

because the regional meetings and

statutory timeframes for those

regulations have already passed. The

HEA does not restrict the Secretary’s

authority to make additional regulatory

changes in this area, and changes to the

regulations may therefore be made

without using negotiated rulemaking.

Even though negotiated rulemaking

was not required for these regulations,

the Secretary believes that the

opportunities afforded to the higher

education community during the

extended comment period to provide

input regarding the proposed

regulations are consistent with the spirit

of cooperation that underlies the

negotiated rulemaking process. In the

numerous meetings held during the

extended comment period with

representatives from institutions, higher

education associations, and other

interested parties, the meeting

participants identified many areas in the

proposed regulations that the Secretary

has since modified and improved to

more accurately measure the relative

financial health of institutions.

The Secretary disagrees that section

498(c)(2) of the HEA requires the

Secretary to utilize particular ratios in

determining financial responsibility.

That section of the HEA merely

provides examples of ratios that the

Secretary may use in determining

whether an institution is financially

responsible, e.g., the statutory reference

to an ‘‘asset to liabilities’’ ratio is a

generic rather than a specific reference

or requirement. Moreover, the Secretary

believes that the ratio methodology

established by these regulations not

only incorporates the same aspects of

financial health as the ratios illustrated

in the HEA, but does so in a more

comprehensive manner.

With respect to the comments that the

Secretary should rely on financial

determinations made by accrediting

agencies or financial institutions, the

Secretary notes that section 498(c) of the

HEA requires the Secretary to make

those determinations for institutions

participating in the title IV, HEA

programs. In addition, because the

financial standards used by other parties

reflect the mission of those parties or are

used by those parties to initiate or

continue a business relationship, there

is no assurance that determinations

made under those standards by those

parties will have a direct bearing on

whether an institution is financially

responsible for the purposes required

under HEA, i.e., that the institution is

able to (1) provide the services

described in its official publications, (2)

administer properly the title IV, HEA

programs in which it participates, and

(3) meet all of its financial obligations

to students and to the Secretary.

Moreover, and absent any provision in

the statute that permits the Secretary to

delegate financial responsibility

determinations to other parties, if the

Secretary adopted the commenters’

suggestion, similarly situated

institutions would be treated differently

depending on the party making the

determination.

Changes: None.

Part 2. Comments Regarding the Timing

and Implementation of New Financial

Standards

Comments: Several commenters

recommended that the Secretary

postpone any changes to the financial

responsibility standards until after

reauthorization of the HEA. The

commenters argued that if new

standards are implemented now, these

standards might be changed during the

reauthorization process or the statute

may be amended to include other

requirements, thus potentially

subjecting institutions to several

different requirements within a few

years. Another commenter suggested

that the proposed standards form the

starting point for discussions between

the Secretary and the higher education

community on reauthorization issues

involving financial responsibility.

Many commenters believed that the

reporting requirements under FASB

116, Accounting for Contributions

Received and Contributions Made, and

FASB 117, Financial Statements of Notfor-Profit Organizations, are too recent

to be thoroughly understood. In

particular, the commenters maintained

that since the impact of these FASB

requirements on the proposed ratio

methodology is not known, the

Secretary should delay publishing final

rules. Along the same lines, commenters

representing proprietary institutions

maintained that the Secretary should

not promulgate the ratio methodology

because it is untested and its impact on

the community is not known.

Discussion: The Secretary believes

that changes to the current financial

responsibility standards are necessary

for the reasons cited in the preamble to

this regulation (see the discussion under

the heading Need for Revising the Rules

in the SUPPLEMENTARY INFORMATION

section of these regulations).

With regard to new accounting

standards under FASB Statements 116

and 117, since most private non-profit

colleges and universities adopted the

new FASB standards for their fiscal

years that ended June 30, 1996, only a

limited number of financial statements

prepared under those standards were

available for examination at the time the

NPRM was published. Based on that

limited number of financial statements,

the proposed strength factors for the

Primary Reserve ratio were set

approximately 66 percent higher than

strength factors for institutions under a

fund accounting model (AICPA Audit

Guide financial reporting model). This

increase in the strength factors was

intended to reflect the fact that under

FASB 116/117 realized and unrealized

gains on investments held as

endowments are included in

unrestricted or temporarily restricted

net assets, whereas under fund

accounting these gains were generally

treated as nonexpendable assets.

Therefore, it was anticipated that the

expendable net assets of all institutions

would increase significantly.

During the extended comment period

KPMG conducted an analysis of

financial statements from 395 non-profit

institutions that adopted FASB 116/117

and found that the impact of the new

accounting standards is not uniform

across the private non-profit sector. The

anticipated impact that expendable net

assets would increase significantly

occurred only among institutions

holding large endowments; the impact

was negligible for institutions with little

or no endowment. Based on the more

thorough KPMG analysis, the Secretary

revises the strength factors for the

Primary Reserve ratio for private nonprofit institutions in a manner that

discounts the effects of the new FASB

standards for all non-profit institutions.

Changes: See the discussion of the

strength factor score for the Primary

Reserve ratio, Analysis of Comments

and Changes, Part 6.

Comments: A commenter representing

proprietary institutions questioned the

manner in which the KPMG study was

conducted. The commenter believed

that small business interests were not

considered since no representatives of

small proprietary institutions were

among those institutional

representatives that assisted with the

KPMG study. Moreover, the commenter

implied that the Secretary did not

consider the comments submitted by a

group of CPAs on behalf of proprietary

institutions regarding the KPMG report,

and therefore may have violated the
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62841

requirement in the Regulatory

Flexibility Act (RFA) that the Secretary

confer with representatives of small

businesses.

Discussion: The Secretary notes that

the suggestions of the group of CPAs

referenced by the commenters were

considered in developing these final

regulations. More significantly,

however, during the extended comment

period the Secretary sought and

obtained the views and comments of

individuals and organizations with

diverse experience in higher education

finance. Specifically, the Secretary met

with organizations representing

proprietary institutions and directly

with persons from proprietary

institutions, including representatives

from small institutions. In addition the

Secretary provided on the Department’s

web site a summary of the views

expressed by the participants at those

meetings and additional information

regarding the ratio methodology.

Changes: None.

Part 3. Comments Regarding Annual

Determinations of Financial

Responsibility

Comments: Many commenters from

private non-profit institutions

maintained that institutions should not

be subjected to annual determinations of

financial responsibility. The

commenters believed that annual

determinations are unnecessarily

burdensome, and represent an

inefficient use of the Secretary’s

resources, particularly in cases in which

an institution has been recently

recertified. The commenters opined that

when a determination is made during

the recertification process that an

institution is financially responsible, the

Secretary has sufficiently discharged his

oversight responsibilities in this area.

Discussion: The Secretary believes

that it is not prudent to ignore the

financial condition of many institutions

for the three- to four-year period

between recertification cycles for

several reasons. First, the financial

condition of an institution may

deteriorate, increasing unnecessarily the

risks to students and taxpayers that the

institution will close or will otherwise

be unable to meet its obligations.

Second, many institutions prepare an

annual audited financial statement for

other purposes, so the only burden that

may result from an annual

determination stems from the

institution’s failure to satisfy the

standards of financial responsibility.

Lastly, if the Secretary were to adopt the

commenters’ suggestion by establishing

longer term financial standards for all

institutions, those standards would

necessarily need to be much higher than

the standards in these regulations,

resulting in more institutions failing the

standards and creating additional

burdens for those institutions and the

Secretary. Nevertheless, the Secretary

may in the future explore the possibility

of determining the financial

responsibility of certain institutions less

often or only during the recertification

process.

Changes: None.

Part 4. Comments Regarding the

Adequacy and Appropriateness of the

Proposed Ratio Methodology

General comments: Many commenters

from a variety of sectors supported the

direction taken by the proposed

regulations, including customizing the

ratios for each sector. The commenters

agreed with the Secretary that the

proposed methodology provides a better

assessment of an institution’s financial

condition than the regulatory tests

currently in place. However, the

commenters believed that some changes

should be made to the proposed

regulations.

Several commenters asserted that the

proposed ratio methodology is

inadequate because it does not consider

other factors, such as enrollment trends,

used by credit rating agencies like

Moody’s or Standard and Poor’s. The

commenters suggested that along with

using the proposed methodology, the

Secretary should consider an

institution’s Moody’s or Standard and

Poor’s credit rating, and the institution’s

history of handling Federal funds,

before the Secretary determines whether

the institution is financially responsible.

Similarly, one commenter from a nonprofit institution argued that credit

rating agencies place a significant

emphasis on the strength of an

organization’s revenue stream, but the

proposed ratios virtually ignore this

variable. The commenter stated that in

assessing the revenue strength of

educational institutions, the rating

agencies typically review such data as

average SAT scores and student

acceptance rates. It was the commenter’s

view that a revenue strength score

should be part of the evaluation process

and should carry no lesser weight than

that associated with expenses.

Other commenters from non-profit

institutions maintained the ratio

methodology is not valid because it is

not based on traditional measures of

financial strength, and did not take into

account the institution’s total financial

circumstances as required by the HEA.

Another commenter from the non-profit

sector argued that the proposed rules,

because of their emphasis on

profitability, appeared to be designed

for proprietary institutions. The

commenter urged the Secretary to

amend the rules to reflect the difference

in each sector. Several other

commenters from private non-profit

institutions asserted that the proposed

ratio methodology is deficient because it

does not take into account specific

missions of institutions.

Several commenters believed that the

proposed methodology is too restrictive,

arguing that it is too heavily biased in

safeguarding the Secretary from events

that are very rare.

Several other commenters

representing proprietary institutions

maintained that the new methodology

was incomplete because it contained no

way to measure the effectiveness of an

institution’s management.

Other commenters believed that many

small institutions with good educational

and compliance records that pass the

current standards would fail the

standards proposed in the NPRM. The

commenters opined that this outcome

points to a flaw in the manner in which

the methodology treats small

institutions. An accountant for a

proprietary institution argued that

because the proposed methodology does

not provide an adjustment for size, it is

unfair to compare an institution with

$10 million in tuition revenue to an

institution with $500,000 in tuition

revenue by applying the same standards

and criteria to both institutions.

Several commenters maintained that

the proposed methodology is complex

and difficult to understand. The

commenters argued that the proposed

rules will require institutions to rely

more heavily on CPAs, thus increasing

their costs.

Discussion: The Secretary thanks the

commenters supporting the approach

taken under these rules to establish

better, more comprehensive financial

standards and appreciates the

cooperation and effort of commenters

and other participants in the rulemaking

process for sharing their views and

concerns with the Secretary during the

initial and extended comment periods.

With regard to the concerns raised by

the commenters about the adequacy of

the ratio methodology, the Secretary

wishes to make the following points.

First, the ratio methodology is designed

to make appropriate, albeit broad,

distinctions between the sectors of

higher education institutions. The

Secretary acknowledges that the

methodology does not directly consider

intra-sector differences nor does it take

into account all of the variables or

elements suggested by the commenters

regarding the mission or organizational
62842 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

structure of institutions. To do so would

create an enormously complex model

that as a practical matter would be

impossible to implement. Rather, the

methodology focuses on key ratios and

differences between the sectors that the

Secretary believes are the most critical

in evaluating fairly the relative financial

health of all institutions along a

common scale.

Second, the adequacy of the ratio

methodology should be judged in the

context of both its design objectives and

the associated regulatory provisions that

complement those objectives. In

developing these regulations the

Secretary sought to minimize two

potential errors—that a financially

healthy institution would fail the ratio

standard and be inappropriately subject

to additional requirements and burdens,

and that a financially weak institution

would satisfy the ratio standard and

later fail to carry out its obligations at

the expense of students and taxpayers.

The ratio methodology, in combination

with the alternative standards

established by these regulations (see

Analysis of Comments and Changes,

Part 9), reflects the Secretary’s decision

to err on the side of allowing some

financially weak institutions to

participate in the title IV, HEA programs

but in a manner that protects the

Federal interest.

Third, the Secretary disagrees that the

ratio methodology is flawed because it

does not provide an adjustment for the

size of an institution. To the contrary,

an adjustment for size is unnecessary

because a ratio converts amounts into a

metric that is relative to an institution’s

own size, making possible a comparison

of that institution to other institutions

regardless of the size of those

institutions. This comparative analysis

is the basic design element of the ratio

methodology that enables the Secretary

to evaluate the relative financial health

of all institutions along a common scale.

Similarly, the Secretary disagrees that

the methodology favors large or publicly

traded institutions. Presumably, the

commenters are referring to a situation

where a large institution is not

dependent upon a single revenue stream

or has access to wider donor bases or

more capital markets than a small

institution. While this flexibility may

advantage a large institution, the

Secretary believes that flexibility is

inherent to the institution and beyond

the scope of the methodology. The fact

that a large institution may be able to

improve its financial condition by

managing its resources effectively also

holds true for a small institution,

particularly since the ratios account for

an institution’s performance relative to

its size.

With regard to the comment from the

non-profit sector that the proposed ratio

methodology appeared to be designed

for proprietary institutions because it

emphasized profitability, the Secretary

notes that the measure of profitability

(the Net Income ratio) accounted for 50

percent of the composite score for

proprietary institutions, but for only 10

percent of the composite score for nonprofit institutions. As discussed more

fully under Part 7 of the Analysis of

Comments and Changes (Comments

regarding the weighting of the proposed

ratios), the Secretary has revised the

proposed percentages for the Net

Income ratio to more accurately reflect

the differences between the sectors of

postsecondary institutions.

The Secretary disagrees that the

methodology will require institutions to

rely more heavily on CPAs. As

illustrated in the appendices to these

regulations, an institution can readily

calculate its composite score from its

audited financial statements, provided

that those statements are prepared in

accordance with GAAP. Furthermore,

by limiting the number of ratios, the

Secretary believes that it should not be

difficult for any institution to determine

the impact that its business and

programmatic decisions have or will

have on its financial condition as

measured by the methodology.

Changes: None.

Comments regarding alternative

ratios: Several commenters argued that

the proposed ratio methodology is

limited and arbitrary, suggesting

alternative ratios that should be used

instead, including: the acid test ratio; a

debt to equity ratio; a title IV, HEA loan

program default ratio; a debt to revenue

ratio; a longevity ratio; a debt service

coverage ratio; and a measure of

working capital.

Several commenters believed that the

Primary Reserve ratio disadvantages

institutions that converted short-term

liabilities into long-term debt to meet

the acid test ratio requirement.

A commenter from an accrediting

agency asserted that the composite score

based on the proposed ratio

methodology is inadequate in assessing

an institution’s financial health, and

that other measures such as operating

income, debt levels, availability of

working capital, and significant items

contained in notes to the financial

statements should be used instead.

Discussion: The Secretary considered

a number of ratios that could be used in

addition to or in place of the proposed

ratios, including the ratios suggested by

the commenters, but decided to replace

only the proposed Viability ratio, with

an Equity ratio. As discussed below,

while the ratios suggested by the

commenters are valid measures, taken

individually or as a whole they measure

the financial health of an institution

more narrowly than do the ratios

established by these regulations. In

selecting the ratios, the Secretary

considered the extent to which those

ratios provided broad measures of the

following fundamental elements of

financial health:

1. Financial viability: The ability of an

institution to continue to achieve its

operating objectives and fulfill its

mission over the long-term;

2. Profitability: Whether an institution

receives more or less than it spends

during its fiscal year;

3. Liquidity: The ability of an

institution to satisfy its short-term

obligations with existing assets;

4. Ability to borrow: The ability of an

institution to assume additional debt;

and

5. Capital resources: An institution’s

financial and physical capital base that

supports its operations.

The Secretary believes that the ratios

used in the methodology, Primary

Reserve, Equity, and Net Income, not

only measure these fundamental

elements well, but that they do so in a

manner that takes into account the total

resources of an institution. With respect

to the ratios suggested by the

commenters, the Secretary wishes to

make the following points.

The Secretary agrees that the acid test

ratio (cash and cash equivalents divided

by current liabilities) is a useful

measure of highly liquid assets available

to meet current obligations, and it is

used in the current regulations as a test

of financial responsibility. However, the

acid test is not included in the ratio

methodology for several reasons. First, it

has been the Department’s experience

that certain institutions manipulate the

ratio elements to satisfy the 1:1 acid test

standard, such as by reclassifying

current liabilities as long-term

liabilities. Second, the information

needed to calculate the ratio is difficult

to extract from the financial statements

prepared for non-profit institutions

because that information is not a

required disclosure (assets and

liabilities are not necessarily classified

on those financial statements as current

and noncurrent). Moreover, expendable

capital (as measured by the Primary

Reserve ratio) is a broader and more

important element of financial health

than highly liquid capital, because it

mitigates the effects of differing cash

management and investment strategies

used by institutions. For example, an
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62843

institution that invests excess cash in

other than short-term instruments may

fail the acid test requirement, whereas

that excess cash, regardless of how it is

invested, is considered an expendable

resource under the Primary Reserve

ratio. For these same reasons, Working

Capital ratios (working capital is the

difference between current assets and

current liabilities) are not included in

the methodology.

With respect to Cash Flow ratios, the

Secretary considered several measures

of cash provided from operations to

cover debt payments. However, cash

flow (taken directly from the Cash Flow

Statement) can be easily manipulated.

For example, delaying payment to

creditors by simply extending the

normal payment terms to 120 days

would give the appearance that cash has

been provided by operations. Therefore,

the Secretary decided to retain the Net

Income ratio which, as an accrual-based

measure, recognizes expenses when

they are incurred, not when they are

paid.

The Secretary considered an

Operating Income ratio that would

measure income from operations as a

percentage of net revenue, but the

results of that ratio would only partially

address the question of whether an

institution operated within its means

during its fiscal year. By comparison,

the Net Income ratio measures net

income as a percentage of net revenues

after operations and other non-operating

items and thus provides a more

complete measure of whether an

institution spent more than it brought in

during the fiscal year.

The Secretary also considered

adjusting the Net Income ratio for noncash items, but decided instead to make

an allowance for the largest non-cash

item—depreciation expense—in the

strength factors for this ratio (see

Analysis of Comments and Changes,

part 6).

With regard to the Debt to Equity ratio

and the other suggested Debt ratios, the

Secretary notes that, like the proposed

Viability ratio, these ratios cannot be

applied universally. Based on the

audited financial statements reviewed

by KPMG during the extended comment

period, approximately 35 percent of

proprietary institutions and 13 percent

of private non-profit institutions have

no debt. In addition, Debt to Revenue

and Debt Service Coverage ratios, while

providing insight as to how the

institution is managing its debt, are less

important than a measure of leverage

itself. For these and other reasons, the

Secretary includes in the ratio

methodology an Equity ratio (tangible

equity divided by tangible total assets)

as the primary measure of leverage.

The Secretary is not convinced that

the utility of a Longevity measure or

ratio is on par with the utility of the

ratios used in the methodology. Unlike

the ratios used in the methodology that

measure the actual financial condition

of an institution, it is not clear how a

Longevity measure could be used as part

of the methodology. A Longevity

measure merely implies that an

institution that has been operating for

many years will continue to operate, but

provides no insight regarding the

institution’s current financial condition

or its ability to satisfy its obligations.

Moreover, a Longevity measure cannot

be used as an independent test because

it has no predictive value at the

institutional level. Based on data

obtained from Dun & Bradstreet

regarding the probabilities of credit

stress and bankruptcy, the Secretary

found that institutions that have been in

existence for more than 30 years have

on average more likelihood of enduring

credit stress and less likelihood of going

bankrupt than institutions that are less

than 30 years old. However, there were

a significant number of institutions in

the data group that have been in

existence for more than 30 years that

were rated by Dun & Bradstreet as

representing high risks of late payments

or financial failure. In addition, the

Secretary reviewed the files of closed

institutions and found that a significant

percentage of those institutions (12

percent) were in existence for more than

25 years.

With regard to the notes to financial

statements and independent

accountants’ reports, the Secretary

wishes to clarify that these notes and

reports are reviewed by the Secretary to

determine if an institution complies

with other standards or elements of

financial responsibility. For example, if

an auditor expresses a ‘‘going-concern’’

opinion, the institution is not

financially responsible even if it

satisfies all other standards. However,

the information contained in the notes

and reports does not always constitute

a sufficient basis on which the Secretary

makes or can make a determination of

financial responsibility.

Changes: The proposed ratio

methodology is revised, in part, by

replacing the Viability ratio with the

Equity ratio.

Comments regarding the use of ratios:

One commenter from the proprietary

sector argued that the proposed ratio

methodology should not be used to

determine that an institution is not

financially responsible. The commenter

stated that the AICPA CPA/MAS

Technical Consulting Practice Aid No. 3

warns of the shortcomings of ratio

analysis, including improper

comparisons that do not take into

account size, geographical location and

business practices, and other variables

such as depreciation and number of

years considered by that analysis. Based

on these shortcomings, the commenter

concluded that a financially strong

institution may fail to achieve the

required composite score requirement or

be forced to make unsound business

decisions solely to meet the

requirement. Although the commenter

believed that the proposed ratio

methodology could be used to

determine that an institution is

financially responsible, the commenter

recommended that the Secretary allow

an institution that fails to achieve the

composite score to demonstrate its

financial strength without imposing the

letter of credit requirement.

Discussion: The Secretary disagrees.

The practice aid is specifically designed

to provide a consulting or accounting

practitioner illustrative examples of the

use of financial ratio analysis

techniques in performing a comparative

analysis of a client organization with

other appropriate organizations.

The ‘‘shortcomings’’ referred to by the

commenter relate to factors that should

be considered by the practitioner in

understanding the differences that may

occur between comparable companies

and explaining those differences to the

client. To the extent practicable, the

ratio methodology developed for these

regulations mitigates these differences

by evaluating the financial health of an

institution relative to other institutions,

and by measuring an institution’s

financial health against a minimum

standard established by the Secretary. In

addition, the individual ratio definitions

are constructed to account for reporting

and accounting differences between the

sectors of higher education institutions.

While other factors, such as operating

structure, could affect an institution’s

performance, the consequences of those

factors reflect management decisions

that fall outside the scope of the

Secretary’s review.

Changes: None.

Comments regarding public

institutions: One commenter argued that

there is no need for Federal financial

standards for public institutions for

several reasons.

First, the commenter maintained that

there is no danger of a ‘‘precipitous

closure’’ of a public institution because,

in his State, the closure of a State

college or university requires the

approval of the State General Assembly.

Moreover, the commenter believed that
62844 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

in authorizing a closure, the General

Assembly would be careful to protect

the interests of students and all

creditors. In any event, the commenter

opined that the Secretary could recover

any monies due from a closed State

institution by offset against future aid to

other State institutions. For local public

institutions (community colleges), the

commenter stated that, in his State, a

closure would have to be approved in a

general election. However, the closure

of a local institution cannot adversely

affect student refunds or other liabilities

of the institution because State law

requires the continuance of property tax

assessments until all debts of the

institution are paid in full.

Second, the commenter noted that

public institutions are subject to far

more official oversight than private or

proprietary institutions. In his State, the

activities of State institutions are

monitored by, among others, the State

Controller, the State Auditor, and the

State Commission on Higher Education.

Third, the commenter pointed out

that public institutions are subject to

more public scrutiny than are private

and proprietary institutions, i.e., public

institutions conduct their affairs in

public, publish budgets, hold governing

board meetings that are open to the

public, and make their financial

statements available for public

inspection. The commenter believed

strongly that this scrutiny enhances the

financial responsibility of public

institutions.

Fourth, the commenter noted that the

1973 AICPA Audit Guide is obsolete for

colleges and universities under FASB

jurisdiction and will soon be obsolete

for other public institutions. The

commenter stated that the Government

Accounting Standards Board (GASB)

intends to publish an exposure draft on

its Colleges and Universities Reporting

Model at the end of March 1997 and a

final Statement of Financial Reporting

Standards in the second quarter of 1988.

According to the commenter, since the

proposed reporting model makes major

changes to public institutions’ financial

statements, it is unlikely that any ratio

definitions based on the 1973 AICPA

Audit Guide will be useful when the

new model takes effect (probably the

fiscal year starting in 2000). The

commenter suggested therefore that the

Secretary delay promulgating financial

ratio standards for public institutions

until the new GASB standards are in

effect.

Next, the commenter argued that the

proposed methodology’s reliance on

profits and expendable fund balances is

inappropriate for public institutions,

and may be contrary to State public

policy. The commenter believed that

unlike private non-profit and

proprietary institutions that need to

have sufficient reserves (or be able

generate the profits necessary to

accumulate sufficient reserves) to

continue operations during economic

fluctuations, public institutions have

much less need for reserves because

their major funding sources are less

susceptible to those fluctuations.

In addition, the commenter stated that

in his State, public policy prohibits

State institutions from accumulating

large expendable funds balances. The

State General Assembly appropriates

funds for the purpose of meeting the

immediate education needs of State

residents and not for creating

institutional reserves. The commenter

continued that consistent with this

policy, the State does not fund colleges

and universities for the long-term

compensated absence liabilities that

those institutions are required to accrue

under GASB Statement No. 16 (the State

funds these liabilities when they

become due). Consequently, the

commenter believed that the existence

of these liabilities virtually guarantees

that smaller State institutions will fail

the proposed ratio standards. Moreover,

the commenter argued that the proposed

ratio standards do not sufficiently

recognize the differences between

public sector financial reporting

requirements (GASB) and private sector

requirements (FASB).

Several other commenters maintained

that some State institutions would not

achieve the required composite score if

they are required to include in the

calculation of the proposed ratios, items

that are beyond the control of those

institutions. Therefore, the commenters

suggested that it would be fairer to

allow State institutions to exclude from

the ratio analysis items such as plant

debt and certain employee benefits that

are the obligation of the State or funded

by the State.

For several reasons, commenters

representing public institutions believed

that the Secretary should amend

proposed § 668.174(a)(1). Under this

section, an institution that fails to

achieve the required composite score

may demonstrate to the Secretary that it

is nevertheless financially responsible if

the institution’s liabilities are backed by

the full faith and credit of the State or

by an equivalent government entity.

First, the commenters recommended

that the Secretary qualify the term

‘‘liabilities’’ by adding the phrase ‘‘that

may arise from the institution’s

participation in the title IV, HEA

programs.’’ In support of this

recommendation, the commenters noted

that in both of the other alternatives

under this section, liabilities are either

based on or limited to the amount of

title IV, HEA program funds received by

an institution. Moreover, the

commenters argued that if the Secretary

interprets ‘‘liabilities’’ to mean all

balance sheet liabilities of an

institution, the State would have to

accept these liabilities as General

Obligations of the State. According to

the commenters, since most States have

constitutional prohibitions against

general obligation debt, States would be

prohibited from providing the required

backing for any institution that has

revenue bonds or similar debt

outstanding.

Next, the commenters recommended

that the Secretary amend the term

‘‘equivalent government entity’’ by

adding the phrase ‘‘including local

governments or separate districts with

taxing authority’’ to clarify that the

guarantee required under § 668.174(a)(1)

may be provided by any entity that has

the taxing power to validate its

guarantee.

Discussion: The Secretary agrees with

many of the points made by the

commenters and therefore does not

establish in these regulations a

composite score standard for public

institutions. Instead of satisfying the

composite score standard, an institution

must notify the Secretary that it is

designated as a public institution by the

State, local or municipal government

entity, tribal authority, or other

government entity that has the legal

authority to make that designation, and

provide a letter from an official of that

State or government entity confirming

that it is a public institution.

Changes: The composite score

standard and Primary Reserve

requirements proposed under

§ 668.172(a)(1)(i) and (ii) for public

institutions are eliminated. The

replacement provisions described above

are relocated under § 668.171(c).

Comments regarding third-party

servicers: Several commenters believed

strongly that the proposed regulations

are unsuitable for third-party servicers,

noting that the KPMG study did not

include an analysis of third-party

servicers. The commenters argued that

the servicer business sector is

fundamentally different from any type

of institutional educational sector,

pointing out that the contractual

obligations and legal structures of

servicers are different than those of

institutions.

In addition, the commenters

contended that while the proposed

requirements regarding alternative

financial standards and the actions the
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62845

Secretary may take against entities that

fail to satisfy the standards may be

appropriate for institutions, these

alternate standards and actions are not

applicable or appropriate for third-party

servicers. For these reasons, the

commenters requested the Secretary to

put aside the proposed rules and work

with third-party servicers to formulate

new, more applicable rules.

Several other commenters

representing third-party servicers

argued that since the proposed

methodology favors entities with high

equity and low debt, it is inappropriate

for third-party servicers that have low

equity and high debt but generate high

income streams. Moreover, the

commenters noted that while the

Secretary consulted with third-party

servicers in establishing the current

regulations (as part of the Negotiated

Rulemaking process), third-party

servicers were not consulted before

these proposed rules were published.

Therefore, the commenters

recommended that the Secretary

continue to evaluate third-party

servicers under the current regulations.

Several commenters representing

third-party servicers maintained that the

alternative of submitting a letter of

credit of up to 50 percent of title IV,

HEA program funds does not apply to

third-party servicers. The commenters

suggested instead that third-party

servicers that are collection agencies for

FFELP funds post a fidelity bond in the

amount equal to the amount held each

month by the agency in its trust account

on behalf of the guarantors prior to

remittance to the guarantor. These

commenters argued that such a standard

represents the current industry practice

to protect guaranty agencies with which

a collection agency contracts, from loss

caused by the agency’s actions.

Discussion: The Secretary agrees to

develop in the future financial

standards solely for third-party

servicers. In the meantime, those

servicers must comply with the

requirements under 34 CFR Parts 668

and 682.

Changes: The third-party servicer

requirements under proposed

§ 668.171(b) are removed.

Part 5. General Comments Regarding the

Proposed Ratios

Comments regarding the Primary

Reserve ratio: Many commenters

opposed the requirement that public

and private non-profit institutions must

have a positive Primary Reserve ratio to

meet the general standards of financial

responsibility. The commenters

maintained that this requirement

represents a separate, single standard,

contradicting both the intent of

proposed ratio methodology and the

statutory requirement that the Secretary

consider an institution’s total financial

condition.

Several commenters from non-profit

institutions believed that the Primary

Reserve ratio favors colleges and

universities that accumulate resources

to safeguard Federal funds rather than

expend those resources to provide

student services. The commenters

argued that this preference is not only

contrary to the operation and mission of

most colleges and universities, it will

result in inflationary pressures that

create tuition increases.

Several commenters argued that

institutions will be forced to reduce

teaching and other staff to attain

adequate scores for the Primary Reserve

ratio. The commenters reasoned that

reducing ‘‘total expenses’’ to improve

the ratio score necessarily reduces

salaries and wages for teachers and staff

because salaries and wages comprise the

largest component of ‘‘total expenses’’ at

most institutions.

A commenter from a non-profit

institution argued that expended title

IV, HEA program funds should be

subtracted from ‘‘total expenses’’

because these funds are not included in

‘‘total unrestricted income.’’ Likewise,

the commenter believed that revenues

expended from restricted endowments

should not be included in ‘‘total

expenses’’ if those funds are not

counted in ‘‘total unrestricted income.’’

Other commenters opined that the

Primary Reserve ratio treats non-profit

institutions unfairly because the

numerator excludes most restricted

assets, but the denominator does not

exclude the expenses attributable to

those assets.

Some commenters suggested that the

Secretary refine the term ‘‘expenses’’ in

several ways. First, it should be adjusted

so that it reflects cash consumption

rather than non-cash accounting

charges—such non-cash charges as

depreciation and amortization expense

should be eliminated, while principal

repayments on debt should be added.

Second, expenses associated with

sponsored programs should be

eliminated. These commenters, and

other commenters, maintained that

sponsored program expenses, such as

those associated with the U.S.

Government-sponsored scientific

research programs, are a function of

those research programs and can

generally be eliminated upon

termination of those programs (during

the course of the program, expenses are

funded by revenues received from the

sponsoring agency). The commenters

concluded that the Secretary should not

penalize an institution whose

researchers are capable of generating

significant grants.

Discussion: The Primary Reserve ratio

provides a measure of an institution’s

expendable or liquid resource base in

relation to its overall operating size. It

is, in effect, a measure of the

institution’s margin against adversity.

Specifically, the Primary Reserve ratio

measures whether an institution has

financial resources sufficient to support

its mission—that is, whether the

institution has (1) sufficient financial

reserves to meet current and future

operating commitments, and (2)

sufficient flexibility in those reserves to

meet changes in its programs,

educational activities, and spending

patterns. Therefore, the Secretary

continues to believe that an institution

with a negative Primary Reserve ratio

has serious financial difficulties.

If an institution’s Primary Reserve

ratio is negative, expendable net assets

are in a deficit position. In those cases

the institution will need to generate

surpluses to replenish the deficit, or

may be forced to draw on other

resources or sell off assets to make ends

meet, thus increasing the uncertainty

that the institution will be able to meet

its obligations. However, because an

Equity ratio is now included in the

methodology, the Secretary eliminates

the proposed provision that a non-profit

institution is not financially responsible

if it has a negative Primary Reserve

ratio. The Equity ratio measures the

amount of total resources that are

financed by owners’ investments,

contributions, or accumulated earnings

(or conversely, the amount of total

resources that are subject to claims of

third parties) and thus captures an

institution’s overall capitalization

structure and, by inference, its overall

leverage. Because the Equity ratio

supplements the measure of the amount

of expendable reserves provided by the

Primary Reserve ratio with a measure of

other capital resources available to

support the institution, it provides a

measure of resources that could mitigate

the effects of a negative Primary Reserve

ratio.

With regard to the comments about

total expenses, those expenses,

including salaries paid to faculty and

staff, are part of the commitment of an

institution to provide services to

students. The relative size of each

component in an institution’s annual

operating budget is a management

decision. In addition, the Secretary

notes that based on the AICPA Audit

Guide for Not-for-Profit Organizations

issued on June 1, 1996, most title IV,
62846 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

HEA program funds will not be

included in total expenses of colleges

and universities. For example, payments

made to those institutions under the

Direct Loan, Federal Family Education

Loan, Federal Pell Grant, and Federal

Supplementary Educational

Opportunity Grant programs are not

included in total expenses reported on

the statement of activities. In addition,

the Audit Guide will require

scholarship expenses to be netted

against tuition income in the revenue

portion of the statement.

The Secretary disagrees that the

definition of the term ‘‘expenses’’ as

used in the Primary Reserve ratio

should exclude non-cash charges such

as depreciation and amortization and,

except in certain circumstances,

sponsored program expenses. The

Primary Reserve ratio measures an

institution’s expendable or liquid

resource base in relation to its overall

operating size. Operating size is the total

of all expenses incurred by the

institution in the course of its business

and is a key financial element because

it provides the best view of the size of

its programmatic activities and

commitments. Because depreciation

expense represents a charge to

operations that reflects the future

replenishment of the existing plant (and

replaces the actual cash outlays for

equipment and repairs formerly in the

revenue and expenditures statement of

private non-profit institutions under the

fund accounting model), it represents a

commitment of capital resources to the

institution and reflects its overall

operating size.

The Secretary disagrees that an

institution can eliminate expenses

relating to U.S. Government-sponsored

scientific research programs

immediately upon the termination of

those programs. To the contrary,

because many universities require

highly specialized facilities and

equipment to conduct research under

those programs, they will likely incur

significant upfit and other costs in redeploying their research facilities in the

event of a loss in program funding.

Therefore, the Secretary considers

scientific research expenditures to be an

appropriate component of the operating

size of an institution since the

institution is committed to making those

expenditures until adjustments can be

made.

However, the Secretary agrees that in

certain instances sponsored program

expenses should be excluded from the

ratio calculations. The Secretary

believes that an institution that receives

HEA grant program funds, especially

those associated with programs that

strengthen institutions or expand access

to higher education, should not fail the

composite score standard solely because

of the expenditure of those funds.

Therefore, the amount of HEA funds

that an institution reports as expenses in

its Statement of Activities for a fiscal

year are excluded from the ratio

calculations but only if these reported

expenses alone are responsible for the

institution’s failure to achieve a

composite score of 1.5 for that fiscal

year.

Changes: The Secretary eliminates the

requirement proposed under

§ 668.172(a)(1)(ii) that a public or

private non-profit institution must have

a positive Primary Reserve ratio.

Proposed § 668.173(e), describing the

items that are excluded from the ratio

calculations, is relocated under

§ 668.172(c) and revised, in part, to

provide that the Secretary may exclude

from the ratio calculations reported

expenses of HEA program funds under

the conditions described previously.

Comments regarding the Viability

ratio: A commenter from a non-profit

institution maintained that the implicit

assumption of the Viability ratio is that

an institution should minimize or

eliminate debt in order to preserve the

accumulation of assets. The commenter

opined that such a philosophy would

lead to institutions avoiding the creation

of revenue-creating assets, such as

residence halls. Accordingly, the

commenter believed that the correct

measurement should be the amount of

risky loans that an institution

undertakes, and recommended therefore

that the amount of loans secured by

collateral be eliminated from the

denominator of the Viability ratio.

Similarly, many commenters opined

that the proposed definition of adjusted

equity will discourage institutions from

financing property, plant and

equipment from current revenues. The

commenters believed that institutions

will elect instead to assume long-term

debt even if the assumption of long-term

debt is contrary to good business

practice.

For several reasons, many

commenters opposed the proposed

adjustment for proprietary institutions

that would limit the threshold factor for

the Viability Ratio to the threshold

factor for the Primary Reserve ratio in

cases where the institution’s Primary

Reserve ratio threshold factor is a one or

a two. First, these commenters

maintained that such an adjustment

defeats the purpose of measuring

financial responsibility on the basis of

three ratios. Second, the commenters

argued that if the reason for this

adjustment is to circumvent possible

abuse and manipulation of the Viability

ratio, then there may be something

wrong with using the ratio as part of the

methodology. Third, the commenters

argued that it is arbitrary and unfair to

assume, based on the premise that the

institution has manipulated its financial

report, that an institution’s Viability

ratio will always be higher than its

Primary Reserve ratio. Rather, the

commenters maintained that an

institution could achieve a high

Viability ratio through careful financial

management. The commenters

recommended therefore that the

Secretary use this adjustment only if the

reason for using it is consistent with the

concepts underlying the proposed ratio

methodology. Similarly, commenters

maintained that this adjustment is

unfair to non-profit institutions that

have no debt, because the weighting for

the Primary Reserve ratio increases from

55 percent to 90 percent.

One commenter suggested that if an

institution has no debt, the Secretary

should allow an institution to show the

amount of long-term debt that it would

be able to obtain, such as, by

demonstrating to the Secretary that the

institution has a line of credit, or by

providing to the Secretary a letter from

a bank indicating the bank’s willingness

to make a long-term loan to the

institution.

Many other commenters from the

proprietary sector believed the Secretary

should reward an institution that has no

debt for its sound management

practices, rather than penalize that

institution by increasing the weighting

for its Primary Reserve ratio from 20

percent to 50 percent. These

commenters, and other commenters,

suggested instead that for an institution

that has no debt the Secretary should

assign a threshold factor of 5.0 on its

Viability ratio, or weight the Viability

ratio at 30 percent, or both. Another

commenter maintained that the amount

of equity needed to achieve a strength

factor score of 3.0 on the Viability Ratio

is excessive and penalizes an institution

for using leverage prudently. This

commenter proposed that the amount of

equity that results in achieving a

strength factor score of 3.0 should

instead yield a strength factor score of

5.0.

Another commenter suggested that an

institution’s Viability ratio strength

factor be limited to two times the

Primary Reserve strength factor in cases

where the institution has a Primary

Reserve strength factor score of 1.0 or

2.0. According to the commenter, this

weighting scheme would allow an

institution with no debt, but with a

reasonable Primary Reserve ratio score,
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62847

to pass the ratio standards if it has a bad

year (i.e., achieves only a strength factor

score of 1.0 on the Net Income ratio).

The commenter further stated that

under this approach, a similarly situated

institution with a Primary Reserve ratio

strength factor score of 1.0 would not

pass the ratio standards.

Several commenters from proprietary

institutions asserted that eliminating the

Viability ratio for institutions that have

no debt is particularly unjust because

the current acid test ratio compels

institutions to remain debt-free. One of

the commenters argued that the

proposed adjustment to the Viability

ratio acts to raise the Primary Reserve

weighting for proprietary institutions to

a level required of non-profits despite

the real differences between these

sectors. The commenter asserted that

this methodology would only encourage

institutions to take out debt in order to

use the Viability ratio, rather than

discourage that practice. The

commenter suggested that if the

Secretary chooses to keep this

methodology, the Net Income and

Primary Reserve ratios should be

weighted at 80 percent and 20 percent,

respectively.

Discussion: The Secretary proposed

the Viability ratio because it measures

one of the most basic elements of clear

financial health: the availability of

expendable resources (resources which

can be accessed in short order) to cover

debt should the institution need to settle

its obligations. As such, it is useful in

measuring the financial condition of

most institutions. However, the

Secretary has decided to remove the

Viability ratio from the ratio

methodology established in these

regulations for the following reasons.

First, in linking the results of the

Viability and Primary Reserve ratios the

Secretary sought to discourage an

institution from manipulating its

Viability ratio by taking on a small

amount of debt solely to inflate its

composite score. However, linking the

two ratios may result in a composite

score that understates the financial

health of an institution that legitimately

carries a small amount of debt.

Second, based on analyses conducted

by KPMG during the extended comment

period of 507 audited financial

statements from proprietary institutions

and 395 audited financial statements

from private non-profit institutions, the

Secretary found that 35 percent of those

proprietary institutions and 13 percent

of those non-profit institutions had no

long-term debt. Accordingly, the

Viability ratio could not be applied to a

significant number of institutions in

each sector—the composite score for

those institutions would therefore be

determined solely on the results of the

Primary Reserve and Net Income ratios.

The Secretary agrees that this was a

shortcoming in the proposed

methodology, and includes in the ratio

methodology established by these

regulations only ratios that can be

applied to all institutions.

In view of the public comments, the

Secretary agrees that certain aspects of

the proposed methodology associated

with the Viability ratio may cause,

unintentionally, tensions between an

institution’s desire to make appropriate

business decisions and the institution’s

compliance with the proposed

regulations. Among these business

decisions are those related to whether

an institution should finance the cost of

plant assets with external sources, or

whether it should fund the cost of those

investments internally with revenues

from operations (or from some

combination of those sources). From the

analysis performed during the extended

comment period, the Secretary found

that some institutions chose to utilize

internal resources to fund their plant

assets as opposed to borrowing from

external sources. For some of those

institutions, that choice was a prudent

business decision that is not reflected

directly in either the Viability or

Primary Reserve ratios. The impact of

those business decisions is now

reflected in the Equity ratio.

Changes: The proposed Viability ratio

is replaced by the Equity ratio.

Comments regarding the numerator of

the Primary Reserve and Viability

ratios—Expendable Net Assets or

Adjusted Equity: Commenters from nonprofit institutions asserted that the

numerator of the Viability and Primary

Reserve ratios mistakenly neglects

permanently restricted endowment net

assets. The commenters maintained that

revenue generated from these assets not

only helps fund operations, but also

helps to provide scholarships to

students that generate more revenue for

the institution. Some commenters

believed that the Primary Reserve and

Viability ratios should also include

some percentage of the physical plant

which is free and clear of debt, arguing

that excluding physical plant from the

numerators of these ratios will only

encourage institutions to keep assets in

cash rather than invest in physical

assets that benefit students. Alternately,

these commenters, and other

commenters, asserted that if physical

plant is not included in the numerator

of the Primary Reserve ratio, then

depreciation costs on physical plant

should not be included in ‘‘total

expenses’’ of the denominator of this

ratio.

Another commenter representing

private non-profit institutions objected

to the blanket exclusion of related party

receivables from the ratio calculations.

The commenter asserted that this

exclusion would impact negatively

many institutions that depend on

church pledges, and suggested instead

that the Secretary consider such factors

as prior payment history and the

financial strength of the related party

before making a decision to exclude

these receivables.

A few commenters suggested that

expendable net assets exclude an

institution’s liability for post-retirement

benefits, maintaining that this liability

represents a very long-term moral

obligation that will not render any

institution incapable of teaching its

students or discharging its obligations

under the title IV, HEA programs.

Many commenters from the

proprietary sector, including students,

objected to the definition of ‘‘adjusted

equity’’ as used in the numerator of the

Primary Reserve and Viability ratios.

The commenters asserted that excluding

fixed assets (property, plant, and

equipment) and intangible assets from

the definition will cause institutions to

forego investing in new educational

equipment and educational facilities,

resulting in an erosion in the quality of

education students receive. Moreover,

these commenters argued that the

proposed treatment of equity is

counterproductive because it creates a

disincentive for owners to invest the

resources necessary to provide quality

education.

Based on the information provided by

the Secretary during the extended

comment period, one commenter

calculated the Primary Reserve ratio for

the 30 Dow Jones companies. According

to the commenter, 18 of those

companies would receive a strength

factor score of zero, and only 9 would

receive a strength factor score of 2.0 or

3.0. In order for 50 percent of these

companies to achieve a strength factor

score of 2.0 or 3.0, the commenter

indicated that the suggested ratio score

of .20 would need to be reduced to .07.

From this analysis, the commenter

concluded that the suggested strength

factors for the Primary Reserve ratio do

not appear to be reasonable and

recommended that the Secretary modify

the proposed definition of adjusted

equity to include fixed assets.

One commenter opposed the

proposed definition of adjusted equity,

arguing that the definition is not

explained or justified, and that it is

contrary to evaluations conducted by
62848 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

other agencies, such as the Securities

and Exchange Commission (SEC). The

commenter suggested that if the

Secretary is attempting to ascertain

through this definition which assets the

institution holds that have value and

may easily be converted to cash, then all

items that result in cash flow should be

included. An example of this would be

that all of an institution’s deferred

income (reflected as a liability on the

balance sheet) will not be paid in cash.

In particular, the commenter maintained

that many of the costs associated with

an institution’s recruiting activities will

already have been incurred and when

the deferred income is recognized on

the institution’s income statement as

shareholder equity, the cash outlay will

be less than the revenue, i.e., if the cash

outlay is 55 percent of the revenue, the

remaining 45 percent of the deferred

income should be added to equity to

arrive at the institution’s adjusted

equity.

Another commenter from a

proprietary institution objected to the

proposed definition of ‘‘adjusted

equity’’ because it does not measure the

debt capacity of an institution. This

commenter suggested that the definition

be changed to ‘‘net tangible assets plus

unused lines of credit.’’

Several commenters maintained that

the proposed definition of ‘‘adjusted

equity’’ does not capture the

institution’s ability to adjust to periods

of declining revenue, which the

commenters believed is the aim of the

Primary Reserve and Viability ratios.

Discussion: The Secretary disagrees

with the commenters who suggested

that the definition of expendable net

assets mistakenly excludes permanently

restricted net assets. The Primary

Reserve ratio is a measure of the

resources available to an institution on

relatively short notice, and therefore the

ratio measures only expendable net

assets. Permanently restricted net assets

are neither liquid or expendable, except

in the event of some legal action, and

therefore do not form any part of the

resource measured by this ratio. The

Secretary wishes to emphasize that the

non-liquid resources represented by

permanently restricted assets are

measured by the Equity ratio.

With regard to the comment

concerning the applicability of the

Primary Reserve ratio to the 30 Dow

Jones companies, the Secretary notes

that the ratio methodology is designed

to measure the elements of financial

health that are appropriate for

postsecondary institutions, not for

manufacturing and industrial entities,

which comprise most of the Dow Jones

companies.

The Secretary disagrees that fixed

assets should be included in adjusted

equity or that plant assets should be

included in the definition of expendable

net assets. Because the Primary Reserve

ratio provides a measure of an

institution’s expendable resource base

in relation to its overall operating size,

the logic for excluding net investment in

plant is twofold. First, plant assets

represent sunk costs to be used in future

years by an institution to fulfill its

mission—plant assets will not normally

be sold to produce cash since they will

presumably be needed to support ongoing programs. Moreover, in some

instances there is a lack of a ready

market to turn the assets into cash, even

if they are not needed programmatically.

Second, excluding net plant assets is

necessary in identifying the expendable

or relatively liquid net assets (that

would be used as a component of any

measure of liquid equity) available to

the institution on relatively short notice.

Including plant assets would distort the

measure of liquid equity, and therefore

would distort an important short-term

measure of the institution’s financial

health. (The regulatory practice of

excluding fixed assets is not unique to

these rules. Various other regulated

industries, such as depository

institutions and broker dealers, are also

subject to practices that exclude or limit

the extent that fixed assets may

comprise regulatory capital.) The

Secretary notes that all tangible assets

are considered by the Equity ratio.

The definition of expendable net

assets excludes from those assets an

institution’s post-retirement benefits

obligation.

The Primary Reserve ratio is not

meant to capture debt or ability to

borrow, but to measure the institution’s

expendable reserves. A measure of debt

and ability to borrow is incorporated in

the Equity ratio.

The Secretary disagrees that the

proposed definition of ‘‘adjusted

equity’’ does not capture an institution’s

ability to adjust to periods of declining

revenue because the balance sheet

ratios, Primary Reserve and Equity,

represent the resources accumulated

over time by the institution that are

available to the institution to make

necessary adjustments.

Changes: None.

Comments regarding the Equity ratio:

Several commenters from proprietary

institutions who opposed excluding

fixed assets from adjusted equity (in

calculating the Primary Reserve ratio)

believed that this exclusion not only

discourages institutions from investing

in educational equipment, but rewards

institutions that invest the least, i.e.,

those institutions that lease instead of

purchase equipment.

Most commenters supported the

suggestion made by the Secretary during

the extended comment period to use an

Equity ratio instead of the proposed

Viability ratio. Some of these

commenters believed that the use of an

Equity ratio not only resolves many of

the problems associated with the

Viability ratio; it is also a good measure

of how well an institution is capitalized

and an indirect measure of an

institution’s ability to borrow.

Moreover, these commenters opined

that an Equity ratio encourages the kind

of behavior that the Secretary should

want to encourage—reinvestment in the

institution.

Similarly, several commenters

believed that the Equity ratio provides

a necessary measure of capital

investment, and argued that it is a better

ratio than the liquidity ratio under

current regulations. One of these

commenters stated that liquidity ratios

measure assets that can be removed

fraudulently, whereas capital

investment ratios measure assets that

can be used to determine the owner’s

commitment to the institution.

Other commenters supporting the use

of an Equity ratio recommended that the

ratio include endowment assets in the

numerator. However, some of these

commenters suggested the Secretary

should not raise the strength factors for

the Equity ratio to compensate for the

inclusion of endowment assets because

this would disadvantage institutions

with little or no endowments. Another

commenter believed that excluding

endowment assets from the Equity ratio

would treat all institutions more fairly.

Discussion: The Secretary reiterates

that fixed assets are not expendable

assets and are thus not included in

calculating the Primary Reserve ratio.

However, fixed assets are included (as

part of the total resources of the

institution) in the Equity ratio. In

providing a measure of capital

resources, the Equity ratio supplements

the expendable resources measured by

the Primary Reserve ratio.

By comparing equity to total assets,

the Equity ratio indicates the share of

assets shown on the institution’s

balance sheet that the institution

actually owns, reflecting the

commitment to the institution of the

owners or persons that control the

institution, and provides insight into the

capital structure of the institution, i.e.,

it indicates whether an institution has

acquired a disproportionate amount of

its assets utilizing debt. Excessive

amounts of debt will adversely affect the
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62849

ratio and little or no debt will have the

opposite effect.

The Secretary notes that Permanently

Restricted Net Assets (which include

the permanently restricted piece of

endowment funds) are included in the

numerator of the Equity ratio. However,

in including those assets the Secretary

did not adjust the strength factors for

the Equity ratio. The strength factor

values for the Equity ratio are not

normalized to the relative equity of

institutions in either sector; therefore

inclusion of permanently restricted

endowment in the calculation of the

Equity ratio will help the ratio results of

institutions with large endowments, but

will not hurt the ratio results of

institutions with little or no

endowment.

Changes: The ratios described under

proposed § 668.173 are relocated under

§ 668.172 and revised to include the

Equity ratio. The Equity ratio is

specifically defined for proprietary

institutions under Appendix F and for

private non-profit institutions under

Appendix G.

Comments regarding the Net Income

ratio: A few commenters believed that

the proposed Net Income ratio is not fair

to proprietary institutions, arguing that

since the ratio is constructed and

weighted in a manner that does not

allow institutions that have operating

losses to meet the composite score

standard, those institutions would be

forced to submit a letter of credit. One

of these commenters asserted that

operating losses sometimes occur due to

changing economic circumstances (e.g.,

the acquisition and redevelopment of a

financially-troubled institution), but

that this condition is usually not a

permanent feature of the institution’s

financial condition. Accordingly, the

commenter suggested that one way of

remedying this inequity would be for

the Secretary to determine that an

institution is financially responsible if

the institution satisfies the composite

score requirement for two years in a

three-year cycle, or three years in a fouryear cycle.

Similarly, other commenters believed

that the Net Income ratio should be

eliminated because it represents only

the results from operations for one fiscal

year but does not take into

consideration prior year reserves that

may be available to offset negative net

income in any year.

Several commenters representing

proprietary institutions asserted that

institutions operating in states such as

Oregon, Texas, Florida, Alaska, and

Nevada that have taxes on gross receipts

or property rather than on income are

disadvantaged by the Net Income ratio

because taxes on gross receipts or

property are always reflected as a

business tax in operating expenses

rather than an income tax.

Many commenters from proprietary

institutions maintained that, although it

is important under the proposed

methodology to attain a strength factor

score of at least 3.0 on the Primary

Reserve ratio (so that the Viability ratio

can be counted independently),

attaining that strength factor requires

that adjusted equity be at least 30

percent of annual expenses. The

commenters argued that this strength

factor was too high for several reasons.

First, the commenters opined that

retaining 30 percent of equity as a

reserve fund creates a disincentive to

invest in property and equipment.

Second, the commenters stated that

retaining equity rather than distributing

profits to shareholders exposes a forprofit institution to an ‘‘accumulated

earnings tax’’ of 39.6 percent on profits

in excess of $250,000, unless the

institution provides a reasonable

business reason for retaining the equity

and a plan for its use. Under this 30

percent requirement, the commenters

maintained that an institution with as

little as $833,333 in annual expenses

would be exposed to the accumulated

earnings tax. Third, the commenters

maintained that it is very unusual for a

business that is expected to provide a

return on investment to retain equity

exclusive of fixed assets in an amount

equal to 30 percent of a year’s expenses.

Similarly, several commenters

representing proprietary institutions

maintained that the ratios erroneously

ignore differences between Chapter S

and C corporations, particularly in

regard to accumulated earnings tax. The

commenters argued that since the

treatment of owners’ salaries is

discretionary under both types of

corporations, the proposed methodology

creates an incentive for owners to

manipulate their salaries (or dividends

and other equity distributions) to meet

the composite score. The commenters

further stated that this manipulation

runs afoul of income and payroll tax

laws, and that regulations should not

entice owners to behave in this manner.

One of these commenters suggested that

the Secretary define ‘‘income before

taxes’’ as the profit before owners’

salaries and distributions so that all

proprietary institutions are treated in

the same manner with respect to

calculating the Net Income ratio.

Discussion: An institution must

generate surpluses to build reserves for

future program initiatives and to

increase its margin against adversity.

However, the Secretary accepts that

there will be circumstances where this

is not possible. Therefore, the strength

factors for the Net Income ratio allow an

institution to earn some points toward

its composite score if the institution

incurs a small loss.

Regarding the comment that the Net

Income ratio does not consider prioryear reserves, the Secretary reminds the

commenters that those reserves are

considered by the Primary Reserve and

Equity ratios.

With regard to the Accumulated

Earnings Tax, the Secretary would like

to clarify that the only portion of

stockholders’ equity that is subject to

the tax is retained earnings. Other

components of equity such as common

stock and other capital are not subject

to this tax. Moreover, the Secretary

believes that any potential exposure to

the accumulated earnings tax on excess

profits is a tax planning issue regardless

of the value of the strength factors for

the Primary Reserve ratio (of the 507

financial statements reviewed for

proprietary institutions, the Primary

Reserve ratio was 0.30 or higher for 84

or 17 percent of these institutions; of

those 84 institutions, only 39 had equity

(retained earnings) greater than

$250,000). These and other institutions

should already be considering the

potential impact of the tax, including

ways to use earnings accumulated

beyond the IRS limits for reasonable

business needs. In any event, the

Secretary notes that the changes made to

the proposed methodology for other

reasons minimize an institution’s

exposure to the accumulated earnings

tax—the Viability ratio has been

eliminated, and a Primary Reserve ratio

result of 0.15 (as opposed to the

proposed result of 0.30) is now required

to earn the maximum strength factor

score for that ratio.

If earnings are accumulated beyond

the IRS limits, IRS regulation 26 CFR

1.537–2(b) provides some broad criteria

that can be used to support the

contention that earnings are being

accumulated for the reasonable needs of

the business, including to: (1) Provide

for bona fide business expansion or

plant replacement, (2) acquire a

business enterprise through purchasing

stock or assets, (3) provide for the

retirement of bona fide indebtedness

created in connection with the trade or

business, (4) provide necessary working

capital for the business, (5) provide for

investments in or loans to customers or

suppliers if necessary to maintain the

business of the corporation, and (6)

provide for the payment of reasonable

anticipated product liability losses, an

actual or potential lawsuit, the loss of a

major customer, or self-insurance. A
62850 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

business contingency can be considered

a reasonable need if the contingency is

likely to occur (e.g. flood losses in a

flood prone area). The accumulation of

earnings to provide against unrealistic

contingencies is not considered a

reasonable need.

The Secretary notes that there are

several other ways to determine

reasonable working capital needs,

including the ‘‘Bardahl’’ formula.

Institutions should work with their tax

advisor with respect to these matters.

The Secretary disagrees that the

methodology should discount Gross

Receipt Tax paid by institutions in

certain States because these taxes, just

like other sales and property taxes that

differ from State to State, are a cost of

doing business.

Changes: The strength factors and

weighting percentages for the Primary

Reserve and Net Income ratios are

revised (see Analysis of Comments and

Changes, Parts 6–7).

Comments regarding the market value

of assets: A commenter from a nonprofit institution noted that the Viability

ratio ignores the market value of assets

(assets are booked at cost for balance

sheet presentations), but that lenders

look to market values when considering

collateral to secure long-term debt.

Consequently, the commenter argued

that an institution’s ability to borrow in

order to liquidate or restructure debt

may be a better measure of financial

viability than an institution’s ability to

liquidate long-term debt from

expendable resources.

Similarly, several commenters from

proprietary institutions maintained that

since the proposed ratio methodology

does not consider the market value of

real estate, it depresses the financial

score of an institution that holds

valuable properties, particularly if those

properties have been depreciated over a

long period of time. One commenter

argued that this is evidenced by the fact

that the commenter’s institution was

rated ‘‘good’’ by Dun and Bradstreet as

of June 30, 1995, and passes the current

financial responsibility standards under

§ 668.15, but would fail the proposed

ratio standards. The commenter

suggested that this problem could be

solved either by allowing the institution

to credit back the difference between the

net book value of the property and the

secured debt (mortgage), or allow the

institution to provide and include as an

asset the amount of the property’s

appraised value as certified by an

appraiser. A few commenters suggested

that the term ‘‘expendable net assets’’

include at least the book value (if not

the market value) of property, plant, and

equipment, arguing that it is unrealistic

to assume that these assets are valueless

or incapable of being liquidated.

Discussion: The Secretary has decided

not to consider the market value of

property, plant, and equipment because

accepting the market value of those

assets would introduce a significant

amount of subjectivity into the ratio

calculations—the appraised value of

those assets may differ depending on

the person making the appraisal and the

method by which that appraisal is made

(such as future cash flows or

comparable sales). In addition, the ratio

methodology would favor unfairly an

institution that chose to bear appraisal

costs over an institution that did not

similarly do so.

Changes: None.

Comments regarding second-tier and

trend analysis: Several commenters

suggested that the Secretary perform a

‘‘second-tier analysis’’ or use trend data

to determine whether an institution that

fails to achieve the required composite

score is nevertheless financially

responsible.

Other commenters believed that trend

analysis is more revealing than the

proposed one-year snapshot of an

institution’s financial health and

suggested that the Secretary require that

CPAs include that analysis as part of the

institution’s audited statements. One of

these commenters stated that since

trend data is available to an institution’s

current CPA, the CPA could add a

footnote to the financial statement that

contained the required ratio results for

the institution’s three most current

fiscal years, as well as an average for

that three-year period.

Another commenter argued that the

proposed ratio methodology is useless

because it employs hybrid ratios that

cannot be benchmarked. This

commenter proposed instead that the

standards consist of a liquidity ratio, a

trend analysis of cash flows from

operations, and a different, better

defined income ratio.

One commenter believed that the

proposed methodology should be

discarded in favor of more easily

constructed measures, including a threeyear averaged adjusted current ratio of

1:1 that would compare tangible current

assets with adjusted current liabilities

and a five- to ten-year trend analysis of

cash flows from operations.

Discussion: In addition to the ratios

suggested by the commenters previously

discussed under this Part, the Secretary

considered other ratios (Age of Plant,

Cash Income, Secondary Reserve, and

Debt to Total Assets) that could be used

as secondary measures.

The Secretary did not adopt these

ratios because, like the ratios suggested

by the commenters, they measure

financial health more narrowly than the

Primary Reserve, Equity, and Net

Income ratios. Moreover, the Secretary

believes that these ratios do not provide

significant additional insight with

respect to evaluating the financial

health of an institution that would

warrant their inclusion in the

methodology.

Although the Secretary believes that

trend analysis could be a useful

approach or consideration in

determining whether an institution is

financially responsible, historical data

regarding the ratios and the ratio

methodology must first be obtained and

analyzed before promulgating

regulations.

Changes: None.

Comments regarding extraordinary

gains and losses: Several commenters

representing the proprietary sector

opposed the proposal under which the

Secretary may exercise discretion in

determining whether an institution is

financially responsible. Under this

proposal, the Secretary may decide to

exclude extraordinary gains and losses,

income or losses from discontinued

operations, prior period adjustments,

and the cumulative effects of changes in

accounting principles. The commenters

argued that the uncertainty inherent in

this proposal would make it difficult for

an institution to calculate the ratios

(preventing the institution from

determining its regulatory status), and to

develop a plan to compensate for a

treatment that may exclude these items.

Moreover, the commenters believed that

if some institutions are favored by this

discretionary treatment, public

confidence in the fairness of the

proposed methodology would be

eroded. For these reasons, the

commenters suggested that the proposal

be amended by eliminating the

Secretary’s discretion in favor of

excluding these items for all

institutions.

Discussion: The commenters are

correct that extraordinary gains and

losses, income or losses from

discontinued operations, prior period

adjustments, and the cumulative effects

of changes in accounting principles,

should be excluded from the calculation

of the Net Income ratio because these

items are generally non-recurring and

do not reflect the institution’s

continuing operations. The Secretary

notes that these items are generally

excluded from the ratio calculations.

The commenters are also correct in

arguing that the ratio methodology

should treat all institutions fairly with

respect to these items, and that is the

basis for the Secretary’s discretion. It
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62851

has been the Secretary’s experience that

certain institutions do not present these

items in accordance with GAAP or

employ questionable accounting

treatments that beneficially distort their

financial condition. Consequently, the

Secretary retains the discretion to

include or exclude these items, or

include or exclude the effects of

questionable accounting treatments.

Changes: The items that the Secretary

may exclude from the ratio calculations

proposed under § 668.173(e) are

relocated under § 668.172(c) and revised

to provide that the Secretary generally

excludes extraordinary gains or losses,

income or losses from discontinued

operations, prior period adjustments,

the cumulative effect of changes in

accounting principles, and the effect of

changes in accounting estimates. This

section is also revised to provide that

the Secretary may include or exclude

the effects of questionable accounting

treatments.

Comments regarding unsecured

related party receivables and intangible

assets: Several commenters maintained

that because GAAP requires that an

asset possess value before it can be

included in a financial statement, the

Secretary improperly excludes all

unsecured related party receivables on

the assumption that those receivables

have no value. The commenters

believed that in order to obtain a

complete and accurate picture of an

institution’s cash flow, and thus

financial condition, the Secretary must

change the definition of ‘‘adjusted

equity’’ to include intangible assets,

unsecured related party receivables, and

fixed assets that the institution’s

independent auditor determines have

value and liquidity. The commenters

suggested that adjusted equity include

at least the following: (1) Fixed assets

and intangible assets that the

institution’s CPA determines to have

value and liquidity, and (2) unsecured

related party receivables, if the related

party co-signs the institution’s Program

Participation Agreement and satisfies

the same financial ratios required of the

institution.

Other commenters suggested that

equity be defined in accordance with

the FASB pronouncement, ‘‘Accounting

for the Impairment of Long-Lived

Assets’’, maintaining that all

authoritative accounting

pronouncements must be taken into

account in preparing financial

statements under GAAP.

Several commenters argued that

excluding intangible assets disregards

accounting conventions used when

acquisitions occur.

A commenter asserted that the

definition of intangible assets contained

in Accounting Principles Board (APB)

Opinion No. 17 is too vague to be

useful, and that the final rules should

include a clarification of the term,

specifically as it relates to deferred tax

benefits, deferred direct response

advertising costs, deferred enrollment

expenses, and prepaid expenses.

A few commenters responding to the

alternative set forth by the Secretary

during the extended comment period for

dealing with intangible assets—that

intangibles could either be excluded

from the calculation of the Equity ratio

or that the strength factors for the Equity

ratio could be increased to compensate

for including intangibles—generally

preferred to exclude intangibles because

this alternative would disadvantage

fewer institutions. One of these

commenters suggested, however, that

the Secretary include intangible assets

but not increase the strength factors in

cases where those assets are less than 10

percent of shareholders’ equity. Another

commenter suggested that the Secretary

include in the calculation of the ratios

a portion of intangible assets but require

that an institution amortize those assets

over a limited period, for example eight

years.

Other commenters from proprietary

institutions believed that the Secretary

should exclude intangible assets

because of the difficulties in valuing

those assets.

Discussion: The Secretary uses the

term ‘‘intangible assets’’ with the same

meaning as the definition contained in

APB Opinion No. 17, Intangible Assets,

and disagrees that this definition is

unsuitable for regulatory purposes. That

definition, which may not be all

inclusive, includes specifically

identifiable intangibles, i.e., patents,

franchises, and trademarks. The

definition also includes the most

common intangible asset, goodwill.

‘‘Goodwill’’ is the common name used

to describe the excess of the cost of an

acquired enterprise over the sum of

identifiable net assets. The Secretary

notes that items such as deferred tax

assets and liabilities, deferred

enrollment expenses, deferred direct

response advertising costs and prepaid

expenses do not meet the definition of

an intangible asset in accordance with

the definition in APB Opinion No. 17.

The Secretary does not agree that

intangible assets should be included in

the calculation of the ratios, because

those assets generally represent amounts

that are not readily available to meet

obligations. In addition, the Secretary

believes that including those assets

would inject a very subjective element

into the ratio calculations, leading to an

evaluation of financial health that

would be arbitrary, or that could

overstate significantly the financial

health of an institution. Although

amounts on financial statements are

estimates to varying degrees, goodwill

valuation is particularly subjective. In

reviewing the financial statements of the

proprietary sector, the Secretary found

that the two most common intangibles

were goodwill (excess purchase price

over the fair value of assets purchased)

and covenants not to compete. Clearly

there is no established market for those

assets and assigning a value to those

assets for purposes of determining

financial responsibility would be

subjective at best. Moreover, there is the

problem of the nature of the asset

itself—it is highly unlikely that an

institution could sell intangible assets to

meet its general obligations. If an

institution finds itself in need of

liquidating assets during its normal

business cycle to meet obligations, an

asset such as goodwill is likely

impaired. Also, in reviewing financial

standards for other industries like

banking and securities, the Secretary

found that removing intangibles when

calculating regulatory equity is a

generally accepted practice.

With regard to unsecured related

party receivables, the empirical data

show that these receivables occur

mainly in the proprietary sector where

an institution is one entity in a

commonly-controlled business group.

Generally, unsecured related party

receivables result from various

intercompany transactions including

shifting cash from one entity to another

in the form of advances, intercompany

sales for goods and services, or through

more formal borrowing arrangements.

Because the control over the repayment

of the transaction usually lies

completely with the ‘‘owners’’ of the

business group, the receivable has little

or no value to the institution whose

financial responsibility is being

evaluated. Also, in an administrative

proceeding, unsecured or

uncollateralized related party

receivables are not recognized by the

judge as assets available to satisfy the

obligations of an institution. For these

reasons, the Secretary excludes these

receivables from the ratio calculations.

With regard to the commenters from

private colleges and universities who

objected to the blanket exclusion of

related party receivables from the ratio

calculations, these commenters are

likely referring to annual pledges from

churches or other benefactors, and not

to related party receivables as defined

under GAAP. On this matter, the
62852 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

Secretary follows the guidance of FASB

Statement 116, which prescribes criteria

for recording pledges (unconditional

promises to give) in the financial

statements of colleges and universities

as net contributions receivable. The

Statement defines the term ‘‘promise to

give’’ using the common meaning of the

word promise—a written or oral

agreement to do (or not to do)

something. A promise to give is a

written or oral agreement to contribute

cash or other assets to another entity. A

promise carries rights and obligations—

the recipient of a promise to give has a

right to expect that the promised assets

will be transferred in the future, and the

maker has a social and moral obligation,

and generally a legal obligation, to make

the promised transfer. The making or

receiving of an unconditional promise

to give is an event that, like other

contributions, meets the fundamental

recognition criteria. The Secretary will

include these assets (such as pledges

from church related organizations,

community foundations, and trust

funds) in the calculation of the

numerators of the Primary Reserve and

Equity ratios if they meet these

requirements as set forth under FASB

116 and are recorded as an economic

resource in an institution’s audited

financial statements.

With regard to deferred marketing

costs, the Secretary is concerned that

institutions that record deferred direct

response advertising costs as an asset

are not always following the letter or

spirit of the published guidance on this

subject. The Secretary has experienced

significant abuses with regard to

recording those costs—institutions are

listing items as assets that do not meet

the criteria in the Accounting Standards

Division—Statement of Position (SOP)

93–7, Reporting on Advertising Costs. In

instances where the Secretary

determines that abuses are occurring the

Secretary will exclude those assets from

the ratio calculations.

With respect to deferred direct

response advertising costs, the Secretary

will specifically determine whether (1)

the primary purpose of the advertising

is to elicit sales to customers who have

responded to that advertising, and (2)

that advertising results in probable

future benefits.

Specific documentation that the

Secretary may request with respect to

the first item includes the following:

(1) Files indicating the customer

names and the related direct-response

advertisement;

(2) A coded order form, coupon or

response card, included with an

advertisement, indicating the customer’s

name; and

(3) A log of customers who have made

phone calls to a number appearing in an

advertisement, linking those calls to the

advertisement.

The Secretary also reminds

institutions that the conditions in SOP

93–7 must be met in order to report the

costs of direct-response advertising as

assets. The Secretary believes that those

conditions are narrow because it is

generally difficult to determine the

probable future benefits of the

advertising with the degree of reliability

sufficient to report related costs as

deferred assets.

Changes: None.

Part 6. Comments Regarding the

Proposed Strength Factors

Comments regarding the scoring

process: Several commenters

maintained that the proposed ratio

methodology is flawed because slight

changes in a single factor could create

an unusual variance in an institution’s

composite score.

Other commenters noted that an

institution could automatically receive a

strength factor score of 1.0 on all its

ratios regardless of its financial

condition, and questioned this

procedure given that it would equate

institutions that have a net loss or

deficit with institutions that are

profitable and have positive equity.

Several commenters were concerned

that the media would use the composite

scores of institutions in frivolous and

very misleading ways such as ranking

institutions by those scores.

Discussion: The Secretary agrees that

under the proposed methodology a

minor difference in a ratio result could

disproportionately affect an institution’s

composite score. For example, a

proprietary institution with a Primary

Reserve ratio result of 0.29 would be

assigned a strength factor score of 2.0,

whereas another institution with only a

marginally better ratio result of 0.30

would be assigned a higher strength

factor, 3.0. Assuming that all other

factors are equal, the latter institution

would receive a higher composite score

even though the ratio results of both

institutions are essentially the same. In

addition, because the proposed strength

factors represent a range of ratio results,

a proprietary institution with a Primary

Reserve ratio result of 0.30 would be

assigned the same strength factor as an

institution with a higher ratio result,

0.49. To eliminate the effects of

differences in ratio results, the Secretary

establishes in these regulations linear

algorithms under which a strength

factor score is calculated based on an

institution’s actual ratio result. For

example, the strength factor score for a

proprietary institution with a Primary

Reserve ratio result of 0.15 is calculated

by multiplying that ratio result by a

constant, using the algorithm 0.15 × 20

= 3.0.

The Secretary also agrees that the

proposed procedure of assigning a

strength factor score of 1.0 for negative

ratio results does not differentiate

sufficiently the financial health of

institutions on the lower end of the

scoring scale. In addition, the Secretary

believes that for the purpose of these

regulations, it is not necessary to

differentiate greatly among institutions

at the higher end of the scale. Therefore,

in keeping with the methodology’s

design objective that an institution must

demonstrate strength in one aspect of

financial health to compensate for a

weakness in another aspect and to

provide greater differentiation among

institutions on the lower end of the

scale, the Secretary establishes in these

regulations a scoring scale of negative

1.0 to positive 3.0.

In developing the strength factor

scores for each of the ratios along this

scale, the Secretary considered an

institution’s ability to satisfy its mission

objectives relating to technology, capital

replacement, human capital, and

program initiatives. Specifically, the

strength factor score reflects the extent

to which an institution has the financial

resources to:

(1) Replace existing technology with

newer technology;

(2) Replace physical capital that wears

out over time;

(3) Recruit, retain, and re-train faculty

and staff (human capital); and

(4) Develop new programs.

The Secretary acknowledges that the

importance of satisfying these objectives

varies from institution to institution but

believes that an institution must satisfy

these objectives over time, not only to

demonstrate that it has the financial

resources necessary to provide the

education and services for which its

students contract, but also to meet the

changing needs of its students and the

demands of the marketplace.

The Secretary wishes to emphasize

that the methodology measures only the

financial ability of an institution to

carry out these objectives. The

methodology does not, nor is it intended

to, assess the quality of an institution’s

educational programs or facilities; such

quality assessments are made by the

institution’s accrediting agency.

Changes: The procedures for

calculating the composite score

proposed under § 668.173(a) are revised

and relocated under § 668.172(a) to

provide for the calculation of the

strength factor scores. In addition,
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62853

proposed Appendix F is revised and

supplemented by a new Appendix G, to

reflect a scoring scale from negative 1.0

to positive 3.0, and to incorporate the

linear algorithms used to calculate the

strength factor scores for each of the

ratios.

Comments regarding the strength

factors:

Primary Reserve ratio: Several

commenters believed that the required

ratio results associated with the strength

factors should be lowered for

proprietary institutions to reflect the

shorter programs offered by those

institutions, arguing that since the ratio

appears to gauge an institution’s

financial ability to complete a program,

fewer resources are needed to ensure the

completion of short programs.

One commenter opined that the ratio

values underlying the Primary Reserve

ratio strength factors for proprietary

institutions are too high, noting that

none of the large proprietary

corporations he surveyed maintained

adjusted equity equal to 30 percent of

their total year expenses. The

commenter argued that as the strength

factor levels for this ratio are unfairly

comparable to those proposed for nonprofit institutions, the Secretary should

adjust the proprietary sector strength

factors as follows:

Ratio result Strength

factor

.05 or less ..................................... 1

.06–.14 .......................................... 2

.15–.24 .......................................... 3

.25–.34 .......................................... 4

.35 or more ................................... 5

Another commenter also

recommended that the Secretary revise

the Primary Reserve ratio strength

factors as indicated previously, arguing

that the proposed factors penalize any

institution that chooses to invest in

property and equipment.

Another commenter from a

proprietary institution argued that since

the Primary Reserve ratio does not

consider the timing of expenses or the

differences between variable and fixed

expenses, the ratio is difficult to value

(it overlooks too many variables, such as

normal business cycles for fixed

expenses, and the ability of institutions

to forego variable expenses during times

of fiscal distress). The commenter

suggested that if the Secretary

establishes a Primary Reserve ratio in

final regulations, the middle range of

the strength factors for this ratio should

reflect about 60–90 days of expenses, or

about 17–25 percent of total annual

expenses.

Equity ratio: Several commenters from

proprietary institutions maintained that

the proposed ratio standards do not

recognize unused lines of credit or other

direct measures of ability to borrow.

One commenter suggested that such a

measure should be constructed by

comparing fixed assets to long-term

debt, with strength factors as follows:

Ratio result Strength

factor

0.0–0.18 ........................................ 1

0.19–0.39 ...................................... 2

0.40–0.59 ...................................... 3

0.60–0.79 ...................................... 4

>0.79 ............................................. 5

Another commenter maintained that

the suggested Equity ratio should be

amended to include such a measure.

One commenter from a proprietary

institution maintained that the strength

factors for the Equity ratio should be set

by considering an acceptable ratio of

long-term assets to long-term liabilities.

The commenter argued that an

institution that is growing will expend

its asset base in advance of recording

income generated by those assets.

According to the commenter, assuming

a current ratio of 1:1, a ratio of long-term

assets to long-term liabilities should

have the following strength factors:

Ratio result Strength

factor

0.0 ................................................. 0

.10 ................................................. 1

.20 ................................................. 2

.25 ................................................. 3

Net Income ratio: Many commenters

from the proprietary sector believed that

the proposed strength factors for the Net

Income ratio are too high. Several of

these commenters opined that the

emphasis placed on profitability under

the proposed methodology might tempt

institutions to raise tuition and cut back

on educational outlays, thus

shortchanging students and lowering

the quality of education.

Several commenters from the

proprietary sector objected to the Net

Income ratio, arguing that it would

discourage institutions from investing in

property, plant, and equipment because

it measures net income after

depreciation. The commenters

suggested two alternatives: (1) Retaining

the proposed strength factors but

reconstructing the ratio so that it is

based on operating profit; or (2)

retaining the proposed ratio but

adjusting the strength factors.

One commenter from a proprietary

institution stated that certain

accrediting agencies take a strong stance

against profits in excess of five percent.

The commenter suggested therefore that

the Secretary take this into account in

establishing strength factors for the Net

Income ratio.

Although several commenters agreed

that the strength factors for proprietary

institutions should be higher than those

for non-profit institutions to take taxes

into account, the commenters believed

that the difference in the proposed

strength factors between these sectors is

excessive. Assuming a tax rate of 40

percent, the commenters suggested that

comparable and fairer strength factors

for proprietary institutions should be set

at 166 percent of those for non-profit

institutions. Under this suggestion, the

resulting strength factors would be:

Ratio result Strength

factor

<0 .................................................. 1

0–.0166 ......................................... 2

0.0167–.049 .................................. 3

0.050–.082 .................................... 4

>0.082 ........................................... 5

Another commenter argued that the

strength factors for the Net Income ratio

for proprietary institutions should be set

at 3.0 for a five percent profit level, and

the rest of the range set as follows:

Ratio result Strength

factor

<.02 ............................................... 1

0.02–.035 ...................................... 2

0.036–.05 ...................................... 3

0.051–.075 .................................... 4

>.075 ............................................. 5

One commenter suggested the

following strength factors, opining that

the proposed strength factors penalize

an institution that returns some of its

operating profit to students (by

providing better qualified faculty and

updated teaching tools and equipment,

and increasing student services):

Ratio result Strength

factor

<0 .................................................. 1

0–.017 ........................................... 2

0.018–.049 .................................... 3

0.050–.082 .................................... 4

>.082 ............................................. 5

A commenter suggested that the

Secretary establish a strength factor

score of 3.0 for a net income ratio of .03,

to reflect the amount of State and

Federal income taxes an institution

must pay.

Another commenter from a

proprietary institution argued that a low

profit percentage does not necessarily

indicate financial weakness since
62854 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

income tends to be lower for a

financially healthy institution during

periods of expansion. Accordingly, the

commenter suggested the following

strength factors:

Ratio result Strength

factor

<0.0 .......................................................... 1

0.0–.015 ................................................... 2

>0.015 ...................................................... 3

One commenter recommended that

the Secretary establish equal strength

factor levels for proprietaries and nonprofits, amend the numerator of the

ratio for proprietaries to ‘‘Income After

Taxes’’, and impute the taxes for

proprietary institutions that are

Subchapter S corporations or

partnerships.

Discussion: The Secretary thanks the

commenters for their suggestions

regarding the proposed strength factors.

In view of these comments, other

comments regarding the proposed

ratios, and the analysis performed by

KPMG during the extended comment

period, the Secretary revises the

proposed strength factors.

In developing the strength factor

scores for each of the ratios, the

Secretary started by selecting critical

points along the scoring scale and

determining the appropriate value (ratio

result) for each of those points. For

example, a strength factor score of 1.0

represents the lowest ratio result that

the Secretary believes an institution

must achieve to continue operations,

absent any adverse economic

conditions. With respect to the Net

Income ratio, a strength factor score of

1.0 equates to a ratio result of zero—the

point where an institution just barely

operated within its means. At this point,

the institution broke even on an accrual

basis, but it did not add to or subtract

from its overall wealth. Moving down

the scale, a strength factor score of zero

indicates that the institution may have

generated sufficient cash to meet its

operating expenses, but, on an accrual

basis, the institution incurred a loss. On

the upper end of the scale, a strength

factor score of 3.0 indicates that the

institution not only operated within its

means, but that it added to its overall

wealth. The Secretary then drew a line

that best fit those values, resulting in the

linear algorithms.

Strength factor scores for the Primary

Reserve ratio: The strength factor score

for the Primary Reserve ratio for a

proprietary institution is calculated

using the following algorithm:

Strength factor score = 20 × Primary

Reserve ratio result. The strength factor

score for the Primary Reserve ratio for

a private non-profit institution is

calculated using the following

algorithm:

Strength factor score = 10 × Primary

Reserve ratio result. The charts below

show the strength factor scores for

specific Primary Reserve ratio results.

PRIMARY RESERVE RATIOS’ STRENGTH FACTOR

SCORES FOR PROPRIETARY INSTITUTIONS

A Ratio Result of Algorithm (20 X

Ratio Result)

Equals a

Strength

Factor

Score of

¥.05 or less .................. 20 X (¥.05) ... ¥1.0

0 .................................... 20 X 0 ............ 0

.05 ................................. 20 X .05 ......... 1.0

.075 ............................... 20 X .075 ....... 1.5

.15 or greater ................ 20 X .15 ......... 3.0

PRIMARY RESERVE RATIOS’ STRENGTH FACTOR

SCORES FOR PRIVATE NONPROFIT INSTITUTIONS

A Ratio Result of Algorithm (10 X

Ratio Result)

Equals a

Strength

Factor

Score of

¥.10 or less .................. 10 X ¥.10 ...... ¥1.0

0 .................................... 10 X 0 ............ 0

.10 ................................. 10 X .10 ......... 1.0

.15 ................................. 10 X .15 ......... 1.5

.30 or more ................... 10 X .30 ......... 3.0

As illustrated in the charts, for any

strength factor score, the Primary

Reserve ratio result is twice as high for

a non-profit institution as it is for a

proprietary institution. There are two

reasons for this difference.

First, proprietary institutions

generally have shorter business cycles

than non-profit institutions, i.e., a

proprietary institution generally has

new classes starting throughout the year

whereas a non-profit institution

typically has only two to four starts

(semesters or quarters) each year.

Because of these shorter business cycles

proprietary institutions are generally not

as dependent on reserves of liquid

assets (as measured by Primary Reserve

ratio) since they can rely more on

tuition revenues for necessary liquidity.

In comparison, non-profit institutions

must generally maintain greater

amounts of liquid resources to fund

short-term operations because of the

longer period of time between receipt of

new revenues.

Second, proprietary institutions

should generally be able to obtain

additional capital more quickly than

non-profit institutions because owners,

unlike trustees, are free to invest cash as

needed to support operations and

owners may increase expendable

resources by leaving earnings in the

institution. On the other hand, nonprofit institutions are generally

dependent on contributions from donors

as their primary source of additional

capital.

Discussion of Strength Factor Scores for

the Primary Reserve Ratio

Strength factor score of 1.0: A strength

factor score of 1.0 indicates that an

institution has very little margin against

adversity. For a proprietary institution,

expendable resources equal only five

percent of its total expenses (stated

another way, the institution has about

18 days worth of resources that can be

liquidated in the short-term to cover

current operations). For a non-profit

institution, expendable resources equal

only 10 percent of its total expenses (the

institution has about 37 days worth of

resources that can be liquidated in the

short-term to cover current operations).

At this level of expendable resources,

the Secretary believes that an institution

may be able to make payroll and meet

existing obligations, but it will have

difficulty financing any of its mission

objectives. With respect to the

fundamental elements of financial

health, a strength factor score of 1.0

indicates relative weakness in viability

and liquidity.

Strength factor score of zero: Moving

down the scale, a strength factor score

of zero indicates than an institution has

no margin against adversity—the value

of its liabilities is equal to the value of

its expendable assets.

With no expendable resources, the

Secretary believes that the institution

will have difficulty meeting existing or

future obligations without additional

revenue or support, i.e., the institution

is very sensitive to fluctuations in

revenues or unexpected losses and will

need to access shortly some resources

from additional borrowing, capital

infusions, or conversions from nonexpendable assets to pay bills if it does

not generate sufficient resources from

revenues. With respect to the

fundamental elements of financial

health, a strength factor score of zero

indicates weakness in financial viability

and liquidity. Below this level, an

institution receives negative points

toward its composite score.

Strength factor score of negative 1.0:

A strength factor score of negative 1.0

means that an institution has negative

expendable resources—the value of its

liabilities exceeds the value of its

expendable assets.

At this level, the Secretary believes

the institution will have serious

difficulties satisfying existing

obligations, and even more difficulties

meeting any of its mission objectives.

Because the institution is financing

daily operations from another source, it

must demonstrate some strength in that

other source (revenue or ability to

borrow) to earn positive points toward
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62855

its composite score. A strength factor

score of negative 1.0 indicates extreme

weakness in viability and liquidity.

Strength factor score of 3.0 : On the

other end of the scale, a strength factor

score of 3.0 indicates that an institution

has a healthy margin against adversity.

For a proprietary institution,

expendable resources are equal to 15

percent of its total expenses. The

institution has about 55 days worth of

resources that can be liquidated in the

short-term to cover current operations—

one or more class starts. For a non-profit

institution, expendable resources are

equal to 30 percent of its total expenses.

The institution has about 110 days

worth of resources that can be

liquidated in the short-term to cover

current operations—about one semester.

At this level of expendable resources,

the Secretary believes that an institution

has the resources to invest in human

and physical capital and new program

initiatives. The institution demonstrates

strength in the fundamental elements of

financial viability and liquidity.

In assessing the reasonableness of the

strength factors for the Primary Reserve

ratio, the Secretary compared these

factors to the standards set by Moody’s.

Moody’s, a primary bond rating agency,

uses an expendable resources to

operations ratio (similar to the Primary

Reserve ratio) in analyzing credit

worthiness. The Secretary notes that the

Moody’s ratio is more conservative than

the Primary Reserve ratio because it

considers only unrestricted net assets as

expendable resources whereas the

Primary Reserve ratio generally includes

unrestricted net assets and temporarily

restricted net assets as expendable

resources. The median Moody’s ratio for

non-profit institutions with a bond

rating of Aa is 4.58 for small institutions

and 3.28 for large institutions. (As this

ratio decreases, the relative financial

health of the institution decreases.) The

median Moody’s ratio for institutions

with a Baa bond rating is 0.669 for large

institutions and 0.449 for small

institutions. The Moody’s definition of

their Baa grade is: ‘‘Medium grade

obligations, i.e., they are neither highly

protected nor poorly secured. They lack

outstanding characteristics and in fact

have speculative characteristics as

well.’’ Institutions in this category

represent a reasonable credit risk, but

absent some other factor or set of

circumstances, Moody’s would not

consider those institutions to be

financially healthy.

The Secretary notes that while there

are differences between the Moody’s

ratio and the Primary Reserve ratio, the

Primary Reserve ratio result necessary to

earn the highest strength factor (0.30 for

non-profit institutions, and 0.15 for

proprietary institutions) is lower than

the median standard set by Moody’s for

investment grade institutions (0.669 or

0.449).

The Secretary believes it is

appropriate that the Primary Reserve

strength factors are lower than the

standards set by Moody’s for two

reasons. First, the ratio methodology is

designed to assess an institution’s

financial health over the short-term (a

12- to 18-month time horizon), whereas

the repayment period of the bonds being

rated is generally long-term. Second, the

rating agencies are assessing repayment

capabilities in the normal course

without abnormal events such as

spending endowment funds or

liquidating fixed assets.

Strength Factor Scores for the Equity

Ratio

The strength factor score for the

Equity ratio for both proprietary and

non-profit institutions is calculated

using the following algorithm:

Strength factor score=6 × Equity ratio

result.

The chart below shows the strength

factor scores for specific Equity ratio

results.

EQUITY RATIO

A ratio result of:

Algorithm

(6 × ratio result)

Equals

a

strength

factor

score of:

¥0.167 or less ...... 6 ×¥0.167 .. ¥1

0 ............................. 6 × 0 ............ 0

0.167 ...................... 6 × 0.167 ..... 1

0.250 ...................... 6 × 0.250 ..... 1.5

0.50 or more .......... 6 × 0.50 ....... 3

Discussion of Strength Factor Scores for

the Equity Ratio

Strength factor score of 1.0: For a

proprietary institution, a strength factor

score of 1.0 indicates that the owner is

just beginning to demonstrate a

financial commitment to the business

since the institution’s assets are greater

than its liabilities, but not by much. For

a non-profit institution, a strength factor

score of 1.0 may reflect a permanent

endowment that provides some revenue

or that may be drawn upon in extreme

circumstances. In either case, most of

the institution’s assets are subject to

claims of third parties—for every $10.00

in assets, the institution has $8.33 in

liabilities. Stated another way, the

institution’s liabilities are five times

greater than its equity.

The Secretary believes that this

relatively small amount of equity

indicates that the institution will have

difficulty borrowing at favorable market

rates and that it has a very limited

ability to meet its technology and

capital replacement needs. With respect

to the fundamental elements of financial

health, a strength factor score of 1.0

indicates relative weakness in financial

viability, ability to borrow, and capital

resources.

Strength factor score of zero: Moving

down the scale, an absence of equity

(strength factor score of zero) provides

no evidence of an owner’s financial

commitment to the business since there

are no accumulated earnings or invested

amounts beyond the institution’s

liabilities to third parties. For a nonprofit institution, the absence of net

assets indicates that there is little or no

permanent endowment to draw upon in

extreme circumstances.

At this level, the value of the

institution’s assets is equal to the value

of its liabilities. Consequently, the

Secretary believes that the institution

will have difficulty obtaining additional

financing because there may not be any

assets to secure that financing. For an

institution with relatively old plant

assets that have been fully depreciated,

zero equity implies that the institution

must rely on additional revenues,

including pledges or capital infusions,

to build or invest in the future. For an

institution with newer plant assets, zero

equity implies that the institution has

stretched its borrowing capacity beyond

a reasonable limit. With respect to the

fundamental elements of financial

health, a strength factor score of zero

indicates weakness in viability, ability

to borrow, and capital resources. Below

this level, an institution receives

negative points toward its composite

score.

Strength factor score of negative 1.0:

A strength factor score of negative 1.0

means that the institution is virtually

insolvent since its obligations to third

parties are greater than the assets it has

to satisfy those obligations. For every

$11.67 (or more) in liabilities, the

institution has just $10.00 in assets.

At this level, the Secretary believes

that the institution has no ability or a

significantly diminished ability to

borrow because it has no resources, or

very limited resources, to offer as

collateral that are not already subject to

claims of third parties. Moreover, the

institution will have difficulty meeting

any of its mission objectives. The

institution will need to demonstrate

strength in another source

(profitability), or the owner will need to

make a capital infusion, to earn positive

points toward its composite score. With

respect to the fundamental elements of

financial health, a strength factor score
62856 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

of negative 1.0 indicates extreme

weakness in viability, ability to borrow,

and capital resources.

Strength factor score of 3.0: On the

upper end of the scale, a strength factor

score of 3.0 provides evidence of an

owner’s financial commitment to the

business, and for a non-profit

institution, it indicates the

accumulation of substantial net assets,

including permanent endowment. The

institution’s assets are significantly

greater than its liabilities—for every

$10.00 in assets the institution has $5.00

in liabilities. Stated another way, the

institution’s liabilities are less than its

equity.

At this level, the Secretary believes

that an institution has the resources

necessary to borrow significant amounts

at favorable market rates, replace

physical capital as needed, and fund

new program initiatives. A strength

factor score of 3.0 indicates strength in

financial viability, ability to borrow, and

capital resources.

As with the Primary Reserve ratio, the

Secretary tested the reasonableness of

the Equity ratio strength factor scores by

comparing the scores in this case, to the

data compiled by Robert Morris

Associates (RMA). The Secretary notes

that although RMA compiles survey

data from various industries, it forms no

conclusions about those industries from

that data. RMA uses a total liabilities to

tangible net worth ratio (total liabilities

divided by (total tangible assets—total

liabilities)) that is similar to the Equity

ratio ((total tangible assets—total

liabilities) divided by tangible assets).

By using the RMA data, lending

institutions and other investors can see

how a particular institution’s ratio result

compares to industry averages.

In the RMA 1996 Annual Statement

Studies, the median total liabilities to

tangible net worth ratio score for

colleges and universities (SIC #8221)

was generally around 0.50 but went as

high as 2.7 for small institutions—a 0.50

ratio result indicates that for every $3.00

of assets, there is $1.00 in liabilities. For

SIC #8299, Services-School and

Educational Services (proprietary

institutions), the median was around

1.3, but went as high as 2.4—a ratio

result of 1.3 indicates that for every

$1.77 of assets, there is $1.00 in

liabilities.

Although the 2 to 1 (assets to

liabilities) relationship necessary to earn

the highest score for the Equity ratio is

slightly lower than the RMA median for

proprietary institutions, 2.3 to 1 (and

much lower than the RMA median for

non-profit institutions, 3 to 1), the

Secretary believes that the strength

factor score for the Equity ratio is

reasonable for two reasons. First, the

methodology is designed to differentiate

more among institutions on the lower

end of the scoring scale, not at the

median or high end ranges. Second, the

methodology measures an institution’s

financial health over a relatively short

time horizon, 12-to-18 months, whereas

users of the RMA data are evaluating the

institution over a much longer time

frame.

Strength Factor Scores for the Net

Income Ratio

The strength factor score for the Net

Income ratio for a proprietary institution

is calculated using the following

algorithm:

Strength factor score=1+(33.3 × Net

Income ratio result). The strength factor

score for the Net Income ratio for a

private non-profit institution is

calculated using the following

algorithms:

If the Net Income ratio result is

negative, the Strength factor

score=1+(25 × Net Income ratio result);

If the Net income ratio result is

positive, the Strength factor score=1+(50

× Net Income ratio result); or

If the Net Income ratio result is zero,

the Strength factor score=1.

The charts below show the strength

factor scores for specific Net Income

ratio results.

NET INCOME RATIOS’ STRENGTH FACTOR SCORES FOR PROPRIETARY INSTITUTIONS

A ratio result

of:

Algorithm

1+(33.3×net income ratio result)

Equals a

strength

factor

score of:

¥0.06 or less 1+(33.3×¥0.06) ¥1.0

¥0.03 .......... 1+(33.3×¥0.03) 0

0.00 .............. 1+(33.3×0.00) ... 1.0

0.015 ............ 1+(33.3×0.015) 1.5

0.06 or more 1+(33.3×0.06) ... 3.0

Net Income Ratios’ Strength Factor

Scores for Private Non-Profit Institutions

A ratio result

of:

Algorithm (see

below)

Equals a

strength

factor

score of:

¥0.08 (or

less).

1+(25×¥0.08) .. ¥1.0

¥0.04 .......... 1+(25×¥0.04) .. 0

0.00 .............. If ratio equals

zero, strength

factor score

automatically

equals 1.

1.0

0.01 .............. 1+(50×0.01) ...... 1.5

Net Income Ratios’ Strength Factor

Scores for Private Non-Profit Institutions—Continued

A ratio result

of:

Algorithm (see

below)

Equals a

strength

factor

score of:

0.04 (or

greater).

1+(50×0.04) ...... 3.0

The Secretary is convinced by the

commenters not to unduly penalize

institutions that incur a small operating

loss, and to maintain a more neutral

position on those institutions that break

even. Therefore, the Secretary allows an

institution with a small operating loss to

earn positive points toward its

composite score by taking into account

that the institution may be generating

positive cash flow despite those losses.

Based on the analysis conducted by

KPMG during the extended comment

period, the Secretary found that, on

average, three percent of the expenses

for proprietary institutions related to

non-cash items such as depreciation or

amortization. The corresponding

amount for non-profit institutions was

approximately four percent. The

Secretary believes that an institution

should generally be able to endure three

or four percent losses before being

forced to rely on expendable reserves or

its ability to raise additional capital or

sell off any of its infrastructure to

continue operations. Although the

Secretary found that some institutions

had significantly higher amounts of

depreciation, limiting the depreciation

estimate to these percentages adds a

degree of conservatism to the

methodology. If higher percentages were

adopted, an institution would be able to

incur larger operating losses (including

cash losses) before receiving negative

points toward its composite score.

Moreover, higher depreciation estimates

would have the perverse effect of

rewarding an institution that incurred

sizable operating losses but had little or

no depreciation expense (the

institution’s assets may be nearly or

fully depreciated, indicating

technological and physical

obsolescence). Therefore, the Secretary

set a strength factor score of 1.0 for the

Net Income ratio at the point where an

institution is estimated to break even on

an accrual basis, and a strength factor

score of zero at the point where an

institution is estimated to break even on

a cash basis.

The Secretary also agrees with the

commenters from the proprietary sector

that the combined effect of the proposed

strength factors and weighting placed
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62857

too much emphasis on the Net Income

ratio. In addition, research conducted by

KPMG during the extended comment

period indicates that a six percent

return on revenue for proprietary

institutions, and a four percent return

for non-profit institutions, are

reasonable values for those institutions

to earn the highest strength factor score

for the Net Income ratio.

Industry Norms and Key Business

Ratios, published by Dun & Bradstreet,

indicates that the return on sales ratio

(net profit after taxes divided by annual

sales) for the middle quartile of

comparable industries (SIC codes 82,

8243, 8244, and 8299) is three or four

percent. The Almanac of Business and

Industrial Financial Ratios, authored by

Leo Troy, Ph.D., shows that similar

industries’ typical pre-tax profit as a

percentage of net sales is between two

and seven percent. As with the Moody’s

and RMA data discussed earlier, the

information published by Dun &

Bradstreet and Leo Troy is used only to

test the reasonableness of the strength

factor scores for the Net Income ratio.

In addition, Moody’s uses a return on

unrestricted net assets ratio and their

literature shows that the median results

for small non-profit institutions is

0.043—very close to the 0.04 Net

Income ratio result needed to earn the

highest strength factor score. For large

non-profit institutions, the median

result is 0.052. The Secretary notes that

the ratio used by Moody’s excludes

investment gains and measures net

income as a percentage of net assets, not

total revenue, so it is not perfectly

comparable with the Net Income ratio.

Discussion of Strength Factor Scores for

the Net Income Ratio:

Strength factor score of 1.0: A strength

factor score of 1.0 indicates that an

institution just barely operated within

its means. On an accrual basis, the

institution broke even. At this level the

institution is able to fund historical

capital replacement costs, but is not

completely providing for the future

replenishment of its capital assets.

The Secretary believes that an

institution needs to generate operating

surpluses because, absent those

surpluses, it cannot grow its margin

against adversity without capital

infusions or donor contributions. A

strength factor score of 1.0 indicates

relative weakness on the fundamental

financial element of profitability.

Strength factor score of zero: Moving

down the scale, a strength factor score

of zero indicates that an institution did

not operate within its means during its

operating cycle, but may have broken

even on a cash basis, i.e., the institution

may have generated sufficient cash to

meet its operating expenses, but it did

not fund its non-cash expenses. On an

accrual basis, a proprietary institution

incurred a loss equal to three percent of

its total revenues, and a non-profit

institution incurred a loss equal to four

percent of its total revenues.

At this level, the Secretary believes

that an institution is unable to fund its

capital replacement costs and that it

cannot continue operations for an

extended time without depleting its

equity. A strength factor score of zero

indicates weakness on the fundamental

financial element of profitability. Below

this level, an institution receives

negative points toward its composite

score.

Strength factor score of negative 1.0:

A strength factor score of negative 1.0

indicates that an institution not only did

not operate within its means, but that its

operations most likely produced

negative cash flow since losses

exceeded non-cash expenses. On an

accrual basis, a proprietary institution

incurred losses equal to 6 percent (or

more) of its total revenues, while a nonprofit institution incurred losses equal

to 8 percent (or more) of its revenues.

At this level, the institution decreased

its margin against adversity and

continued losses will deplete its other

resources. A strength factor score of

negative 1.0 indicates weakness in the

fundamental financial element of

profitability.

Strength factor score of 3.0: On the

upper end of the scale, a strength factor

score of 3.0 indicates that an institution

not only operated within its means, but

added to its overall wealth, thus

increasing its margin against adversity.

On an accrual basis, a proprietary

institution generated operating

surpluses equal to at least six percent of

its total revenues, and a non-profit

institution generated surpluses equal to

at least four percent of its total revenues.

At this level, the Secretary believes

that the institution is not only funding

its capital replacement costs, but that it

has operating surpluses to invest in new

program initiatives and human and

physical capital. A strength factor score

of 3.0 indicates strength on the

fundamental financial element of

profitability.

Changes: As discussed in this Part,

proposed Appendix F is revised and

supplemented by a new Appendix G to

reflect the strength factor scores for each

of the ratios, and to provide the linear

algorithms used to calculate those

scores.

Part 7. Comments Regarding the

Weighting of the Proposed Ratios

Comments: A commenter from a

proprietary institution believed that the

proposed strength factor values and

weighting of the Primary Reserve ratio

for proprietary institutions are too low.

The commenter argued that the

weighting given to the Primary Reserve

ratio should be at least equal to the

weighting given to the Net Income ratio

because the retained wealth of an

institution, which can be used to

weather financial difficulties, is just as

important as the one-year profit earned

by the institution. Accordingly, the

commenter suggested that the Secretary

weight the ratios as follows: 40 percent

for the Primary Reserve ratio, 30 percent

for the Net Income ratio, and 30 percent

for the Viability ratio.

A commenter from a proprietary

institution opined that if the Secretary

substitutes an Equity ratio for the

Viability ratio, the Secretary should

weight the Equity ratio the most because

it is the ratio that best measures longterm financial stability.

Commenters from proprietary

institutions believed that a 50 percent

weighting on the Net Income ratio

placed too much emphasis on the shortterm financial situation of the

institution. One of these commenters

suggested instead that all of the ratios

should be weighted equally. Along the

same lines, other commenters from

proprietary institutions favored

lowering the weighting of the Net

Income ratio from 50 percent to 30

percent or 40 percent, while another

commenter suggested that the Secretary

assign the same weight to the Net

Income ratio for proprietary institutions

that is assigned to non-profit

institutions.

Some commenters believed that the

proposed weighting of the income ratio

would lead to fiscal mismanagement

(institutions would need to stockpile

profits to meet the ratio standards) or

encourage unscrupulous for-profit

institutions to declare and pay out huge

dividends to owners.

One commenter representing

proprietary institutions appreciated the

Secretary’s willingness to revise the

proposed ratio weights in response to

public comment, but believed that the

suggested revised weights moved too far

in reducing the weight of the Net

Income ratio and increasing the weight

of the Primary Reserve ratio for

proprietary institutions. The commenter

asserted that because the proprietary

sector consists of a variety of

institutions of different sizes, structures,

and management philosophies (and
62858 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

must deal with a variety of different tax

issues), the Secretary should place the

majority of the weight on the

combination of the ratios that measure

financial health in the short and longterm: the Net Income and Equity ratios.

The commenter suggested that an

equitable weighting would be in the

neighborhood of 40 percent for the

Equity ratio, 40 percent for the Net

Income ratio, and 20 percent for the

Primary Reserve ratio.

Another commenter believed that the

two most important factors for

determining the financial responsibility

of a proprietary institution are whether

the institution is making a profit and the

amount of tangible net worth the

institution has available to sustain

losses. Accordingly, the commenter

suggested that the Secretary weight the

Net Income ratio at 50 percent, the

Equity ratio at 30 percent, and the

Primary Reserve ratio at 20 percent.

Alternatively, the commenter opined

that weighting the Net Income and

Equity ratios at 40 percent each would

also be reasonable. The commenter

believed strongly that the weighting for

the Primary Reserve could be increased

above 20 percent, but only if the ratio

results required for the corresponding

strength factors are reduced or if the

Secretary modifies the definition of

adjusted equity to include fixed assets.

Other commenters suggested various

other weighting percentages that the

Secretary should adopt for proprietary

institutions, including weighting the

Equity ratio at 30 percent, the Primary

Reserve ratio at 20 percent, and the Net

Income ratio at 50 percent.

A commenter representing private

non-profit institutions argued that the

Secretary should consider any

institution to be financially responsible

if that institution has positive

expendable net assets and generates an

annual surplus of revenues over

expenses because such an institution

does not represent a threat to Federal

funds. Accordingly, the commenter

recommended that the Secretary weight

the Net Income ratio more heavily and

in a manner that establishes the

financial responsibility standard for

private non-profit institutions as

breaking even or running a small

surplus annually. Similarly, another

commenter from a private non-profit

institution objected that the proposed

ratio methodology weights the two

balance sheet ratios (Viability and

Primary Reserve) more heavily than the

income statement ratio (Net Income).

The commenter believed that this

weighting scheme minimizes the value

of strong operating results (as measured

by annual changes in unrestricted net

assets), and favors unfairly institutions

with substantial expendable net assets.

Along the same lines, another

commenter suggested that the Primary

Reserve and Net Income ratios for

private non-profit institutions be

weighted equally.

Other commenters from the non-profit

sector believed that the Primary Reserve

ratio was too heavily weighted (55

percent), arguing that such a weighting

would create a disincentive for

institutions to invest internal funds in

plant assets even if those assets were

revenue producing (such as

dormitories).

Discussion: The Secretary thanks the

commenters for their suggestions

regarding the weighting percentages.

Discussion Regarding the Relative

Importance (Weighting Percentages) of

each of the Ratios for Proprietary

Institutions

Regarding these and other comments

from proprietary institutions that the

weighting percentage for the Primary

Reserve ratio should not be increased

from the proposed level of 20 percent,

the Secretary notes that expendable

resources are measured by two of the

proposed ratios, Primary Reserve and

Viability, that together carry a combined

weight of 50 percent. The Primary

Reserve ratio measures expendable

resources in relation to total expenses

and the Viability ratio measures

expendable resources in relation to total

long-term debt. Since the proposed

Viability ratio has been eliminated in

favor of the Equity ratio, the Secretary

believes that the weighting percentage

for the Primary Reserve ratio must be

increased because it is the only

remaining measure of an institution’s

expendable resources. However, the

Secretary does not believe that the

weighting percentage of the Primary

Reserve ratio should be increased to

reflect the combined weight given to

expendable resources under the

proposed methodology because the

importance of expendable resources to

proprietary institutions is somewhat

mitigated for two reasons. First, since

proprietary institutions have frequent

class starts they can rely more on tuition

revenues than on reserves of liquid

assets to meet near-term needs. Second,

by comparing expendable equity to

debt, the Viability ratio provided a

measure of an institution’s ability to

borrow that is now provided by the

Equity ratio.

The Secretary agrees with the

commenters who argued that the

Primary Reserve and Equity ratios are

just as or more important than the Net

Income ratio because together these

balance sheet ratios reflect all of the

resources accumulated over time by an

institution that are available to the

institution to support its current and

future operations. By comparing

tangible equity to tangible total assets,

the Equity ratio provides a measure of

the total resources that are financed by

accumulated earnings and owner

investments, or, stated another way, the

amount of an institution’s assets that are

subject to claims of third parties. In so

doing, the Equity ratio provides an

indication of the commitment of an

owner to the institution—a higher ratio

indicates a greater commitment on the

owner’s part because a greater

percentage of the owner’s capital is at

risk than would otherwise be the case if

that institution was either highly

leveraged or the owner had taken capital

out of the institution. However, unlike

the Primary Reserve ratio (or the

Viability ratio), the Equity ratio does not

provide a direct measure of the amount

of resources that an institution has to

meet its near-term obligations. Rather,

the Equity ratio provides a high-level

view of an institution’s overall

capitalization, and by inference its

proportionate ability to borrow. Thus,

the Equity ratio supplements the direct

measure of the resources that an

institution has available in the nearterm (i.e., expendable resources

measured by the Primary Reserve ratio)

by providing a measure of all of the

resources available to the institution to

support its operations. In combination,

the Primary Reserve and Equity ratios

reflect the financial viability of an

institution; that is, the ability of the

institution to continue to achieve its

operating and mission objectives over

the long-term.

With regard to the weighting of the

Net Income ratio, the Secretary is

convinced by the commenters that in

emphasizing profitability (by weighting

the Net Income ratio at 50 percent), the

proposed methodology may encourage

proprietary institutions to cut back on

necessary educational expenses or

engage in other inappropriate behaviors.

In addition, the Secretary agrees with

these and other commenters that minor

operating losses or year-to-year

fluctuations in profits may not severely

impair an institution from meeting its

operating objectives in any particular

year as long as the institution has other

resources available to support its

operations. For these reasons, the

Secretary believes that the weighting

percentage for the Net Income ratio

must be reduced. However, the Net

Income ratio must still carry a

significant weight because operating
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62859

profits increase the institution’s

financial health over time and are

necessary for a proprietary institution to

meet one of its primary objectives—to

distribute earnings to owners and

shareholders.

Discussion Regarding the Relative

Importance (Weighting Percentages) of

Each of the Ratios for Non-Profit

Institutions

The Secretary agrees that the

weighting percentage for the Net Income

ratio must be increased because the

proposed methodology does not

adequately account for strong operating

performance. However, that increase

must be limited because, unlike

proprietary institutions, generating

operating surpluses is not an objective

of many non-profit institutions. In

addition, accumulated operating

surpluses are reflected in the Equity

ratio.

The Secretary also agrees with the

comments that the proposed weighting

of Primary Reserve ratio (55 percent) is

too high and that emphasizing the

importance of expendable resources

may create a disincentive for

institutions to invest internal funds in

necessary non-expendable assets. By

using internal funds to finance the cost

of plant assets, an institution’s

expendable resources are reduced,

lowering both its Primary Reserve and

Viability ratios. Because these two ratios

carry a combined weight of 90 percent

under the proposed methodology, a

business decision to use internal funds

for these purposes may substantially

impact an institution’s composite score.

Although the Secretary believes that the

weighting percentage of the Primary

Reserve ratio must be reduced, it must

still carry a significant weight for two

reasons. First, since the operating cycles

for non-profit institutions are generally

tied to semesters or terms (as compared

to proprietary institutions that generally

have more frequent class starts), nonprofit institutions must rely more on

expendable reserves than on tuition

revenues to meet near-term needs.

Second, since the Viability ratio has

been eliminated in favor of the Equity

ratio that considers all of an institution’s

resources (including fixed assets and

endowments), the impact of any

reduction in expendable reserves

reflected by the Viability ratio is also

eliminated.

Changes: In view of this discussion,

and the professional judgment of the

Department and KPMG, the Secretary

establishes the following weighting

percentages:

Ratio

Proprietary

institutions

(percent)

Private nonprofit institutions (percent)

Primary Reserve 30 40

Equity ................ 40 40

Net Income ........ 30 20

Proposed Appendix F is revised and

supplemented by a new Appendix G to

reflect these weighting percentages.

Part 8. Comments Regarding the

Proposed Ratio Methodology as a Test of

Financial Responsibility.

Comments regarding the composite

score standard: Many commenters from

private non-profit institutions opposed

the creation of a ‘‘bright line’’ standard

(i.e., the 1.75 composite score) based on

the KPMG report. These commenters

maintained that the KPMG report did

not establish a test of financial

responsibility, but merely recommended

a screening process under which the

Secretary could easily identify problem

institutions. The commenters

recommended that the Secretary remove

the bright line standard as a test of

financial responsibility and instead

perform additional analyses of

institutions falling below the 1.75

composite score before determining

whether those institutions are

financially responsible.

Several commenters from proprietary

institutions maintained that the 1.75

composite score was too high, and that

the Secretary should either abandon or

revise the proposed methodology.

One commenter from a proprietary

institution suggested that because of the

uncertainty of the impact of these ratios,

the Secretary should establish a threeyear period of evaluation during which

the composite score would be set at

1.25.

Several commenters opined that the

Secretary should not conclude that an

institution is not financially responsible

solely because it failed to achieve a 1.75

composite score. The commenters

asserted that certain occurrences, such

as retirement incentive plans formulated

to downsize an institution, could make

it appear that the institution is not

financially responsible under the

proposed ratio methodology, when in

fact the institution is financially

healthy. The commenters suggested that

the Secretary should determine that an

institution is not financially responsible

only if an independent auditor indicates

concern about the institution’s financial

health in the Independent Auditor’s

Report or Management Letter comments.

A commenter from a proprietary

institution suggested that the Secretary

establish the composite score

requirement based on the following

rationale: if the Secretary allows an

institution that loses money to pass the

composite score requirement, the

institution should be allowed to pass

only if it is able under the other ratios

to operate for 45 days by using its equity

to meet current expenses. According to

the commenter, this would lead to the

following set of strength factors and

weightings for a passing composite

score of 1.0: a Primary Reserve Ratio

result of .06 would equal a strength

factor score of 1.0, weighted at 20

percent; an Equity Ratio result (defined

as net worth/expenses) of .125 would

equal a strength factor score of 2.0,

weighted at 40 percent; and a Net

Income Ratio result that was negative,

resulting in a strength factor score of

zero, weighted at 40 percent. The

commenter suggested that the absolute

value of the Net Income Ratio, when

negative, should be no less than 50

percent of equity in order for the

institution to pass. The commenter also

suggested that an institution with

negative equity, or with an operating

loss that is in excess of 50 percent of its

net worth, should fail the ratio tests.

Discussion: With regard to the first set

of comments, the Secretary

acknowledges that there were differing

expectations about the intended use of

the methodology. However, the

Secretary disagrees that the KPMG

report did not provide a basis for

proposing a regulatory test (the

composite score standard) solely

because the report did not describe how

the Secretary would determine the

disposition of those institutions that

would not satisfy that test. The

Secretary provided alternatives for those

institutions as part of the proposed rule.

Moreover, the methodology detailed in

that report provided a measure of the

financial health of institutions along a

scale from which the Secretary could

reasonably propose a regulatory test of

financial responsibility.

The Secretary agrees with the

commenters that the composite score

standard under the proposed

methodology is too rigorous, mainly

because that methodology was designed

to evaluate the financial health of an

institution over a two-to four-year time

horizon.

In the methodology established by

these regulations, the strength factor

scores and weighting percentages are

revised to measure the financial health

of an institution over a much shorter

time horizon, 12-to-18 months, to

correspond with the period that

generally passes before the Secretary

receives financial statements from

institutions and makes financial
62860 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

responsibility determinations based on

those statements.

In determining the minimum value of

the composite score that an institution

would need to achieve to demonstrate

that it is financially responsible, the

Secretary sought to identify the score at

which an institution should not only

have some margin against adversity, but

also the resources to fund to some

extent its technology, capital

replacement, human capital, and

program needs. The Secretary

understands that institutions have

differing funding needs and that it may

not be necessary for some institutions to

fully fund those needs every year.

However, the Secretary believes that for

an institution to demonstrate that it has

the financial ability to provide, and to

continue to provide in times of fiscal

distress, the education and services for

which its students contract, it must over

time generate or acquire the resources to

adequately fund its needs and to grow,

if necessary, its margin against

adversity. Along these lines, the

Secretary establishes a composite score

standard of 1.5.

As discussed previously under

Analysis of Comments and Changes,

Part 6, a strength factor score of 1.0

represents the lowest ratio result that

the Secretary believes an institution

must achieve to continue operations,

absent any adverse economic

conditions. A hypothetical institution

with strength factor scores of 1.0 for all

of the ratios achieves a composite score

of 1.0. At this level on the scoring scale,

the institution has very little margin

against adversity, is just barely living

with its means, and most of its assets are

subject to claims of third parties.

Although the institution may be able to

make its payroll and meet its existing

obligations, it will have difficulty

borrowing at favorable market rates.

Moreover, because it has very limited

resources, the institution will have

difficulty funding its technology, capital

replacement, and program needs.

Moving below this level on the scoring

scale, it becomes very difficult for the

institution to satisfy existing

obligations, and even more difficult to

fund any of its technology, capital

replacement, human capital, and

program needs. Moving up the scale, the

institution’s overall financial health

increases incrementally. At a composite

score of 1.5, the institution operated

within its means and added somewhat

to its overall wealth, and has some

margin against adversity. At this level,

the institution is funding historical

capital replacement costs and has

operating surpluses to provide funding

for some investment in human and

physical capital, but it has no excess

funds to support new program

initiatives or major infrastructure

upgrades. In addition, while the

institution may be able to borrow at

favorable market rates, it may need to

borrow to replace physical capital.

The Secretary notes that the specific

financial characteristics of institutions

may differ somewhat from those of this

hypothetical institution, depending on

the strength or weakness those

institutions demonstrate in the

fundamental elements of financial

health. However, since the methodology

measures those strengths and

weaknesses along a common scale and

takes into account the relative

importance of the fundamental

elements, the overall financial health of

an institution at any given composite

score is the same as that of any other

institution with that composite score.

To illustrate the differences between

groups of institutions scoring above and

below the composite score standard, the

following charts show the median value

of each ratio for those institutions.

EMPIRICAL DATA FOR PROPRIETARY

INSTITUTIONS, MEDIAN RATIO RESULTS

Range of

composite

scores

Equity

ratio

Primary

reserve

ratio

Net income

ratio

0.5 to 0.9 ..... 0.089 0.008 0.017

1.0 to 1.4 ..... .180 .038 .024

1.5 to 1.9 ..... .294 .094 .009

EMPIRICAL DATA FOR NON-PROFIT

INSTITUTIONS, MEDIAN RATIO RESULTS

Range of

composite

scores

Equity

ratio

Primary

reserve

ratio

Net oncome

ratio

0.5 to 0.9 ..... 0.388 ¥0.087 ¥0.017

1.0 to 1.4 ..... .583 .009 ¥0.001

1.5 to 1.9 ..... .602 .087 .004

These ranges are selected to reflect the

difference between the minimum

composite score that the Secretary

believes an institution must attain to

continue operations (1.0) and the

composite score that an institution must

attain to be financially responsible (1.5).

To characterize the ratio results of

institutions in these ranges, the median

(the value that falls in the middle of the

range) was chosen as the measure of

central tendency because unlike the

mean or mode, the median ignores

extreme values, except to account for

their location with respect to the middle

value of the range.

For proprietary institutions in the 0.5

to 0.9 composite score range, the

median value of the Net Income ratio

indicates relative strength in one

fundamental element of financial

health—profitability. However, that

strength is outweighed by weaknesses in

the Equity and Primary Reserve ratios.

In contrast, the proprietary institutions

scoring in the 1.5 to 1.9 range show

relative strength in the Equity and

Primary Reserve ratios. These strengths

in viability, liquidity, capital resources,

and ability to borrow, account for 70

percent of the composite score and

outweigh those institutions’ relative

weakness in profitability.

For non-profit institutions in the 0.5

to 0.9 composite score range, the

median value for the Equity ratio

indicates relative strength in ability to

borrow, viability, and capital resources,

but that strength is outweighed by

serious weaknesses in the Primary

Reserve and Net Income ratios which

account for 60 percent of the composite

score. In the 1.5 to 1.9 range, the

positive Primary Reserve and Net

Income ratios, although relatively weak,

supplement those institutions’ strength

in the Equity ratio.

Changes: The composite score

standard proposed under § 668.172(a) is

relocated to § 668.171(b) and revised to

provide that to be financially

responsible an institution must achieve

a score of at least 1.5.

Part 9. Comments Regarding Alternative

Means of Demonstrating Financial

Responsibility

Comments regarding the proposed

precipitous closure alternative: A

commenter from a higher education

association believed that the Secretary

should amend the proposed precipitous

closure alternative by eliminating the

qualifying requirement that an

institution must satisfy the general

standards of financial responsibility for

its previous fiscal year. The commenter

opined that the ratios are not short-term

measures of financial health that can be

corrected quickly by an institution and

suggested that an institution should

only have to show that its financial

condition has not worsened during the

year in which the institution relied on

this alternative in order to use it again.

The commenter reasoned that if the

institution’s financial health is

improving, it poses less of a risk in

subsequent years.

Many commenters from proprietary

institutions opposed the proposed

precipitous closure requirements. The

commenters believed that by including

personal financial guarantees, the

Secretary elevated the precipitous

closure standard beyond the current

past performance and going concern

requirements. These commenters and
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62861

many others from the non-profit sector

maintained that the proposed

requirement of personal financial

guarantees is neither supported by, nor

in keeping with, section 498(c)(3)(C) of

the HEA. The commenters believed that

the Secretary should retain the current

alternatives described in § 668.15(d)(2)

under which an institution that fails to

satisfy the general standards may

demonstrate that it is nevertheless

financially responsible.

Many other commenters opposed the

concept of requiring personal financial

guarantees under any circumstances.

Some commenters from non-profit

institutions maintained that personal

financial guarantees would be

impossible to obtain from their trustees

or would lead persons to refuse to serve

as trustees or would create conflicts of

interest for trustees. Several commenters

representing proprietary institutions

believed that personal financial

guarantees are unfair and arbitrary,

because the guarantees would expose

the owners of small family businesses to

the loss of personal assets, including

their homes and savings.

Several other commenters

recommended that instead of

immediately requiring a letter of credit

or personal financial guarantees from an

institution that fails to achieve the

composite score, the Secretary should

use a longer term analysis of the

institution’s financial condition,

including the institution’s management

record. These commenters believed that

if an institution failed the general

standards one year out of several, more

extensive forms of reporting or

monitoring should be required to

determine whether the institution is

improving (particularly when the

institution’s failure to meet the ratio

standards results from normal

fluctuations in the business cycle).

Discussion: With regard to the

comment that the Secretary should

eliminate the requirement that an

institution must satisfy the general

standards of financial responsibility for

its previous fiscal year to qualify for the

proposed alternative, the Secretary

notes that this requirement was

originally established as part of the

precipitous closure exception under the

financial responsibility regulations

published on April 29, 1994. Under that

exception an institution was not

required to post a surety or enter into

provisional certification to continue

participating in the title IV, HEA

programs. To minimize the Federal risks

from unprotected participation, the

Secretary structured the exception so

that it was available only to an

institution that (1) was financially

responsible in its fiscal year prior to the

year in which it sought to qualify under

the exception, (2) demonstrated that its

deteriorated financial condition was not

exacerbated by benefits given to owners

or related parties, and (3) otherwise

demonstrated, by satisfying certain

conditions, that it had sufficient

resources to ensure that it would not

close precipitously. That structure

allowed a qualifying institution one year

to improve its financial condition and

prevented that exception from becoming

a means for the institution to continue

participating under a lower standard of

financial responsibility than that

required of all other institutions (for

more information, see 59 FR 34964–

34965).

In keeping with the concept that the

precipitous closure exception should

provide an opportunity for a financially

weak institution to improve its financial

condition, but instead of requiring the

institution to demonstrate that it had

not engaged in certain practices that

could have led to its deteriorated

financial condition, the Secretary

proposed that an institution would need

to attain a composite score of at least

1.25 and the owners, trustees, or other

persons exercising substantial control

over the institution would have to

provide personal financial guarantees.

The proposed composite score was

intended to establish a minimum

threshold below which an institution’s

financial condition had so seriously

deteriorated that additional protections,

such as surety or provisional

certification, would be required

immediately to protect the Federal

interest. For institutions scoring at or

above that minimum threshold, the

Secretary proposed requiring personal

financial guarantees based on the

reasoning that if the owner or person

exercising substantial control over the

institution was willing to risk the loss

of his or her personal assets on behalf

of the institution, the Secretary would

accept the corresponding risk to the

Federal interest by allowing that

financially weak institution to continue

to participate in the title IV, HEA

programs.

In light of the comments, the

Secretary acknowledges that requiring

personal financial guarantees may

prevent some institutions from

qualifying under the proposed

alternative. Moreover, the Secretary is

convinced by these and other

commenters that instead of immediately

requiring personal financial guarantees

or a surety, a more considered and less

burdensome approach should be

adopted for institutions that do not

satisfy the composite score standard.

Along these lines, and in view of the

preceding discussion, the Secretary

establishes in these regulations the

‘‘zone’’ alternative under which a

financially weak institution has up to

three consecutive years to improve its

financial condition without having to

post a surety, provide personal financial

guarantees, or participate under a

provisional certification. To qualify

initially under this alternative, an

institution must achieve a composite

score in the zone from 1.0 to 1.4, and

to continue to qualify, must achieve a

composite score of at least 1.0 in each

of its two subsequent fiscal years. If the

institution does not score at least 1.0 in

one of those subsequent fiscal years or

does not sufficiently improve its

financial condition so that it satisfies

the composite score standard (achieves

a composite score of at least 1.5) by the

end of the three-year period, the

institution must satisfy another alternate

standard under these regulations to

continue to participate in the title IV,

HEA programs. However, the institution

may qualify again under the zone

alternative for its fiscal year following

the next fiscal year in which it achieves

a composite score of at least 1.5.

The zone alternative is not available

to an institution scoring below 1.0

because there is considerable

uncertainty regarding the ability of the

institution to continue operations and

satisfy its obligations to students and to

the Secretary. For that institution, the

Secretary believes that additional

oversight and surety are required

immediately to protect the Federal

interest.

On the other hand, an institution

scoring in the zone should generally be

able to continue operations for the next

12-to-18 months, absent any adverse

economic event. However, because of

that institution’s limited ability to deal

with adversity and its overall weak

financial condition, the Secretary

believes it is necessary to monitor more

closely the operations of that institution,

including its administration of title IV,

HEA program funds. Accordingly, under

the zone alternative the Secretary

requires an institution to provide timely

information regarding certain oversight

and financial events that may adversely

impact the institution’s financial

condition, but that the Secretary would

not generally become aware of until six

months after the end of the institution’s

fiscal year when that institution submits

its audited compliance and financial

statements. The following chart

compares the proposed precipitous

closure alternative to the zone

alternative.
62862 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

Provision Proposed precipitous closure alternative,

§ 668.174(a)(3) Zone alternative, § 668.175(d)

To qualify initially under the

alternative, an institution

must.

1. Achieve a composite score of 1.25 to 1.74 (on a

scale from 1.0 to 5.0);.

2. Satisfy all of the general standards of financial responsibility for its previous fiscal year;.

3. Provide personal financial guarantees from owners,

board of trustees, or other persons exercising substantial control over institution; and.

4. Demonstrate to the Secretary that it will not close

precipitously.

1. Achieve a composite score of 1.0 to 1.4 (on a scale

from negative 1.0 to positive 3.0).

Informational and Administrative Procedures

Rather than having to satisfy the qualifying requirements under the proposed precipitous closure alternative, an institution must provide information regarding certain oversight and financial events and comply

with cash management and other provisions.

To continue to qualify, an institution must.Not available; an institution could qualify under this alternative for only one year.Achieve a composite score no less than 1.0 in each of

its next two years under the alternative and continue

to comply with the Informational and Administrative

Procedures above.

Institution may qualify again

under the alternative.

For its fiscal year following the year that it satisfies the

composite score standard (1.75).

For its fiscal year following the next year that it satisfies

the composite score standard (1.5 or greater).

With regard to the reporting

requirements under the zone alternative,

an institution must provide information

to the Secretary no later than 10 days

after the following events occur: (1) Any

adverse action taken against it by its

accrediting agency, (2) any event that

causes the institution, or related entity,

to realize any liability that was noted as

a contingent liability in the institution’s

or related entity’s most recent audited

financial statements, (3) any violation

by the institution of any existing loan

agreement, (4) any failure of the

institution to make a payment in

accordance with its existing debt

obligations that results in a creditor

filing suit to recover funds under those

obligations, (5) any withdrawal of

owner’s equity from the institution by

any means, including by declaring a

dividend, or (6) any extraordinary

losses.

In addition, the Secretary may, on a

case-by-case basis, require an institution

to submit its compliance and financial

statement audits earlier than six months

after the end of its fiscal year or provide

information about its current operations

and future plans.

With regard to administering title IV,

HEA program funds, the Secretary is

mindful of the concerns raised by

commenters about the onerous nature of

the reimbursement payment method.

Therefore, the Secretary amends the

Cash Management regulations under

subpart K to include a new payment

method, cash monitoring, that is in

several respects similar to

reimbursement but much less onerous.

Like the reimbursement payment

method, an institution under the cash

monitoring payment method must first

make disbursements to eligible students

and parents before the Secretary

provides title IV, HEA program funds to

the institution for the amount of those

disbursements.

However, under cash monitoring, the

Secretary (1) allows the institution itself

to make a draw of title IV, HEA program

funds for the amount of the

disbursements the institution has made

to eligible students and parents, or (2)

reimburses the institution for those

disbursements based on a modified and

more streamlined review and approval

process. For example, instead of

requiring the institution to provide

specific documentation for each student

to whom the institution made a

disbursement, and reviewing that

documentation before providing funds

to the institution, the Secretary may

simply require the institution to identify

those students and their respective

disbursement amounts and provide title

IV, HEA program funds to the

institution based solely on that

information. The Secretary further

amends subpart K to provide that an

institution that is placed under the cash

monitoring payment method is subject

to the disbursement and certification

provisions that apply to FFEL Program

funds, but in keeping with the nature of

cash monitoring, the Secretary may

modify those provisions.

For an institution that qualifies under

the zone alternative, the Secretary

determines whether to provide title IV,

HEA program funds to the institution

under one of the cash monitoring

payment options or by reimbursement.

As part of its compliance audit, an

institution must require its auditor to

express an opinion on its compliance

with the requirements under the zone

alternative, including its administration

of the payment method under which the

institution received and disbursed title

IV, HEA program funds. If an institution

fails to comply with the information

reporting or payment method

requirements, the Secretary may

determine that the institution no longer

qualifies under this alternative.

Finally, with respect to the other

comments regarding personal financial

guarantees, the Secretary would like to

clarify that under section 498(e) of the

HEA the Secretary may require these

guarantees from an institution with past

performance problems or from an

institution that fails, or has failed in the

preceding five years, to satisfy the

general standards of financial

responsibility.

Changes: The precipitous closure

alternative proposed under

§ 668.174(a)(3) is replaced by the zone

alternative. The zone alternative is

located under § 668.175(d) of these

regulations.

The Cash Management regulations

under subpart K are revised in several

ways. First, § 668.162(a)(1) is amended

to include cash monitoring as a payment

method under which the Secretary may

provide title IV, HEA program funds to

an institution. Second, a new paragraph

(e) is added to § 668.162 that sets forth

the provisions of the cash monitoring

payment method. Lastly, a new

paragraph (f) is added to § 668.167 to

provide that the Secretary may require

an institution under the cash monitoring

payment method to comply with the

disbursement and certification

provisions that apply to institutions

placed under the reimbursement

payment method. This paragraph also

provides that the Secretary may modify

those disbursement and certification

procedures for institutions under cash

monitoring.

The provisional certification

alternatives proposed under § 668.178

(b) through (d) are relocated under

§ 668.175 (f) and (g) and revised to

clarify when and the conditions under

which the Secretary may require an

institution, or the persons who exercise

substantial control over the institution,

to provide personal financial

guarantees. Also, these sections are

amended by removing the proposed
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62863

requirement that an institution must

demonstrate that it will not close

precipitously and providing in place of

that requirement that an institution

must comply with the zone provisions

under § 668.175 (d)(2) and (3).

Comments regarding the irrevocable

letter of credit alternative: Many

commenters maintained that the

proposed rules continue to contradict

statutory language in specifying that

letters of credit be for one-half of all

annual title IV, HEA disbursements,

rather than for one-half of potential

annual liabilities.

A commenter representing private

non-profit institutions asserted that the

letter of credit alternative was not

feasible for small, frugal, tuition-driven

institutions. The commenter suggested

that the Secretary should not require

these institutions to provide letters of

credit unless the institutions have audit

or program review liabilities.

Many commenters contended that

providing a letter of credit payable to

the Secretary erodes an institution’s

financial condition, affects negatively an

institution’s ability to provide

educational services, and could lead to

the precipitous closure of an institution

that would otherwise have continued

operations. One of these commenters

reasoned that this provision is counterintuitive—an institution that could

afford to secure a letter of credit would

not need to because it would probably

pass the ratio standards, but an

institution that did not pass the ratio

standards probably could not afford to

secure the letter of credit.

Similarly, another commenter

recommended that in cases where

institutions fail to meet the composite

score standard for one year, the

Secretary should adopt an accrediting

agency approach and work with those

institutions by helping them create a

formal recovery plan instead of

imposing letter of credit requirements

that would weaken those institutions’

financial condition.

Several commenters from the

proprietary sector suggested that the

Secretary expand the alternative

methods of demonstrating financial

responsibility for small institutions to

include a provision under which those

institutions could provide a letter of

credit in the amount of five percent or

10 percent of their prior-year title IV,

HEA program funds. The commenters

stated that this alternative would be

more equitable because a small

institution may not be able to afford the

cost of obtaining a large letter of credit,

or have available sufficiently large

credit lines to secure a 50 percent letter

of credit. The commenters also

recommended that for all institutions,

an alternative should be the provision of

a letter of credit in an amount ranging

from five percent to 50 percent of the

institution’s prior-year title IV funds,

tied to the perceived shortfall in funds,

or to the operating loss that triggered the

institution’s failure to meet the

standards.

Discussion: The Secretary continues

to believe that the practice of equating

the institution’s potential liabilities with

the amount of funds received during a

prior year is reasonable, especially since

the law takes into consideration the

value of potential loan discharges and

unpaid student refunds. The thresholds

used to measure financial responsibility,

and to establish appropriate minimum

surety levels, do not take into

consideration additional risks that may

be present at institutions where there

have been demonstrated compliance

problems in administering the title IV,

HEA programs. For that reason, the

larger surety that allows an institution

to be considered financially responsible

may be as low as 50 percent, the

minimum required under the law which

states that such a surety must be not less

than one-half of its annual potential

liabilities. In the alternative, the

Secretary may certify the institution

provisionally and require the institution

to post a letter of credit as low as 10

percent of its prior year’s funding.

Where compliance issues are

identified with an institution that does

not demonstrate financial responsibility

under these regulations, or where

greater risks are identified in the

institution’s deteriorated financial

condition, the corresponding amounts

of surety required to either demonstrate

financial responsibility or participate

under provisional certification will be

higher. Although this larger surety may

impose additional hardships on an

institution that is experiencing financial

difficulties, the corresponding higher

risks arising from that institution’s

continued participation in the title IV,

HEA programs warrant the additional

protection to the Federal interests.

With respect to the comments that the

Secretary should provide an alternative

under which an institution would be

allowed to post a small letter of credit

to demonstrate that it is financially

responsible, the Secretary notes that this

alternative is not permitted under the

law. Under section 498(c)(3)(A) of the

HEA, an institution that does not satisfy

the general standards of financial

responsibility must post a letter of credit

of not less than one-half of its potential

annual liabilities to demonstrate that it

is financially responsible. For this

reason, the Secretary structured the

zone alternative to allow a financially

weak institution with no compliance

problems to continue to participate as a

financially responsible institution for up

to three consecutive years. This

alternative provides institutions scoring

in the zone a reasonable period of time

to improve their financial condition by

working with their accrediting bodies

through the formal recovery plans

mentioned by the commenter, or by

other means. To the extent that an

institution is unable to raise its

composite score to 1.5 or higher after

three years, or if the institution’s

composite score decreases below 1.0,

that institution will generally be able to

continue to participate in the title IV,

HEA programs by posting a large surety

or under a provisional certification with

a smaller surety.

Changes: None.

Comments regarding other

alternatives: One commenter from a

non-profit institution believed that the

calculation of a few ratios cannot begin

to compare as a true measure of

financial strength to a credit rating

received by an institution from a major

rating agency. Therefore, instead of the

proposed methodology the commenter

suggested that the Secretary consider

any institution whose debt is rated as

investment grade (BBB/Baa) or better to

be financially responsible.

Many commenters from proprietary

institutions argued that in accordance

with the language contained in section

498(c)(3)(A) of the HEA, the Secretary

should allow institutions to post

performance bonds as well as letters of

credit as an alternative to meeting ratio

standards of financial responsibility.

A commenter from a higher education

organization representing public and

non-profit institutions suggested the

following alternatives for any degreegranting, regionally accredited

institution that is designated as a public

institution by the State in which it is

located or that has been in continuous

existence for 25 years or since the

authorization of the HEA in November

1965: (1) The institution can meet

reasonable tests of self-insurance

covering the potential liability of onehalf of its annual funding under the title

IV, HEA programs, (2) the institution

participates in an insurance pool

approved by the Secretary that

indemnifies the institution for one-half

of its annual funding under the title IV,

HEA programs, (3) the institution

presents a letter of credit covering at

least one-half of its annual funding

under the title IV, HEA programs, or (4)

the institution presents other financial

instruments, satisfactory to the

Secretary, to cover one-half of the
62864 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

institution’s funding under the title IV,

HEA programs.

Similarly, another commenter from a

non-profit institution suggested the

Secretary (1) should consider that an

institution is financially responsible if

the institution has been continuously

operating with the same management

structure for the past 20 years, (2) apply

financial responsibility standards only if

an institution has exceeded the

maximum allowable default rate; and (3)

should consider an institution a

financial risk and place that institution

on some type of probation if the

institution has experienced five or more

consecutive years of operating deficits,

declining net assets, declining net

worth, or declining enrollments.

A commenter from a higher education

association representing proprietary

institutions believed that the 50 percent

letter of credit alternative was onerous

and excessive and suggested that the

Secretary consider the following

alternatives: (1) A letter of credit equal

to 25 percent of the amount of title IV,

HEA program funds received by an

institution during the previous year, (2)

a performance bond, (3) a 10 percent

letter of credit if the institution

participates in a State tuition recovery

program, (4) instead of reimbursement,

the use of an escrow account under

which an institution would be allowed

to draw title IV, HEA program funds

when it earned those funds, (5) a

financial guarantee, or infusion of

additional capital, by a parent

corporation on behalf of an institution,

or (6) a 10 percent letter of credit

combined with provisional certification

but not the reimbursement payment

method.

Discussion: Some of the suggested

alternatives, such as those relating to

longevity, trend analysis, and smaller

letters of credit, are not included in

these regulations based on the

discussion under Analysis of Comments

and Changes, Part 9. Regarding the

suggestion that the Secretary permit

institutions to post performance bonds

rather than letters of credit, it has been

the Secretary’s experience that

performance bonds are virtually

uncollectible and thus provide little or

no protection to the Federal interest.

With respect to the commenters’

suggestion that institutions should be

able to use self-insurance or insurance

pooling as a method of providing surety,

the Secretary notes that a letter of credit

may be obtained on behalf of an

institution from a bank by a number of

different entities, and that these

regulations do not prevent several

institutions (or other entities) from

entering into an arrangement with a

bank under which their pooled

resources would be used to obtain a

letter of credit for an institution that is

required to post surety. In the absence

of any specific information from the

commenters regarding self-insurance or

insurance pooling, the Secretary does

not modify the regulations to permit any

type of insurance pooling that would

provide anything other than a letter of

credit as surety for an institution.

In response to the comment regarding

bond ratings, the Secretary believes that

it is unlikely that an institution with an

investment grade bond rating will not

achieve a composite score of at least 1.5

because, as noted under Analysis of

Comments and Changes, Part 6, the

financial standards used by rating

agencies are more stringent than the

standards under these regulations.

While the regulations permit an

institution to use its participation in an

approved State tuition recovery plan as

a substitute for a surety that would

otherwise be required if the institution

failed to make its refunds in a timely

manner, the Secretary does not believe

that these plans are appropriate

resources to consider for paying

liabilities that arise from an institution’s

administration of the title IV, HEA

programs.

The Secretary notes that the cash

monitoring payment method may also

be used instead of reimbursement for

institutions that participate under a

provisional certification. This new

payment method will reduce the

relative burden noted by the

commenters who suggested that the

reimbursement requirement should be

eliminated from the provisional

certification procedures.

Changes: The provisional certification

alternatives proposed under § 668.178

(b) through (d) are relocated under

§ 668.175 (f) and (g) and revised to

provide that the Secretary may require

an institution under either of these

alternatives to disburse and request title

IV, HEA program funds under the cash

monitoring payment method.

Comments regarding alternatives for

new institutions: Some commenters

objected to the proposal contained in

§ 668.174(b)(2) under which the

Secretary has the discretion to establish

the amount of a letter of credit based on

the amount of title IV, HEA program

funds the Secretary expects that a new

institution will receive for the first year

it participates under these programs.

The commenters believed that the

Secretary could use this discretion to

establish arbitrarily high letters of

credit. As an alternative, the

commenters suggested that the Secretary

enter into an agreement with an

institution establishing the amount of

title IV, HEA program funds the

institution may draw down during its

initial year of participation. Under this

arrangement, the institution would

initially submit a letter of credit based

on the agreed amount and submit

additional letters of credit during the

year if the institution needed to draw

down title IV, HEA program funds in

excess of the agreed amount.

Discussion: While the commenters’

suggestion has merit, even if an

institution agreed to submit additional

letters of credit as a condition under a

provisional certification, there is no

assurance that the institution would be

able to submit those letters of credit. In

that circumstance, the institution’s

continued participation in the title IV,

HEA programs would be severely

jeopardized, placing at risk both

students who relied on Federal funds to

attend the institution and the Secretary

for providing those funds.

To the extent that the Secretary

accepts the risk to the Federal interest

by allowing a financially weak

institution to participate for the first

time in the title IV, HEA programs, that

risk must be mitigated at the onset by a

letter of credit for an amount that the

Secretary estimates is sufficient to cover

the institution’s potential liabilities.

This is not to say that the Secretary will

determine the amount of that letter of

credit without conferring with the

institution.

Changes: None.

Part 10. Comments Regarding Past

Performance

Comments regarding substantial

control: A commenter representing

proprietary institutions was concerned

that the past performance standards

under proposed § 668.167(a)(1) could

adversely affect innocent people. The

commenter described a situation where

an individual acting as a courtappointed officer of an institution

undergoing reorganization under

Chapter 11 could be harmed if the

institution has title IV, HEA program

liabilities and that individual is unable

to bring the institution out of Chapter 11

status. The commenter believed that

under the current rules, the Secretary

would consider that the individual

exercised substantial control over this

failed institution and thus, because of

the unpaid program liabilities could not

subsequently exercise substantial

control over another institution, i.e.,

because of the individual’s past

performance, another institution would

not risk losing its ability to participate

in the title IV, HEA programs by

allowing the individual to exercise
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62865

substantial control. The commenter

suggested that the Secretary modify the

regulations to exclude from these

provisions a person who was not

employed by an institution at the time

that the institution incurred title IV,

HEA, program liabilities but who is

retained either for the purpose of

assisting in a reorganization plan or by

a bankrupt corporation under a courtapproved process.

Discussion: The commenter correctly

notes that the regulations cause an

institution to fail the financial

responsibility standards if a person that

exercises substantial control over the

institution either held an ownership

interest in another institution that owes

a liability or exercised substantial

control over that other institution. The

regulations also provide that such a

failure can be cured either by showing

that the liability from the other

institution is being repaid under an

agreement with the Secretary, or that the

person has repaid a portion of that

liability that is equivalent to the former

ownership interest. If the person did not

hold an ownership interest in the other

institution, but was instead a board

member or executive officer of that

institution or related entity, that

person’s repayment liability is capped at

25 percent of the applicable liability.

Furthermore, the regulations provide

that the institution whose financial

responsibility is being determined may

show that the person identified as

exercising substantial control over the

institution should nevertheless be

considered to lack that control, or the

institution may show that the person

lacked that control over the institution

that owes the liability.

The analysis made under this

provision will take into consideration

whether the liability arose when the

person was exercising control over the

institution, and whether that person

should have ensured that the institution

paid the liability. In the commenter’s

example, it could be reasonable to

conclude that a court-appointed

bankruptcy trustee with no prior

dealings with the institution, who took

control when no funds remained

available to pay the liability, would not

now cause another institution to fail the

financial responsibility requirements. In

other situations where someone has

taken control over an institution that

continued to participate in the title IV,

HEA programs, it may be appropriate to

hold that person accountable under the

regulations if prior liabilities remained

unpaid.

Changes: None.

Comments regarding administrative

actions, program review and audit

findings: One commenter representing

proprietary institutions questioned the

provision in proposed § 668.177(a)(2)

under which an institution would not

be considered financially responsible if

it had been limited, suspended, or

terminated (LS&T) by the Secretary or

by a guaranty agency. The commenter

maintained that limitations by guaranty

agencies could have nothing to do with

the financial condition of the institution

(for example, the practice of an agency

to limit the level of its guarantees to a

certain amount per year). Therefore, the

commenter believed that these

limitations, or any other action taken by

guaranty agencies, fall beyond the scope

of this provision. The commenter

suggested that if a guaranty agency

questions the financial condition of an

institution, the agency should refer that

institution to the Secretary before any

action is taken.

Other commenters representing

proprietary institutions opined that the

proposed provisions under

§ 668.177(a)(3) are arbitrary. Under

these provisions, the Secretary would

consider that an institution is not

financially responsible based on a

material finding in an audit or program

review in one of the previous five years.

The commenters argued that such a

finding might have nothing to do with

the financial responsibility of an

institution.

Several commenters noted that since

the Secretary does not conduct program

reviews of all institutions on a regular

basis, the limitation on financial

responsibility tied to the findings of the

institution’s two most recent program

reviews should be changed to reflect a

fixed period of time.

One commenter noted that erroneous

program review findings that are settled

in favor of an institution are sometimes

not settled in a timely fashion. The

commenter suggested that the Secretary

delay making a determination that an

institution is not financially responsible

under the past performance standards

until after the appeal process is

completed.

Discussion: The Secretary reminds the

commenters that in addition to

satisfying the numeric standard

regarding its financial condition (i.e.,

the composite score standard), to be

financially responsible under the

provisions in the HEA, an institution

must demonstrate that it administers

properly the title IV, HEA programs in

which it participates and that it meets

all of its financial obligations, including

repayments to the Secretary for debts

and liabilities arising from its

participation in those programs. An

institution that is the subject of an

adverse action taken by the Secretary or

a guaranty agency, or that had a material

finding of a program violation in an

audit or program review, has clearly

mismanaged title IV, HEA program

funds and is therefore not financially

responsible under these provisions.

The Secretary agrees with the

commenters who noted that the

proposed past performance provision

under which an institution is not

financially responsible if that institution

had a material finding in either of its

two most recent program reviews

should be changed because those

reviews are not conducted of all

institutions on a routine basis.

Changes: The past performance

provision regarding program reviews

under proposed § 668.177(a)(3)(ii) is

relocated under § 668.174(a)(2) and

revised to parallel the two-year

compliance audit requirement.

Part 11. Comments Regarding

Administrative Actions and Other

Requirements

Comments regarding the procedures

under which the Secretary initiates an

LS&T action: A commenter representing

proprietary institutions argued that the

provision under proposed

§ 668.177(a)(3)(iii) is arbitrary and

highly punitive, because the Secretary

would determine that an institution is

not financially responsible if the

institution submits its financial

statements a day late or the Secretary

rejects the institution’s financial

statements. The commenter maintained

that this provision is unnecessary since

the Secretary already has recourse under

§ 668.178(a) to initiate an action to limit,

suspend, or terminate an institution.

Several commenters from private nonprofit institutions asserted that the

Secretary should not take an action to

limit, suspend, or terminate an

institution unless (1) the institution fails

to correct or cure deficiencies cited in

an audit report within ninety days after

receiving formal notification of those

deficiencies from the Secretary, or (2)

the institution fails to submit an audit

report within 30 days after receiving

formal notification that the Secretary

has not received that audit report.

Discussion: Under the regulations, an

institution is required to submit audits

within a fixed time period, and an

institution’s failure to do so is a serious

matter. The Secretary expects that

institutions will work diligently to

ensure that the combined financial

statement and compliance audit is

submitted on time. To the extent that

the commenters suggest that an

institution may inadvertently fail to

submit an audit on time, that mistake is
62866 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

routinely corrected when the institution

is contacted by the Department and

asked to provide the missing audit

immediately.

The question of whether it may be

appropriate to initiate an administrative

action against an institution based upon

deficiencies or program violations that

are identified in an institution’s audit is

best resolved on a case-by-case basis.

Furthermore, an institution should not

wait for the Secretary to notify it of

program violations identified in its own

audit report before the institution takes

steps to correct those violations.

Changes: None.

Comments regarding teach-out plans:

Many commenters from proprietary

institutions opposed any additional

requirements relating to institutions on

provisional certification, on the grounds

that current requirements already

provide the Secretary with sufficient

oversight authority. The commenters

specifically opposed the suggested

provision that would require teach-out

plans from institutions on provisional

certification, arguing that earlier teachout proposals failed because of serious

implementation problems.

Discussion: The Secretary is still

considering whether it is feasible to

require institutions to routinely provide

teach-out plans when a review of the

financial statements shows that the

institution does not demonstrate

financial responsibility. Although the

Secretary may ask for this information

on a case-by-case basis where some

heightened risk of closure is indicated,

no broader requirement will be included

in the regulations at this time.

Changes: None.

Part 12. Comments Regarding the

Proposed Transition Period

Comments: Many commenters

supported the concept of a transition

period under proposed § 668.171 during

which the Secretary would consider an

institution to be financially responsible

if it failed the proposed ratio standards

but passed the current standards.

However, the commenters suggested

that the proposed one-year transition

rule be extended to a two-year or threeyear period. Some of these commenters

agreed that a one-year transition period

was necessary to ensure that the

standards are not applied retroactively,

but suggested that an additional year

would be required to allow the

Secretary to test and assess the impact

of the standards. Other commenters

stated that a longer transition period

was necessary so that institutions could

structure their operations to meet the

standards. Several commenters

recommended that the Secretary allow

institutions to use either the current or

proposed standards for an indefinite

period of time.

Many commenters from the

proprietary sector recommended that

the Secretary allow institutions to use

the exceptions to the general standards

now contained under § 668.15(d) during

the transition period.

Several commenters from the

proprietary sector asked the Secretary to

clarify how the transition period would

work for institutions that have fiscal

years ending December 31.

Discussion: The Secretary has

considered the suggestions from the

commenters to extend the transition

period, but continues to believe that the

proposed one-year window during

which an institution may use either the

current standards or the new standards

is reasonable. Moreover, a number of

changes have been made to the

proposed regulations that will minimize

any difficulties that an institution may

encounter in adjusting to the new

measures. For example, an institution

whose composite score is less than 1.5

may continue to participate as a

financially responsible institution for up

to three consecutive years under the

zone alternative so long as its composite

score is greater than 1.0. Furthermore,

by extending the comment period and

delaying the issuance of final

regulations until 1997, the final

regulations will not go into effect until

July 1, 1998. This delay in publication

while additional comments were sought

has also provided institutions with

additional time to evaluate their

operations under the ratio analysis

framework that has been proposed and

discussed with the community.

The Secretary agrees to allow an

institution that does not satisfy the

composite score standard for the

transition year to demonstrate that it is

financially responsible by satisfying the

standards or alternative requirements

under § 668.15 or by qualifying under

an alternative standard in § 668.175 of

these regulations. The Secretary clarifies

that such an institution may use the

transition-year alternative only once and

only for its fiscal year beginning

between July 1, 1997 and June 30, 1998.

For any fiscal year beginning on or after

the effective date of these regulations,

July 1, 1998, an institution must satisfy

the requirements under these

regulations.

In the commenter’s example, the

transition-year alternative is available to

an institution for its fiscal year

beginning on January 1, 1998 and

ending on December 31, 1998.

Changes: The transition-year

provisions proposed under § 668.171(c)

are relocated under § 668.175(e) and

revised to provide that an institution

may demonstrate that it is financially

responsible by satisfying the

requirements under §§ 668.15(b)(7),

(b)(8), (d)(2)(ii), or (d)(3), as applicable.

Part 13. Comments Regarding Debt

Payments

Comments: One commenter

representing proprietary institutions

questioned the need for the general

standard regarding debt payments

contained in the proposed

§ 668.172(a)(3), particularly in view of

the proposed ratio methodology. The

commenter maintained that there might

be reasons why an institution would be

late in paying debts or be in violation of

a loan agreement, including disputes

over the nature and amount of the debt.

The commenter believed that in those

cases, the violation or delinquency does

not indicate financial instability.

Another commenter recommended that

the general standards contain a

provision that allows for the resolution

of disputes between an institution and

a creditor who has filed suit on a debt

that is 120 days past due. Along the

same lines, another commenter noted

that since there are no alternatives for

an institution that is not current in its

debt payments, the Secretary should not

initiate an action to terminate such an

institution without providing the

institution an opportunity to rectify this

situation.

Discussion: As a condition of

demonstrating financial responsibility,

an institution is expected to conduct its

business affairs in a manner that enables

the institution to pay its debts in a

timely manner. When any creditor files

suit against an institution to collect a

debt that is more than 120 days late, the

Secretary believes that there is a

significantly increased risk that Federal

funds could be used improperly, or that

Federal funds held in the institution’s

bank account could be sought by a

creditor through the legal system.

Furthermore, since such a lawsuit

between an institution and a creditor is

unlikely to present Federal questions

where the Department would be likely

to intervene in the legal proceedings, it

is reasonable to require the institution to

be provisionally certified and post a

small letter of credit. The Secretary

believes that this additional protection

to the taxpayers is warranted where an

unpaid, or even disputed, debt has

prompted a creditor to initiate a legal

proceeding to obtain a judgment against

the institution. When an institution fails

to demonstrate financial responsibility

under the regulations due to the filing

of such a lawsuit, the institution would
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62867

be given an opportunity to be certified

provisionally and post a surety unless

other problems were identified that

involved the institution’s administration

of the federal student aid programs.

Changes: None.

Part 14. Comments Regarding the

Definition of Terms

Comments: Several commenters

requested that the Secretary provide

detailed definitions for the following

terms used for the financial ratios under

proposed § 668.173: intangibles, total

expenses, income before taxes, total

revenues (particularly if refunds,

returns, and allowances are deducted),

and long-term debt and total long-term

debt (especially as to whether the last

two terms include or exclude the

current portion of the debt, and whether

the terms include long-term debt owed

stockholders or other related parties or

entities). One of these commenters

believed that the term ‘‘income before

taxes’’ should be defined as ‘‘income

from continuing operations before

extraordinary items and changes in

accounting principles.’’

One commenter asked whether total

revenues include those items included

under gross revenues or net revenues as

those terms are used on financial

statements. This commenter also asked

how the definition of total expenses

related to the captions ‘‘operating

expenses’’ and ‘‘other expenses and

income’’ on financial statements, and

whether drop and withdrawal accounts,

interest, and other non-operating

expenses should be included in the

definition of total expenses.

Another commenter asked for

clarification of the term ‘‘unrestricted

income.’’ This commenter asserted that

under Statement of Financial

Accounting Standards 117, unrestricted

income can be defined either as total

unrestricted income (tuition, fees,

contributions, auxiliary revenues, etc.)

before considering net assets released

from restrictions, or it can be defined as

unrestricted income plus any net assets

released from restrictions.

Discussion: To assist in clarifying the

final regulations, the Secretary provides

definitions for the following terms:

Total Expenses—Expenses are

outflows or other using up of assets or

incurrences of liabilities (or a

combination of both) from delivering or

producing goods, rendering services, or

carrying out other activities that

constitute the entity’s ongoing major or

central operations. Losses are decreases

in equity (net assets) from peripheral or

incidental transactions of an entity and

from all other transactions and other

events and circumstances affecting the

entity except those that result from

expense or distributions to owners.

Total expenses in the context of this

final rule include both operating and

non-operating expenses and losses,

except extraordinary losses meeting the

criteria of APB Opinion No. 30,

paragraph 19. Therefore, total expenses

for proprietary institutions includes

items such as costs of sales, selling and

administrative expenses (including

interest and depreciation) and other

non-operating losses. Total expenses for

private non-profit institutions includes

similar items of expense and is defined

as the required line item in the

Statement of Activities entitled Total

Expenses for those institutions reporting

under the new accounting standards

FASB Statement 117.

Total Revenues—Revenues are

inflows or other enhancements of assets

of an entity or settlements of its

liabilities (or combination of both) from

delivering or producing goods,

rendering services, or other activities

that constitute the entity’s ongoing

major or central operations. Gains are

increases in equity (net assets) from

peripheral or incidental transactions of

an entity and from all other transactions

and other events and circumstances

affecting the entity except those that

result from revenues or investments by

owners. Total revenues in the context of

this final rule includes both revenues

and gains, except extraordinary gains

meeting the criteria of APB Opinion No.

30, paragraph 19. Therefore, total

revenues for proprietary institutions

includes items such as tuition and fees,

bookstore revenues, investment gains,

other income and miscellaneous

revenue. Revenues are reported net of

refunds, returns, allowances and

discounts (including tuition discounts)

and drop and withdrawals. Total

revenues for private non-profit colleges

and universities includes similar items

of revenue and is defined as the

required line item in the Statement of

Activities typically entitled Total

Unrestricted Income for those

institutions reporting under the new

accounting standards FASB Statement

117. Unrestricted income includes

unrestricted revenues, gains and other

support including net assets released

from restrictions during the period.

The Secretary wishes to clarify that

the definition of total revenues includes

net assets released from restrictions of

private non-profit colleges and

universities. In accordance with the

AICPA Audit and Accounting Guide for

Not-for-Profit Organizations as of June 1,

1996, certain items such as investment

gains may be reported net of fees with

appropriate disclosure in the footnotes

to the financial statements.

Income Before Taxes—Income before

taxes is defined as income from

operations before extraordinary items,

discontinued operations, and changes in

accounting principles. The Secretary

wishes to clarify that the definition of

income before taxes does not include

income or loss from discontinued

operations. However, the Secretary may

consider the effect of extraordinary

items, discontinued operations, and

changes in accounting principle in the

overall evaluation of financial

responsibility.

Changes: None.

Part 15. Comments Regarding the

Proposed Standards and Requirements

for Institutions Undergoing a Change in

Ownership

Comments regarding the proposed

letter of credit and personal financial

guarantee provisions: Several

commenters believed that the Secretary

took an extreme position that will

prevent owners from selling their

institutions by proposing under

§ 668.175 that a new owner either (1)

submit a letter of credit equal to 50

percent of the title IV, HEA program

funds that the Secretary estimates the

institution will receive during its first

year under new ownership, or (2)

provide personal financial guarantees.

Some commenters opposed the

requirement of financial guarantees for

several reasons. First, the commenters

maintained that since recent changes of

ownership have resulted in financially

stronger rather than financially weaker

institutions, the guarantees are not

necessary. Second, they believed that

the guarantees would slow the process

of obtaining approval from the Secretary

for a change of ownership. Third, the

commenters argued that the provision

for personal financial guarantees is not

common in the business world and

would negate the concept of a

corporation. Moreover, the commenters

opined that personal financial liability

should only be required in cases

involving personal wrongdoing; in other

cases, it only serves to discourage strong

owners from buying financially troubled

institutions.

Many other commenters from

proprietary institutions stated that they

would support the proposed rules for

institutions that change ownership only

if: (1) The new rules speed up the

process under which the Secretary

determines whether to allow those

institutions to participate in the title IV,

HEA programs, or (2) provide

uninterrupted participation for

institutions that change ownership.
62868 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

However, the commenters did not

believe the proposed rules would

achieve either of these objectives.

Comments regarding the

consolidating date of the acquisition

balance sheet: Several commenters

maintained that requiring a

consolidating date of the acquisition

balance sheet would be unnecessary,

expensive, and time consuming. Some

of these commenters asserted that such

a requirement would limit the

marketability of institutions, or destroy

the value of small institutions, because

it would require an institution to close

its books as of the acquisition date and

have a complete audit performed,

resulting in large audit costs and losses

of time. According to one of the

commenters, these costs could be

avoided for a publicly traded

corporation if the Secretary would agree

to determine financial responsibility

from the information contained in the

financial statements included as part of

the corporation’s quarterly reports to the

SEC. The commenter noted that these

financial statements would be no more

than 90 days old, and believed that the

Secretary could rely on their accuracy

for two reasons: the SEC levies criminal

penalties against corporations that file

inaccurate statements, and the

statements are reviewed by an

independent CPA.

Another commenter requested the

Secretary to clarify how the current

requirement under which an institution

provides an audited balance sheet when

it applies for a change of ownership

differs from the proposed requirement

that the institution submit a

consolidating date of acquisition

balance sheet.

Comments containing alternative

proposals for institutions undergoing a

change in ownership: Several

commenters suggested that an

institution undergoing a change of

ownership that meets the general

requirements should be exempt from the

letter of credit or personal financial

guarantees requirements if the

institution achieves the required ratio

score based on a balance sheet audit or

an audited financial statement that

covers only part of a year. The

commenters preferred this approach

over the proposed requirements under

which the Secretary would maintain the

letter of credit or keep in place the

personal financial guarantees until the

institution completed a full fiscal year.

One commenter offered several ways

to deal with changes of ownership.

First, the commenter suggested that the

Secretary charge a reasonable fee for

processing change of ownership

applications, believing that it is fair to

compensate the Secretary for

committing trained staff to process

application requests timely. Moreover,

the commenter opined that this

suggestion would eliminate frivolous

and unqualified requests. Second, the

commenter believed that the Secretary

should examine applications from

existing owners purchasing existing

institutions differently from new owners

with no experience in the school

business entering the business. In either

case, the commenter argued that the

Secretary should approve a change of

ownership request without interrupting

the acquired institution’s title IV, HEA

program funds if the owner satisfies

certain conditions. For an existing

owner, the owner must demonstrate that

he or she has managed an institution

participating in the title IV, HEA

programs to the highest standards.

According to the commenter, the

owner’s current institution must have:

(1) A low cohort default rate (20 percent

or lower), (2) an excellent job placement

rate (80 percent or more), (3) less than

1 percent audit exceptions, (4) been in

business for five years or more, and (5)

resolved any actions taken by the

Secretary, an accrediting agency, or the

State.

For a new owner purchasing an

existing institution, the commenter

suggested that the Secretary (1) require

that owner to submit a letter of credit (or

cash) for an amount equal to three

months of the amount of title IV, HEA

program funds that the institution

received in the prior year, and (2) limit

any increase in the amount of title IV,

HEA program funds the institution

receives during its first 12 months under

new ownership to 10 percent over the

amount the institution received in the

prior year.

Another commenter suggested

lowering the percentage of the letter of

credit, asserting that no business

acquiring an institution could possibly

post a letter of credit for 50 percent of

the title IV, HEA program funds that the

institution would receive.

Finally, a commenter from a

proprietary institution suggested that

the Secretary could establish standards

for the Equity and Primary Reserve

ratios for institutions that change

ownership that are higher than the

standards established for participating

institutions.

Comments regarding other change of

ownership issues: A commenter

requested that the Secretary clarify

whether the proposed requirements for

an institution undergoing a change

would eliminate the current provision

under which that institution is

provisionally certified.

Another commenter inquired whether

the excluded transactions described

under § 600.31(e) would continue to

exempt an institution from the change

of ownership provisions under

proposed § 668.175.

One commenter argued that it was

erroneous to assume that a change of

ownership results in a change of

control. The commenter believed that a

change of ownership occurs when a

corporation releases a majority of its

stock on the market. However, the

commenter reasoned that a change of

control does not occur if a large number

of shareholders acquire that stock since

no shareholder acquires a controlling

interest. Moreover, the commenter

concluded the Secretary should not

require a financial statement audit or

surety if the corporation was financially

responsible before such an event

because the financial condition of the

corporation does not change as a result

of this event. Therefore, the commenter

suggested that the Secretary amend

proposed § 668.175(a) so that it applies

only to a change of ownership that

results in a new person or entity

exercising substantial control over the

institution, or if the institution’s

financial statement is affected by the

change.

Comments regarding additional

locations: Several commenters opposed

the proposal under which the Secretary

could require personal financial

guarantees or letters of credit for

additional locations of an institution,

arguing that it is inappropriate to

require such letters or guarantees in any

situation other than one involving past

misconduct. Moreover, the commenters

believed that the Secretary should not

consider the expansion of operations as

an event that requires heightened

scrutiny.

Another commenter added that it was

inappropriate to single out additional

locations for heightened scrutiny since

other forms of expansion, including the

rental of additional buildings or the

expansion of housing or research

facilities, could have an equal impact on

an institution’s financial situation. In

any event, the commenter suggested that

the guarantees should only remain in

place until the institution demonstrates

that it is financially responsible and that

such guarantees should not exceed 50

percent of the amount of title IV, HEA

program funds that would be received

by the additional location.

One commenter asked that the

Secretary clarify the types of financial

surety that would be required for an

additional location. The commenter

stated that if the surety was limited to

personal financial guarantees, a publicly
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62869

traded corporation could not add

locations, because shareholders who are

purely investors would also be required,

but would refuse, to provide personal

guarantees. Therefore, the commenter

recommended that the Secretary accept

instead irrevocable letters of credit.

Another commenter suggested that

decisions regarding additional locations

should be made by accrediting agencies

in accordance with the regulations

contained in § 602.27. Under this

suggestion, if the accrediting agency

determines that an institution is

administratively capable and financially

responsible, then the institution would

be allowed to open the additional

location without any other restrictions.

If the accrediting agency determines

otherwise, then the institution would

not be allowed to open that location

even if the institution is willing to

provide a surety.

A commenter asserted that it was

important to describe the conditions

under which the Secretary would draw

upon a surety provided when an

institution adds an additional location,

because these conditions will

profoundly affect the cost of the surety.

In particular, the commenter asked

whether the Secretary would draw upon

the surety only if an institution closed,

or under other circumstances, and

whether the amount drawn would be

the amount equal to unpaid refunds and

improperly disbursed title IV, HEA

program funds, or some other amount.

Discussion: The Secretary thanks the

commenters for their suggestions and

recommendations under this Part, but

notes that several issues raised by the

commenters relating to institutional

participation, application and

certification procedures, and additional

locations fall beyond the scope of the

proposed financial responsibility

regulations. Consequently, the Secretary

could not amend the applicable sections

of the regulations that address those

areas and procedures. Moreover,

because changes to those areas and

procedures will likely affect how the

Secretary determines whether

institutions undergoing a change of

ownership are financially responsible,

and to harmonize any new financial

standards with those changes, the

Secretary will delay promulgating final

financial responsibility regulations for

those institutions. In the meantime, the

financial responsibility of an institution

that undergoes a change of ownership

will be determined under current

regulations and administrative

procedures.

Changes: The Secretary withdraws the

provisions under proposed § 668.175

that an institution undergoing a change

in ownership would be financially

responsible only if the persons or

entities acquiring an ownership interest

in that institution provide personal

financial guarantees or letters of credit.

The Secretary will in the future propose

regulations regarding changes of

ownership and other related issues.

Final Regulatory Flexibility Analysis

The Secretary has determined that a

substantial number of small entities are

likely to experience significant

economic impacts from this regulation.

Thus, the Regulatory Flexibility Act

(RFA) required that an Initial Regulatory

Flexibility Analysis (IRFA) of the

economic impact on small entities be

performed and that the analysis, or a

summary thereof, be published in the

Notice of Proposed Rulemaking. The

IRFA was performed and a summary

was published in the Notice of Proposed

Rulemaking for this rule. This Final

Regulatory Flexibility Analysis (FRFA)

discusses the comments received on the

IRFA and fulfills the other RFA

requirements.

The Department of Education has a

long history of providing compliance

assistance to institutions participating

in the Title IV, HEA programs, in the

form of guidance, training, and access to

staff for individualized assistance. The

Department will provide similar support

to institutions in implementing this new

rule. This assistance fulfills the letter

and the spirit of the RFA requirement

that this assistance is provided to small

entities.

Summary of Significant Issues Raised

by the Public Comments on the IRFA,

a Summary of the Assessment of the

Department of Such Issues, and a

Statement of Any Changes Made in the

Proposed Rule as a Result of Such

Comments

In the notice of proposed rulemaking,

the Secretary invited comments on the

IRFA, particularly comments on the

definition of small entities, the

estimation of the number of institutions

likely to experience economic impacts,

and the estimated costs of alternative

demonstrations of financial

responsibility. No comments were

received on these issues, but other

comments on the RFA and small entities

were received. These comments are

discussed here.

Comments: Many commenters from

the proprietary sector maintained that

the Secretary had not met the burden of

proof required in the RFA regarding the

Department’s reasons for taking action.

Discussion: The RFA requires the

Secretary to publish a description of the

reasons why action by the Department

was taken and a succinct statement of

the objectives of, and legal basis for, the

final rule. In the next section of this

FRFA and in the preamble, the

Secretary describes why the Department

took action. The Secretary believes this

explanation satisfies the RFA

requirements.

Changes: None.

Comments: A commenter representing

proprietary institutions questioned the

manner in which the first KPMG study

was conducted. The commenter

believed that small business interests

were not considered since no

representatives of small proprietary

institutions were among those

institutional representatives that

assisted with the first KPMG study.

Moreover, the commenter asserted that

this omission, as well as the fact that the

Secretary did not consider the

comments submitted by a group of CPAs

on behalf of proprietary institutions

regarding the first KPMG report,

violated the requirement in the RFA that

the Secretary confer with

representatives of small businesses.

Discussion: The Secretary has

conferred extensively with

representatives of all types of

postsecondary institutions throughout

the period of this rulemaking process.

This consultation goes well beyond the

RFA requirement that the Secretary

confer with representatives before the

final rule is published. This

consultation is evidenced by the fact

that the group of CPAs to whom this

commenter referred had received the

first KPMG report when that report was

in its draft stage, and had time to

consider and provide extensive

comments on that draft report. The

Secretary distributed a draft of that

report to all sectors, including

representatives of small proprietary

institutions. The comments received

were considered carefully by the

Department and KPMG before the

August 1996 KPMG report was issued,

and considered again before the NPRM

was published. During the comment

period on this rule, the Secretary had

extensive discussions with the

postsecondary community, as discussed

in the preamble. These discussions

included several representatives of

small for-profit and small non-profit

institutions.

Changes: None.

Comments: Many commenters from

proprietary institutions concluded from

the discussion in the IRFA section of the

NPRM that the ratio standards are

weighted heavily against the for-profit

sector.

Discussion: The Secretary feels that

the ratio standards are correctly tailored
62870 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

to measure financial health at different

institutions. The final rule has been

designed so that institutions across all

sectors that demonstrate similar levels

of financial health receive similar

scores. Thus, a proprietary institution

that earns a score of 2.0 will have

approximately the same level of

financial health as a non-profit

institution with the same score. As

discussed in the IRFA, the estimates of

the number of institutions experiencing

economic impacts used in that analysis

were based on the best information

available at that time. That information

came from a judgmental sample of

financial statements in which

financially weak institutions were

intentionally over-sampled in order to

provide as clear a picture as possible of

these institutions. The estimates

contained in this FRFA were obtained

from a non-judgmental sample of

institutions and thus represent

improved estimates of the number of

institutions likely to experience

economic impacts. It is true that

institutions in the proprietary sector are

more likely to experience negative

economic impacts from this rule. The

degree to which a higher proportion of

proprietary institutions do not attain

passing scores is consistent with the

lower levels of financial health in that

sector evidenced by the audited

financial statements analyzed by the

Department and KPMG.

Changes: The FRFA contains

improved estimates of the number of

institutions likely to experience

economic impacts. These estimates are

based on a larger and non-judgmental

sample.

Comments: Several commenters from

proprietary institutions asserted that the

proposed standards favor large or

publicly traded corporations at the

expense of small and new institutions.

Other commenters believed that many

small institutions with good educational

and compliance records that pass the

current standards would fail the

proposed standards. The commenters

opined that this outcome points to a

flaw in the manner in which the

methodology treats small institutions.

An accountant for a proprietary

institution argued that because the

proposed methodology does not provide

an adjustment for size, it is unfair to

compare an institution with $10 million

in tuition revenue to an institution with

$500,000 in tuition revenue by applying

the same standards and criteria to both

institutions.

Discussion: As discussed elsewhere in

the preamble, the final methodology

does account for the size of the

institution by using ratios that consider

an institution’s financial strength in

relation to certain characteristics of the

institution. It is estimated that between

105 and 165 small institutions that pass

the current standards would fail the

new standards. The Secretary believes

that, based on this more comprehensive

and accurate measure, these institutions

have a sufficiently poor financial

condition to warrant additional

oversight of the Federal funds

administered by these institutions,

irrespective of their educational and

compliance records.

Changes: None.

Comments: A commenter representing

private non-profit institutions asserted

that the letter of credit alternative was

not feasible for small, frugal institutions

that are tuition-driven. The commenter

suggested that these institutions should

not be required to provide letters of

credit, or that only those institutions

that have audit or program review

liabilities be required to provide a letter

of credit. Several commenters from the

proprietary sector stated that a small

institution may not be able to afford the

cost of obtaining a large letter of credit,

or have available sufficiently large

credit lines to secure a 50 percent letter

of credit. The commenters stated that a

more equitable alternative would be for

the Secretary to expand the alternative

methods of demonstrating financial

responsibility for small entities to

include a provision under which those

entities could provide a letter of credit

in the amount of five percent or 10

percent of their prior-year title IV, HEA

program funds. The commenters also

recommended that for all institutions,

an alternative should be the provision of

a letter of credit in an amount ranging

from five percent to 50 percent of the

institution’s prior-year title IV funds,

tied to the perceived shortfall in funds,

or to the operating loss that triggered the

institution’s failure to meet the

standards.

Discussion: The Secretary

understands that small (and large)

institutions that are in poor financial

condition may have difficulty obtaining

a 50 percent letter of credit. This

requirement is only imposed on

institutions whose ability to continue

operations is highly uncertain.

Furthermore, there are other alternatives

by which institutions can continue to

participate in the title IV, HEA programs

without posting a 50 percent letter of

credit. For instance, institutions can

participate under provisional

certification by posting a 10 percent

letter of credit. Other alternative

methods were considered and rejected,

including the alternatives described by

the commenters. These alternatives are

discussed earlier.

Changes: This final rule contains the

zone alternative, under which

financially weak institutions may

continue to participate without posting

a letter of credit.

Comments: Several commenters

representing proprietary institutions

believed that personal financial

guarantees are unfair and arbitrary,

because the guarantees would expose

the owners of small family businesses to

the loss of personal assets, including

their homes and savings.

Discussion: The proposed alternative

of providing personal financial

guarantees was intended to provide

owners with additional options, and

was available at the discretion of the

owner of the institution. The provision

of collateral is standard operating

practice in the financial sector and this

proposed alternative was offered to

provide institutions with flexibility in

meeting the financial responsibility

standards. The Secretary does not feel

that providing an alternative that can be

exercised at the option of the small

business owner is unfair or arbitrary.

However, the resources of the

Department can be better utilized in

administering the provision associated

with the zone alternative than in

administering personal financial

guarantees.

Changes: The personal financial

guarantee alternative has been removed

from the final rule.

Description of the Reasons Why Action

by the Department Was Taken and a

Succinct Statement of the Objectives of,

and Legal Basis for, the Final Rule

The Secretary is directed by section

498(b) of the HEA to establish that

institutions participating in title IV,

HEA programs are financially

responsible. The Department, as part of

its regulatory reinvention process, has

analyzed the current standards for

institutions to demonstrate financial

responsibility and found that

improvements are both possible and

needed. The tests of financial

responsibility are being modified so that

they more accurately reflect the

financial health of the institutions

participating in the programs. The

modifications provide different tests for

each postsecondary sector. Institutions

are evaluated according to standards

appropriate to their sector and financial

practices and conditions. More

information about the need and

justification for this rule can be found

elsewhere in the preamble.
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62871

Description and Estimate of the Number

of Small Entities to Which the Proposed

Rule Will Apply

The Secretary has applied the U.S.

Small Business Administration (SBA)

Size Standards to the set of institutions

that will be affected by this rule.

Postsecondary educational institutions

are classified in the Standard Industry

Classification (SIC) in Major Industry

82—Educational Services. Within this

SIC, all subclassifications except Flight

Training Schools have the same

criterion for qualifying as a small

business. This criterion is that the

business have total annual revenue less

than or equal to $5 million. Thus, for

the purposes of analyzing this

regulation, for-profit and non-profit

businesses with total annual revenue

less than or equal to $5 million are

considered small entities. For public

institutions, the SBA standard is that

the governmental body that is

responsible for the institution have a

population less than 50,000. For

instance, a postsecondary vocational

institution that is operated by a county

with a population under 50,000 would

be considered a small governmental

entity using the SBA Size Standard.

In order to determine the number of

small institutions to which the rule will

apply, an analysis was performed using

a census of postsecondary educational

institutions. This census is named the

Integrated Postsecondary Educational

Data System (IPEDS) and is maintained

by the U.S. Department of Education’s

National Center for Education Statistics

(NCES). All postsecondary educational

institutions that participate in the title

IV, HEA programs are required, as a

condition of participation, to fully

participate in the IPEDS data

collections. The last year for which

finance data were collected covered the

1993–94 academic year. These data

were required to categorize the

institutions by their total revenue. The

actual data point that is collected is

‘‘Total Current Fund Revenue,’’ which

is used as a proxy for Total Revenue.

The differences between this measure

and the measure used by SBA are

considered negligible; in any case, this

is the only measure available. For small

governmental entities, data on the size

of the population of the governing body

was not available for this analysis.

However, a decision was made to err on

the side of including more institutions

rather than run the risk of including too

few in the ‘‘small’’ category. For that

reason, any public institution that was

controlled at any level below that of a

state was considered a small institution

for this part of the analysis. No

adjustment was available for growth or

shrinkage of the number of participating

institutions. However, the analysis

shows that a substantial number of

small entities will be affected by the

proposed rule and no adjustment factor

would change that, so the question of

adjusting to current program

participation levels is not important for

the determination of whether a

substantial number of small entities

would be affected by the proposed

regulation.

The estimates are that this rule will

apply to 1,690 small for-profit entities,

660 small non-profit entities, and 140

small governmental entities. The RFA

directs that these small entities be the

sole focus of the Regulatory Flexibility

Analysis.

Estimate of the Number of Institutions

Experiencing Economic Impacts From

the Rule

There are no significant adverse

economic impacts of these regulations

on public entities. This is because

public entities are assumed to satisfy the

financial responsibility requirements by

virtue of their backing by the full faith

and credit of the State or other

governmental body where they are

located. The minimal reporting

requirements contained in this rule for

public entities to establish their public

status do not represent a significant

economic impact. It is estimated that

this would represent four hours of time

per institution. Using a loaded labor rate

of $20.00 per hour, this would cost each

small public institution $80.00. This is

similar to the paperwork burden

associated with the current rule with

regard to public institutions, so no

change in the economic impact on these

entities is expected.

The small for-profit and small nonprofit entities that would experience

adverse economic impacts from this rule

are those that would not pass the new

financial responsibility test and would

be required to provide additional surety

to continue participating in the title IV,

HEA programs, or to comply with the

heightened monitoring required of

institutions.

Any institution that does not pass the

financial ratio test can post a letter of

credit worth at least 50 percent of its

previous year’s title IV, HEA program

funds. Institutions that use this

alternative will be considered

financially responsible.

Institutions that fail the financial ratio

test can post a letter of credit worth at

least 10 percent of their previous year’s

title IV, HEA program funds, comply

with additional reporting requirements,

provide early financial audits if

requested, and participate under

reimbursement or one of the cash

monitoring payment methods.

Institutions that use this alternative will

not be considered financially

responsible and will be provisionally

certified to participate in the programs.

Institutions that fall into the zone can

participate by complying with

additional reporting requirements,

providing early financial audits if

requested, and participating under

reimbursement or one of the cash

monitoring payment methods.

Institutions in the zone that use this

alternative will be considered

financially responsible. This alternative

method of demonstrating financial

responsibility for institutions in the

zone is available for only three out of

any four years. An institution which

was in the zone for three years must

pass the ratio test at the end of the third

year or it will be considered to have

failed the financial ratio test and must

participate under one of the alternatives

described above (50 percent letter of

credit, or 10 percent letter of credit with

provisional certification and heightened

monitoring).

The Department contracted with

KPMG to perform an analysis of the

financial tests that will be conducted on

audits submitted by participating

institutions. Using the KPMG sample to

infer to the population, the following

estimates were obtained. An estimated

total of 220–390 small institutions that

failed the old financial responsibility

test would have passed the new test or

been eligible for the zone alternative,

had it been in effect during this period.

For these institutions, the proposed

changes would have had a positive

economic impact because they would

have been spared the expense of an

alternative demonstration of financial

responsibility. At the same time, an

estimated total of 280–415 small

institutions that passed the old financial

responsibility test would have failed or

fallen into the zone under the new test.

For these institutions, these changes

would have had a negative impact

because they would have had to go to

the expense of posting surety or

heightened monitoring, or both, as

discussed in the next section. A fuller

description of these institutions, broken

down by the type of organization, is

presented in Table 1.
62872 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

TABLE 1. ESTIMATED NUMBER OF INSTITUTIONS EXPERIENCING ECONOMIC IMPACTS

Status with regard to old and new financial responsibility tests Small for-profit

institution

Medium and

large for-profit

institution

Small nonprofit institutionMedium and

large for-profit

institution

Old test: Pass. New test: Pass (no economic impact) .................................... 1,300–1,400 75–125 300–350 875–950

56%–71% 29%–83% 50%–81% 53%–68%

Old test: Pass. New test: Zone (adverse economic impact) ........................... 150–200 15–25 25–50 20–40

6%–10% 6%–17% 4%–12% 1%–3%

Old test: Pass. New test: Fail (adverse economic impact) .............................. 100–150 15–25 5–15 10–20

4%–8% 6%–17% 1%–3% 0%–1%

Old test: Fail. New test: Pass (positive economic impact) .............................. 75–125 10–20 50–100 400–450

3%–6% 4%–13% 8%–23% 24%–32%

Old test: Fail. New test: Zone (positive economic impact) .............................. 75–125 5–15 20–40 50–100

3%–6% 2%–10% 3%–9% 3%–7%

Old test: Fail. New test: Fail (possible positive economic impact) .................. 275–325 30–50 30–50 50–100

12%–16% 12%–33% 5%–12% 3%–7%

Source: Department and KPMG analysis from sample data.

Estimates of Economic Impacts

The economic impact of the new

financial tests depends on the

alternative method that the institution

uses to continue participating in the

title IV, HEA programs. It is impossible

to determine what alternative these

entities will choose. Of course, one

alternative that is available to entities is

to discontinue participation in the

programs. Using the economic principle

of profit-maximization (or costminimization for non-profit entities),

entities that would choose to

discontinue participation have

demonstrated that their cost of

withdrawal is lower than their cost of

these alternative methods for

demonstrating financial responsibility.

Therefore, these costs represent

estimates of maximum economic costs

associated with the choice of alternative

certification or withdrawal from the title

IV, HEA programs. It is difficult to

determine the cost of withdrawal from

participation in these programs.

Post a Letter of Credit Equal to at Least

50 Percent of the Institution’s Prior

Year Title IV, HEA Program Funds

The cost of posting a letter of credit

varies according to the particular

financial situation of the institution

employing this alternative. The cost also

depends on the type of relationship that

the institution has with its bank. The

costs estimated here assume that the

institution has no relationship with a

bank that would allow the bank to rely

on its institutional knowledge to more

accurately determine the risk of having

to pay out the letter of credit. Thus, the

estimates here are overstated for at least

some institutions that have such a

relationship with their banks.

For the purposes of this analysis,

costs will be estimated for a small

institution of typical size. An institution

with annual title IV revenue of $2

million would be required to post a

letter of credit of $1 million. The

bankers representing local, regional, and

national commercial banks contacted by

KPMG stated that they would charge a

fee of between 0.75 percent and 1.25

percent for such an institution, or

between $7,500 and $12,500. In

addition, the bankers stated that the

institution would be required to

collateralize the letter of credit. Using

an opportunity cost of the collateral of

four points above the prime rate (12.5

percent), this would represent an

estimated opportunity cost of $125,000.

The bankers indicated that the fees and

requirements would be similar for both

proprietary and private non-profit

institutions.

It is estimated that about one-fifth of

the institutions that fail the financial

responsibility test will choose to post a

50 percent letter of credit. This estimate

represents the best professional

judgment of Department program staff.

Institutions that fail the old and new

standards and are already participating

with this alternative will not experience

an economic impact from this provision.

This estimate is based on the

assumption that none of the institutions

in the zone will choose to post a 50

percent letter of credit, since the other

alternative for institutions in the zone

has a lower economic impact. The letter

of credit alternative is available for

institutions in the zone under the

statute. Some institutions may

experience different economic costs

than those estimated here and find the

50 percent letter of credit alternative

more attractive than the other

requirements in the zone alternative.

Post a Letter of Credit Equal to at Least

10 percent of the Institution’s Prior

Year Title IV Funds and Participate

Under Provisional Certification

As discussed above, the costs of

securing a letter of credit depend on the

particular financial situation of the

institution and the type of relationship

that the institution has with its bank.

For the purposes of this analysis,

costs will be estimated for a small

institution of typical size. An institution

with annual Title IV revenue of $2

million would be required to post a

letter of credit of $200,000. The bankers

contacted by KPMG stated that they

would charge a fee of between 0.75

percent and 1.25 percent for such an

institution, or between $1,500 and

$2,500. In addition, the bankers stated

that the institution would be required to

collateralize the letter of credit. Using

an opportunity cost of the collateral of

four points above the prime rate (12.5

percent), this would represent an

estimated opportunity cost of $25,000.

The bankers indicated that the fees and

requirements would be similar for both

proprietary and private non-profit

institutions.

It is estimated that about four-fifths of

the institutions that fail the financial

responsibility test will choose to post a

10 percent letter of credit. This estimate

represents the best professional

judgment of Department program staff.

Institutions that fail the old and new

standards, and are already participating

with this alternative, will not

experience an economic impact from

this provision.

Additional Reporting

Institutions that fail the financial

responsibility ratio test or use the zone

alternative to demonstrate financial

responsibility will be required to report

significant adverse financial or oversight

events to the Department. It is estimated
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62873

that about one-fifth of institutions using

the zone alternative will have an

average of 1.5 events per year that they

would have to report to the Department.

It is estimated that about one-third of

institutions that fail the ratio test will

have an average of two events per year

that they would have to report to the

Department.

Reporting each event is expected to

take about 15 minutes. Using a loaded

labor rate of $20.00 per hour, reporting

each event will cost the institutions

$5.00. An estimated one-fifth of the

institutions using the zone alternative

will experience an average economic

impact of $7.50. An estimated one-third

of the institutions that fail the ratio test

will experience an average economic

impact of $10.00.

These estimates represent the best

professional judgment of Department

program staff.

Early Submission of Audits

Institutions that fail the financial

responsibility ratio test or use the zone

alternative to demonstrate financial

responsibility may be required to submit

early financial audits to the Department,

at the Department’s discretion. It is

expected that these institutions will be

required to submit these audits within

60 days of the end of the fiscal year. It

is estimated that the Department will

exercise that discretion for about onehalf of the institutions using the zone

alternative, and about two-thirds of the

institutions that fail the ratio test.

The only economic impact

institutions will experience from being

required to submit their audited

financial statements early is any higher

fees that may be charged to the

institutions by their auditors. KPMG

researched the types of fees that a

national, regional and local accounting

firm would typically charge for this

service. It was estimated that a small

institution with about $2.5 million in

total revenue and one campus would be

charged between $6,000 and $8,000 in

additional fees for a combined financial

and compliance audit performed in

January or February. The accounting

firms also stated that institutions with

fiscal years that do not end on December

31 would probably not be subject to

additional fees as long as they receive

sufficient advance notice of this

requirement.

Cash Monitoring, Type 1

Institutions that are required to obtain

title IV, HEA program funds through the

first type of cash monitoring will be

required under § 668.162(e)(1) to credit

students’ accounts before drawing

federal funds. The institution’s

compliance audit will contain

verification that this did occur

throughout the year. There is no

additional paperwork associated with

this option. There will be some minimal

one-time costs associated with changing

from the advance payment method to

this payment method. It is difficult to

estimate what changing payment

systems might cost since it would vary

depending on the administrative

structure of the institution. It is

expected that it might take a small

institution an estimated 40 hours to

reprogram its financial system and make

other adjustments. Using a loaded labor

rate of $50.00 per hour for this type of

technical work, the estimated economic

impact is $2,000. Since institutions are

expected to credit students’ accounts

and draw federal funds in the same

banking day, there should be no

borrowing costs associated with this

payment method. Under the advance

payment system, institutions are

allowed to keep up to $250 in interest

earned from depositing federal funds in

advance of disbursing it to students.

Institutions that are no longer able to

participate on advance payment would

lose the portion of that $250 they were

able to earn.

It is estimated that about three-fourths

of the institutions participating under

the zone alternative will be placed on

this level of cash monitoring. It is

estimated that about five-eighths of

institutions who fail the ratio test and

participate under the 10 percent letter of

credit alternative will be placed on this

level of cash monitoring.

Institutions that fail the old and the

new test of financial responsibility and

participate under provisional

certification may experience a positive

economic benefit from this provision.

Under current rules, institutions can

only participate under the current

reimbursement system. To the degree

that these institutions are allowed to

participate using a less stringent type of

cash monitoring than that available

under current rules, they will

experience a positive economic benefit.

Cash Monitoring, Type 2

Institutions that are required to obtain

title IV, HEA program funds through the

second type of cash monitoring will be

required under § 668.162(e)(2) to credit

students’ accounts and provide some

documentation of students and amounts

before receiving federal funds. The

institution’s compliance audit will

contain verification that this did occur

throughout the year. Institutions will be

required to document students and

amounts and submit this to the

Department. This is expected to

represent about one hour of paperwork

for the small institution and cost about

$20.00 using a loaded labor rate of

$20.00 per hour. As discussed above,

there will be some one-time costs

associated with changing from the

advance payment method to this

payment method, which are estimated

at $2,000. Institutions are expected to

credit students’ accounts and receive

federal funds within six days.

Institutions will be receiving some or

even all of the federal funds in the form

of student charges, so they are not

expected to be required to borrow the

entire amount of the delayed funds.

However, they will experience the

economic impact of not having the

opportunity to use these funds for that

six-day period. The opportunity cost of

capital is estimated here at the

borrowing rate. It is assumed that

institutions in such a situation could

obtain a short-term loan at their bank for

an annual interest rate of prime plus

four points, or about 12.5 percent. This

yields an economic cost of about $2,000

per million dollars of title IV, HEA

program funds received annually. As

discussed above, institutions would also

lose up to $250 in interest fees on

advance payments they may have been

earning.

It is estimated that about one-eighth of

the institutions participating under the

zone alternative will be placed on this

type of cash monitoring. It is estimated

that about one-eighth of the institutions

who fail the ratio test and participate

under the 10 percent letter of credit

alternative will be placed on this type

of cash monitoring.

Institutions that fail the old and the

new tests of financial responsibility and

participate under provisional

certification may experience a positive

economic benefit from this provision.

Under current rules, institutions can

only participate under the current

reimbursement system, under

§ 668.162(d). To the degree that these

institutions are allowed to participate

using a less stringent type of cash

monitoring than that available under

current practice, they will experience a

positive economic benefit.

Reimbursement

Institutions that are required to obtain

title IV, HEA program funds through the

current reimbursement system will be

required to credit students’ accounts

and provide supporting documentation

to the Department before receiving

federal funds. The institution’s

compliance audit will contain

verification that this did occur

throughout the year. Institutions will be

required to compile the paperwork and
62874 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

submit this to the Department. This is

expected to represent about five hours

of paperwork, that will cost about $100

using a loaded labor rate of $20.00 per

hour. As discussed above, there will be

some one-time costs associated with

changing from the advance payment

method to this payment method, which

are estimated at $2,000. Institutions are

expected to credit students’ accounts

and be reimbursed with federal funds

within 24 banking days. As discussed in

more detail above, there is an economic

cost of not having the use of those funds

for that 24 day period, which is

estimated at $8,000 per million dollars

of title IV, HEA funds received

annually. As discussed above,

institutions would also lose up to $250

in interest fees on advanced payments

they may have been earning.

It is estimated that about one-eighth of

the institutions participating under the

zone alternative will be placed on

reimbursement. It is estimated that

about one-fourth of the institutions who

fail the ratio test and participate under

the 10 percent letter of credit alternative

will be placed on reimbursement.

Optional Disclosure in Audited

Financial Statement of HEA

Institutional Grants

Institutions that would otherwise fail

or be required to use the zone

alternative that wish to have their HEA

institutional grants excluded from the

calculation of their ratios would be

required to have the amount of the HEA

institutional grant disclosed in a note to

their financial statements, or in a

separate attestation. KPMG researched

the types of fees that a national, regional

and local accounting firm would

typically charge for this service. It was

estimated that a small institution with

about $2.5 million in total revenue and

one campus would be charged about

$300 for this information disclosed as a

note to the financial statements, and

between $2,000 and $3,000 if the

institution chose to have this disclosed

as a separate attestation. It is assumed

that institutions will choose the note

disclosure due to its lower cost.

It was not possible to estimate the

number of institutions that could be

able to take advantage of this option,

since these data were not available from

the audited financial statements

analyzed here.

TABLE 2.—SUMMARY OF ESTIMATED ADVERSE ECONOMIC IMPACTS ON SMALL ENTITIES

Action (not all actions are required of all institutions) Institutions that fail the ratio test Institutions using the zone alternative

50 percent letter of credit .................................. One-fifth of institutions will pay fees of $7,500

to $12,500 per million, plus estimated opportunity cost of $125,000 per million.

No institutions eligible for the zone alternative

are expected to post letters of credit.

10 percent letter of credit .................................. Four-fifths of institutions will pay fees of

$7,500 to $12,500 per million, plus estimated opportunity cost of $125,000 per million.

No institutions eligible for the zone alternative

are expected to post letters of credit.

Additional reporting ........................................... One-third of institutions will have average paperwork costs of about $10.One-fifth of institutions will have average paperwork costs of about $7.50.

Early submission of audits ................................ Two-thirds of institutions will have increased

audit costs of between $6,000 and $8,000.

One-half of institutions will have increased

audit costs of between $6,000 to $8,000.

Cash monitoring, type 1 .................................... Five-eighths of institutions who fail the ratio

test and participate under the 10 percent letter of credit alternative will have: costs of

changing payment system of about $2,000;

and loss of interest revenue up to $250.

Three-fourths of institutions will have: costs of

changing payment system of about $2,000;

and loss of interest revenue up to $250.

Cash monitoring, type 2 .................................... One-eighth of institutions who fail the ratio test

and participate under the 10 percent letter

of credit alternative will have: paperwork

costs of $20; costs of changing payment

system of about $2,000; borrowing costs (or

opportunity cost of capital) of about $2,000

per million dollars of Title IV funds received;

and loss of interest revenue up to $250.

One-eighth of institutions will have: paperwork

costs of $20; costs of changing payment

system of about $2,000; borrowing costs (or

opportunity cost of capital) of about $2,000

per million dollars of Title IV funds received;

and loss of interest revenue up to $250.

Reimbursement ................................................. One-fourth of institutions who fail the ratio test

and participate under the 10 percent letter

of credit alternative will have: paperwork

costs of $100; costs of changing payment

system of about $2,000; borrowing costs (or

opportunity cost of capital) of about $8,000

per million dollars of Title IV funds received.

One-eighth of institutions will have: paperwork

costs of $100; costs of changing payment

system of about $2,000; borrowing costs (or

opportunity cost of capital) of about $8,000

per million dollars of Title IV funds received.

Action ................................................................ Institutions that initially fail but employ optional

disclosure to raise score into zone.

Institutions that initially fall into the zone but

employ optional disclosure to raise score to

passing.

Optional disclosure of HEA institutional grants An unknown number of institutions will have

an economic impact of $300.

An unknown number of institutions will have

an economic impact of $300.

NOTE: All of the figures in this table are estimates. The previous discussion provides a complete explanation of how these estimates were

made.
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62875

Description of Significant Alternatives

Which Accomplish the Stated

Objectives of Applicable Statutes and

Which Minimize Any Significant

Economic Impact of the Final Rule on

Small Entities

While the Department considered

alternative means of satisfying many

specific provisions, as discussed in the

Analysis of Comments and Changes to

this final rule, there are no other

significant alternatives that would

satisfy the same legal and policy

objectives while minimizing the impact

on small entities. The factual, policy,

and legal reasons for selecting the

alternative adopted in the final rule.

The adopted approach balances

regulatory reform values and improved

accountability in a reasonable fashion.

Consistent with the Secretary’s

Regulatory Relief Initiative,

participating institutions are subject to

the minimum requirements that

adequately protect the Federal fiscal

interest. A substantial number of

institutions will experience a reduced

regulatory burden as a result of these

rules. The Secretary believes that the

proposed approach is the least

complicated and burdensome for small

(and large) entities involved in the

administration of the title IV, HEA

programs while still allowing for the

proper protection of the Federal fiscal

interest and the interests of students and

their parents.

For the purposes of performing this

regulatory flexibility analysis, the

alternative of ‘‘no action’’ could be

considered a significant alternative. If

the Secretary did not undertake any

action in this area, small (and large)

entities would not experience the

economic impacts imposed by this

regulation. However, as described in the

preamble to this final rule, the Secretary

believes that this action is required to

further Department initiatives and to

better protect the Federal fiscal interest.

This is discussed further in the next

section.

Why Each One of the Other Significant

Alternatives to the Rule Considered by

the Department Which Affect the

Impact on Small Entities Was Rejected

The Department considered many

alternatives to this rule. Significant

alternatives that were considered but

determined not to meet the policy

objectives are discussed in the next

section. The policy objectives for this

rule are discussed at length in the

preamble. These various alternatives

might have had an effect on the impact

on small entities to the degree that they

might have led to a different result from

the ratio test. Some of these alternatives

are discussed at greater length

elsewhere in the Analysis of Comments

and Changes.

Case-by-Case Precipitous Closure

Alternative

The Department considered

performing a case-by-case analysis of

institutions that marginally failed the

regulatory standard (i.e., the composite

score standard) to determine if they

were in danger of closing precipitously.

This alternative was rejected for several

reasons. This alternative would have

required significantly more resources

than the Department has available for

such an activity and would have been

difficult to enforce. This alternative

could have conceivably reduced the

impact on small entities, if there was

additional information not available in

the ratio approach that would have led

an individualized analysis to determine

that the institution was not in danger of

precipitously closing. However, the

fairness of such a system could be

suspect and the policy goal of having a

fair rule that is known and consistently

applied would have been undermined.

In addition, the Secretary believes that

the ratio analysis takes the total

financial condition into account, so that

it would be an exceedingly rare event

for an institution with a very low score

to have sufficient financial strength to

warrant continued participation. The

zone alternative chosen employs as

much case-by-case treatment as the

Department considers appropriate and

manageable. The alternative chosen

gives the case management teams some

discretion with regard to the stringency

of the additional monitoring that will be

required.

Continuous Improvement Zone

Alternative

The Department considered requiring

institutions to demonstrate continuous

improvement to be eligible to use the

zone alternative. This alternative was

rejected for several reasons. In such a

system, an institution would be required

to have a score that was continuously

rising. For instance, an institution with

a score of 1.1 would have to score

higher in the subsequent year in order

to be able to use the zone alternative in

a second year. The Secretary believes

that the final score accurately reflects

the institution’s financial health. A

continuous improvement model would

mean, for instance, that two institutions

with a score of 1.3 would be treated

differently depending on their scores

the previous year. An institution with a

score of 1.3 in the current year that

scored a 1.0 the previous year would

have demonstrated improvement while

the institution that scored 1.3 in both

years would not have demonstrated

improvement, leading to different

regulatory results. The policy goal of

treating institutions in a similar

situation equitably would not have been

satisfied if a continuous improvement

model were chosen. The zone

alternative chosen does require

institutions to demonstrate

improvement, in that institutions must

score at or above the regulatory standard

by the end of the third year. In addition,

this option would add to the complexity

of administering the rule.

Secondary Analysis

The Department considered various

types of secondary analysis for

institutions that marginally failed the

ratio test. One type of secondary

analysis that was considered was to

calculate some additional ratios and

assign bonus points for institutions with

high values in these additional ratios.

These alternatives were rejected for

several reasons. Extensive analysis of

the audited financial statements did not

uncover any additional ratios that

provided sufficient useful information

about an institution’s financial

condition, such as the secondary reserve

ratio or a ratio of equity to expenses.

Other ratios were rejected because they

lent themselves to manipulation, such

as cash flow ratios or current ratios.

Some ratios were rejected because they

could not be calculated for all

institutions, such as the Viability ratio

or a debt service ratio.

Personal Financial Guarantees

The Department considered allowing

institutions to demonstrate financial

responsibility by providing personal

financial guarantees at their option. This

alternative was proposed in the NPRM,

but rejected for several reasons. This

proposed alternative was not considered

to be desirable by the community. The

resources that the Department would

have devoted to administering this

alternative were determined to be better

employed in managing the zone

alternative.

Requiring Institutions Only To Pass the

Ratio Test for Most Years

The Department considered a

methodology by which institutions

would have only been required to pass

the ratio test in two of three years, or in

three of four years. This alternative was

rejected for several reasons. Such a

methodology would have allowed an

institution to marginally pass for two

years, while failing miserably the third

year. However, an analysis of data of
62876 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

closed institutions indicates that

institutions that fail the ratio test should

not be allowed to continue to participate

without some additional surety to

protect the Federal interest.

Analysis of Information Not on General

Purpose Audited Financial Statements

The Department considered including

information that was not available on

audited financial statements. This

alternative was rejected for several

reasons. The Department does not have

sufficient resources to determine the

veracity of unaudited information that

institutions would have provided under

this alternative, such as enrollment data

or similar types of information. The

Department did consider requiring

certain types of information that could

have been attested to by the institution’s

auditor and disclosed in a note to the

audited financial statement. KPMG

advised the Department about the types

of information that could be audited,

and it was determined that the types of

information that could have been

attained using this method, combined

with the difficulties in implementing a

note disclosure, would not provide

sufficient additional information

beyond that contained in the ratio

methodology chosen.

Conclusion

The Secretary concludes that a

substantial number of small entities are

likely to experience significant adverse

economic impacts from the proposed

rule, offset by significant positive

economic effects on a slightly smaller

number of small entities. As discussed

in the section referring to the costbenefit assessment of this proposed rule

pursuant to Executive Order 12866, the

Secretary has concluded that the costs

are justified by the benefits. In this case,

the benefits are reduced Federal fiscal

liabilities as well as improved service to

students participating in the title IV,

HEA programs.

Paperwork Reduction Act of 1995

Sections 668.171(c), 668.172(c)(5),

668.174(b)(2)(i), 668.175(d)(2)(ii),

668.175(f)(2)(iii), and 668.175(g)(2)(i)

contain information collection

requirements. As required by the

Paperwork Reduction Act of 1995, the

U.S. Department of Education has

submitted a copy of these sections to

OMB for its review. (44 U.S.C. 3504(h)).

Assessment of Educational Impact

In the NPRM published September 20,

1996, the Secretary requested comment

on whether the proposed regulations in

this document would require

transmission of information that is being

gathered by, or is available from, any

other agency or authority of the United

States.

Based on the response to the proposed

rules on its own review, the Department

has determined that the regulations in

this document do not require

transmission of information that is being

gathered by, or is available from, any

other agency or authority of the United

States.

Electronic Access to This Document

Anyone may view this document, as

well as all other Department of

Education documents published in the

Federal Register, in text or portable

document format (pdf) on the World

Wide Web at either of the following

sites:

http://gcs.ed.gov/fedreg.htm

http://www.ed.gov/news.html

To use the pdf you must have the Adobe

Acrobat Reader Program with Search,

which is available free at either of the

previous sites. If you have questions

about using the pdf, call the U.S.

Government Printing Office toll free at

1–888–293–6498.

Anyone may also view these

documents in text copy only on an

electronic bulletin board of the

Department. Telephone: (202) 219–1511

or, toll free, 1–800–222–4922. The

documents are located under Option

G—Files/Announcements, Bulletins and

Press Releases.

Note: The official version of this document

is the document published in the Federal

Register.

List of Subjects in 34 CFR Part 668

Administrative practice and

procedure, Colleges and universities,

Student aid, Reporting and

recordkeeping requirements.

Dated: November 14, 1997.

Richard W. Riley,

Secretary of Education.

(Catalog of Federal Domestic Assistance

Number: 84.007 Federal Supplemental

Educational Opportunity Grant Program;

84.032 Federal Family Educational Loan

Program; 84.032 Federal PLUS Program;

84.032 Federal Supplemental Loans for

Students Program: 84.033 Federal WorkStudy Program; 84.038 Federal Perkins Loan

Program; 84.063 Federal Pell Grant Program;

84.069 Federal State Student Incentive Grant

Program, and 84.268 Direct Loan Program)

The Secretary amends part 668 of title

34 of the Code of Federal Regulations as

follows:

PART 668—STUDENT ASSISTANCE

GENERAL PROVISIONS

1. The authority citation for part 668

continues to read as follows:

Authority: 20 U.S.C. 1085, 1088, 1091,

1092, 1094, 1099c and 1141, unless

otherwise noted.

Subpart B—Standards for Participation

in the Title IV, HEA Programs

§ 668.13 [Amended]

2. Section 668.13 is amended by

removing paragraphs (d) and (e), and by

redesignating paragraph (f) as paragraph

(d).

§ 668.23 [Amended]

3. Section 668.23 is amended by

removing paragraph (f) and

redesignating paragraphs (g) and (h) as

paragraphs (f) and (g), respectively.

Subpart K—Cash Management

4. Section 668.162 is amended by

revising paragraph (a)(1), and by adding

a new paragraph (e) to read as follows:

§ 668.162 Requesting funds.

(a) General. (1) The Secretary has sole

discretion to determine the method

under which the Secretary provides title

IV, HEA program funds to an

institution. In accordance with

procedures established by the Secretary,

the Secretary may provide funds to an

institution under the advance,

reimbursement, just-in-time, or cash

monitoring payment methods.

* * * * *

(e) Cash monitoring payment method.

Under the cash monitoring payment

method, the Secretary provides title IV,

HEA program funds to an institution

under the provisions described in

paragraph (e)(1) or (e)(2) of this section.

Under either paragraph (e)(1) or (e)(2) of

this section, an institution must first

make disbursements to students and

parents for the amount of title IV, HEA

program funds that those students and

parents are eligible to receive, before the

institution—

(1) Submits a request for funds under

the provisions of the advance payment

method described in paragraph (b) of

this section, except that the institution’s

request may not exceed the amount of

the actual disbursements the institution

made to the students and parents

included in that request; or

(2) Seeks reimbursement for those

disbursements under the provisions of

the reimbursement payment method

described in paragraph (d) of this

section, except that the Secretary may

modify the documentation requirements

and review procedures used to approve

the reimbursement request.

5. Section 668.167 is amended by

adding a new paragraph (f) to read as

follows:
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62877

§ 668.167 FFEL program funds.

* * * * *

(f) An institution placed under the

cash monitoring payment method. The

Secretary may require an institution that

is placed under the cash monitoring

described under paragraph § 668.162(e),

to comply with the disbursement and

certification provisions under paragraph

(d) of this section, except that the

Secretary may modify the

documentation requirements and review

procedures used to approve the

institution’s disbursement or

certification request.

6. A new subpart L is added to read

as follows:

Subpart L—Financial Responsibility

Sec.

668.171 General.

668.172 Financial ratios.

668.173 Refund reserve standards.

668.174 Past performance.

668.175 Alternative standards and

requirements.

§ 668.171 General.

(a) Purpose. To begin and to continue

to participate in any title IV, HEA

program, an institution must

demonstrate to the Secretary that it is

financially responsible under the

standards established in this subpart. As

provided under section 498(c)(1) of the

HEA, the Secretary determines whether

an institution is financially responsible

based on the institution’s ability to—

(1) Provide the services described in

its official publications and statements;

(2) Administer properly the title IV,

HEA programs in which it participates;

and

(3) Meet all of its financial

obligations.

(b) General standards of financial

responsibility. Except as provided under

paragraphs (c) and (d) of this section,

the Secretary considers an institution to

be financially responsible if the

Secretary determines that—

(1) The institution’s Equity, Primary

Reserve, and Net Income ratios yield a

composite score of at least 1.5, as

provided under § 668.172 and

Appendices F and G;

(2) The institution has sufficient cash

reserves to make required refunds, as

provided under § 668.173;

(3) The institution is current in its

debt payments. An institution is not

current in its debt payments if—

(i) It is in violation of any existing

loan agreement at its fiscal year end, as

disclosed in a note to its audited

financial statements or audit opinion; or

(ii) It fails to make a payment in

accordance with existing debt

obligations for more than 120 days, and

at least one creditor has filed suit to

recover funds under those obligations;

and

(4) The institution is meeting all of its

financial obligations, including but not

limited to—

(i) Refunds that it is required to make

under § 668.22; and

(ii) Repayments to the Secretary for

debts and liabilities arising from the

institution’s participation in the title IV,

HEA programs.

(c) Public institutions. The Secretary

considers a public institution to be

financially responsible if the

institution—

(1)(i) Notifies the Secretary that it is

designated as a public institution by the

State, local or municipal government

entity, tribal authority, or other

government entity that has the legal

authority to make that designation; and

(ii) Provides a letter from an official

of that State or other government entity

confirming that the institution is a

public institution; and

(2) Is not in violation of any past

performance requirement under

§ 668.174.

(d) Audit opinions and past

performance provisions. Even if an

institution satisfies all of the general

standards of financial responsibility

under paragraph (b) of this section, the

Secretary does not consider the

institution to be financially responsible

if—

(1) In the institution’s audited

financial statements, the opinion

expressed by the auditor was an

adverse, qualified, or disclaimed

opinion, or the auditor expressed doubt

about the continued existence of the

institution as a going concern, unless

the Secretary determines that a qualified

or disclaimed opinion does not have a

significant bearing on the institution’s

financial condition; or

(2) As provided under the past

performance provisions in § 668.174(a)

and (b)(1), the institution violated a title

IV, HEA program requirement, or the

persons or entities affiliated with the

institution owe a liability for a violation

of a title IV, HEA program requirement.

(e) Administrative actions. If the

Secretary determines that an institution

is not financially responsible under the

standards and provisions of this section

or under an alternative standard in

§ 668.175, or the institution does not

submit its financial and compliance

audits by the date permitted and in the

manner required under § 668.23, the

Secretary may—

(1) Initiate an action under subpart G

of this part to fine the institution, or

limit, suspend, or terminate the

institution’s participation in the title IV,

HEA programs; or

(2) For an institution that is

provisionally certified, take an action

against the institution under the

procedures established in § 668.13(d).

(Authority: 20 U.S.C. 1094 and 1099c and

section 4 of Pub. L. 95–452, 92 Stat. 1101–

1109)

§ 668.172 Financial ratios.

(a) Appendices F and G, ratio

methodology. As provided under

Appendices F and G to this part, the

Secretary determines an institution’s

composite score by—

(1) Calculating the result of its

Primary Reserve, Equity, and Net

Income ratios, as described under

paragraph (b) of this section;

(2) Calculating the strength factor

score for each of those ratios by using

the corresponding algorithm;

(3) Calculating the weighted score for

each ratio by multiplying the strength

factor score by its corresponding

weighting percentage;

(4) Summing the resulting weighted

scores to arrive at the composite score;

and

(5) Rounding the composite score to

one digit after the decimal point.

(b) Ratios. The Primary Reserve,

Equity, and Net Income ratios are

defined under Appendix F for

proprietary institutions, and under

Appendix G for private non-profit

institutions.

(1) The ratios for proprietary

institutions are:

For proprietary institutions:
62878 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

Primary Reserve ratio = Adjusted Equity

nses

Equity ratio = Modified Equity

ssets

Net Income ratio = Income Before Taxes

nues

Total Expe

Modified A

Total Reve

(2) The ratios for private non-profit

institutions are:

Primary Reserve ratio = Expendable Net Assets

nses

Equity Ratio = Modified Net Assets

ssets

Net Income ratio = Change in Unrestricted Net Assets

Total Unrestricted Revenues

Total Expe

Modified A

(c) Excluded items. In calculating an

institution’s ratios, the Secretary—

(1) Generally excludes extraordinary

gains or losses, income or losses from

discontinued operations, prior period

adjustments, the cumulative effect of

changes in accounting principles, and

the effect of changes in accounting

estimates;

(2) May include or exclude the effects

of questionable accounting treatments,

such as excessive capitalization of

marketing costs;

(3) Excludes all unsecured or

uncollateralized related-party

receivables;

(4) Excludes all intangible assets

defined as intangible in accordance with

generally accepted accounting

principles; and

(5) Excludes from the ratio

calculations Federal funds provided to

an institution by the Secretary under

program authorized by the HEA only

if—

(i) In the notes to the institution’s

audited financial statement, or as a

separate attestation, the auditor

discloses by name and CFDA number,

the amount of HEA program funds

reported as expenses in the Statement of

Activities for the fiscal year covered by

that audit or attestation; and

(ii) The institution’s composite score,

as determined by the Secretary, is less

than 1.5 before the reported expenses

arising from those HEA funds are

excluded from the Primary Reserve

ratio.

(Authority: 20 U.S.C. 1094 and 1099c and

section 4 of Pub. L. 95–452, 92 Stat. 1101–

1109)

§ 668.173 Refund reserve standards.

(a) General. The Secretary considers

that an institution has sufficient cash

reserves (as required under

§ 668.171(b)(2)) to make any refunds

required under § 668.22 if the

institution—

(1) Satisfies the requirements of a

public institution under § 668.171(c)(1);

(2) Is located in a State that has a

tuition recovery fund approved by the

Secretary and the institution contributes

to that fund; or

(3) Demonstrates that it makes its

refunds timely, as provided under

paragraph (b) of this section.

(b) Timely refunds. An institution

demonstrates that it makes required

refunds within the time permitted under

§ 668.22 if the auditor(s) who conducted

the institution’s compliance audits for

the institution’s two most recently

completed fiscal years, or the Secretary

or a State or guaranty agency that

conducted a review of the institution

covering those fiscal years—

(1) Did not find in the sample of

student records audited or reviewed for

either of those fiscal years that—

(i) The institution made late refunds

to 5 percent or more of the students in

that sample. For purposes of

determining the percentage of late

refunds under this paragraph, the

auditor or reviewer must include in the

sample only those title IV, HEA program

recipients who received or should have

received a refund under § 668.22; or

(ii) The institution made only one late

refund to a student in that sample; and

(2) Did not note for either of those

fiscal years a material weakness or a

reportable condition in the institution’s

report on internal controls that is related

to refunds.

(c) Refund findings. Upon a finding

that an institution no longer satisfies a

refund standard under paragraph (a)(1)

or (2) of this section, or that the

institution is not making its refunds

timely under paragraph (b) of this

section, the institution must submit an

irrevocable letter of credit, acceptable

and payable to the Secretary, equal to 25

percent of the total amount of title IV,

HEA program refunds the institution

made or should have made during its

most recently completed fiscal year. The

institution must submit this letter of

credit to the Secretary no later than—

(1) Thirty days after the date the

institution is required to submit its

compliance audit to the Secretary under

§ 668.23, if the finding is made by the

auditor who conducted that compliance

audit; or

(2) Thirty days after the date that the

Secretary, or the State or guaranty

agency that conducted a review of the

institution notifies the institution of the

finding. The institution must also notify

the Secretary of that finding and of the

State or guaranty agency that conducted

that review of the institution.

(d) State tuition recovery funds. In

determining whether to approve a

State’s tuition recovery fund, the

Secretary considers the extent to which

that fund—

(1) Provides refunds to both in-State

and out-of-State students;

(2) Allocates all refunds in accordance

with the order required under § 668.22;

and

(3) Provides a reliable mechanism for

the State to replenish the fund should

any claims arise that deplete the fund’s

assets.
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62879

(Authority: 20 U.S.C. 1094 and 1099c and

section 4 of Pub. L. 95–452, 92 Stat. 1101–

1109)

§ 668.174 Past performance.

(a) Past performance of an institution.

An institution is not financially

responsible if the institution—

(1) Has been limited, suspended,

terminated, or entered into a settlement

agreement to resolve a limitation,

suspension, or termination action

initiated by the Secretary or a guaranty

agency, as defined in 34 CFR part 682,

within the preceding five years;

(2) In either of its two most recent

compliance audits had an audit finding,

or in a report issued by the Secretary

had a program review finding for its

current fiscal year or either of its

preceding two fiscal years, that resulted

in the institution’s being required to

repay an amount greater than 5 percent

of the funds that the institution received

under the title IV, HEA programs during

the year covered by that audit or

program review;

(3) Has been cited during the

preceding five years for failure to submit

in a timely fashion acceptable

compliance and financial statement

audits required under this part, or

acceptable audit reports required under

the individual title IV, HEA program

regulations; or

(4) Has failed to resolve satisfactorily

any compliance problems identified in

audit or program review reports based

upon a final decision of the Secretary

issued pursuant to subpart G or H of this

part.

(b) Past performance of persons

affiliated with an institution. (1)(i)

Except as provided under paragraph

(b)(2) of this section, an institution is

not financially responsible if a person

who exercises substantial control over

the institution, as described under 34

CFR 600.30, or any member or members

of that person’s family, alone or

together—

(A) Exercises or exercised substantial

control over another institution or a

third-party servicer that owes a liability

for a violation of a title IV, HEA program

requirement; or

(B) Owes a liability for a violation of

a title IV, HEA program requirement;

and

(ii) That person, family member,

institution, or servicer does not

demonstrate that the liability is being

repaid in accordance with an agreement

with the Secretary.

(2) The Secretary may determine that

an institution is financially responsible,

even if the institution is not otherwise

financially responsible under paragraph

(b)(1) of this section, if—

(i) The institution notifies the

Secretary, within the time permitted

and in the manner provided under 34

CFR 600.30, that the person referenced

in paragraph (b)(1) of this section

exercises substantial control over the

institution; and

(ii) The person referenced in

paragraph (b)(1) of this section repaid to

the Secretary a portion of the applicable

liability, and the portion repaid equals

or exceeds the greater of—

(A) The total percentage of the

ownership interest held in the

institution or third-party servicer that

owes the liability by that person or any

member or members of that person’s

family, either alone or in combination

with one another;

(B) The total percentage of the

ownership interest held in the

institution or servicer that owes the

liability that the person or any member

or members of the person’s family,

either alone or in combination with one

another, represents or represented under

a voting trust, power of attorney, proxy,

or similar agreement; or

(C) Twenty-five percent, if the person

or any member of the person’s family is

or was a member of the board of

directors, chief executive officer, or

other executive officer of the institution

or servicer that owes the liability, or of

an entity holding at least a 25 percent

ownership interest in the institution

that owes the liability; or

(iii) The applicable liability described

in paragraph (b)(1) of this section is

currently being repaid in accordance

with a written agreement with the

Secretary; or

(iv) The institution demonstrates to

the satisfaction of the Secretary why—

(A) The person who exercises

substantial control over the institution

should nevertheless be considered to

lack that control; or

(B) The person who exercises

substantial control over the institution

and each member of that person’s family

nevertheless does not or did not

exercise substantial control over the

institution or servicer that owes the

liability.

(c) Ownership interest. (1) An

ownership interest is a share of the legal

or beneficial ownership or control of, or

a right to share in the proceeds of the

operation of, an institution, an

institution’s parent corporation, a thirdparty servicer, or a third-party servicer’s

parent corporation. The term

‘‘ownership interest’’ includes, but is

not limited to—

(i) An interest as tenant in common,

joint tenant, or tenant by the entireties;

(ii) A partnership; and

(iii) An interest in a trust.

(2) The term ‘‘ownership interest’’

does not include any share of the

ownership or control of, or any right to

share in the proceeds of the operation of

a profit-sharing plan, provided that all

employees are covered by the plan.

(3) The Secretary generally considers

a person to exercise substantial control

over an institution or third-party

servicer if the person—

(i) Directly or indirectly holds at least

a 20 percent ownership interest in the

institution or servicer;

(ii) Holds, together with other

members of his or her family, at least a

20 percent ownership interest in the

institution or servicer;

(iii) Represents, either alone or

together with other persons under a

voting trust, power of attorney, proxy, or

similar agreement, one or more persons

who hold, either individually or in

combination with the other persons

represented or the person representing

them, at least a 20 percent ownership in

the institution or servicer; or

(iv) Is a member of the board of

directors, the chief executive officer, or

other executive officer of—

(A) The institution or servicer; or

(B) An entity that holds at least a 20

percent ownership interest in the

institution or servicer.

(4) The Secretary considers a member

of a person’s family to be a parent,

sibling, spouse, child, spouse’s parent or

sibling, or sibling’s or child’s spouse.

(Authority: 20 U.S.C. 1094 and 1099c and

section 4 of Pub. L. 95–452, 92 Stat. 1101–

1109)

§ 668.175 Alternative standards and

requirements.

(a) General. An institution that is not

financially responsible under the

general standards and provisions in

§ 668.171, may begin or continue to

participate in the title IV, HEA programs

by qualifying under an alternate

standard set forth in this section.

(b) Letter of credit alternative for new

institutions. A new institution that is

not financially responsible solely

because the Secretary determines that

its composite score is less than 1.5,

qualifies as a financially responsible

institution by submitting an irrevocable

letter of credit, that is acceptable and

payable to the Secretary, for an amount

equal to at least one-half of the amount

of title IV, HEA program funds that the

Secretary determines the institution will

receive during its initial year of

participation. A new institution is an

institution that seeks to participate for

the first time in the title IV, HEA

programs.

(c) Letter of credit alternative for

participating institutions. A
62880 Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations

participating institution that is not

financially responsible either because it

does not satisfy one or more of the

standards of financial responsibility

under § 668.171(b), or because of an

audit opinion described under

§ 668.171(d), qualifies as a financially

responsible institution by submitting an

irrevocable letter of credit, that is

acceptable and payable to the Secretary,

for an amount determined by the

Secretary that is not less than one-half

of the title IV, HEA program funds

received by the institution during its

most recently completed fiscal year.

(d) Zone alternative. (1) A

participating institution that is not

financially responsible solely because

the Secretary determines that its

composite score is less than 1.5 may

participate in the title IV, HEA programs

as a financially responsible institution

for no more than three consecutive

years, beginning with the year in which

the Secretary determines that the

institution qualifies under this

alternative. (i)(A) An institution

qualifies initially under this alternative

if, based on the institution’s audited

financial statement for its most recently

completed fiscal year, the Secretary

determines that its composite score is in

the range from 1.0 to 1.4; and

(B) An institution continues to qualify

under this alternative if, based on the

institution’s audited financial statement

for each of its subsequent two fiscal

years, the Secretary determines that the

institution’s composite score is in the

range from 1.0 to 1.4.

(ii) An institution that qualified under

this alternative for three consecutive

years or for one of those years, may not

seek to qualify again under this

alternative until the year after the

institution achieves a composite score of

at least 1.5, as determined by the

Secretary.

(2) Under this zone alternative, the

Secretary—

(i) Requires the institution to make

disbursements to eligible students and

parents under either the cash

monitoring or reimbursement payment

method described in § 668.162;

(ii) Requires the institution to provide

timely information regarding any of the

following oversight and financial

events—

(A) Any adverse action, including a

probation or similar action, taken

against the institution by its accrediting

agency;

(B) Any event that causes the

institution, or related entity as defined

in the Statement of Financial

Accounting Standards (SFAS) 57, to

realize any liability that was noted as a

contingent liability in the institution’s

or related entity’s most recent audited

financial statement;

(C) Any violation by the institution of

any loan agreement;

(D) Any failure of the institution to

make a payment in accordance with its

debt obligations that results in a creditor

filing suit to recover funds under those

obligations;

(E) Any withdrawal of owner’s equity

from the institution by any means,

including by declaring a dividend; or

(F) Any extraordinary losses, as

defined in accordance with Accounting

Principles Board (APB) Opinion No. 30.

(iii) May require the institution to

submit its financial statement and

compliance audits earlier than the time

specified under § 668.23(a)(4); and

(iv) May require the institution to

provide information about its current

operations and future plans.

(3) Under the zone alternative, the

institution must—

(i) For any oversight or financial event

described under paragraph (d)(2)(ii) of

this section for which the institution is

required to provide information,

provide that information to the

Secretary by certified mail or electronic

or facsimile transmission no later than

10 days after that event occurs. An

institution that provides this

information electronically or by

facsimile transmission is responsible for

confirming that the Secretary received a

complete and legible copy of that

transmission; and

(ii) As part of its compliance audit,

require its auditor to express an opinion

on the institution’s compliance with the

requirements under the zone alternative,

including the institution’s

administration of the payment method

under which the institution received

and disbursed title IV, HEA program

funds.

(4) If an institution fails to comply

with the requirements under paragraphs

(d)(2) or (3) of this section, the Secretary

may determine that the institution no

longer qualifies under this alternative.

(e) Transition year alternative. A

participating institution that is not

financially responsible solely because

the Secretary determines that its

composite score is less than 1.5 for the

institution’s fiscal year that began on or

after July 1, 1997 but on or before June

30, 1998, may qualify as a financially

responsible institution under the

provisions in § 668.15(b)(7), (b)(8),

(d)(2)(ii), or (d)(3), as applicable.

(f) Provisional certification

alternative. (1) The Secretary may

permit an institution that is not

financially responsible to participate in

the title IV, HEA programs under a

provisional certification for no more

than three consecutive years if—

(i) The institution is not financially

responsible because it does not satisfy

the general standards under § 668.171(b)

or because of an audit opinion described

under § 668.171(d); or

(ii) The institution is not financially

responsible because of a condition of

past performance, as provided under

§ 668.174(a), and the institution

demonstrates to the Secretary that it has

satisfied or resolved that condition.

(2) Under this alternative, the

institution must—

(i) Submit to the Secretary an

irrevocable letter of credit that is

acceptable and payable to the Secretary,

for an amount determined by the

Secretary that is not less than 10 percent

of the title IV, HEA program funds

received by the institution during its

most recently completed fiscal year;

(ii) Demonstrate that it was current on

its debt payments and has met all of its

financial obligations, as required under

§ 668.171(b)(3) and (b)(4), for its two

most recent fiscal years; and

(iii) Comply with the provisions

under the zone alternative, as provided

under paragraph (d)(2) and (3) of this

section.

(3) If at the end of the period for

which the Secretary provisionally

certified the institution, the institution

is still not financially responsible, the

Secretary may again permit the

institution to participate under a

provisional certification, but the

Secretary—

(i) May require the institution, or one

or more persons or entities that exercise

substantial control over the institution,

as determined under § 668.174(d), or

both, to submit to the Secretary

financial guarantees for an amount

determined by the Secretary to be

sufficient to satisfy any potential

liabilities that may arise from the

institution’s participation in the title IV,

HEA programs; and

(ii) May require one or more of the

persons or entities that exercise

substantial control over the institution,

as determined under § 668.174(d), to be

jointly or severally liable for any

liabilities that may arise from the

institution’s participation in the title IV,

HEA programs.

(g) Provisional certification alternative

for persons or entities owing liabilities.

(1) The Secretary may permit an

institution that is not financially

responsible because the persons or

entities that exercise substantial control

over the institution owe a liability for a

violation of a title IV, HEA program

requirement, to participate in the title
Federal Register / Vol. 62, No. 227 / Tuesday, November 25, 1997 / Rules and Regulations 62881

IV, HEA programs under a provisional

certification only if—

(i)(A) The persons or entities that

exercise substantial control, as

determined under § 668.174(d), repay or

enter into an agreement with the

Secretary to repay the applicable

portion of that liability, as provided

under § 668.174(c)(2)(ii); or

(B) The institution assumes that

liability, and repays or enters into an

agreement with the Secretary to repay

that liability;

(ii) The institution satisfies the

general standards and provisions of

financial responsibility under § 668.171

(b) and (d), except that institution must

demonstrate that it was current on its

debt payments and has met all of its

financial obligations, as required under

§ 668.171(b)(3) and (b)(4), for its two

most recent fiscal years; and

(iii) The institution submits to the

Secretary an irrevocable letter of credit

that is acceptable and payable to the

Secretary, for an amount determined by

the Secretary that is not less than 10

percent of the title IV, HEA program

funds received by the institution during

its most recently completed fiscal year.

(2) Under this alternative, the

Secretary—

(i) Requires the institution to comply

with the provisions under the zone

alternative, as provided under

paragraph (d)(2) and (3) of this section;

(ii) May require the institution, or one

or more persons or entities that exercise

substantial control over the institution,

or both, to submit to the Secretary

financial guarantees for an amount

determined by the Secretary to be

sufficient to satisfy any potential

liabilities that may arise from the

institution’s participation in the title IV,

HEA programs; and

(iii) May require one or more of the

persons or entities that exercise

substantial control over the institution

to be jointly or severally liable for any

liabilities that may arise from the

institution’s participation in the title IV,

HEA programs.

(Authority: 20 U.S.C. 1094 and 1099c and

section 4 of Pub. L. 95–452, 92 Stat. 1101–

1109)

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[FR Doc. 97–30859 Filed 11–24–97; 8:45 am]

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