Financial Responsibility Standards Proposed Regulations — How Stable Is Your Institution?

The U.S. Department of Education (ED) recently released proposed rule changes for strengthening monitoring and oversight of colleges and universities. These changes cover general standards of financial responsibility, and add new reporting requirements, among other updates reviewed below. We recommend that institutions review these changes to identify any potential issues.

That New Rule Feeling

Remember the start of school each year, especially as an elementary student? It felt uncertain. You encountered a new teacher, new classmates, and a different set of classroom rules. I admit, it’s hard to remember that long ago, but you get the idea.  Isn’t waiting for the ED’s proposed regulations a similar mental process?  ED’s release of the proposed rules to protect students by strengthening ED oversight and monitoring of colleges and universities had that same feeling.  ED is taking the approach of “more classroom rules”.  This article will cover a summary of the key changes to the proposed financial responsibility regulations.

Summary of Financial Responsibility Rule Changes

The proposed financial responsibility regulations cover three main areas.

• Tightening requirements of the general standard of financial responsibility for financial situations which pose higher risk
• Reporting of specifically defined events (“Triggers”) between during an institution’s fiscal year
• Codifying requirements that have been in place for Change in Ownership (CIO) along with adding new financial responsibility tests

As with any regulations, the impact on institutions, in some cases, will be dependent upon ED’s interpretation of the event(s), and their review and interpretation of the financial impact.  Some of the changes are bright-line distinctions, which are reasonable for a regulatory agency to require. Others are more discretionary and undefined which provides broad latitude to ED, potentially leading to biased oversight.  No federal regulation will ever be perfect in this regard so institutions should review the financial responsibility proposed regulations and submit comments before the 30-day period ends on June 20, 2023.

General Standards of Financial Responsibility

At the highest level, ED is tightening the regulations surrounding the general standards of financial responsibility which are located in 668.171. Remember that the general standards include numerous items and not just the composite score ratio.

Key Points

• Failure to pay Title IV credit balances was added to 668.171(b)(3)(i) so this section includes Title IV refunds and credit balances,
• Failing to make a payment in accordance with an existing undisputed financial obligation for more than 90 days (668.171(b)(3)(iii)),
• Fails to satisfy payroll obligations in accordance with its published payroll schedule – 668.171(b)(3)(iv), and
• Borrowing funds from retirement plans or restricted funds without authorization – 668.171(b)(3)(v).

McClintock & Associates Interpretation

Overall, these are reasonable proposed changes as these types of transaction generally give an auditor concern.  One potential comment: The existing undisputed financial obligation for more than 90 days doesn’t have any materiality exception.  An unpaid financial obligation good merely exists because of operational oversight, billing errors by the vendor, or the obligation has limited financial impact.

Mandatory and Discretionary Triggers

The most impactful section of the proposed regulations reset of the mandatory and discretionary triggers.  Like a pendulum swing on a clock, ED reverted to many of the 2016 triggers.  ED clearly wants to understand and assess more events and conditions than under the current regulations on a real time basis in order to perform the oversight functions.

Mandatory Triggers: Key Points

• Separate financial protection for each individual trigger and it appears that financial protection may have to be maintained for two full fiscal years following ED’s notice that requires the posting of the financial protection.
• The timing for reporting the triggering event is defined in 668.717(f) and is still a ten-day requirement except for 90/10 failure which remains at 45 days.
• Institutions can continue to provide support to ED in the form of insurance proof, creditor waived violations, provide resolution to the triggering event, or additional information as to why the triggering event will not have a material adverse impact.
• Mandatory triggers, 668.171(c) – ED will require financial protection if the condition is met.
  • Expanded to cover claims, settlements, arbitration proceeding, discharge obligations, recoupment of borrower defense to repayment claims, and qui tam lawsuits under specific circumstances. Some of these reporting triggers are subject to a composite score ratio (CSR) of 1.5 while others are not.
  • For any institution which submitted a change in ownership (CIO) application, which has a debt or liability under 668.171(c)(2)(i)(B) or (C) (sued by Federal or state authority or qui tam lawsuit) or cost of adjudicated claims under the loan discharge provisions at any point through the second full fiscal year after the CIO occurred.
  • A proprietary institution with a CSR of less than 1.5, there is withdrawal of equity by any means in the first full fiscal year after the CIO and the recomputed CSR is less than 1.0.
  • A teach-out plan is required by a regulatory agency.
  • Cited by state licensing or authority agency for failing to meet a requirement and notice is provided that licensure or authorization will be withdrawn or terminated if institution doesn’t take necessary steps to come into compliance.
  • Institution lost eligibility to participate in another Federal educational assistance program.
  • An institution’s audited financial statements reflect an equity contribution in the last quarter of their fiscal year and the institution made a distribution in the first two quarters of the following fiscal year, and the offset of the distribution results in a recalculated CSR less than 1.0.

McClintock & Associates Interpretation

We note that some of these events are an indication of financial instability so ED’s triggers are prudent.  However, other events are not an indication of financial instability.

The closure of an additional location will now require financial protection and that teach out could be financially beneficial to the institution.  The infusion of equity into an institution in the fourth quarter and the withdrawal in the following year isn’t necessarily an intent to manipulate the CSR as noted in the preamble to the proposed regulations.  The Internal Revenue Code designed pass-through entities to have this flexibility for tax purposes.  Many small business owners retain their financial capital personally instead of inside the company as the tax code was designed.  However, we do understand ED’s concern if the financial capital isn’t residing in the institution.  A debt or liability incurred by an institution after a CIO may have been an event considered at the time of the sale and have been covered via a working capital adjustment, an escrow agreement indemnification, adjustment to a seller note payable, or a claw-back provision.  Establishment of financial protection on the new owner of the institution for an event which was addressed in the purchase agreement is prohibitive to the selling process.  Finally, state action has the potential to be interpreted in an overly broad manner depending on the citation.

Discretionary Triggers: Key Points

In 668.171(d) – ED will consider financial protection upon further review of the event.

• Accrediting agency or licensing authority agency places institution on probation or issues a show cause order.
• Institution is subject to default or other condition under a credit agreement or financing arrangement which has a monetary or nonmonetary impact, the creditor changes terms of the agreement or takes other sanctions / penalties, or the creditor takes action to terminate, withdraw, limit, or suspend the agreement. This trigger covers a range of actions related to credit agreements.
• Significant fluctuations in Title IV volume.
• Pending borrower defense to payment claims which could be subject to recoupment.
• Discontinuance of programs and locations that exceed set thresholds.
• State citations for failing to meet a requirement.
• One or more educational programs have lost the eligibility to participate in another Federal educational assistance program due to an administrative action against the institution.

McClintock & Associates Interpretation

The discretionary triggers, as defined, provide ED undefined latitude to interpret and impose financial conditions.  Triggers such as significant Title IV volume, state citations for failure to meet a requirement, or a creditor-imposed condition are events which are either undefined or the impact is wide ranging.  Thus, institutions are unable to fully prepare and predict ED’s reaction. ED’s oversight can be either benevolent or arbitrary and capricious.  No institution is perfect, never makes errors or doesn’t have some down financial results, thus minor violations will occur which are normally cured in time or with limited financial impact.  However, an overly harsh ED response could be detrimental to curing minor violations.  This is the concern for many institutions.

Change-in-Ownership (CIO) Requirements

The final area of major changes is formally codifying the financial requirements surrounding CIO at 668.176.  ED has dedicated this section solely to change of ownerships which will provide some clarity as to the regulations and formally document standard practices and financial thresholds which have been in existence.

Key Points

• An institution’s new owners will have to provide two years of audited financial statements or financial protection (letter of credit or cash escrow) equal to 25% of the prior year’s Title IV aid will be required, 10% if only one year is available. ED indicated they would evaluate the new owner’s composite score and other financial factors.
• Under 668.176(b)(3), new financial responsibility tests were added related to losses and tangible net worth over the past two years. In addition, document passing composite score ratio and meets other requirements in part 668, subpart L. (668.176
• An institution not financially responsible would have to provide financial protection of not less than 10% of the prior year’s Title IV aid and follow the zone requirements in 668.175(d).
• ED will be allowed to assess if debt service is inconsistent based upon school enrollments.
• Same day balance sheet at the time of closing must reflect an acid test of 1:1 and positive tangible net worth. Financial protection equal to 25% of the prior year’s Title IV aid must be provided if both tests aren’t passed.

McClintock & Associates Interpretation

The regulations clarify many existing practices of ED.  However, ED will have more tools to evaluate a change in ownership.  For example, under 668.176(b)(3) the assumption seems to be these tests will be evaluated on the new owner’s financial statements and the risk is that ED could assess this on both the target and the buyer.  This may limit an institution looking to be a “white knight” and save a failing school.  The regulation surrounding ED’s ability to assess whether the new owner can service the debt levels has limited specifics and leaves significant discretion to ED.

Last Word

While the above changes are probably the most significant, there are additional updates worth reviewing. ED also added requirements for disclosure of recruiting, advertising and pre-enrollment costs in the audited financial statements, seems to imply that letters of credit under these standards may be required to be held for two full fiscal years, allows for stackable forms of financial protection, and limits the zone alternative to three years.

These regulations provide significantly more powers to ED in overseeing financial responsibility of audited financial statements and change in ownership.  Management should closely review these regulations and understand the impact of these proposed regulations to begin planning for the potential July 1, 2024 effective date.