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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 authorize

FR part
IV
PublicationDate: 11/25/97
FRPart: IV
RegPartsAffected: Citation : (R)668.139
Citation : (R)668.162
Citation : (R)668.167
Citation : (R)668.23
PageNumbers: 62829-62887
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.
CommentDueDate:

                          
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[


[Federal Register: November 25, 1997 (Volume 62, Number 227)]
[Rules and Regulations]
[Page 62829-62887]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr25no97-10]


[[Page 62829]]

_______________________________________________________________________

Part IV





Department of Education





_______________________________________________________________________



34 CFR Part 668



Student Assistance General Provisions; Final Rule


[[Page 62830]]



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
Secs. 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:
<bullet> Overview of the Standards and Provisions of Financial
Responsibility.
<bullet> Community Involvement in the Regulatory Process.
<bullet> The Secretary's Responsibility for Assessing the Financial
Condition of Participating Institutions.
<bullet> Need for Revising the Rules.
<bullet> The Final Rule.
<bullet> Provisions for Public Institutions.
<bullet> The Ratio Methodology for Private Non-Profit and
Proprietary Institutions.
<bullet> Overview of the Methodology.
<bullet> Issues Raised in the Notice of Proposed Rulemaking and
other Department Publications.
<bullet> Substantive Changes to the NPRM.
<bullet> 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.

[[Page 62831]]



Statutory Components of Financial Responsibility
------------------------------------------------------------------------
Financial obligations Administration of Financial condition
(provisions for debt the title IV, HEA (ratio standards)
payments, refunds, and programs (past ---------------------
repayments) performance and
----------------------------- program compliance
provisions)
---------------------- HEA sections
HEA sections 498(c)(1)(C) HEA sections 498(c)(1)(A)
498(c)(1)(B) and
498(d)
------------------------------------------------------------------------
The extent to which an The extent to which The extent to which
institution: an institution or an institution has
(1) Satisfies its the persons or the resources
obligations to students entities that necessary to:
and to the Secretary, exercise (1) Provide and to
including making refunds substantial control continue to
to students in a timely over the provide the
manner and repaying institution education and
program liabilities to administer properly services
the Secretary; and the title IV, HEA described in its
(2) Is current in its debt programs. official
payments. 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 Secs. 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 non-profit 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 Sec. 668.175 of these regulations and illustrated in
the following table.

Alternative Standards
------------------------------------------------------------------------
Alternative Used when: Provisions
------------------------------------------------------------------------
Letter of credit \for a An institution that The institution may
new institution. seeks to begin to
participate in the participate by
title IV, HEA submitting a letter
programs for the of credit for at
first time does not least 50 percent of
satisfy the the title IV, HEA
composite score program funds that
standard but the Secretary
satisfies all other determines the
applicable institution will
standards and receive during its
provisions. initial year of
participation, as
provided under Sec.
668.175(b).
Letter of credit for a A participating The institution may
participating institution. institution does continue to
not satisfy one or participate as a
more of the financially
standards of responsible
financial institution by
responsibility submitting a letter
(including the of credit for at
composite score least 50 percent of
standard) or the the title IV, HEA
institution's program funds the
auditor expresses institution
an adverse, received during its
qualified, or last completed
disclaimed opinion, fiscal year, as
or the auditor provided under Sec.
expresses doubt 668.175(c).
about the continued
existence of the
institution as a
going concern.
Provisional certification... A participating The institution may
institution:. participate under a
(1) Does not provisional
satisfy the certification by
composite score submitting a letter
standard or any of credit for at
provision least 10 percent of
regarding its the title IV, HEA
financial program funds the
obligations; or institution
(2) Has or had a received during its
program last completed
compliance fiscal year and
problem as meeting other
provided under provisions
Sec. 668.174 but described under
satisfied or Sec. 668.175(f).
resolved that
problem.
Provisional certification The persons or The institution may
for an institution where entities that continue to
persons or entities owe exercise participate under a
liabilities. substantial control provisional
over the certification if it
institution owe a satisfies the
liability for a provisions
violation of a described under
title IV, HEA Sec. 668.175(g).
program requirement.
------------------------------------------------------------------------
\A 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.


[[Page 62832]]

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:
<bullet> 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.
<bullet> 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.
<bullet> 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

[[Page 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 Non-Profit 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.

[[Page 62834]]

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:

[[This file contains the "Financial Ratios" on page 62834 in
Portable Document Format (PDF). It can be viewed with version 3.0 or greater
of the free Adobe Acrobat Reader software.]]

For private non-profit institutions:

[[This file contains the "Financial Ratios" on page 62834 in
Portable Document Format (PDF). It can be viewed with version 3.0 or greater
of the free Adobe Acrobat Reader software.]]

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

[[Page 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, non-profit 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 x 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 \
Calculate the ratio results Calculate strength factor score by Calculate weighted score
use of the appropriate algorithm (multiply strength factor score
by weighting percentage)
----------------------------------------------------------------------------------------------------------------
Primary reserve ratio = .06.. .06 x 20 = 1.20 1.20 x 30% = 0.36000
Equity ratio = .27........... .27 x 6 = 1.620 1.620 x 40% = 0.64800
Net income ratio = .029...... (.029 x 33.3) + 1 = 1.9657 1.9657 x 30% = 0.58971
----------------------------------------------------------------------------------------------------------------
\Step 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

[[Page 62836]]

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 Sec. 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

[[Page 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-in-time 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 Sec. 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 non-profit 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

[[Page 62838]]

this alternative), the Secretary will consider collective guarantee or
insurance-pooling requests on a case-by-case 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:
<bullet> The scope and purpose statement of the new subpart L (p.
49556).
<bullet> 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).
<bullet> Financial responsibility standards and other requirements
for institutions undergoing a change of ownership (p. 49558).
<bullet> Past performance standards (p. 49559).
<bullet> 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).
<bullet> 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.
<bullet> 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.
<bullet> 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 non-profit institutions, and
to take into account additional data on proprietary institutions.
<bullet> Possible modifications to the weighting percentages of the
ratios, including the weighting for the proposed Equity ratio.
<bullet> 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.
<bullet> 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.
<bullet> Community suggestions regarding the treatment of goodwill
in the calculation of the ratios.
<bullet> 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.
<bullet> Discussions of the utility of using a cash flow analysis.
<bullet> Discussions of the treatment of institutional grants and
other fully-funded operations in the calculation of the ratios.
<bullet> 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.
<bullet> 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.
<bullet> Community suggestions for altering the proposed standards
for changes of ownership.
<bullet> 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.
<bullet> 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.
<bullet> 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.
<bullet> The proposed Viability ratio has been replaced by the
Equity ratio.
<bullet> 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.
<bullet> The proposed strength factor tables have been replaced by
linear algorithms.
<bullet> 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.
<bullet> 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).
<bullet> 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.
<bullet> 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).
<bullet> 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 Sec. 668.15
continue to apply to those entities.
<bullet> 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

[[Page 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
Sec. 668.23(f)(3) (previously codified under Sec. 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
Sec. 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 Sec. 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

[[Page 62840]]

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 Not-for-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 non-profit 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

[[Page 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 non-profit 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

[[Page 62842]]

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 non-profit 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

[[Page 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
non-cash 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

[[Page 62844]]

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 Sec. 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 Sec. 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 Sec. 668.172(a)(1)(i) and (ii) for public
institutions are eliminated. The replacement provisions described above
are relocated under Sec. 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

[[Page 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
Sec. 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,

[[Page 62846]]

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 re-deploying 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
Sec. 668.172(a)(1)(ii) that a public or private non-profit institution
must have a positive Primary Reserve ratio.
Proposed Sec. 668.173(e), describing the items that are excluded
from the ratio calculations, is relocated under Sec. 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,

[[Page 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 non-profit 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

[[Page 62848]]

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 on-going 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

[[Page 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 Sec. 668.173 are
relocated under Sec. 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 four-year 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 for-profit 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
prior-year 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

[[Page 62850]]

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
non-profit 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 Sec. 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
three-year 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

[[Page 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 Sec. 668.173(e) are relocated under
Sec. 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

[[Page 62852]]

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 x 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 Sec. 668.173(a) are revised and relocated under
Sec. 668.172(a) to provide for the calculation of the strength factor
scores. In addition,

[[Page 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 non-profit
institutions, the Secretary should adjust the proprietary sector
strength factors as follows:

------------------------------------------------------------------------
Strength
Ratio result 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:

------------------------------------------------------------------------
Strength
Ratio result 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:

------------------------------------------------------------------------
Strength
Ratio result 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:

------------------------------------------------------------------------
Strength
Ratio result 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:

------------------------------------------------------------------------
Strength
Ratio result 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):

------------------------------------------------------------------------
Strength
Ratio result 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

[[Page 62854]]

income tends to be lower for a financially healthy institution during
periods of expansion. Accordingly, the commenter suggested the
following strength factors:

------------------------------------------------------------------------
Strength
Ratio result 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 non-profits, 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 x 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 x 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
------------------------------------------------------------------------
Equals a
Algorithm (20 X Ratio Strength
A Ratio Result of Result) 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
------------------------------------------------------------------------
Equals a
Algorithm (10 X Ratio Strength
A Ratio Result of Result) 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, non-profit 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 non-expendable 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

[[Page 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 x Equity ratio result.
The chart below shows the strength factor scores for specific
Equity ratio results.

Equity Ratio
------------------------------------------------------------------------
Equals a
strength
A ratio result of: Algorithm (6 x ratio factor
result) score
of:
------------------------------------------------------------------------
-0.167 or less...................... 6 x -0.167............. -1
0................................... 6 x 0................. 0
0.167............................... 6 x 0.167............. 1
0.250............................... 6 x 0.250............. 1.5
0.50 or more........................ 6 x 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 non-profit 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

[[Page 62856]]

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 x 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 x Net Income ratio result);
If the Net income ratio result is positive, the Strength factor
score=1+(50 x 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
------------------------------------------------------------------------
Equals a
Algorithm 1+(33.3 x net strength
A ratio result of: income ratio result) factor
score of:
------------------------------------------------------------------------
-0.06 or less................. 1+(33.3 x -0.06)............ -1.0
-0.03......................... 1+(33.3 x -0.03)............ 0
0.00.......................... 1+(33.3 x 0.00)............. 1.0
0.015......................... 1+(33.3 x 0.015)............ 1.5
0.06 or more.................. 1+(33.3 x 0.06)............. 3.0
------------------------------------------------------------------------


Net Income Ratios' Strength Factor Scores for Private Non-Profit
Institutions
------------------------------------------------------------------------
Equals a
strength
A ratio result of: Algorithm (see below) factor
score of:
------------------------------------------------------------------------
-0.08 (or less)............... 1+(25 x -0.08).............. -1.0
-0.04......................... 1+(25 x -0.04).............. 0
0.00.......................... If ratio equals zero, 1.0
strength factor score
automatically equals 1.
0.01.......................... 1+(50 x 0.01)............... 1.5
0.04 (or greater)............. 1+(50 x 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

[[Page 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 non-profit 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 long-term financial stability.
Commenters from proprietary institutions believed that a 50 percent
weighting on the Net Income ratio placed too much emphasis on the
short-term 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

[[Page 62858]]

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 long-term: 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 near-term (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

[[Page 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), non-profit 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:

------------------------------------------------------------------------
Private non-
Proprietary profit
Ratio institutions institutions
(percent) (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 three-year 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

[[Page 62860]]

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
------------------------------------------------------------------------
Primary Net
Range of composite scores Equity reserve income
ratio ratio 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
------------------------------------------------------------------------
Primary Net
Range of composite scores Equity reserve oncome
ratio ratio 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
Sec. 668.172(a) is relocated to Sec. 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

[[Page 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 Sec. 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.

[[Page 62862]]



------------------------------------------------------------------------
Proposed precipitous
Provision closure alternative, Zone alternative,
Sec. 668.174(a)(3) Sec. 668.175(d)
------------------------------------------------------------------------
To qualify initially under 1. Achieve a 1. Achieve a
the alternative, an composite score of composite score of
institution must. 1.25 to 1.74 (on a 1.0 to 1.4 (on a
scale from 1.0 to scale from negative
5.0);. 1.0 to positive
2. Satisfy all of 3.0).
the general Informational and
standards of Administrative
financial Procedures
responsibility for Rather than having
its previous fiscal to satisfy the
year;. qualifying
3. Provide personal requirements under
financial the proposed
guarantees from precipitous closure
owners, board of alternative, an
trustees, or other institution must
persons exercising provide information
substantial control regarding certain
over institution; oversight and
and. financial events
4. Demonstrate to and comply with
the Secretary that cash management and
it will not close other provisions.
precipitously.
To continue to qualify, an Not available; an Achieve a composite
institution must. institution could score no less than
qualify under this 1.0 in each of its
alternative for next two years
only one year. under the
alternative and
continue to comply
with the
Informational and
Administrative
Procedures above.
Institution may qualify For its fiscal year For its fiscal year
again under the alternative. following the year following the next
that it satisfies year that it
the composite score satisfies the
standard (1.75). 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
Sec. 668.174(a)(3) is replaced by the zone alternative. The zone
alternative is located under Sec. 668.175(d) of these regulations.
The Cash Management regulations under subpart K are revised in
several ways. First, Sec. 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 Sec. 668.162 that sets forth the provisions of the cash
monitoring payment method. Lastly, a new paragraph (f) is added to
Sec. 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
Sec. 668.178 (b) through (d) are relocated under Sec. 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

[[Page 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 Sec. 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 counter-intuitive--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 degree-granting, 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
one-half 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

[[Page 62864]]

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
Sec. 668.178 (b) through (d) are relocated under Sec. 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 Sec. 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 Sec. 668.167(a)(1) could adversely affect
innocent people. The commenter described a situation where an
individual acting as a court-appointed 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

[[Page 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 court-approved 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 Sec. 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 Sec. 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 Sec. 668.177(a)(3)(ii) is relocated under
Sec. 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
Sec. 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 Sec. 668.178(a) to initiate an
action to limit, suspend, or terminate an institution.
Several commenters from private non-profit 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

[[Page 62866]]

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 teach-out 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 Sec. 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 three-year 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 Sec. 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 Sec. 668.15 or by qualifying under an
alternative standard in Sec. 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
Sec. 668.171(c) are relocated under Sec. 668.175(e) and revised to
provide that an institution may demonstrate that it is financially
responsible by satisfying the requirements under Secs. 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 Sec. 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

[[Page 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 Sec. 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 Sec. 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.

[[Page 62868]]

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 Sec. 600.31(e) would continue to exempt an institution
from the change of ownership provisions under proposed Sec. 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 Sec. 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

[[Page 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 Sec. 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
Sec. 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

[[Page 62870]]

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.

[[Page 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 non-profit 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.

[[Page 62872]]



Table 1. Estimated Number of Institutions Experiencing Economic Impacts
----------------------------------------------------------------------------------------------------------------
Medium and Medium and
Status with regard to old and new financial Small for- large for- Small non- large for-
responsibility tests profit profit profit profit
institution institution institution 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 cost-
minimization 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

[[Page 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 one-half 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
Sec. 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
Sec. 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 Sec. 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

[[Page 62874]]

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 that Institutions using
institutions) fail the ratio test the zone alternative
------------------------------------------------------------------------
50 percent letter of credit. One-fifth of No institutions
institutions will eligible for the
pay fees of $7,500 zone alternative
to $12,500 per are expected to
million, plus post letters of
estimated credit.
opportunity cost of
$125,000 per
million.
10 percent letter of credit. Four-fifths of No institutions
institutions will eligible for the
pay fees of $7,500 zone alternative
to $12,500 per are expected to
million, plus post letters of
estimated credit.
opportunity cost of
$125,000 per
million.
Additional reporting........ One-third of One-fifth of
institutions will institutions will
have average have average
paperwork costs of paperwork costs of
about $10. about $7.50.
Early submission of audits.. Two-thirds of One-half of
institutions will institutions will
have increased have increased
audit costs of audit costs of
between $6,000 and between $6,000 to
$8,000. $8,000.
Cash monitoring, type 1..... Five-eighths of Three-fourths of
institutions who institutions will
fail the ratio test have: costs of
and participate changing payment
under the 10 system of about
percent letter of $2,000; and loss of
credit alternative interest revenue up
will have: costs of to $250.
changing payment
system of about
$2,000; and loss of
interest revenue up
to $250.
Cash monitoring, type 2..... One-eighth of One-eighth of
institutions who institutions will
fail the ratio test have: paperwork
and participate costs of $20; costs
under the 10 of changing payment
percent letter of system of about
credit alternative $2,000; borrowing
will have: costs (or
paperwork costs of opportunity cost of
$20; costs of capital) of about
changing payment $2,000 per million
system of about dollars of Title IV
$2,000; borrowing funds received; and
costs (or loss of interest
opportunity cost of revenue up to $250.
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 One-eighth of
institutions who institutions will
fail the ratio test have: paperwork
and participate costs of $100;
under the 10 costs of changing
percent letter of payment system of
credit alternative about $2,000;
will have: borrowing costs (or
paperwork costs of opportunity cost of
$100; costs of capital) of about
changing payment $8,000 per million
system of about dollars of Title IV
$2,000; borrowing funds received.
costs (or
opportunity cost of
capital) of about
$8,000 per million
dollars of Title IV
funds received.
Action...................... Institutions that Institutions that
initially fail but initially fall into
employ optional the zone but employ
disclosure to raise optional disclosure
score into zone. to raise score to
passing.
Optional disclosure of HEA An unknown number of An unknown number of
institutional grants. institutions will institutions will
have an economic have an economic
impact of $300. 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.


[[Page 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

[[Page 62876]]

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 cost-benefit 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
Work-Study 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


Sec. 668.13 [Amended]

2. Section 668.13 is amended by removing paragraphs (d) and (e),
and by redesignating paragraph (f) as paragraph (d).


Sec. 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:


Sec. 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:

[[Page 62877]]

Sec. 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 Sec. 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.


Sec. 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
Sec. 668.172 and Appendices F and G;
(2) The institution has sufficient cash reserves to make required
refunds, as provided under Sec. 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 Sec. 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
Sec. 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
Sec. 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
Sec. 668.175, or the institution does not submit its financial and
compliance audits by the date permitted and in the manner required
under Sec. 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
Sec. 668.13(d).

(Authority: 20 U.S.C. 1094 and 1099c and section 4 of Pub. L. 95-
452, 92 Stat. 1101-1109)


Sec. 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:

[[Page 62878]]

[[This file contains the "Financial Ratios" on page 62878 in
Portable Document Format (PDF). It can be viewed with version 3.0 or greater
of the free Adobe Acrobat Reader software.]]


(2) The ratios for private non-profit institutions are:

[[This file contains the "Financial Ratios" on page 62878 in
Portable Document Format (PDF). It can be viewed with version 3.0 or greater
of the free Adobe Acrobat Reader software.]]

(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)


Sec. 668.173 Refund reserve standards.

(a) General. The Secretary considers that an institution has
sufficient cash reserves (as required under Sec. 668.171(b)(2)) to make
any refunds required under Sec. 668.22 if the institution--
(1) Satisfies the requirements of a public institution under
Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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.


[[Page 62879]]


(Authority: 20 U.S.C. 1094 and 1099c and section 4 of Pub. L. 95-
452, 92 Stat. 1101-1109)


Sec. 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 third-party 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)


Sec. 668.175 Alternative standards and requirements.

(a) General. An institution that is not financially responsible
under the general standards and provisions in Sec. 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

[[Page 62880]]

participating institution that is not financially responsible either
because it does not satisfy one or more of the standards of financial
responsibility under Sec. 668.171(b), or because of an audit opinion
described under Sec. 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 Sec. 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
Sec. 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 Sec. 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 Sec. 668.171(b) or because of
an audit opinion described under Sec. 668.171(d); or
(ii) The institution is not financially responsible because of a
condition of past performance, as provided under Sec. 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
Sec. 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 Sec. 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
Sec. 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

[[Page 62881]]

IV, HEA programs under a provisional certification only if--
(i)(A) The persons or entities that exercise substantial control,
as determined under Sec. 668.174(d), repay or enter into an agreement
with the Secretary to repay the applicable portion of that liability,
as provided under Sec. 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 Sec. 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
Sec. 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)

BILLING CODE 4000-01-P

[[Pages 62882-4]]

[[This file contains the new "Appendix F" on pages 62882-4 in
Portable Document Format (PDF). It can be viewed with version 3.0 or greater
of the free Adobe Acrobat Reader software.]]


[[Pages 62885-7]]

[[This file contains the new "Appendix G" on pages 62885-7 in
Portable Document Format (PDF). It can be viewed with version 3.0 or greater
of the free Adobe Acrobat Reader software.]]


[FR Doc. 97-30859 Filed 11-24-97; 8:45 am]
BILLING CODE 4000-01-C




]

Last Modified: 07/28/1998