By Joan Berkes, Policy & Federal Relations Staff

Editor’s Note: This article is the first in a series of three that detail final rules published on November 1, 2016. These articles follow up on a brief overview provided in Today’s News on November 1. The final rules affect several different areas of regulation: borrower defenses to repayment of federal student loans; institutional financial responsibility measures; adjustments to other discharge provisions; and several other miscellaneous items.

This article focuses on changes to the standards of financial responsibility which institutions must meet to maintain eligibility to participate in the TItle IV programs. The second article in this series will explain the borrower defenses rules. The third article will examine the changes to other loan discharges and miscellaneous provisions.

Final regulations published on November 1 make extensive changes to the Department of Education’s (ED) standards under which a non-profit or for-profit institution’s financial responsibility is judged, effective July 1, 2017. An institution that does not meet the applicable standards of financial responsibility, or an acceptable alternative, is not eligible to participate in the Title IV federal student aid programs. The standards and alternatives are located at 668.171 and 668.175 of the General Provisions regulations.

In the final rules, ED confirms that for public institutions, it will continue to rely on the full-faith and credit of a state to cover any Title IV-related debts and liabilities. Thus, a public institution has not been and will not be subject to the general standards of financial responsibility and is considered financially responsible as long as it does not violate any past performance provision. ED points out that has on occasion placed public institutions on heightened cash monitoring for failing to file required audits in a timely manner, but even then has never required a public institution to provide financial protection of any type beyond the full-faith and credit of the institution’s state.

The new rules, primarily at 668.171, alter the structure of the current financial responsibility regulations, and create a new system under which nonprofit and for-profit institutions must provide financial protection to the federal government when an institution’s financial stability appears to be threatened. The rules establish triggers that indicate, or may indicate, such a threat, so that ED can assess whether action is needed to protect the federal interest when the triggering event occurs rather than waiting for a weakness to be revealed through the audit process.

These final rules also make changes to the alternative standards at 668.175 under which an institution that does not meet the general standards can continue to participate. The alternatives include provisions for institutions that lose their designation as financially responsible due to the occurrence of a triggering event or condition identified in the new regulations as a threat or potential threat to the institution’s financial stability.

Revised General Standards of Financial Responsibility

The standards of financial responsibility will continue to be based on the same three broad measures in current use, which ensure that the institution is able to:

• Provide the services described in its official publications and statements;
• Meet all of its financial obligations; and
• Provide the administrative resources necessary to comply with Title IV requirements.

As is currently the case, four general standards of financial responsibility for nonprofit and for-profit institutions are derived from those broad measures. Some of the new general standards retain the current rule, and some are substantially different:

The core of the final rules is the treatment of events or conditions (“triggers”) that signal a potential failure to meet financial obligations and provide necessary administrative resources. The new rules expand greatly the identification of imminent risk and treat each trigger in one of three ways:

• An automatic presumption that the event or condition, upon occurrence, causes an institution to lose its standing as financially responsible under the general standards;
• An automatic presumption that the event or condition carries losses or liabilities that will affect its composite score; or
• A closer look to determine whether ED can, at its discretion, demonstrate that the event or condition causes loss of financial responsibility.

Triggers that result in an automatic loss of financial responsibility under the general standards will require the institution to establish its eligibility under an alternate standard. Triggers that may affect an institution’s composite score are assessed by actually recalculating that score and taking action based on the result. ED explains in the preamble to the final rule that the current composite score methodology has two limitations: “The score is calculated based on the audited financial statements for the most recent fiscal year of the institution, and the audited financial statements recognize threatened risks only if accounting rules require the institution to recognize those events.” Thus, when new events occur after the close of an audit period, or are not reflected in audited financial statements, ED will assess whether the event affects the institution’s ability to be financially responsible by projecting its effect on the composite score by:

• Quantifying the potential losses and other impacts attributable to the trigger, by a methodology defined in the regulations;
• Adjusting the institution’s financial statements on which the most recent composite score was calculated to reflect the amount of loss; and
• Using the adjusted statements to recalculate the institution’s composite score.

If the recalculated composite score falls below 1.0, the institution will not be considered financially responsible, and will be required to provide financial protection according to which alternative standard it chooses to continue its Title IV participation. If the recalculated composite score falls from a passing score of at least 1.5 to a failing score that is at least 1.0, ED will not require financial protection, nor will the recalculated score subject the institution to the increased reporting and monitoring requirements of the “zone” alternative standard (normally imposed if an institution’s routinely calculated score based on audited financial statements is 1.0 to 1.4).

Financial protection is generally a letter of credit, but in some cases under the final rules may be satisfied by a set-aside taken from Title IV funds an institution would receive over a nine-month period. An institution can also demonstrate that it has insurance to cover debts and liabilities that might arise from the triggering event.

For other triggering events that cause the institution to no longer be considered financially responsible, but where recalculation of the composite score is not appropriate, the institution would have to satisfy an alternate standard under 668.175, which may include providing financial protection.

Triggering Events

In the proposed rules from which these final rules are adopted, ED categorized the triggers as either automatic or discretionary. The final rules retain that distinction, but some of the events listed as automatic in the proposed rules have been shifted to discretionary in the final rule. The assessment of impact has also been revised from the proposed rule, and the associated financial protection is revised. For example, setting off multiple triggers would have resulted in stacked financial protection guarantees under the proposed rules.  By using the recalculated composite score approach, ED can fine tune the appropriate amount of protection needed.

The regulations include timeframes within which an institution must report the occurrence of a triggering event or condition. The timeframe differs depending on the trigger. The rules also allow an institution to show in its report that the condition or event no longer exists, has no significant impact, or is otherwise resolved.

Automatic triggers. An institution is deemed unable to meet its financial or administrative obligations under the following automatic triggers (briefly stated here, more fully detailed in the regulations):

• Certain actual or potential debts, liabilities, and losses, if the resultant recalculated composite score falls below 1.0, that result or may result from:
• A final judgment in a judicial proceeding or from an administrative proceeding or determination,
• Borrower defense-related lawsuit that has been pending for 120 days,
• Other litigation, contingent on certain court actions,
• Accrediting agency requirement to submit a teach-out plan that covers the closing of the institution or any of its additional locations/branches,
• Gainful employment programs that could become ineligible based on their final debt-to-earnings rates for the next award year, or
• For a proprietary institution whose composite score is less than 1.5, withdrawal of an owner’s equity.
• Non-Title IV revenue: For its most recently completed fiscal year, a proprietary institution did not derive at least 10 percent of its revenue from sources other than Title IV.
• A publicly traded institution is currently subject to one or more of the following actions or events:
• Securities and Exchange Commission (SEC) actions warning the institution that it may suspend trading on the institution’s stock,
• SEC required annual or quarterly report has not been filed timely, or
• Exchange actions notifying the institution that it is not in compliance with exchange requirements, or its stock is delisted.
• The two most recent cohort default rates are 30 percent or greater (as determined after resolution of challenges/appeals).
• An auditor expressed an adverse, qualified, or disclaimed opinion, or doubt about the institution as a going concern, unless ED determines a qualified or disclaimed opinion does not significantly bear on the institution’s financial condition.

Discretionary triggers. Events or conditions that signal the need for a closer look by ED to determine whether there is an event or condition that is reasonably likely to have a material adverse effect on the financial condition, business, or results of operations of the institution, include but are not limited to:

• Significant fluctuation in Direct Loan or Pell amounts received by the institution;
• Citation for failure of a state licensing or authorizing agency requirement;
• Failure of a financial stress test;
• High annual dropout rates;
• Accrediting agency action for failing to meet one or more of the agency’s standards;
• Violation of a provision or requirement in a loan agreement, allowing certain sanctions, penalties, or fees;
• Pending claims for borrower defense discharge; or
• ED expects a significant number of borrower defense claims due to lawsuit, settlement, judgement, or finding from a state or federal administrative proceeding. 

Alternative Financial Responsibility Standards

As noted above, an institution that loses its qualification as financially responsible may be able to continue participation in Title IV if it meets an alternative standard. The alternative standards are available under current rules, but the new regulations alter the following alternatives:

Letter of credit alternative. As is currently the case, an institution that fails any of the standards (including, under the new rules, because it has tripped a trigger) can continue to participate if it submits an irrevocable letter of credit to ED for at least half of the Title IV funds received in its most recent complete fiscal year. The new regulations allow ED to accept other forms of financial protection, which will be described in a separate Federal Register notice.

Zone alternative. As is currently the case, an institution that is not financially responsible solely because it fails to achieve a financial ratio composite score of at least 1.5, but has a composite score of at least 1.0, can continue to participate under the zone alternative for up to 3 consecutive years, as long as the composite score remains in the 1.0 – 1.4 “zone.” This score is based on its routine calculation from audited financial statements, not on a recalculated score attributable to one or more triggers.

The zone alternative does not require financial protection, but does place the institution on the heightened cash monitoring or reimbursement payment method, as well as other steps to ensure closer oversight, including earlier audits. Currently, an institution participating under this alternative must report the occurrence of certain potentially adverse events to ED. Under the final rules, some of those events are shifted over to the new trigger component of the general standards. For example, certain adverse accrediting agency actions or violation of a loan provision currently must be reported by institutions that are in the zone. Under the new rules, those occurrences will have to be reported by an institution that otherwise meets the general standards and may cause it to lose its standing as financially responsible.

Provisional certification alternative. As is currently the case, an institution may accept provisional certification to continue participation in Title IV if it is not financially responsible. Under the new rules, an institution will have this option if its routine composite score is less than 1.5 or its recalculated composite score based on certain automatic triggers is less than 1.0, or if it lacks the ability to meet financial obligations and provide administrative resources (that is, it trips any other trigger). This alternative can also be used if it is not financially responsible because it is subject to a past performance provision, if the issue has been resolved (as is currently the case) or because of a problematic audit opinion. The same restrictions on drawing down funds and other increased oversight as required for the zone alternative apply to this alternative, and the same changes made to reporting of adverse events apply here.

The provisional certification alternative requires financial protection from nonprofit or for-profit institutions (a letter of credit or other acceptable guarantee), but the amount differs from the current rule of at least 10 percent of Title IV funds received in its most recent complete fiscal year: the final rule starts with a 10 percent base, and adds an additional amount to cover fully any estimated losses as determined by ED. This structure gives ED an opportunity to consider how the occurrence of certain multiple triggers would be treated. The final rule preamble points out that as the composite score decreases, “the institution may be required to provide an added amount of protection where supported by the particular facts and circumstances— including the history of the institution, the nature of the risks posed, the presence of existing liabilities to the Department, the presence, amount, and rate at which borrower defense claims are being filed, and the likelihood that the risk will result in increases in borrower defense claims.”

In general, ED retains financial protections under the provisional certification alternative until either the institution’s routine composite score (based on audited financial statements that recognize losses from all triggering events for which the protection was required) rises to at least 1.0, or until recalculated composite score rises to at least 1.0 and triggering events have ceased to exist.

The final rules also amend sections in the regulations governing the fine, limitation, suspension, and termination processes to support the new financial protection requirements.

New Disclosures

The final rules create two new disclosures, one applicable to all schools subject to the financial responsibility triggers, and one specific to proprietary institutions. Any school that trips certain triggers will have to deliver a financial protection disclosure to current and prospective students. The content and format of the disclosure and the specific triggers that require the disclosure will be detailed by ED based on consumer testing.

Proprietary institutions must provide a warning to current and prospective students if the institution’s loan repayment rate, calculated by ED using the same methodology used for gainful employment programs, shows that the “median borrower” has not paid down the balance of each loan received for enrollment in the institution by at least $1 during the most recently completed award year. The “median borrower” reflects this situation when the loan repayment rate is less than 0.5.

The final rules also amend program participation agreements to oblige any institution to provide a closed school discharge application to its enrolled students if it must submit a teach-out plan prompted by any of the following circumstances: the initiation of an adverse action by ED, the institution’s state authorizing agency, or its accrediting agency; planned closure of a location that provides 100 percent of a program; cessation of the institution’s operations. The institution will have to describe the benefits and consequences of a closed school discharge as an alternative to completing an educational program through a teach-out agreement.

This look at the new financial responsibility regulations does not include all of the details in the final rule or the explanatory preamble. Institutional administrators who monitor the financial health of their schools will need to read through the new rules fully to understand the potential impact. As questions of interpretation come up, NASFAA will continue to provide information.

Publication Date: 11/10/2016

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