[Federal Register Volume 62, Number 227 (Tuesday, November 25, 1997)]
[Rules and Regulations]
[Pages 62830-62887]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-30859]



[[Page 62829]]

_______________________________________________________________________

Part IV





Department of Education





_______________________________________________________________________



34 CFR Part 668



Student Assistance General Provisions; Final Rule

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

[[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:
     Overview of the Standards and Provisions of Financial 
Responsibility.
     Community Involvement in the Regulatory Process.
     The Secretary's Responsibility for Assessing the Financial 
Condition of Participating Institutions.
     Need for Revising the Rules.
     The Final Rule.
     Provisions for Public Institutions.
     The Ratio Methodology for Private Non-Profit and 
Proprietary Institutions.
     Overview of the Methodology.
     Issues Raised in the Notice of Proposed Rulemaking and 
other Department Publications.
     Substantive Changes to the NPRM.
     Analysis of Comments and Changes.
    On September 20, 1996, the Secretary published in the Federal 
Register a Notice of Proposed Rulemaking (NPRM) addressing a variety of 
topics, including a ratio methodology that would be used in part to 
determine whether an institution is financially responsible (61 FR 
49552-49574). The NPRM also included financial responsibility standards 
for third-party servicers that enter into a contract with a lender or 
guaranty agency, and provisions for submitting financial statement and 
compliance audits, adding additional locations, and changes of 
ownership that result in a change of control (61 FR 49552-49574). On 
November 29, 1996, the Secretary published final regulations governing 
submissions of financial statement and compliance audits and other 
aspects of financial responsibility, but delayed establishing final 
standards regarding the ratio methodology and other proposed provisions 
(including changes of ownership and additional locations), pending 
further comment, study, and review (61 FR 60565-60577).
    The Secretary provided an extensive opportunity for public 
involvement and comment on these final regulations. On December 18, 
1996, the Secretary reopened the comment period until February 18, 1997 
for the delayed standards and provisions (61 FR 66854). On February 18, 
1997, the Secretary extended that comment period until March 24, 1997 
(62 FR 7333-7334). On March 20, 1997, the Secretary again extended the 
comment period until April 14, 1997 (62 FR 13520).
    These regulations establish under a new Subpart L the provisions 
and standards of financial responsibility that an institution must 
satisfy to begin or continue to participate in the title IV, HEA 
programs. Furthermore, these regulations amend certain sections of 
Subparts B and K to harmonize the requirements under those sections 
with the provisions and standards under Subpart L. As discussed more 
fully under Parts 4 and 15 of the Analysis of Comments and Changes, 
these regulations do not establish new standards of financial 
responsibility for lender or guaranty agency third-party servicers, or 
new provisions regarding additional locations and changes of ownership.

Overview of the Standards and Provisions of Financial 
Responsibility

    As provided under section 498 of the HEA, the Secretary determines 
whether an institution is financially responsible based on the extent 
to which an institution satisfies three statutory components, which are 
illustrated below.

[[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 \1\ 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.                     
------------------------------------------------------------------------
\1\ 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:
     The Department again engaged KPMG to assist the Department 
in reexamining the proposed ratio methodology, considering public 
comments and suggestions to change and improve the methodology, and 
conducting additional empirical studies of financial statements and 
other sources of information. Much of this additional work was based on 
suggestions made by the community.
     The Department held meetings with more than 20 
representatives of higher education associations and institutions on 
February 5, 1997 and March 11, 1997, with nine representatives of 
proprietary institutions on February 27, 1997, and with four 
representatives of higher education associations and public 
institutions on April 4, 1997. The Department also conducted a number 
of other meetings with parties representing individual institutions or 
groups of institutions.
     For purposes of public consideration and comment, the 
Department published on the Office of Postsecondary Education's World-
Wide Web site, minutes of the meetings with representatives of 
postsecondary education associations, information regarding possible 
changes to the proposed ratio methodology, and the results of some of 
the empirical studies. The Department also made available, for viewing 
on-line, the KPMG report on which the Department based the proposed 
ratio methodology.
    Many commenters expressed their appreciation to the Secretary for 
the open, collaborative, and cooperative nature of this rulemaking 
process and for the extensive opportunities for public and community 
involvement. The Secretary in turn appreciates the commenters' 
thoughtful and constructive contributions to this process.

The Secretary's Responsibility for Assessing the Financial Condition of 
Participating Institutions

    The statute and the legislative record show that Congress expects 
the Secretary to determine whether institutions participating in the 
title IV, HEA programs are financially sound and administratively 
capable of providing the education they advertise (Higher Education 
Amendments of 1992, Report of the Committee on Education and Labor, 
House of Representatives, One Hundred Second Congress, Second Session, 
p. 74). Congress authorized the Secretary (at that time, the 
Commissioner) to establish financial responsibility standards with the 
passage of the Education Amendments of 1976 (Pub. L. 94-482), and 
reinforced that authority in subsequent amendments to the HEA. In those 
amendments, but particularly in the legislative history leading to the 
1992 Amendments, Congress made clear that the Secretary should 
scrutinize closely the financial condition of institutions with regard 
to their capacity to fulfill their educational and administrative 
responsibilities, and thus expected the Department to ``play a more 
active role'' in the gatekeeping process (i.e., determining whether 
institutions should begin to participate in the title IV, HEA programs 
and overseeing participating institutions to determine whether those 
institutions should continue to participate).
    In keeping with the statute and congressional intent, the Secretary 
establishes in these regulations the standards and provisions that a 
postsecondary institution must satisfy to demonstrate that it is 
financially sound enough for students to confidently invest their time 
and money in programs offered by the institution, and for the Federal 
government, on behalf of taxpayers, to provide that institution with 
access to substantial amounts of public funds. The Department is 
committed to carrying out the Secretary's gatekeeping and oversight 
responsibilities in a manner that ensures accountability and program 
integrity but that provides as much flexibility to, and places as 
little burden on, institutions as possible.

Need for Revising the Rules

    The current regulations have enabled the Department to identify and 
take action against many financially weak problem institutions that 
drew the attention of Congress. The Secretary nevertheless believes 
that problems still exist that call for continued close scrutiny, and 
undertook an extensive process to develop more effective regulations 
for the following reasons.
    First, the Secretary believes that the standards need to be revised 
to provide a more comprehensive measure of an institution's financial 
condition. As previously noted, the current standards provide discrete 
measures of certain aspects of an institution's financial condition. 
Those aspects are measured by three independent tests--an acid test 
ratio, a test for operating losses, and a test of tangible net worth. 
However, because each test provides a measure of financial health 
without regard to the other tests or to other resources available to an 
institution, the assessment made under each of these tests does not 
always reflect the overall financial condition of an institution.
    Second, because the current standards do not consider the extent to 
which an institution satisfies or fails to satisfy the tests, the 
Department cannot readily make distinctions among (1) institutions that 
are clearly not financially healthy, (2) institutions that are 
financially sound enough to participate in the title IV, HEA programs, 
and (3) institutions whose financial health is questionable. 
Consequently, a more considered approach is needed to evaluate the 
relative level of financial health of institutions to more closely tie 
the Department's gatekeeping and oversight efforts to the corresponding 
risk to the

[[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:
    [GRAPHIC] [TIFF OMITTED] TR25NO97.020
    
    For private non-profit institutions:
    [GRAPHIC] [TIFF OMITTED] TR25NO97.021
    
    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 \1\
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                     
----------------------------------------------------------------------------------------------------------------
\1\ 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:
     The scope and purpose statement of the new subpart L (p. 
49556).
     A proposal to modify the precipitous closure alternative 
to demonstrating financial responsibility, and a clarification of the 
types of alternatives to demonstrating financial responsibility 
available to new institutions (pp. 49557-49558).
     Financial responsibility standards and other requirements 
for institutions undergoing a change of ownership (p. 49558).
     Past performance standards (p. 49559).
     An outline of additional requirements and administrative 
actions, including requirements for institutions that are provisionally 
certified, and an outline of administrative actions taken when an 
institution fails to demonstrate financial responsibility (p. 49559).
     The contents of the proposed Appendix F (p. 49559).
    The following list summarizes the areas of discussion that were 
posted on the Department's World-Wide Web site. This site is located at 
(http://www.ed.gov/offices/OPE/PPI/finanrep.html). This web site will 
remain active at least until the regulations are fully effective.
     The possibility of using in the ratio analysis an Equity 
ratio either as an additional ratio, or as a substitute for the 
Viability ratio; and a discussion of the components of, and possible 
strength factor scores for, that ratio.
     Possible adjustments to the threshold factors to take into 
account new data of the effects of Financial Accounting Standards Board 
(FASB) Statements 116 and 117 on private non-profit institutions, and 
to take into account additional data on proprietary institutions.
     Possible modifications to the weighting percentages of the 
ratios, including the weighting for the proposed Equity ratio.
     Possible modifications to the calculation of composite 
scores from the ratio analysis to eliminate ``cliff effects,'' 
including the possible use of a linear algorithm or the addition of 
more strength factor categories to linearize the composite scores.
     Possible modifications to the scoring scale, including 
truncating the upper end of the scale to eliminate unnecessary 
differentiation of institutions that attain high composite scores.
     Community suggestions regarding the treatment of goodwill 
in the calculation of the ratios.
     Community suggestions for a secondary tier of analysis, 
and suggested changes to the alternative means of demonstrating 
financial responsibility for those institutions that fail the ratio 
test.
     Discussions of the utility of using a cash flow analysis.
     Discussions of the treatment of institutional grants and 
other fully-funded operations in the calculation of the ratios.
     Discussions of donor income with regard to determining the 
financial responsibility of non-profit institutions, and in particular 
of institutions that have continued for many years on tight budgets 
with a minimal financial cushion.
     The treatment of debt in the proposed ratio methodology, 
including concerns that the proposed ratio methodology could penalize 
institutions for taking on necessary amounts of debt to expand or to 
invest in infrastructure, and suggestions for the evaluation of 
institutions that remain debt-free.
     Community suggestions for altering the proposed standards 
for changes of ownership.
     Discussions of the utility and practicality of using a 
trend analysis rather than a snapshot approach, and community 
suggestions that financial responsibility need not be determined 
annually, at least for stronger institutions.
     Community suggestions for revising the ``full faith and 
credit'' alternative for public institutions.

Substantive Changes to the NPRM

    The following discussion reflects substantive changes made to the 
NPRM in the final regulations.
     The proposed ratio standards for public institutions have 
been eliminated in favor of a revised approach in implementing the 
statutory alternative that an institution is financially responsible if 
it is backed by the full faith and credit of a State or equivalent 
government entity.
     The proposed Viability ratio has been replaced by the 
Equity ratio.
     The proposed scoring scale has been modified to range from 
negative 1.0 to positive 3.0, rather than from 1.0 to 5.0. The low end 
of the range, below 1.0, indicates the poorest financial condition. At 
the high end, a score of 3.0 indicates financial health.
     The proposed strength factor tables have been replaced by 
linear algorithms.
     The proposed ratio results necessary to earn points along 
the scoring scale have been lowered to reflect a time frame of 12-to-18 
months rather than 3-to-4 years.
     As a result of revising the scoring scale and the strength 
factor scores, and the change in focus from 3-to-4 years to 12-to-18 
months, the minimum composite score for establishing financial 
responsibility has been changed from the proposed standard of 1.75 (on 
a scale of 1.0 to 5.0) to 1.5 (on a scale of negative 1.0 to positive 
3.0).
     The proposed precipitous closure alternative has been 
modified and implemented in these regulations as the zone alternative. 
Under the zone alternative, an institution whose composite score is 
less than 1.5 but equal to at least 1.0 may participate in title IV, 
HEA programs as a financially responsible institution for up to three 
consecutive years.
     As part of the modifications to the proposed precipitous 
closure alternative, the provision requiring owners or persons 
exercising substantial control over an institution to provide personal 
financial guarantees is eliminated. Instead, an institution whose 
composite score is less than 1.5 is required to provide information 
regarding certain oversight and financial events, and the Department 
provides title IV, HEA program funds to that institution under the 
reimbursement payment method or under a new, less burdensome payment 
method, Cash Monitoring (discussed above and under part 9 of the 
Analysis of Comments and Changes).
     The proposal to apply the ratio methodology to third-party 
servicers entering into a contact with lenders and guaranty agencies 
has been withdrawn. The financial standards currently under Sec. 668.15 
continue to apply to those entities.
     The proposed revisions to the procedures relating to 
changes of ownership have been withheld pending further review and 
comment.

Executive Order 12866

    These final regulations have been reviewed as significant in 
accordance with Executive Order 12866. Under the

[[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]]

[GRAPHIC] [TIFF OMITTED] TR25NO97.022


    (2) The ratios for private non-profit institutions are:
    [GRAPHIC] [TIFF OMITTED] TR25NO97.023
    
    (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)

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