This report was originally published 12/1/09.

The U.S. Department of Education (DOE) distributed its first round of proposals to the negotiated rulemaking panel on Monday on Program Integrity Issues in the higher education space.  The initial hearings for this year’s negotiated rulemaking sessions were held from November 2-6.  You can find more details on the initial hearings and the schedule for subsequent hearings here.  As a reminder here are the 14 issues which the Department of Education planned to address as part of the Program Integrity negotiated rulemaking sessions:

1. Definition of High School Diploma for the Purpose of Establishing Institutional Eligibility to Participate in the Title IV Programs, andStudent Eligibility to Receive Title IV Aid
2. Ability to Benefit
3. Misrepresentation of Information to Students and Prospective Students
4. Incentive Compensation
5. State authorization as a component of institutional eligibility
6. Gainful Employment in a Recognized Occupation
7. Definition of a credit hour
8. Agreements between Institutions of Higher Education
9. Verification of Information Included on Student Aid Applications
10. Satisfactory Academic Progress
11. Retaking Coursework
12. Return of Title IV Funds: Term based programs with modules or compressed courses
13. Return of Title IV Funds: taking attendance
14. Disbursement of Title IV Funds

It is a long list. Many of these issues are highly controversial and regulatory changes would likely have large implications on the earnings prospects for many of the publicly traded for-profit education providers. As part of the negotiated rulemaking process the Department of Education provides a list of proposed regulations following the first session.  Those proposals will then be discussed and debated at the second session which will be held next week. The Department of Education will then issue revised proposals, which will be discussed and debated the week of January 25th, 2010.  We expect that final regulations will be introduce sometime in the Summer/Fall of 2010 for enforcement starting in 2011.

The Department of Education has yet to release the full Program Integrity regulation proposals on theFederal Register or the Negotiated Rulemaking homepage, which would normally be the place to find relevant information to the negotiated rulemaking process. However, the folks at insidehighered.com have provided links to regulatory change proposals on three of the issues:  Incentive compensation (Issue #4), gainful employment (Issue #6), and misrepresentation of information to students (Issue #3).  We have reviewed the proposals.  One thing should be very obvious – the orientation of the Department of Education towards the for-profit education sector has shifted dramatically.  This is not to say that the DOE wants to villify operators in the space, but it is clear that they want to reel in what could be perceived as excesses and lax regulatory compliance in the sector.  We think the proposals, if passed could have far reaching implications on the earnings profiles of COCO, ESI and WPO.  Please keep in mind that these are just proposals and in some cases could be “watered down” during the negotiated rulemaking process.  Below we discuss our thoughts on the DOE’s proposed regulatory changes on three of the Program Integrity Issues.

Incentive Compensation

For as long as we have been following the for-profit education sector, “incentive compensation”, or the notion that enrollment counselors should not be compensated exclusively based on the number of students they enroll, has been a source of great controversy.  The initial regulations were included as part of the Higher Education Act of 1992 during a time when cohort default rates exceeded 25% nationally.  The spirit of the initial regulation was to crack-down on “diploma mills” where students that could “fog a mirror” were being enrolled.  Cohort default rates rapidly declined and 100’s of for-profit education institutions closed.  There is no question that the initial regulation was effective in curbing excess in the space.

Ten years later, the Department of Education created a series of “safe harbors” that allowed schools to increase compensation to enrollment counselors and recruiters under profit-sharing plans and salary increases as long as they were not based “solely” on the number of students enrolled.  Between 1992 and 2002, a number of for-profit education companies grew to achieve national scale. Their lobbying influence increased and student loan cohort default rates were at record lows.  The argument was made that the operators in the space were subject to repeated lawsuits (as they still are today) related to violation of the incentive compensation provisions and that the language was not clear on what compensation policies could be allowed.  In theory the safe harbors that were created enabled companies in the space to establish clear compensation policies for its enrollment counselors and recruiters.  The creation of the safe harbors did not eliminate the controversy surrounding the space and many companies such as APOL, COCO, ESI and WPO have been subject to qui tam actions over the past 4-5 years related to incentive compensation.  It is a difficult issue to address effectively.  While we think that those enrollment counselors that are effective should earn more than those that are not, it’s also clear that the safe harbors provide too much wiggle-room for operators in the space to foster an “aggressive” enrollment culture.

The Department of Education Proposes to Eliminate All Incentive Compensation Safe Harbors

Here is the specific language from the DOE:

“Consistent with the majority of the comments made by the participants, the Department believes that the specific language of the statute is clear, and that the elimination of all of the regulatory “safe harbors” would best serve to effectuate congressional intent.”

Based on the initial statement, this appears to be one proposed regulatory change that the DOE views as a high probability of occurring.  It is difficult to quantify how this will impact operators in the space from a lead conversion and enrollment growth perspective.  It certainly will make it more difficult to retain enrollment counselors and historically enrollment counselor retention has been highly correlated to lower cost-per-start. We think the proposal to address compensation paid to Internet based recruitment and admissions activities is arguably the most onerous for operators in the space.  Here is the specific language from the DOE:

““Safe harbor” (J) permits compensation paid for Internet-based recruitment and admission activities. This form of recruitment is not exempt from the statutory ban on incentive compensation. Technological advancements and developments in Internet-based activities since this “safe harbor” was adopted, and the frequency with which such activities are now relied upon, creates further cause for concern.“

The proliferation of Internet based lead-generators has been a boon for the for-profit education sector.  Internet based lead costs are still considerably lower on average than those for other media sources. Internet-based lead generation has been a favorable operating margin tailwind for operators in the sector for the past 5-7 years.  For-profit education providers are some of the largest advertisers on the Internet.  There are many for-profit postsecondaryeducation providers that have structured cost-per-action/enrollment agreements with lead generators.  Based on the language above, it appears the DOE wants to address those operators specifically.  Does this mean that cost-per-action arrangements will be banned? As the proposal is currently worded, it certainly seems that way.  This could have much broader implications on the growth trajectory of several operators in the space, much more so than the elimination of the other safeharbors in our opinion.

We expect that for-profit education providers and the Career College Association will attempt to fight this proposal “tooth and nail”. Based on the manner in which the DOE worded their proposal it appears it could be an uphill climb.

Gainful Employment

Historically, there has been a great deal of controversy surrounding the job placement rates that many operators in the for-profit education sector use for standards of accreditation and for marketing purposes.  Questions surrounding what constitutes employment in a student’s respective field of study have existed since we have been following the sector.  Skeptics argue that job placement rates are vastly over-stated and have enabled companies in the sector to continue to enroll students based on the promise of a higher earnings profile that has a lower likelihood of occuring than the job placement data would suggest.

As part of its first round of regulatory proposals, the DOE chose not to address the issue of gainful employment and how placement rate statistics should be effectively monitored and calculated. However, the DOE has introduced a mechanism which we think could be far more onerous for operators in the space – tuition caps based on educational value added or student debt burdens.

As long-time followers of our research know, we have been focused on educational affordability and the dwindling, if not outright negative return on educational investment for students attending schools owned by ESI.  You can read more detail here.  The entire sector has always been supported by the notion that “the more you learn, the more you earn”.  Over the past several years, aggressive tuition price increases have diluted the return on educational investment for many programs offered by for-profit postsecondary education providers.  During his years in the private sector, undersecretary Shireman focused on expanding access to higher education and affordability.  The DOE’s proposal to provide an alternative to a “gainful employment” regulatory mechanism appears to reflect Mr. Shireman’s focus on achieving favorable returns on educational investment.  Here is the specific language:

“Option 1: Reasonable relationship between the cost of the program expected earnings:

The difference in annual earnings between a high school graduate and a person who completes a vocational program would represent the “value added by the program.” We would consider the cost/earnings relationship to be reasonable if the cost of the program is less than 3 times (or some other multiple) the value added. If the cost/earnings relationship is not reasonable, we would no longer consider the program to be eligible for title IV aid.“

The DOE also proposed a second mechanism:

“Option 2: Debt/Income ratio

Another approach would be to look at whether a student’s starting annual income is adequate to repay the average debt service obligation for someone completing a specific program, while still having an adequate amount available to meet living expenses. For example, in a particular field the average debt for a student completing a certificate program is $9000. That student would have annual loan repayments totaling $1250. For a debt-to-income ratio of 5 percent, a minimum qualifying income of at least $25,000 would be required to satisfy a “gainful employment” standard. For the qualifying income, we could use BLS data or wage data reliably obtained by institutions.“

We have argued for some time that free-market forces would eventually introduce increased elasticity of demand into the higher education space.  We have already started to see growing signs of a mind-shift among consumers towards the cost of higher education.  The DOE has taken this a step further. There is no question, that a student allocating 20% of their gross income towards student loan payments is at an incredibly high risk of default, as is the case of many of the associate degree graduates at ESI.   Tuition pricing trends are unsustainable.  We were stunned to hear management of ESI indicate on their 3Q09 earnings conference call that they planned to increase tuition another 5% in 2010.  Based on the placement rate and average starting salary statistics that the company has provided, there is absolutely no fundamental justification for a tuition price increase.  We would argue that ESI needs to reduce tuition in order to restore the affordability equation.  It appears the Department of Education agrees.  Under option 2, in order to comply with a 5% debt/income threshold, based on our estimates ESI would have to reduce tuition in excess of 65%! ESI is not the only company that would be greatly effected under this proposal.  It is more difficult to determine the impact of Option 1 given that we don’t know all of the CIP codes and BLS wage data that would be used to determine “value added”, but rough estimates suggest that the reductions to tuition required under that type of regulation would be meaningful.

How likely is this proposal to be adopted? It is difficult to say, but it is clear that the Department of Education is focused on affordability and educational outcomes, which would suggest greater scrutiny of for-profit education providers with higher priced programs for the foreseeable future.

Misrepresentation of Information to Students

The DOE has introduced a number of proposals that would reign in practices in the sector that could mislead a student about the following topics:

• Accreditation standing
• Credit transferability
• Requirements to complete a course or program
• Refund policies
• Financial aid
• Employment prospects for graduates

The DOE seeks to explicitly establish which practices are not allowed rather than have broad language that bans general misrepresentation to prospective or existing students.  Transfer of credit has been a long-standing issue in the for-profit education sector. In the past, some former students have made allegations that an enrollment counselor or admissions representative suggested that credits from one particular institution would transfer to another. Very few traditional institutions accept credits from for-profit institutions.  The DOE wants to address the manner in which credit transferability is addressed in conversations with prospective and existing students head-on.  Additionally, the DOE has included language that would limit the manner in which operators in the sector could represent employment prospects for graduates of their programs. It appears the DOE is concerned that some marketing campaigns present an unrealistic view of employment prospects upon graduation to prospective students.

In general, we think the proposals for Issue #3 related to misrepresentation would not result in an immediate change to operating policies in the sector, but would provide the DOE with greater regulatory oversight enforcement tools in the future.

We are looking forward to reading the rest of the proposals from the DOE. While our short thesis on COCO, ESI, and WPO is not necessarily predicated on a change to the regulatory framework, it’s becoming increasingly clear that the DOE has adopted a more aggressive regulatory tact.  The negotiated rulemaking process will take many months to complete, but the DOE’s initial proposals represent a “shot across the bow” for the entire sector.  In an environment in which educational outcomes and affordability become paramount, we think the shares of COCO, ESI and WPO could continue to see downside.

As always, please act accordingly….