Schoolhouse Knock

As incoming members of Congress acclimate to Capitol Hill in January, they can expect a tutorial from the for-profit education industry.

Education Secretary Arne Duncan has proposed regulations, due early next year, that would link these higher-ed institutions’ eligibility for government-supported loans to their students’ debt levels and their ability to repay. On the legislative side, Sen. Tom Harkin, D-Iowa, hopes to schedule the latest in a series of hearings on for-profits in the Senate Health, Education, Labor & Pensions Committee. Harkin also hopes to pass legislation curtailing the industry. His biggest concerns: aggressive recruitment, student debt and high levels of withdrawals.

If the government does crack down, it could be a cataclysmic event for these businesses. Loans supported by the government pay close to 90% of tuitions at some schools. Proprietary educators, previously seen as an anti-recessionary investment, have lost billions of dollars in market value since scrutiny increased this year. Were they to be hit with stringent new rules, their share prices could fall a lot more, and their borrowing costs soar. In bearish scenarios, bankruptcies would be likely. A political fight is already under way, presenting yet another test of the Obama administration’s mettle.

The administration says it needs for-profit schools to meet its goals of graduating an additional 8 million college students by 2020. Nevertheless, it is pushing for greater accountability from the schools. The gainful-employment rules, as the Department of Education proposals are called, set a two-pronged test: They would limit the debt for the average student to 12% of total income, and would mandate that at least 35% of students must be paying the principal on their federal loans. If a school violates both provisions, it could lose its eligibility to receive Title IV funding from the government.

The Department of Education originally planned to unveil a full slate of rules before the midterm elections to ensure integrity of for-profit programs that receive federal aid. It punted the more controversial gainful-employment regulations until early in 2011, following an outsized public response. Corinthian Colleges Inc. sponsored a massive public relations campaign predicting catastrophic effects on students, programs and employees. The department received more than 90,000 comments, including protests from the industry and investors, who say the regulations are overly severe and are driven by short sellers’ hyperbole.

"The proprietary, or ‘career’ college, for-profits are endangered by these rules as written — indeed, many, maybe most, would be put out of business if these rules are strictly applied," says Lanny Davis, who handled damage control for Bill Clinton during the Monica Lewinsky scandal and now represents the Coalition for Educational Success, a for-profit industry group. "One wonders whether some of the drivers of these rules, including competitors, had this agenda in mind."

Barry Lucas, who follows the sector for Mario Gabelli’s Rye, N.Y., firm Gabelli & Co., says, "Falling afoul of the gainful-employment rule as it is proposed could [result in] entire programs being shut down."

With a divided Congress, Harkin will have difficulty passing legislation. Gridlock would not in itself stop Duncan from placing tougher restrictions on the industry when the Department of Education issues its final rules in early 2011, but the House could launch legislation intended to rein in the department. One observer called gainful-employment rules a "giant lawsuit waiting to happen."

Duncan was previously chief executive officer of the Chicago Public Schools under Mayor Richard M. Daley. He calls education "the civil rights issue of our generation," and equates learning with economic opportunity and a means to a more egalitarian society. Therein lies a paradox, and political pitfalls. Duncan’s language is uncannily similar to the for-profit educators’ description of their mission: Proprietary schools typically serve underprivileged students who would be less likely to attend a traditional college.

The overriding question is whether the department will soften its rules in the months to come.
One lobbyist suggests that the rules would have been more vulnerable to legal challenges under the Administrative Procedure Act if the government had not taken more time to review the comments.

Lauren Saunders of the National Consumer Law Center says the agency’s decision to delay the application was a prudent one.

"The responses were probably greater than expected, and they needed to address them," she says. "We expect the Department of Education to go forward. We don’t think the election changes that."

Davis says that the Department of Education has overstepped its authority with the gainful-employment rules and suggests that the new House leadership could take a dim view of the proposal.

"What gives them the authority to impose these requirements on students with Title IV loans at career colleges but not at community colleges that are paid for by the taxpayer or nonprofit schools like Harvard and Stanford, which take billions from the government in contracts and student loans?" he asks.

"If it’s because they don’t think they have the authority, why aren’t they seeking it from Congress?"

Davis takes issue with details of the rules. For instance, the Department of Education originally proposed using Bureau of Labor statistics to set its debt-to-income requirements but later decided to use Social Security data that is less accessible.

He says the rules reflect an agenda in which "there is something bad about the word ‘profit,’ and there is something good about the word ‘government.’ "

One industry critic agreed that the rule prescribing a ratio of debt to income may be impossibly complex, not accounting for the varying cost of living in different parts of the country.

The Department of Education would also not consider students who defer payments of principal to be current on their loans.

Marc Lampkin of the Washington lobbying and communications firm Quinn Gillespie & Associates described the provision of the gainful-employment rule as "draconian" because deferment is a legitimate debt management tool that the department recommends students consider if they have trouble repaying.

"If you extended that rule to U.S. not-for-profit medical schools, a substantial number of them would probably be ineligible," Lampkin says. "Many new medical interns and residents defer their student loan repayments." He says that if the Education Department is in a mood to compromise, it could revisit the issue of deferments.

Uncertainty about gainful employment has ravaged for-profit stocks this year. Apollo Group Inc.’s market cap has fallen about $4.5 billion from its 52-week high. ITT Educational Services Inc. and Education Management Corp. have lost close to $2 billion each. Strayer Education Inc. and Corinthian Colleges are down about $1.6 billion and $1.3 billion, respectively.

BMO Capital Markets Corp. ranked various schools’ exposure to the gainful-employment rules in a recent report. Colleges with high levels of risk included the Washington Post Co.’s Kaplan University, which had repayment rates of 27.7%, and ITT Educational Services’ ITT Technical Institute, with a rate of 31.2%.

Several for-profit secondary educators have taken steps to improve the risk profile of the student base. But that has often resulted in lower enrollments.

Apollo Group is the largest of the for-profits, with about $5 billion in revenue and 475,000 students. When the company said in October that enrollments could fall 40% over the coming year, the stock lost a quarter of its value in one day.

The parent of the University of Phoenix recently started to require students with less than 24 credit hours to complete an orientation course. In a pilot program, a spokesman says one in five students dropped out after the orientation. Apollo says it has also stopped linking recruitment compensation to enrollments.

Other issues have dogged Apollo recently. The Department of Education plans to review the University of Phoenix’s handling of federal student financial aid for 2009 and 2010. And the Securities and Exchange Commission has requested information about insider trades during a prior Department of Education review of the University of Phoenix in 2009.

Meanwhile, Apollo is among five companies that Florida’s attorney general is investigating for "possible unfair and deceptive trade practices."

Corinthian Colleges, with more than 110,000 students enrolled in career- and trade-focused programs, said this fall that it will stop taking on so-called ability to benefit, or ATB, students.

These students do not have high-school diplomas or graduate equivalency diplomas, but take a test showing they have the ability to benefit from college. The move could have a significant impact on Corinthian’s rolls: ATB students account for about 15% of enrollment.

The Santa Ana, Calif., company has also spent $10 million on default management programs that keep tabs on students after graduation, and it hired 200 additional guidance counselors.
Aside from gainful employment, Corinthian has issues with the government’s so-called 90-10 rule. The rule prohibits for-profits from obtaining more than 90% of their revenue from government-supported Title IV loans.

Corinthian says that Title IV loans increased 40% from 2006 to 2010. The government granted colleges flexibility on the 90-10 rule, which expires in July. As the relief comes to an end, the company says 42 of its 49 campuses are in danger of violating the limits. The company has said it may raise prices as much as 20% at some of its schools to ensure that Title IV revenue does not exceed 90%.

"We hope and will enter into dialogue with the new Congress in the new year, and we are hoping that we can find a vehicle for them to understand the impact on students of the execution and meaning of the 90-10 rule," Corinthian CEO Peter Waller said during a November earnings call.

Education Management is unique among the large publicly traded proprietary schools in that enrollment grew in its most recent quarter. The Pittsburgh company, which operates The Art Institutes, Argosy University and other schools, surpassed 150,000 students for the first time.
Providence Equity Partners LLC, Goldman Sachs Capital Partners and Leeds Equity Partners LLC acquired Education Management for $3.4 billion in 2006. The firms took the company public in October but maintain a stake.

Providence managing director Paul Salem urged the Department of Education to rethink the pending rulemaking in a letter this September.

"The proposed gainful-employment regulations threaten the viability of the proprietary education sector, putting at risk the educational futures of millions of students," Salem wrote.
Providence has invested more than $2 billion in the U.S. education sector, the letter states.

Since the Department of Education announced its new rules, the firm has deployed $800 million overseas. "Rather than investing this capital in the U.S.," Salem wrote, "we have invested in countries with more certain regulatory environments."

It’s a bold argument from an industry that relies on government aid and guarantees to help it earn the bulk of its revenue.

The Washington Post’s Kaplan accounts for more than 60% of the top line and an even larger share of the operating profits. The education unit has been the profitable ballast that kept the "morning miracle," a newsroom euphemism for the flagship newspaper, from toppling.

Like other educators, Kaplan has introduced a program called "the Kaplan Commitment" that allows students to try classes for a number of weeks without paying. Moody’s Investors Service Inc. expects Kaplan’s Ebitda to fall by 25% to 35% in 2011.

On Capitol Hill, the Senate Health, Education, Labor & Pensions Committee has been a font of criticism. Harkin, the panel’s chairman, held hearings during 2010 and is collecting data from 30 companies in preparation for more hearings and possible legislation.

Another critic, Sen. Dick Durbin, has joked about the industry’s lobbying clout. "The best way I can find to meet former members of Congress whom I have served with over those 20 years is to take on this issue because they have all signed up as lobbyists for these for-profit colleges," the Illinois Democrat said at a hearing. "They’re calling me and saying, ‘Durbin, guess who I’m working for?’ "

Harkin’s committee released a report entitled "Debt Without a Diploma" in September. The report cites a litany of data at 16 proprietary schools, where 57% of students who entered between July 2008 and June 2009 have withdrawn. At 14 for-profit schools, federal dollars accounted for between 85% and 93% of revenue.

About 95% of students at two-year for-profit schools and 93% at four-year for-profit schools took out student loans, more than double the rates at four-year public schools and more than 5 times the rate at community colleges. Meanwhile, one unnamed school added 120,000 new students in a year, but had a net gain in enrollment of only 18,000, reflecting a high level of student churn.

The industry’s response? Its higher levels of debt and defaults are due to the fact that its students often have less economic means and educational background. "Of course we have a higher percentage of students with loans, because we have a higher percentage of the lower-income population," says Harris Miller, president of the Association of Private Sector Colleges and Universities.

Apollo Group said in a recent report that proprietary schools cost taxpayers less per year than public and independent institutions because "they do not receive direct state subsidies and do not benefit from tax-free endowment contributions."

Students at public two- and four-year schools cost taxpayers $11,340 per year, Apollo estimates, because of direct government support, federally subsidized loans and other payments.

Private two- and four-year schools cost $7,000. Proprietary schools generally cost $4,500 a year when factoring in taxes on corporate profits, netting out repayments on student loans and other line items.

Rep. John Kline, R-Minn., who is expected to be the new chairman of the U.S. House Education and Labor Committee, is highly skeptical of expanding regulation on the sector. A letter to the Education Department from Kline and 14 other representatives called the gainful-employment proposal "a convoluted and untested new regulatory scheme" that "would harm individual students and the institutions that serve them." The representatives criticized the department’s plan to collect student income data from the Social Security Administration, treat tuition deferment plans as defaults and other matters.

Sen. John McCain, R-Ariz., a member of the Senate Help committee, also criticizes gainful employment. "On one of the most rare occasions in my long political career, I find myself in complete agreement with Davis," he joked at a September hearing.

The senator said that for-profits were being penalized too harshly and thinks that should change. "And, hopefully, maybe in January if it seems pretty clear, maybe we will have a different agenda for this committee and the United States Senate," McCain said. He reportedly walked out of the hearing.

Harkin may still propose legislation, but it will be difficult to pass anything ambitious.
"The big upside for the industry is that the election definitely takes the wind out of the sails of Harkin, Durbin and others," asserts Quinn Gillespie’s Lampkin.

"Harkin and Durbin in particular want to go further than the gainful-employment regulations. They want to look at things like marketing fees. This all but stops that," Lampkin says.

FrontPoint Partners’ Steve Eisman, the short-selling protagonist of Michael Lewis’ "The Big Short," has short positions on various companies in the for-profit universe, and has been one of the most influential voices in the debate. In speeches and testimony to Congress, he has popularized the comparison of for-profit, post-secondary education and the subprime mortgage market. Eisman said at a May conference that "easy access to government-sponsored debt in the form of Title IV student loans, where the credit is guaranteed by the government," has supported the industry’s growth.

"Thus the government, the students and the taxpayer bear all the risk, and the for-profit industry reaps all the rewards," Eisman said. "This is similar to the subprime mortgage sector, in that the subprime originators bore far less risk than the investors in their mortgage paper." Further, the fund manager said, the industry maximizes Title IV funds by placing students with great financial need in high-cost institutions.

Saunders of the National Consumer Law Center says the subprime analogy is appropriate. "We think there has been a serious problem of predatory lending, of student loans being made to people who have no reasonable prospects of paying them off," she says.

"The difference is that predatory lending can pay off even more in the student loan arena because you get the federal grants and guarantees even if the loan ends up not being repaid."

The industry says the comparison to the subprime mortgage industry is false and reflects either elitist misconception or an investment position. "Nonsense is the way I describe it," says the Association of Private Sector Colleges and Universities’ Miller. "The disclosures required by our institutions are massive, in terms of what you have to tell the students." Miller acknowledges that some abuses, as cited by the Government Accountability Office, occurred, but says the industry is policing itself.

"The idea generally that these are students who are bamboozled into these choices is not correct and is very insulting to the 3.2 million students who have chosen this direction," he says.

Similarly, Davis argues that the subprime analogy is inapt. "The only argument that Mr. Eisman makes is that they depend upon federal guaranteed student loans for revenues. There is absolutely no comparison," he says. "Mr. Eisman would have more credibility if he hadn’t sold short before he started his campaign."

In Washington, the incoming members of Congress have received their ID cards and completed the week of orientation.

Leadership positions and committee membership are still being decided. As charged as the issue has been, there are other issues like healthcare and the Federal Reserve’s quantitative-easing program that command attention. It is difficult to tell the direction that the regulatory fight over for-profits will take in Congress and possibly in the courts. "People should realize things are going to be different now," says one staffer. "The party that supports the industry is going to be in control; you’re going to see legislation to help private business in general."

At least for now, the Department of Education will see its possibilities limited by the GOP’s victory in the House, and that may leave the short sellers disappointed.

"You could have argued that the gainful-employment rules were the floor," says Lampkin. "Now they are probably the ceiling."

THE DEAL