Public Comment: New Rule on Colleges’ Conversions to Nonprofit Status Leaves the Door Open for Abuse

On August 26, Robert Shireman, director of higher education and senior fellow at The Century Foundation, and Carolyn Fast, senior fellow at The Century Foundation, submitted the following public comment to the U.S. Department of Education in response to their notice of proposed rulemaking (NPRM), “Public Comments on Notice of Proposed Rulemaking issued July 28, 2022, Docket ID ED-2022-OPE-0062,” related to changes in ownership and control of higher education institutions. In their letter, they comment on three aspects of the NPRM: the provisions regarding nonprofit conversions, other change-of-ownership provisions, and oversight of nonprofit institutions.

August 26, 2022

Nasser Paydar, Ph.D.
Assistant Secretary for Postsecondary Education
United States Department of Education
400 Maryland Avenue, SW
Room 2C179
Washington, DC 20202

Re: Public Comments on Notice of Proposed Rulemaking issued July 28, 2022, Docket ID ED-2022-OPE-0062

Dear Dr. Paydar:

Thank you for the opportunity to provide comments on the Notice of Proposed Rulemaking (NPRM) issued on July 28, 2022 (Docket ID ED-2022-OPE-0062) related to changes in ownership and control of higher education institutions. The Century Foundation is a progressive, independent think tank that conducts research and drives policy change in higher education and other areas. Our higher education work has lifted the curtain on “covert for-profits”—for-profit colleges that convert to nonprofit status while maintaining financial arrangements that benefit former owners or their affiliates. We provide comments below on three aspects of the NPRM: the provisions regarding nonprofit conversions, other change-of-
ownership provisions, and oversight of nonprofit institutions.

Nonprofit Conversions

The proposed rule addresses the troubling trend of for-profit institutions purporting to convert to nonprofit control in order to reap the regulatory and reputational benefits of nonprofit status, while maintaining financial arrangements that benefit the institution’s former owners or their affiliates. These “insider”¹ arrangements create substantial risks that the institution’s revenues may be improperly channeled away from the institution’s education mission and instead to the former owner’s bank account. They also mislead students and the public, who believe in the consumer protection benefits of legitimate nonprofit control. A 2020 report from the U.S. Government Accountability Office (GAO) found that in as many as one-third of the nearly sixty for-profit to nonprofit conversions examined in the period of 2010 to 2020, former owners or their affiliates were insiders to the conversion transaction, and many continued to play a financial role in the newly established nonprofit.²

We commend the Department for recognizing the serious risks of insider arrangements following for-profit to nonprofit conversions and for taking action to address these risks via this rulemaking. However, the proposed rule includes provisions that could completely undermine the Department’s appropriate oversight of nonprofit institutions. To adequately protect against abuses, the Department must revise the rule to eliminate dangerous loopholes.

The proposed rule seeks to address a serious problem.

The proposed rule addresses the risks of insider abuses of converted nonprofits through revisions to the definition of a nonprofit.³ The proposed rule defines a nonprofit institution as a public or private institution “as to which the Secretary determines that no part of the net earnings of the institution benefits any private entity or natural person” and that meets the further requirements of the proposed rule related to arrangements between the institution and a former owner or other insider. The definition provides that when making a determination of whether an institution is a nonprofit, the Secretary will consider “the entirety of the relationship” between the institution and other parties. This framing recognizes that determinations of nonprofit control may be complex and require a fact-specific analysis of the institution’s relationships with other entities.

Valid conversion transactions involve an independent nonprofit institution purchasing and taking over the for-profit institution without any ongoing financial arrangements with the former owners, directly or indirectly. This type of clean, uncomplicated arrangement is most likely to reflect a fair price reflecting a nonprofit mission, and least likely to be corrupted by insider interests. The proposed definition of a nonprofit provides examples of arrangements between the converted institution and insiders that would, in general, disqualify an institution from recognition as a nonprofit.

First, the proposed rule sensibly prohibits converted nonprofits from entering into arrangements in which the institution owes a debt to an insider. This provision would help protect against overvaluation of the institution by insiders at the point of sale. Owner-financed conversions are highly vulnerable to insider manipulation. In many cases, the transaction involves the sale of intangible assets, such as the reputation of the school or the financial value of being accredited, which are “inherently difficult to value,” making them highly vulnerable to abuse.⁴

Numerous nonprofit conversion deals claim to be based on independent assessments of fair value or “market price,” but subsequently appear to be based on inflated valuations. For example, Keiser University’s intangible assets were initially valued at more than $535 million when it was converted, but the school later reduced its intangible asset valuation by $250 million.⁵ The GAO report describes an unnamed college that similarly recognized a substantial loss on intangible assets acquired in a conversion, noting that “while such a loss may arise for unforeseen reasons (i.e., shifting market conditions), it could also indicate that the college and its assets were knowingly overvalued at the time of the sale to improperly benefit insiders.”⁶

In another example, when Herzing University converted from for-profit to nonprofit, the conversion was originally slated to be owner financed at $86 million. When bank financing was subsequently arranged instead, a year later, the former owner was paid less than half the original amount.⁷ These examples demonstrate the high risks of abuse related to owner-financed conversions and support the need for the proposed rule’s general prohibition on converted institutions’ obligor relationships with insiders.

Second, the proposed rule appropriately prohibits converted nonprofits from entering into revenue-sharing arrangements with former owners. In some conversions, the former owner avoids any possible controversy over asset valuation by “selling” the institution to a nonprofit for a de minimis sum, such as $1, while maintaining a profitable hold on the institution by entering into a long-term revenue-sharing agreement with the converted nonprofit. Revenue-sharing arrangements with insiders are particularly high-risk arrangements because they create an incentive for the insider to work to maximize profits at the expense of the nonprofits’ educational mission.⁸ For example, a revenue-sharing agreement with an insider could incentivize the insider to influence the institution to increase recruitment and marketing and decrease instructional spending to boost the insiders’ profits.

Third, the proposed rule prohibits former owners from entering into other, non-revenue-based contractual arrangements with converted nonprofits. This prohibition would protect against high-risk arrangements, such as where a former owner acts as a landlord to the converted nonprofit.

The proposed rule includes dangerous and unnecessary carve-outs, inviting abuse.

The proposed rule appropriately establishes a general prohibition against debt or other contractor relationships with former owners after the conversion of an institution from for-profit to nonprofit. Given the demonstrated hazards of such arrangements in the nonprofit context, the prohibition is justified and could even be declared in more absolute terms instead of using the “general” qualifier and listing the dangerous practices as examples. The proposed rule, however, goes in the opposite direction, describing exceptions to the prohibitions on revenue sharing and other arrangements that are so vague that they are tantamount to a road map for corrupted transactions. These carve-outs permitting revenue sharing and other contractual arrangements with “affiliates” of former owners should be deleted.

The proposed rule provides that the listed arrangements are “generally” incompatible with nonprofit status. The “generally” language ensures that the Department can allow for limited exceptional cases, where there are no hazards of any ongoing profiteering. For example, the Department might find that an agreement with an insider is compatible with nonprofit status if the arrangement is for a short duration during a transitional period following a conversion. However, the Department should not include any list of allowable exceptions, because doing so is tantamount to establishing a roadmap for future abuses. Pegging an exception to an “affiliated or related” entity simply creates an incentive for former owners to establish affiliates to attempt to fit the exception. Naming “revenue sharing” as allowable under any circumstances simply invites owners to seek a revenue-sharing approach, which is generally inimical to the very idea of nonprofit status.

Finally, the use of a “market price” measure is particularly insidious and inappropriate, inviting abuse, especially if any arrangement is long term or revenue based. The proposed rule asks the Secretary to determine that the payments and terms of the agreement are “comparable to payments in an arm’s length transaction at fair market value.” The phrasing itself begs the question: If the price is comparable, why is the former owner involved? The problem is that “market price” is a vague concept except in the case of a commodity, which education is not. Former owners will overwhelm the Department with paid experts to bolster their claims that they fit the regulatory requirement.

To address these risks, the Department should revise the proposed rule to broadly prohibit revenue sharing and other arrangements with all categories of insiders and eliminate the carve-out for arrangements “based on the market price.” Eliminating the loophole would protect against corruption of nonprofit institutions and would remove the heavy burden from the Department of conducting, and defending, myriad valuation analyses. The proposed regulation’s “generally” language allows for the rare, safe exceptions.

If the Department does make any reference to a “market price” in the regulation, the rule should clarify that the appropriate reference point is a “nonprofit market price.” Nonprofit experts point out that for-profit valuations are “not directly relevant” in the context of nonprofit entities. “Private-market valuations . . . reflect the value of the assets if they were deployed in the for-profit sector, where they can be expected to provide different kinds of services or to different beneficiaries.”⁹ They suggest that “Bids from nonprofit suitors provide at least some information about the firm’s value in that sector.”¹⁰

In addition, the Department should clarify that the rule’s prohibitions on insider arrangements extend to the successors of the former owner and affiliated entities. Otherwise, insiders could easily evade the rule’s prohibitions.

Changes of Ownership and Control

Conversions from for-profit to nonprofit control are not the only changes in ownership that raise risks for students and taxpayers. The proposed rule includes several provisions that address changes in ownership and control outside of the context of nonprofit conversions.

The proposed rule includes provisions that would improve oversight of changes in ownership and control.

The proposed rule includes important clarifications of the Department’s existing oversight authority over changes in ownership and control. The proposed rule makes explicit the Department’s authority to impose conditions on an institution that is subject to a temporary provisional program participation agreement while a change in control is under review by the Department.¹¹ This is an important clarification that will enable the Department to effectively safeguard Title IV funds by imposing such conditions as may be warranted by an institution’s specific circumstances.

Similarly, the proposed rule would make it clear that the Department may revoke Title IV eligibility for institutions undergoing a change in control where the Department determines that the institution no longer meets the requirements of Title IV eligibility.¹² Revocation authority is critical to the Department’s ability to protect the integrity of the Title IV program and prevent waste and abuse of Title IV funds.

In addition, the proposed rule would strengthen oversight of institutions that are undergoing changes in ownership by lowering the threshold for required reporting of a change in ownership from when an entity acquires a 25 percent ownership interest to when a person or entity acquires a 5 percent ownership interest where the change does not result in a change of control.¹³ This change will ensure that the Department has information it needs to evaluate whether a change in ownership presents risks to students and taxpayers from potential disruption or abuse.

The proposed rule would weaken oversight of changes in control by decreasing the range of changes that are subject to Department review.

While the proposed rule is aimed at strengthening oversight of changes in ownership and control, one provision would weaken, rather than strengthen, oversight by limiting the range of transactions that are subject to Department review. Under the current regulations, limited liability companies and similar types of legal entities experience a “change in control” that is subject to Department review when a person acquires control of at least 25 percent of voting stock and control of the corporation. The proposed rule would increase the threshold for a change of control so that a person would have to acquire control of at least 50 percent of voting interests to trigger Department review.¹⁴

This change would decrease the number of transactions subject to review and raise the risk that entities could easily evade review by structuring changes to stay just below the 50 percent threshold. As the Department has acknowledged,¹⁵ changes in ownership and control below 50 percent may also raise significant risks for Title IV institutions. The Department should reconsider the proposal to increase the threshold for review to 50 percent, and instead keep the existing 25 percent threshold.

The Department should provide greater protections where a new owner is unable to demonstrate financial responsibility.

The proposed rule would impose financial protections on institutions undergoing changes in ownership where the new owner is unable to establish financial responsibility because the new owner lacks required appropriate financial statements.¹⁶ However, the financial protections are insufficient to address the significant risks posed by a new owner who may lack financial capacity. The proposed rule provides that where a new owner lacks two years of audited financial statements, the institution would have to provide a letter of credit of at least 10 percent of the prior year’s Title IV funds.¹⁷ While the Department retains discretion to impose a letter of credit for more than this minimum, the Department has historically been hesitant to impose more than the minimum requirements on financially troubled institutions. Accordingly, it is important that the minimum requirements in the rule are sufficient to protect Title IV funds. A 10 percent letter of credit provides paltry protection against a potential collapse and the resulting costs to taxpayers. A better approach would be to increase the minimum requirement to 25 percent or 50 percent.

Similarly, the proposed rule provides inadequate protections where a new owner does not have any acceptable financial statements to demonstrate financial responsibility. In such situations, the proposed rule requires a letter of credit of at least 25 percent of the prior year’s volume of Title IV. However, a new owner with virtually no evidence of financial responsibility constitutes a serious risk to students and taxpayers. Accordingly, the minimum letter of credit requirement for such institutions should be at least 50 percent of the prior year’s Title IV aid.

Nonprofit Oversight

While conversions to nonprofit status pose particular hazards, inappropriate private benefit can emerge at any nonprofit institution. We agree with the Department’s view that institutions should expect that their adherence to appropriate nonprofit operations is subject to review by the Department at conversion, recertification, and whenever relevant information emerges, just as would be true regarding misrepresentations or other violations.

We support the Department’s inclusion of “excess benefit transactions” among the list of behaviors that generally are not compatible with nonprofit status. An institution that has engaged in an excess benefit transaction has provided an inappropriate financial gain to an insider, according to the IRS definitions.¹⁸ An institution that reports an excess benefit transaction, therefore, has violated the core requirement of the Department’s nonprofit definition: that no part of net earnings benefits any private party. The severity of such a violation is evidenced by how infrequently any organization declares such a transaction on IRS annual tax filings: of the 343,000 charities large enough to file a tax return last year, only 85 reported an excess benefit transaction. The provision should be retained.

Finally, we are concerned that in the NPRM preamble, the Department said that it would consider an institution to meet the definition of a nonprofit if its agreements had been approved by the Department and “those agreements remain largely unchanged since the latest review.” Frequently, new information reveals problematic agreements some time after the agreements were consummated. The Department should not prohibit itself from taking a second look at previously approved agreements in those cases.

1. For purposes of these comments, the term “insider” refers to a former owner or an entity related to or affiliated with a former owner, or a current or former employee of the institution or member of its board.
2. “IRS and Education Could Better Address Risks Associated with Some For-Profit College Conversions,” U.S. Government Accountability Office, December 2020, at p. 18.
3. See proposed rule at 600.2.
4. “IRS and Education Could Better Address Risks Associated with Some For-Profit College Conversions,” U.S. Government Accountability Office, December 2020, at p. 29.
5. Robert Shireman, “Dubious Conversions of For-Profit Colleges: Decoding the GAO Report,” The Century Foundation, January 27, 2021, https://tcf.org/content/commentary/dubious-conversions-profit-colleges-decoding-gao-report/.
6. “IRS and Education Could Better Address Risks Associated with Some For-Profit College Conversions,” U.S. Government Accountability Office, December 2020, at p. 47.
7. Robert Shireman, “Dubious Conversions of For-Profit Colleges: Decoding the GAO Report,” The Century Foundation, January 27, 2021, https://tcf.org/content/commentary/dubious-conversions-profit-colleges-decoding-gao-report/.
8. The Department has recognized that insider revenue-sharing agreements raise heightened risks of abuse. In 2019, the Department rejected a request for recognition as a nonprofit from Grand Canyon University as a result of a revenue sharing between the purported nonprofit and its for-profit former owner. The Department found that the institution did not meet the requirements of a nonprofit under the Higher Education Act because the “primary purpose” of the revenue sharing agreement was “to drive shareholder value” to the for-profit former owner. The arrangement “violates the most basic tenet of nonprofit status—that the nonprofit be primarily operated for a tax-exempt purpose and not substantially for the benefit of any other person or entity.” See the Department’s letter dated November 6, 2019, https://www.documentcloud.org/documents/6548158-Grand-Canyon-University-Decision-on-CIO-11-06-19-2.html.
9. John H. Goddeeris and Burton A. Weisbrod, “Conversion from nonprofit to for-profit legal status: Why does it happen and should anyone care?” in To Profit or Not To Profit: The Commercial Transformation of the Nonprofit Sector, Burton A. Weisbrod, ed. (New York: Cambridge University Press, 1998), 129–48.
10. Ibid. Theoretically, the authors say, the nonprofit valuation should be “the present value to society of those services that those assets would deliver over the remainder of their life, if they remain under nonprofit control, less any net subsidies the firm would use in delivering those services.”
11. See proposed rule at 600.20(h)(1).
12. See proposed rule at 600.20(g)(2).
13. See proposed rule at 600.21(a)(6).
14. See proposed rule at 600.31(c).
15. See proposed rule at 600.21.
16. See proposed rule at 600.20(g)(iv)(B)(1).
17. See proposed rule at 600.20(g)(iv)(B)(2).
18. See https://www.irs.gov/charities-non-profits/charitable-organizations/intermediate-sanctions-excess-benefit-transactions and https://www.irs.gov/charities-non-profits/charitable-organizations/disqualified-person-intermediate-sanctions.

Tags: covert for-profit, for profit college