School Stocks Brace For New Regulations

(Updated with analyst commentary.)
WASHINGTON (TheStreet) -- The Obama administration's newly proposed regulations, aimed to protect students at for-profit colleges, are adding pressure to for-profit education stocks. And with mid-term elections coming to a close Tuesday, focus on the postsecondary schools will be even sharper.

"These new rules will help ensure that students are getting from schools what they pay for: solid preparation for a good job," Secretary of Education Arne Duncan said.

The new rules cover everything from restricting incentive-based recruiting practices, the need for new job-training courses and taking action against schools which fail to advertise honestly to requiring schools to notify students of graduation and job placement rates.

Institutions will also be required to limit student enrollment to those who have high school diplomas or can readily demonstrate their readiness for university-level education.

The rules will go into effect in the middle of next year, in time for the fall 2011 semester.

"Although the Department added some positive changes to the package, the requirement that online providers comply with the laws of the states in which their students reside is likely to concern current online providers and make it difficult for schools not already providing online education from doing so," said Dennis Cariello, former Deputy General Counsel for Postsecondary Education & Regulatory Services and current Chair of Regulatory Compliance for the Education Group at law firm DLA Piper.

"While more time is needed to assess the impact of this rule, the provision may prevent the proliferation of online programs just as they are gaining wider acceptance."

"This poses a greater problem for new entrants" into the for-profit education sector, Cariello cautioned, such as those looking to build online institutions.

It is also likely to promote consolidation within the sector, he said, because it will be easier for larger sector players to take on the cost of regulatory compliance.

"The full extent remains to be seen."

"The incentive-based compensation rule will take a bit to comply with," Cariello told TheStreet. "Schools are going to have to review their employment contracts to assess whether they are permissible anymore, and if not, how those employees can be compensated."

Schools will also have to revise their contracts with "aggregators," third-party people who assist in outreach and student recruitment efforts. Typically the aggregators get a cut from for-profit schools based on the time students they send over remain enrolled in the program.

"It was clear from the tone of the report that the department has real issues with those types of arrangements," Cariello said.

Another interesting point, Cariello pointed out, and one that will make doing business more difficult for for-profit schools is the department's word on distance learning, including correspondence and online courses. New rules mandate that schools which serve students in other states must comply with the particular requirements of those states, and must be able to document states' approvals upon request.

Today's mid-term congressional elections "could be the tipping point," said Herb Greenberg in an Oct. 28 appearance on CNBC. He said the gainful employment rule is "key," especially whether the rule will be published before Jan. 5 when the newly elected congressional members are sworn in.

If new members are opposed to the Obama administration's proposals, they could slow down the process and make it more difficult to instate the controversial rule, Greenberg explained.

He also said that market watchers shouldn't discount the importance of the rules published last week by the education department.

While many of the new regulations are likely to pressure for-profit education provider's businesses, Greenberg said last Thursday's share price gains are likely related to investors covering their short positions.

Democratic Senator Tom Harkin of Iowa hopes to tighten legislation on for-profit schools even further.

"This first package of regulations from the Department of Education closes the Bush-era loopholes that allowed this industry to expand predatory recruiting practices that mislead students, and is an important first step toward protecting the billions of taxpayer dollars invested in for-profit colleges," he said.

Cariello said that if Republicans take the House of Representatives, which seems more and more likely in his view, he expects a fair amount of oversight to be done and a delay in enacting new regulations, creating leverage for for-profit institutions. If the education department is able to instate the rules prior to Jan. 5, the gainful employment rule will go into effect, and oversight will follow.

For-profit schools traded sharply lower over the summer when the U.S. government proposed regulations that were seen as hurting the industry's booming earnings growth. The Obama administration argued that for-profit schools like Apollo Group ( APOL), Everest colleges parent Corinthian Colleges ( COCO), Strayer Education ( STRA) and a number of their peers saddle their students with debt yet leave them unequipped for the job market and a means with which to repay the hefty loans.

>>School Stocks Fall on Enrollment Outlook

Worries were amplified after data showed nearly two-thirds of for-profit colleges' students were not repaying their loans. Repayment rates at for-profit schools were just 36% in fiscal 2009, according to research from the Institute for College Access and Success, a student-advocacy group. At private nonprofit schools the repayment rate was 56%, and at state colleges and universities the rate was 54%.

The Higher Education Act of 1965 requires that programs in need of federal aid must provide their students "gainful employment in a recognized profession."

The Department of Education report released Thursday said that students at for-profit schools make up 11% of all higher education students, 26% of all student loans and 43% of all loan defaulters. Students at for-profit schools carry, on average, student loan debt of $14,000, while most community college students do not borrow money to pay for their studies. And more than 25% of for-profit schools receive 80% of their revenue from taxpayer financed federal student aid.

Arguably the most controversial of the proposed regulations, known as the "gainful employment" rule, would cut federal aid to schools where less than 45% of students are able to repay their loans.

The gainful employment rule will be issued early next year. It will consist of a two-part measurement to determine a program's eligibility to receive federal student aid. The measurement is based on loan repayment rates and debt-to-income ratios, and requires a minimum of four years of repayment history and three years of employment history.

In an effort to prevent schools from creating new programs to circumvent the proposed regulations, aiming to "game the system," for-profit institutions must notify the education department of any new programs.

Institutions could be asked to formally apply for new program approval if the Department has any concerns but "expects that very few new programs will be subject to this type of approval."

A number of for-profit education providers -- including DeVry ( DV), Capella Education ( CPLA), ITT Educational Services ( ESI), Apollo Group and Corinthian Colleges ( COCO) -- have warned of declining student enrollment in recent weeks, in anticipation of the new, more restrictive regulations.

>>Apollo Outlook Weighs on School Stocks

-- Written by Miriam Marcus Reimer in New York.

>To contact the writer of this article, click here: Miriam Reimer.

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