Background and History of the So-Called Incentive Compensation Provision of the Higher Education Act

January 21, 2010

In this communication, we discuss the background and history of the so-called "incentive compensation" provision of the Higher Education Act ("HEA"), which is at the core of many of the False Claims Act lawsuits that have been filed against educational institutions.  The incentive compensation provision prohibits schools from paying student recruiters and employees involved in financial aid "any commission, bonus, or other incentive payment based directly or indirectly on success in securing enrollments or financial aid."  Because the incentive compensation provision is at the core of so many of these lawsuits – and because the Department of Education is in the process of yet again considering new regulations relating to the provision – a thorough understanding of the provision and its history is critical. 

Unfortunately, we fear that the Department of Education has either forgotten or chosen to ignore the history and background of this provision.

The Situation in 1992, Which Led Congress to Enact the Incentive Compensation Provision, Was Dramatically Different from the Situation Today

The incentive compensation provision was enacted in 1992 as part of the Higher Education Act’s periodic re-authorization.  At that time, Congress was concerned that "rogue trade schools" were engaging in a series of unethical practices leading to the admission of unqualified students just to obtain federal financial aid.  In fact, by 1992, the average cohort default rate for students at all schools – not just for-profit schools – was an astonishing 22.4 percent.  (The cohort default rates for most, if not all, of the reputable for-profit schools were well below that level.)  Congress heard testimony that these "rogue trade schools" were enrolling students without high school diplomas through bogus "ability to benefit" tests, were keeping the financial aid provided to students who had dropped out of or never attended the schools, and were paying some employees a "by the head" commission for each student enrolled.  According to Congress, this led to the enrollment of many unqualified students, who were unable to repay their loans – leaving the government holding the bag. 

As a result, Congress and the Department of Education took a number of actions to address and attempt to remedy this very bad situation.  They tightened the restrictions relating to admissions based on "ability to benefit" tests, and enhanced the rules requiring schools to return Title IV funding for students who had dropped out or never attended the school.  In addition, they put in place rules authorizing the Department of Education to terminate a school’s eligibility to participate in Title IV programs if it had an unacceptable default rate.  And finally, Congress enacted the "incentive compensation" provision, 20 U.S.C. § 1094(a)(20).

These actions by Congress and the Department worked, and largely solved the significant problems they were designed to address.  In fact, in the 10 years following the 1992 amendments to the Higher Education Act, more than 1100 schools were closed for having excessive default rates.  See U.S. Department of Education, Accountability for Results Works:  College Loan Default Rates Continue to Decline (Sept. 19, 2001).  Moreover, by 2001, the average cohort default rate for all schools had dropped from over 22 percent to below 10 percent.  Id. 

The Plain Language and Intent of the Incentive Compensation Provision

On its face, the incentive compensation provision limits only three discrete forms of compensation – commissions, bonuses, or other incentive payments (i.e., in the nature of a commission or bonus).  The statute is silent with regard to the payment of merit-based salaries.  Based on well-established rules of statutory construction, the statute should not be interpreted to prohibit schools from paying merit-based salaries to their employees involved in recruiting and financial aid.  If Congress had intended to include and prohibit merit-based salaries – the most common form of compensation – it could have and would have included that form of compensation in the statute.  It did not. 

Moreover, in enacting the provision, Congress clarified that this provision was not intended to prohibit schools from employing student recruiters, from paying those student recruiters a salary, and even from adjusting that salary based in part upon their success in enrolling students.  Rather, as the legislative history made clear: 

The conferees wish to clarify, however, that use of the term "indirectly" does not imply that schools cannot base salaries on merit.  It does imply that such compensation cannot solely be a function of the number of students recruited, admitted, enrolled, or awarded financial aid.

H.R. Rep. No. 102-630, pt. G, at 499 (1992) (Conf. Rep.), as reprinted in 1992 U.S.C.C.A.N. 334 (emphasis added). 

The Ninth Circuit, the same court that decided the Hendow case (permitting an incentive compensation qui tam case to survive a motion to dismiss), is also the only appellate court to date to have addressed and interpreted the meaning of the HEA provision.  In a 2008 decision involving U.S. Education, the Ninth Circuit affirmed the dismissal of an incentive compensation qui tam action, holding that the statute does not prohibit "salary reviews generally" or the termination of recruiters who do not meet enrollment quotas.  United States ex rel. Bott v. Silicon Valley Colleges, No. 06-15423, 262 Fed. Appx. 810, 2008 WL 59364, at *1 (9th Cir. Jan. 4, 2008).  The court stated that the HEA provision only prohibits the payment of a "’commission, bonus or other incentive payment’ solely on the basis of recruitment success."  Id. (emphasis added). 

A Period of Great Confusion:  The Department of Education’s Informal Guidance and the CLC Debacle

Notwithstanding its plain language and the clear statement of Congressional intent, the incentive compensation provision caused a fair amount of confusion in the industry over what was permitted and what was prohibited.  For instance, what did it mean to base compensation "indirectly on success in securing enrollments?"  Was a salary paid to recruiters based in part upon enrollment success permissible?  If so, how often could it be adjusted?  Could the adjustment be up and down?  How large could the salary adjustment be?  Could a school provide non-monetary rewards to high performing recruiters?  Does the provision apply to supervisors and management level employees? 

These questions and many others persisted.  During this time (i.e., 1993 through 2001), the Department of Education was willing to entertain questions from schools and would respond to the questions in writing.  Unfortunately, the Department’s guidance was all over the map, and often contradictory.  For instance, while most (but not all) of the Department’s informal letters seemed to permit the payment of merit-based salaries, the guidance varied substantially with regard to the extent to which non-enrollment factors would have to be considered in order for the merit-based salaries to be proper under the statute (i.e., the school must consider "other substantive criteria," "factors other than those relating directly to recruiting," "other substantial performance factors that are not related to . . . enrolling," "not based solely on the number of students . . . enrolled").

In addition, the Department would sometimes inform schools that salaries paid to recruiters were permissible provided they were only adjusted once a year; at other times the Department would state that adjustments twice a year were acceptable.  Similarly, the Department would sometimes inform schools that salaries paid to recruiters were permissible provided they were only adjusted upward; at other times the Department would make no distinction between whether the salaries could be adjusted upward or downward.  Indeed, while the 1992 incentive compensation provision clearly prohibited commissions, another regulation of the Department that remained in effect until 2000 encouraged schools "with a high default rate" to implement a "compensation structure" under which recruiters could earn "progressively greater commissions for students who remain in school for substantial periods."  34 C.F.R. pt. 668, Appendix D (emphasis added).   

As a result, schools were unsure of what was prohibited by the incentive compensation provision.  Indeed, even the Department itself later recognized that its guidance "proved to be problematic and resulted in unclear guidance" to schools.  Fortunately, between 1992 and the end of the decade, this issue was not the subject of any significant administrative actions by the Department or lawsuits by qui tam relators and, as a result, the lack of clarity, while frustrating, did not result in schools facing potential liability for alleged violations of the incentive compensation provision. 

This changed in a dramatic manner in 2000 when the Department of Education, prompted by a qui tam action, issued a Final Program Review Determination to Computer Learning Centers ("CLC") finding that it had violated the incentive compensation provision and requiring that it return over $180 million in Title IV financial aid that CLC’s students had received.  The Department determined that the salaries that CLC paid to its student recruiters did not consider "other substantial performance factors that are not related to . . . enrolling."  CLC was forced to file bankruptcy.  This left thousands of employees and students in the lurch and the government holding the bag for CLC’s students’ debts (which were discharged as a result of the bankruptcy).  It also caught the attention of Congress.  This action by the Department, in addition to a significant increase in the number of qui tam lawsuits that were being brought under the False Claims Act alleging violations of the incentive compensation provision by schools, left the industry extremely nervous about what was and was not permitted by the incentive compensation provision.  Clearly, something needed to be done to address this situation.

The Safe-Harbor Regulations and the Deputy Secretary Memorandum

To its credit, the Department acted promptly and aggressively to address the problem.  Among other things, it initiated a series of negotiated rulemaking sessions to attempt to clarify the incentive compensation provision.  As a result of these sessions, which involved input by members of the industry, members of the non-profit educational sector, and a variety of other stakeholders, the Department issued a series of "safe harbor" regulations in 2002. 

These regulations clarified what conduct was and was not prohibited by the incentive compensation provision, and identified areas of conduct that the Department had determined did not run afoul of the provision and thus would fall within "safe harbors."  There were 12 such "safe harbors" identified, including – perhaps most importantly – one clarifying what type of salary could be paid to student recruiters.  Specifically, this safe harbor clarified in the form of a binding government regulation that an academic institution does not violate the incentive compensation by paying:

fixed compensation, such as a fixed annual salary or a fixed hourly wage, as long as that compensation is not adjusted up or down more than twice during any twelve month period, and any adjustment is not based solely on the number of students recruited, admitted, enrolled or awarded financial aid. 

34 C.F.R. § 668.14(b)(22)(ii)(A) (emphasis added). 

In adopting this regulation, the Department stated that the word "solely" is being used in its "dictionary definition" – which is commonly found to be "alone," "singly," or "exclusively."  In other words, through this regulation, the Department recognized that a school could employ recruiters, pay those recruiters a salary, and even adjust recruiters’ salaries based in part upon enrollment success, provided enrollment success was not the "sole" or only factor considered in determining the adjustment that the recruiter would receive.  Indeed, in the commentary accompanying the safe harbor regulations, the Department recognized that "a recruiter’s job is to recruit."

The safe harbor regulations provided much needed clarity to the industry, and gave schools confidence that certain practices would not be deemed by the Department as violative of the law.  Moreover, the safe harbor regulations provided a number of significant defenses against the ever increasing number of qui tam actions that were being filed against schools.  Specifically, schools were able to argue and demonstrate – often at the pleading stage on motions to dismiss – that the conduct alleged by the relators (for example, paying recruiters a salary based in part upon recruitment success) fell squarely within the safe harbor regulations and therefore was not conduct violating the HEA. 

Just last month, in a case involving Corinthian Colleges, the court dismissed a qui tam lawsuit, with prejudice, on this basis.  United States ex rel. Lee v Corinthian Colleges, No. CV 07-1984 PSG (MANx), 2009 U.S. Dist. LEXIS 120462 (C.D. Cal. Dec. 4, 2009).  In that case, the relators alleged that the school "awarded raises to recruiters if they exceed their recruiting quotas" and "terminates recruiters who fail to satisfy their quotas."  Relators did not (and could not) allege that the raises were based solely on enrollments.  The court found that giving raises to recruiters who exceed their quotas "falls within the safe harbor" and that the termination of recruiters "is not covered by the HEA prohibition on incentive payments."  This sort of defense would, of course, be much more difficult to make if the Department eliminates the safe harbor regulations (as has been suggested).

In addition to enacting safe harbor regulations, the Department also acted internally, by issuing a memorandum clarifying the Department’s enforcement policy for violations of the incentive compensation provision.  Importantly, in this memorandum from the Deputy Secretary, the Department clarified that "the preferable approach is to view a violation of the incentive compensation prohibition as not resulting in monetary loss to the Department" and that "[i]mproper recruiting does not render a recruited student ineligible to receive student aid funds for attendance at the institution on whose behalf the recruiting is conducted."  (Emphases added).  This is in stark contrast to the much more aggressive position that the Department took in the CLC FPRD – requiring the return of all Title IV funds that had been provided to students who attended CLC.

Challenges to Safe Harbor Regulations

As you know, the safe harbor regulations are under attack – by both relators’ counsel and the Department of Education.  While the attacks by relators’ counsel are predictable (and will have to be dealt with in the context of the cases in which they are made), in light of court decisions like those in Bott and Lee, we do not believe that they are all that serious.  We are confident that courts will uphold and rely upon the safe harbor regulations enacted by the Department of Education (at least for as long as they are in effect). 

The same cannot be said about the attack by the Department of Education.  It is very serious and troubling.  In its recent Issue Paper # 4, the Department advocates eliminating the safe harbors because it "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."  The Department’s statement is wrong on so many levels; moreover, it simply ignores the long history and well-established background of the HEA provision set forth in this communication. 

As the Department has acknowledged on any number of occasions, the language of the statute is not at all clear, as evidenced by the Department’s own informal guidance and safe harbor regulations.  Indeed, the Department did "effectuate congressional intent" in the 2002 safe harbor regulations when it made clear that merit-based salaries were proper provided they were not adjusted based solely on enrollments.  The Department’s recent reversal is so inconsistent with its prior statements and – thus far at least – unsupported by any factual, legal or policy basis as to call into question the Department’s motives in re-visiting regulations that it adopted only a few years ago and that brought much needed clarity and predictability in this area. 

Undoubtedly, relators and their counsel would welcome the change proposed by the Department.  Elimination of the safe harbor regulations would let relators argue that any compensation, of any kind, is improper as long as it is based directly or indirectly on enrollments.  It could open the door for an argument that some relators have made that the word "indirectly" in the statute means that any salary which provides any incentive for a recruiter to recruit (i.e., to do one’s job) is illegal.  It would also eliminate several significant defenses that are now available to schools to defend against these actions and to get them dismissed before having to engage in expensive discovery and trial. 

The Department would be wise to back off from the position set forth in Issue Paper # 4 and to preserve the safe harbors, at least in substance.  If it does not do so, however, we believe that the Department’s action – at least based on the current administrative record – is so arbitrary and wrong that the industry should seriously consider a legal challenge to the new regulations under the Administrative Procedure Act ("APA"), which allows challenges to federal regulations in a federal court if the issuance of the regulation is "arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law." 

In ruling on such a challenge under the APA, the court will defer to the Department’s legal interpretation if that interpretation gives effect to the unambiguously expressed intention of Congress.  If the court determines the statute is ambiguous, it will defer to the Department’s legal interpretation if it reflects a permissible construction of the statute.  Further, the Department can depart from its own precedent so long as it provides a reasoned analysis for any change in its interpretation, as well as a reasoned explanation for its departure from precedent.  

In this case, we believe that the Department’s position as set forth in Issue Paper #4 is inconsistent with the clear intent of Congress; does not reflect a permissible construction of the statute; and, based on the record that has been developed to date, does not provide a reasoned basis for departing from precedent.  Thus, we believe that a legal challenge to the new regulations under the APA might very well prove successful. 

It is important to note, however, that in mounting such a legal challenge, the industry will be limited to the record before the Department at the time that it issues the new regulations.  Consequently, it is absolutely critical that members of the industry take part in the Department’s rule-making process so that its voice may be heard now and in any challenge that might be mounted later. 

Gibson Dunn will continue to keep a close eye on the status of the safe harbor regulations, especially in the context of qui tam actions, and will keep you apprised of developments.

Gibson, Dunn & Crutcher LLP

Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding the issues discussed above.  Please contact the Gibson Dunn attorney with whom you work, or any of the following:

Los Angeles
Timothy Hatch (213-229-7368, [email protected])  
James Zelenay (213-229-7449, [email protected])

Orange County
Wayne Smith (949-451-4108, [email protected])

Nick Hanna (949-451-4270, [email protected])
Jared Toffer (949-451-4025, [email protected])

Washington, D.C.
Douglas Cox (202-887-3531, [email protected])

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