UV Letters

Dec 8, 2011 BACK

When Governance Fails – From Pies to Penn State

UV Letter - Volume 1, #12

Recent headlines from higher education remind us that many public officials don’t understand how for-profit universities can be trusted to provide a quality education because their sole motivation is to maximize profits.

The fact that we rely on for-profit companies to provide most goods and services is not something typically called into question in this country. For-profit companies have a clear objective, a single bottom line. And the potential for abuse is obvious: scrimp on quality and increase profits.

The example that comes to mind is old, addled Mrs. Lovett and her meat pies (the “worst pies in London”) from the Sondheim musical, Sweeney Todd. Mrs. Lovett’s pie shop is a textbook example of poor corporate governance. As the for-profit objective is not solely to maximize current year profits, but rather to maximize the present value of the stream of profits into the future, Mrs. Lovett’s “popping pussies into pies” may be good for her business today, but it does not make for a happy ending.

Unlike pies, higher education is almost always a one-time purchase; there are few repeat customers. So it is more likely that the purchase decision is made in a context of asymmetric information.

As the potential for abuse is as clear as the single bottom line of for-profit institutions, Congress and the Department of Education have put in place a series of rules (90/10, CDRs, gainful employment) to help directors and officers of for-profit institutions steer clear. And the penalties are clear as well, ultimately leading to suspension or termination from participation in the Title IV programs.

While the rules might be clearer in some instances, the reason for these rules and penalties could not. So it should come as no surprise that in concert with the recent media and Senator Harkin attention focused on for-profit colleges, the federal government – via the Department of Education, and now also through the Department of Justice’s support of the qui tam lawsuit against Education Management Corp. – has ramped up its enforcement activities over the past few years. The rules are in place to lead for-profit governance to better decisions, and by all accounts for-profits are making better decisions now than they were a few years ago.

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No story in higher education has received as much media attention this year as the tragic events at Penn State. The failure of successive layers of University officials to report an assistant football coach who had been witnessed sexually abusing young boys is unfathomable for an institution whose mission it is to develop young people. But it also represents a massive failure of not-for-profit governance, and by evaluating the government’s response to Penn State, there are some lessons to be learned concerning governance and regulation of colleges.

In contrast to for-profit universities, public and not-for-profit institutions do not have a single bottom line. Public and not-for-profit institutions tend to be more complex than comparable for-profits in order to pursue multifaceted missions and serve a diverse (and sometimes dizzying) array of stakeholders.

The Penn State officials who failed to take action against a known predator might have rationalized they were protecting the football program, and that as the football program’s health was integral the institution due to the national attention, prestige and alumni support it attracted, protecting the assistant coach would serve Penn State’s mission better than reporting him.

While it’s easy to see that such logic is tortured and wrong, what about a public or not-for-profit institution that admits and graduates under-qualified student athletes? Or universities that commit to spend half a million dollars of general funds on tickets to a Bowl Game?

The potential pitfalls of not-for-profit governance – optimizing across multiple bottom lines – are numerous. Consequently – and most relevant to this discussion – they are very hard to regulate.

In the case of Penn State, what action has the Department of Education taken? The only one they could take: launching an investigation to determine if the University complied with Department rules on reporting criminal offenses on campus. Such an investigation is highly unlikely to lead to the same severe penalties that for-profits contend with in similar circumstances of severe governance failure (in the aforementioned EDMC case, the government is seeking up to $33 billion in penalties). Not that it’s the Department’s fault; the criminal reporting rule is the only relevant tool in its regulatory toolbox.

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Governance failure in the for-profit context is predictable and fairly easily regulated, while similar governance failures at not-for-profit and public universities are not. As a result, Secretary Duncan and others would do well to focus more attention on identifying patterns of governance failure in the not- for-profit context.

Not coincidentally, an eerily similar case has come to light at Syracuse University involving sexual abuse by a coach in the other big time money college sport: basketball. We view college football and basketball as the not-for-profit equivalent of incentive compensation: lucrative and likely to result in poor decision making and governance (increasingly now that universities are launching their own cable networks).

Knowing this, the Department of Education ought to be able to develop and implement a set of rules that will assist traditional universities with their governance of college football and basketball. One idea is to keep decision making for these functions completely separate from the academic institution. Football and basketball programs could be run as for-profit companies (and provide fair compensation to players) with independent governance. Their sole shareholder would require only that they contribute a defined amount to the University’s budget each year. And the programs would be highly regulated – just like for-profit universities – to ensure that profit maximization cannot occur at the expense of student athlete welfare.

The irony is that Penn State, like a few other big football and basketball schools, was headed in this direction. Penn State already described its athletic programs as “an auxiliary enterprise” that is “self- supporting.” And you can bet the University’s new president will establish some formal separation going forward.

We hope the Department of Education doesn’t let this crisis pass without significant action: It should borrow a page from its regulation of for-profit universities and establish a new regulatory regime for for- profit college football and basketball programs.

University Ventures (UV) is the only investment firm focused exclusively on the global higher education sector. UV pursues a differentiated strategy centered on partnering with (rather than competing against) traditional institutions. As the future of higher education will be shaped by innovative partnerships between the private sector and traditional institutions, UV is excited to help lead the development of the next generation of colleges and universities on a global scale.

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