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American Association of Cosmetology Schools v. Devos

United States District Court, District of Columbia

June 28, 2017

ELISABETH DEVOS, in her official capacity as Secretary of Education, Defendant. Re Document Nos. 8, 18


          RUDOLPH CONTRERAS United States District Judge.


         In this case, the Court considers whether the Department of Education (“DOE”) acted arbitrarily and capriciously with respect to cosmetology schools when it decided to presumptively use earnings data that does not account for unreported income. Although the DOE was justified in using reported income as the presumptive measure of overall income, it arbitrarily and capriciously made rebutting that presumption overly difficult.

         In setting standards that determine which proprietary schools' graduates are entitled to federally backed student loans, the DOE looks to the rates at which the schools' graduates are “gainfully employed.” To determine whether graduates are gainfully employed, the DOE has adopted a test that compares the graduates' income levels to their levels of debt. To determine the graduates' income, the DOE presumptively uses the Social Security Administration's (“SSA”) income data. This data does not account for income that is not reported to the Internal Revenue Service. Schools may appeal the DOE's use of SSA data through “alternate earnings appeals, ” which, if successful, allow them to use alternate measures of income before the debt-to-earnings rates become final. To submit such an appeal, a school is required to use either state-sponsored data pertaining to over half of its graduates during the relevant timeframe or gather income data on almost all of its graduates through a survey. Schools that fail the debt-to-earnings test for a long enough time lose eligibility for federal loans. Schools at immediate risk of losing federal-loan eligibility are required to warn their students and prospective students that they may be ineligible for student loans in the near future.

         During the notice-and-comment period, several commenters argued that use of SSA data would be unfair to, among others, cosmetology programs, because their graduates disproportionately underreport their income due to high levels of cash-based and self-employment-based earnings, including tips. The commenters suggested that the Bureau of Labor Statistics's survey-based data would better account for unreported income.

         The DOE rejected the commenters' objection to the data and their proposed solution. In rejecting the objection, the DOE reasoned that graduates who do not report their income are subject to civil and criminal penalties, and noted that the SSA data is only one means of determining income; programs can submit alternate earnings appeals to show the DOE that its graduates' average incomes are actually higher than the SSA data indicates. In rejecting the proposed solution, the DOE noted that the Bureau of Labor Statistics data cannot be tied to particular programs, and thus would undermine the purpose of the regulations-to identify individual programs whose graduates are not gainfully employed.

         The American Association of Cosmetology Schools (“AACS”) sued under the Administrative Procedure Act, arguing that these responses were unsatisfactory, and thus the DOE arbitrarily and capriciously failed to adequately consider the unreported-income issue when it promulgated the regulations. AACS is a nonprofit association of cosmetology schools, many of which are at risk of failing the DOE's debt-to-earnings test. In fact, at least three schools have already posted warnings to their students, because they could not feasibly appeal their failing grades. Defendant moves for summary judgment on two procedural grounds and on the basis that the regulations were not arbitrary or capricious.

         Both of the DOE's procedural arguments concern subject-matter jurisdiction. It first argues that AACS does not challenge final agency action, because none of AACS's member-schools have unsuccessfully appealed their failing debt-to-earnings rates. The DOE also argues that AACS does not have standing to bring this action, because it did not identify any individual member-schools with standing in the complaint. The Court holds that AACS is challenging final agency action, because at least three schools have already had to post warnings, and raising an administrative appeal is not a prerequisite to suit under the APA. The Court further holds that AACS has standing to bring this case, because AACS indeed identified adversely affected members and meets all other requirements to establish associational standing to sue on behalf of its members.

         The DOE argues that it did not act arbitrarily and capriciously because it provided a reasoned explanation for its rejection of commenters' concerns about unreported income and their proposed solution. The Court holds that, although the DOE was rational in rejecting the commenters' proposed alternative, it did not adequately address the issue of unreported income. Neither side disputes that SSA data is highly accurate, even though it may be insufficient in certain circumstances. But, as the commenters pointed out-and the government did not dispute-there is a significant problem with this data. Despite the illegality of failing to report earnings to the IRS, many programs' graduates fail to report substantial portions of their income. The DOE proffered two responses to the commenters' problem. First, it argued that civil and criminal penalties deter underreporting. Second, it noted that institutions may submit an alternate earnings appeal to have their graduates' earnings more accurately calculated.

         The existence of penalties-which existed when the commenters' data was collected and will continue to exist into the future, absent some added deterrent-is irrelevant to the issue of undercounting income. In comparison, an alternative means of measuring earnings data is responsive to the problem. The DOE justifiably used SSA data as the default measure of earnings, but supplemented that default methodology with an alternate means of determining income. However, by inexplicably requiring high response rates to submit state-sponsored or survey-based alternate earnings calculations, the DOE narrowly circumscribed the alternate-earnings appeal process, making it unfeasible for certain programs to appeal their designations. To remedy the DOE's arbitrary and capricious narrowing of appellate recourse-and to avoid upending the entire administrative scheme-the Court removes barriers to appeal, making it more widely available for programs subject to the regulations.


         Congress passed Title IV of the Higher Education Act of 1965 (“HEA”) to make postsecondary education more widely available to the general public. See 20 U.S.C. § 1070(a). To broaden the availability of student loans and lower their cost to students, Title IV authorizes the United States government to enter into agreements with postsecondary educational institutions to allow students at their schools to obtain federally guaranteed loans. See Id. § 1094. To protect the taxpayer, the government sets certain conditions that participating institutions must meet. See id.; see also Ass'n of Private Sector Colls. & Univs. v. Duncan (APSCU I), 681 F.3d 427, 435 (D.C. Cir. 2012) (“[S]chools receive the benefit of accepting tuition payments from students receiving federal financial aid, regardless of whether those students are ultimately able to repay their loans. Therefore, Congress codified statutory requirements in the HEA to ensure against abuse by schools.”). Many of those conditions center on the financial success of proprietary institutions' graduates, because such success makes it more likely that the borrower will repay his own loans. See generally 20 U.S.C. § 1094. Under 20 U.S.C. § 1002(b)(1)(A), students at “proprietary institutions of higher education” may receive federal loan assistance only if their school “provides an eligible program of training to prepare students for gainful employment in a recognized occupation.” See also Compl. ¶ 8, ECF No. 1 (emphasis added).

         From 2009 to 2011, the DOE promulgated regulations defining the term “gainful employment” (“GE”) in terms of a debt-to-income test and a debt-repayment test. See Program Integrity: Gainful Employment-Debt Measures, 76 Fed. Reg. 34, 386 (June 13, 2011); see also Ass'n of Private Colls. & Univs. v. Duncan, 870 F.Supp.2d 133, 153-54 (D.D.C. 2012). This Court determined that parts of that rule were arbitrary and capricious under the Administrative Procedure Act (“APA”). See Ass'n of Private Colleges & Universities, 870 F.Supp.2d at 154, 158.

         The DOE again set out to define the term “gainful employment, ” this time focusing only on program graduates' overall debt compared to their earnings, which it refers to as “D/E” rates. See Program Integrity: Gainful Employment, 79 Fed. Reg. 64, 890, 64, 891 (Oct. 31, 2014) (to be codified at 34 C.F.R. pt. 600, 668). “The D/E rates measure evaluates the amount of debt (tuition and fees and books, equipment, and supplies) students who completed a GE program incurred to attend that program in comparison to those same students' discretionary and annual earnings after completing the program.” Id.; see also 34 C.F.R. § 668.404.

         The GE regulations use two tests to determine whether programs “pass, ” each of which is designed to determine whether programs' graduates are earning enough income to justify the government's guarantee of their loans. The first test divides the program's graduates' average loan payment amounts by their average discretionary income amounts.[1] The resulting rate is called the program's “discretionary income rate.”[2] 34 C.F.R. §§ 668.402, 668.404. A program passes if its graduates' loan payments make up, on average, 20 percent or less of their overall discretionary income. See 34 C.F.R. §§ 668.403. So, for example, if a program's graduates were spending an average of $200 per month on student loan payments, its graduates' average monthly discretionary income would have to be $1000 or more for the program to pass.

         The second test divides the program's graduates' average annual loan payments by their average annual income. The resulting rate is called the program's “annual earnings rate.” §§ 668.402, 668.404. A program passes if its graduates' average annual loan payment is 8 percent or less of its graduates' average annual earnings. See 34 C.F.R. § 668.403-04. Using another example, if a program's graduates paid, on average, $800 per year in student loans, they would need to make an average of $10, 000 per year to pass.

         A program is classified as “failing” the GE regulations if its discretionary income rate is greater than 30 percent and its annual earnings rate is more than 12 percent. Id. at § 668.403(c)(2). If a program does not pass either test and its discretionary income rate or its annual earnings rate falls in between the passing and failing rates, then the school is designated as “in the zone” between passing and failing. See Id. § 668.403(c)(3); see also 79 Fed. Reg. at 64, 891. A program loses HEA loan eligibility if (1) it fails for two out of three consecutive years, or (2) it is either in the zone or failing for four consecutive years. 34 C.F.R. § 668.403(c)(4)(i)-(ii).

         To measure program graduates' income rates in calculating a program's discretionary income rate or annual earnings rate, the DOE presumptively uses income data from the Social Security Administration. 34 C.F.R. §§ 668.405, 668.404(c)(1). The SSA data accounts only for earnings that were reported to the IRS for the purpose of calculating income tax. See 79 Fed. Reg. 64, 890.

         If the DOE's presumptive D/E rates, as calculated using SSA data, would leave a program either failing or in the zone, it may file an “alternate earnings appeal” to request an alternative formulation to determine the program's final D/E rates. 34 C.F.R. §§ 668.406(a), 668.409(a)(5). This allows the school to argue that more accurate data exists from which its graduates' average level of earnings can be calculated. See Id. §§ 668.406(b), 668.409(a). The process requires the school to use either an institutional survey of the institution's graduates or a state-sponsored data system, if such a system exists. Id. § 668.406(b)(1). The data generally must be from the same calendar year as the SSA data that the DOE used to calculate the program's D/E rate. Id. § 668.406(a). The state-sponsored data-system avenue requires that the data include more than 50 percent of a program's graduates during the relevant period. See Id. § 668.406(d). With limited exceptions, the institutional-survey avenue requires a school to obtain the earnings data of all of a program's graduates during the relevant period.[3] Id. § 668.406(c). The DOE never explained how it came up with the survey-response or state-based data requirements. See 79 Fed. Reg. at 64, 995-96; see generally 79 Fed. Reg. 64, 890. While an appeal is pending, the school is not considered at risk of losing eligibility the following year. 34 C.F.R. § 668.406(e)(2).

         Notably, if a program successfully appeals the DOE's use of SSA data for the determination of its D/E rates, it can avoid any negative repercussions altogether. Under 34 C.F.R. § 668.409(a)(1), the DOE's “final D/E rates” can include either the presumptive SSA data or a program's successfully proposed alternative. Only after finalizing each program's D/E rate does the DOE finally determine whether the program is passing, failing, or in the zone. Id. § 668.409(a)(2).

         However, if a school does not timely appeal its designation or is unsuccessful in seeking an alternative earnings calculation, it begins to suffer serious consequences. Under the Gainful Employment rules, schools that could lose HEA loan eligibility the following year must provide written warnings to current and prospective students informing them that their “program has not passed standards established by the U.S. Department of Education, ” and that if the institution does not obtain a passing grade, the students may not be able to receive federal student grants or loans the following year. 34 C.F.R. § 668.410(a)(2)(i). The warning requirement was implemented to protect prospective students from programs that might put their loan eligibility into jeopardy. See 79 Fed. Reg. at 64, 894. A program becomes ineligible for federal student loans under the HEA after failing the D/E rates for two out of three consecutive years or by having a combination of failing and in-the-zone rates for four consecutive years. See 34 C.F.R. § 668.403(c)(4)(i)-(ii).

         Federal courts have jurisdiction to review final agency action. 5 U.S.C. § 704. The APA requires reviewing courts to set aside an agency action that is “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” 5 U.S.C. § 706(2)(A). In cases like this one, prior to final publication, the agency is required to submit proposed regulations for a “notice and comment” period, during which interested persons may submit data and views to the agency for its consideration. See 5 U.S.C. § 553.


         The facts in this case are largely undisputed. Plaintiff, the American Association of Cosmetology Schools brings this action under the APA, seeking to enjoin the DOE from enforcing its GE rules. Compl. at 1. AACS is a nonprofit association of accredited cosmetology programs. Compl. ¶ 1. At core, AACS takes issue with the DOE's use of the SSA annual earnings data. See Compl. ¶¶ 15, 35-38. Plaintiff notes that the SSA data is incomplete because it tends to undercount the income of self-employed individuals and individuals who receive a significant amount of their income in the form of tips and cash. J.A. 797, ECF No. 26-1; see also Decl. of Anthony Civitano (“Civitano Decl.”) ¶¶ 25, 28, ECF No.8-1. These two groups, the argument goes, can underreport their income more easily than persons earning paychecks from employer payrolls. J.A. 606; Civitano Decl. ¶ 28. Thus, cosmetology school graduates-who Plaintiff claims are disproportionately self-employed and paid in cash-on average have higher incomes than the SSA's numbers reflect, in many cases as much as double. J.A. 595, 787; Civitano Decl. ¶ 28.

         According to Plaintiff, the DOE was made aware of “this well-known reported income gap phenomenon” by several commenters during the notice-and-comment period of the GE rule promulgation. Compl. ¶¶ 47-48. Indeed, the DOE explicitly acknowledges that these comments included claims that “about half of earnings in service occupations such as cosmetology” are made up of tips, and that many people in the industry are self-employed. See 79 Fed. Reg. at 64, 955. A report by Stanford professor Dr. Eric Bettinger, which was submitted to the agency during the notice-and-comment period, found that both tip income and self-employment income are, on average, underreported by around 60%. See J.A. 594; see also Decl. of Katherine Brodie (“Brodie Decl.”) at 493, ECF No. 8-4.

         Even aside from formal public comments, AACS cites to several sources suggesting that the underreporting of cash-based earnings-including in the cosmetology industry-is widely known to be a serious problem. See Brodie Decl. ¶ 3. For example, AACS provides the House Budget Committee testimony of Russell George, Treasury Inspector General of the Tax Administration, wherein Mr. George states that “self-employed individuals who formally operate . . . businesses . . . are estimated to report only about 68 percent of their income for tax purposes” and “self-employed individuals operating businesses on a cash basis report just 19 percent of their income to the IRS.” Brodie Decl. at 1258. Although these materials were apparently not submitted in connection with notice-and-comment and have little direct relevance, they lend credence to the general idea that the income gap phenomenon is a significant problem.

         The DOE acknowledged that the use of SSA data was imperfect, but generally viewed civil and criminal penalties as sufficient deterrents to underreporting. See 79 Fed. Reg. at 64, 955-56. The pertinent portions of the DOE's responses to the public comments are as follows:

We do not agree that our reliance on reported earnings is flawed because of its treatment of self-employment earnings and tips . . . . We acknowledge that some self-employed individuals may fail to report, or underreport, their earnings. However, [the Internal Revenue Code] requires self-employed individuals to file a return if the individual earns $400 or more for the taxable year. . . . Underreporting subjects the individual to penalty or criminal prosecution. . . .
With respect to the earnings of workers who regularly receive tips for their services, [the Internal Revenue Code] requires individuals to report to IRS their tip earnings for any month in which those tips exceeded $20, and . . . individuals who fail to do so are subject to penalties. . . .
For these reasons, we do not agree with the commenters' assertion that aggregate earnings data provided by SSA . . . are unreliable with respect to workers in occupations that involve significant tip income or a high percentage of income from self-employment. . . . Moreover, the regulations allow an institution to submit an alternate earnings appeal using State databases or a survey.

79 Fed. Reg. at 64, 955-56.

         At least one commenter also proposed an alternate means of calculating income. See id.; J.A. 53, 785; see also Brodie Decl. at 1193-94. That commenter suggested using data gathered by the Bureau of Labor Statistics, which relies on population surveys rather than formally reported income. See J.A. 597, 785; Brodie Decl. at 1193-94. According to Dr. Bettinger, this data would more accurately capture the earnings of, among others, cosmetology-school graduates, because, unlike SSA data, it takes unreported income into account. See Brodie Decl. at 684-85, 1193-94. “[T]hese adjustments would significantly augment the SSA aggregate earnings reported for these occupations, increasing the median earnings by 19 percent and the mean earnings by 24 percent.” 79 Fed. Reg. at ...

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