The U.S. Department of Education's Office of Inspector General (OIG) identified a "serious vulnerability" in distance education programs due to frauds committed by students and recommended a stricter enrollment process for colleges.
Stocks of for-profit colleges, which mostly offer online programs, fell on fears of further decline in enrollment and profit.
In the letter dated September 26, the OIG said it identified increasing number of cases involving large and loosely affiliated groups of individuals who conspired to defraud Title IV programs -- a type of federal loan -- as there were no requirements for verification of student identity.
The letter was available on the department's website only on Thursday.
The OIG asked the department to require colleges to confirm student identity before disbursing funds and collect IP information for the students enrolling in online programs.
It said the department could also limit funds to students enrolled in online programs to avoid cost of room and boarding that are not incurred.
Morningstar analyst Peter Wahlstrom said the recommendations could result in higher costs for the for-profit colleges as they will have to spend more on monitoring and screening for potential fraudsters.
They could also be forced to lower tuition fee if federal aid for these programs falls, he said.
"The bigger impact would be on the margin that the for-profit school can earn," Wahlstrom said.
The OIG said the findings follow numerous investigations conducted over the past six years.
Since 2005, 215 distance education fraud ring participants from 42 different fraud rings have been criminally convicted due to the investigations but this does not represent the full scale of the fraud rings, the OIG said.
The department said it will form a new team and will give priority consideration to actions that can be taken under existing laws and regulations.
Shares of Corinthian Colleges, Bridgepoint, ITT Educational Services and Apollo Group fell about 3 percent in regular trading. The sector index closed down 1 percent.