The government is generally free to provide broadly available student scholarships that students may use at any institution, religious or secular. Such generally available funding programs don't violate the Establishment Clause, though some earlier Supreme Court decisions had held the contrary.

The government is, however, also free to decide to limit such scholarships in certain ways, even when those ways discriminate against religious uses: The Supreme Court has held (in Locke v. Davey) that the government may exclude devotional theology majors from otherwise generally available scholarships, and that this discrimination against religious uses doesn't violate the Free Exercise Clause. The question that Locke leaves open is just what other kinds of exclusion of religious uses from generally available programs are constitutional.

The federal Tenth Circuit court of appeals has just held, in Colorado Christian Univ. v. Weaver, that one thing the government may not do is distinguish between students who go to ordinarily religious institutions and students who go to "pervasively sectarian" institutions. Colorado drew such a distinction for college student scholarships, providing that the scholarships could be used at a wide range of institutions but not at "pervasively sectarian" ones, with the term being further elaborated this way:

An institution of higher education shall be deemed not to be pervasively sectarian if it meets the following criteria:
(a) The faculty and students are not exclusively of one religious persuasion.
(b) There is no required attendance at religious convocations or services.
(c) There is a strong commitment to principles of academic freedom.
(d) There are no required courses in religion or theology that tend to indoctrinate or proselytize.
(e) The governing board does not reflect nor is the membership limited to persons of any particular religion.
(f) Funds do not come primarily or predominantly from sources advocating a particular religion.

The Tenth Circuit held that this discrimination in funding violated two Establishment Clause principles: (1) It impermissibly discriminates among religions, and (2) it requires an unduly "intrusive scrutiny of religious belief and practice."

(1) To begin with, the Tenth Circuit follows Larson v. Valente, a 1982 Supreme Court case that held that the Establishment Clause is violated when a law discriminates among religions even when the discrimination focuses on the religious bodies' facially nonreligious practices -- in Larson, the fraction of contributions to the body that came from its members. Likewise, the Tenth Circuit says, distinguishing between religious institutions that are merely religious and those that are "pervasively sectarian" is a similarly forbidden discrimination. I'm not sure that Larson was correctly decided, but the Tenth Circuit's opinion seems correct given Larson.

(2) The Tenth Circuit goes on to conclude that "Even assuming that it might, in some circumstances, be permissible for states to pick and choose among eligible religious institutions, a second line of Supreme Court precedents precludes their doing so on the basis of intrusive judgments regarding contested questions of religious belief or practice" (emphasis mine). This has sometimes been described as an aspect of the prohibition on "excessive entanglement" between government and religion. And the Tenth Circuit's analysis strikes me as quite solid on the facts: Among other things, inquiring into whether theology classes "tend to indoctrinate or proselytize," into whether the governing board "reflect[s] ... any particular religion," and for that matter into whether faculty, students, trustees, or funders belong to the same "religion" or "religious persuasion" requires improper religious judgments by secular government officials.

To give just one example (and if you want more, read the opinion, which is quite readable),

CCU stated that its students, faculty, and trustees are not of a single religion, because the school is an interdenominational institution; it "unites with the broad, historic evangelical faith rather than affiliating with any specific denomination." The state defendants took a different view: to them, all Christians are of the same religious persuasion, and denominational distinctions do not matter. The "correct" answer to that question depends on one's ecclesiology. But under the First Amendment, the government is not permitted to have an ecclesiology, or to second-guess the ecclesiology espoused by our citizens. "Courts are not arbiters of scriptural interpretation."

The State defendants blithely assumed that they could lump together all "Christians" as a single "religion." But the definition of who is a "Christian" can generate an argument in serious circles across the country. Some students at CCU are members of the Church of Jesus Christ of Latter-Day Saints, or "Mormons." Members of the LDS Church stoutly insist that they are Christians, but some Christians, with equal sincerity and sometimes vehemence, say they are not. In order to administer Colorado's exclusionary law, government officials have to decide which side in this debate is right. Similar questions plague the religious taxonomy of Jehovah's Witnesses, Christian Scientists, Unitarian-Universalists, various syncretistic groups and even (in some circles) the Roman Catholic Church.

To make matters worse, the Commission has (no doubt without animus) applied different standards to different religious traditions. When confronted with the question of whether Regis College was eligible for student scholarships, the Commission (and later the Colorado Supreme Court) focused on the particular denomination, which is Roman Catholicism, and concluded that the institution was eligible. In CCU's case, however, the Commission focused on a broader category: all Christians....

Interestingly, as the court acknowledges, the "pervasively sectarian" vs. "merely religious" distinction that the court concludes is unconstitutional when embodied in statute was once part of the Supreme Court's own Establishment Clause doctrine. That is in fact why the statute contains such a distinction; the legislature was trying to comply with what was then the Establishment Clause requirement. But the Supreme Court has moved away from this distinction in its constitutional test, and I think the criticism of the constitutionality of this distinction as a statutory rule is quite correct.

I do not think that it's likely that the Supreme Court will review this decision -- I know of no circuit or state supreme court split on this particular question, and I think it's unlikely that the Court will see the case as either so important or so obviously wrong that it merits review without a split. I expect this case might be followed by challenges to similar statutes in other circuits, though a quick search for "pervasively sectarian" in Westlaw revealed no statutes that were quite like this one, and only a few that used the phrase at all.

I should note that the author of the decision, Judge Michael McConnell, is one of the nation's leading Establishment Clause scholars (a reputation built on his career as a law professor).