SEC Files Fraud Action Centered on Student Loans

Student loans, and the debt burdening many students at graduation, is an important political topic. It is not generally a subject for the Securities and Exchange Commission. Nevertheless, at the center of is most recent enforcement action is an educational institution that was forced to restate its financial statements as a result of delinquent pools of student loans it held off the books but which had been guaranteed. SEC v. ITT Educational Services, Inc., Civil Action No. 15-cv-00758 (S.D. Ind. Filed May 12, 2015).

Named as defendants are: ITT Educational, a higher education company with over 50,000 student whose shares are trade on the NYSE; Kevin Modany as ITT’s CEO; and Daniel Fitzpatrick, the firm’s CFO.

Most of ITT’s revenue is generated by tuition. Students generally pay that tuition with federal and state student loans. Historically students relied on traditional private education loans. In 2008 and 2009 ITT tried to secure a new source of private loans for its students but failed. The firm then used a temporary credit system for students that required loans.

In 2009 ITT formed two private student loan programs known as PEAKS and CUSO. PEAKS was structured as a trust that sold securities to investors. It used the funds to make over $300 million in loans to ITT students. The CUSO student loan program was funded by a group of credit unions organized by ITT. It made about $141 million in loans to ITT students. Guarantees were extended by ITT to mitigate the risk. If the students defaulted on their loans ITT could be liable for significant guarantee payments.

PEAKS and CUSCO were designed to enable ITT to avoid reporting on their finances. Both were variable interest entities or VIEs. Under GAAP a company must consolidate the financial results of a VIE if its directs the activities that most significantly impact the economic performance of the entity. For PEAKS and CUSCO that activity was loan underwriting and performance. ITT did not, however, consolidate the financial results of the two entities – ITT shareholders were not furnished with direct information about the two programs.

By 2012 the loans in the programs had extremely high default rates. ITT’s guarantee obligations increased. To conceal the poor performance of the two loan programs, and its impact on ITT, the firm and Messrs. Monday and Fitzpatrick used various devices. For example, they created the Payments on Behalf of Borrowers or POBOB program. Under this program the company made payments on behalf of student borrowers who failed to make timely payments. This had the effect of temporarily delaying defaults. Public filings did not mention this program. Rather, those filings made it appear that the student loans were performing well.

Another approach used to conceal the impact of the defaulting loans was “netting.” Under this approach the near term PEAKS guarantee payments ITT projected making were netted against potential future recoveries that were not projected to be realized for years. The disclosed amount was thus millions of dollars lower than the more than $100 million in near term payments ITT was projected to make. The PEAKS program was not consolidated into ITT’s financial statements despite having the kind of control that required such action.

For CUSO the defendants only made the minimum guarantee payments. This was a practice “akin to making minimum payments on a high interest credit card . . .” according to the complaint. Messrs. Modany and Fitzpatrick also concealed important information about the PEAKS and CUSO programs form the auditors. That included internal projections about future guarantee payments and other matters.

The scheme unraveled in early 2014. The auditors began to discover previously undisclosed information about the programs. Eventually ITT was required to restate its financial statements to consolidate PEAKS for periods beginning in the first quarter of 2013 and to reclassify and disclose the timing for CUSO liabilities. In March 2014 ITT paid $40 million to settle claims by PEAKS program participants tied to the firm’s circumvention of the guarantees through the POBOB program. Overall ITT paid millions of dollars on the guarantees because of poor loan performance.

The complaint alleges violations of Exchange Act Sections 10(b), 13(a), 13(b)(2), 13(b)(5) and control person liability under 20(a) and Securities Act Section 17(a) and a failure to reimburse under SOX 304. The case is pending.