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From Securities Regulation Daily, May 12, 2015

SEC says for-profit school gets failing grade over financial antics; company says case “unfounded”

By Mark S. Nelson, J.D.

The SEC today filed a federal civil law suit against for-profit schools company ITT Educational Services, Inc. and its CEO Kevin M. Modany and its CFO Daniel M. Fitzpatrick for allegedly misleading investors and the company’s outside auditor about their efforts to prop up a faltering student loan program. The SEC’s 15-count complaint alleges securities violations focused on how ITT and its executives handled two loan pools that withered from massive defaults (SEC v. ITT Educational Services, Inc., May 12, 2015).

ITT replied vigorously to the SEC’s charges in an afternoon press release. ITT said it is “a financially responsible company” and that it has cooperated with the SEC on “complex accounting issues,” which it said should have been resolved in a different manner. “We vehemently disagree with the SEC's position and we are confident that the evidence does not support the SEC's claims.” ITT also said it hoped other regulators would forebear taking further action against it so it can defend itself in court.

But federal regulators have taken on ITT in the consumer space before. The Consumer Financial Protection Bureau (CFPB) brought a case against ITT last year in the same federal court where the SEC filed its suit. ITT disputed the CFPB’s allegation that it pushed students into risky loans. The district court has since partially denied ITT’s bid to have the CFPB’s case dismissed, but just last month, ITT appealed that ruling to the U.S. Court of Appeals for the Seventh Circuit.

Hatched in C-Suite. SEC Enforcement Director Andrew Ceresney emphasized to reporters attending a media call this morning that ITT’s alleged scheme to hide its true financial condition took root in the company’s executive suite. Ceresney said this was a case where the agency needed to take “swift and decisive” action, and that the SEC’s case against ITT is also part of the agency’s larger focus on financial fraud.

“Modany and Fitzpatrick should have been responsible stewards for investors but instead, according to our complaint, they engineered a campaign of deception and half truths that left ITT’s auditors and investors in the dark concerning the company’s mushrooming obligations,” said Ceresney in a press release issued before the media call.

Last month, ITT announced that Fitzpatrick would retire as executive vice president and CFO, but that he will stay at the company in his current roles during a transition period set to end this October. The letter agreement spelling out the terms of Fitzpatrick’s transition gives ITT the power to retain him for up to four additional months, change his status to senior adviser, or to end the transition with a simple notice, but Fitzpatrick may later become a company adviser. Ceresney said Fitzpatrick’s future status at ITT would not impact the SEC’s case.

Two loan pools. According to the SEC’s law suit, ITT created two pools from which it made loans to students who attended the company’s for-profit schools. One pool, known as the Program for Education Access and Knowledge (PEAKS), was set up as a trust in 2010 in order to securitize loans into securities that were then sold to investors. PEAKS made $300 million in loans from the funds it raised, subject to a guarantee by ITT if loan defaults hit a pre-set threshold.

ITT previously had set up another pool called the Credit Union Service Organization (CUSO) in 2009 to take advantage of funding provided by credit unions that took part in that deal at ITT’s behest. CUSO made $141 million in student loans, but also required ITT to guarantee the credit unions’ interests if a fixed percentage of loans defaulted. While declining to comment on whether the SEC is investigating other similar off-balance sheet arrangements at for-profit schools, Ceresney did note that ITT’s pools were “unusual” in the for-profit education industry.

Staying afloat. The SEC’s complaint details the many varied attempts by Modany and Fitzpatrick, both certified public accountants, to hide ITT’s true financial condition from investors and auditors. The SEC said that by 2012, ITT’s loan pools had begun to rapidly deteriorate, allegedly prompting Modany and Fitzpatrick to get ITT to make minimum payments on CUSO guarantees without disclosing that these payments would lead to much higher ones later.

Likewise, Modany and Fitzpatrick allegedly tried to prop up PEAKS. According to the SEC, the two executives devised a plan they called “Payments on Behalf of Borrowers” (POBOB) in which ITT paid tens of millions of dollars on loans for students who were late in their payments in order to forestall new defaults, but without disclosing this plan to investors. They also netted currently projected guarantee payments against uncertain future recoveries.

The SEC’s case also looks at how ITT dealt with the complexity of PEAKS and CUSO, which the agency said ITT failed to consolidate into its financials. According to the SEC, both PEAKS and CUSO were variable interest entities (VIEs) which, under GAAP, must be consolidated into the financials of a company if it can exert power over the VIE’s performance. The SEC said the failure to consolidate PEAKS deprived investors of needed data about the loan pool’s composition and performance.

Moreover, Modany and Fitzpatrick allegedly misled ITT’s outside auditor regarding the true condition of ITT’s embattled loan pools. Specifically, the SEC cited ITT’s internal guarantee projections, an adverse legal opinion regarding the legality of the POBOB plan, and ITT’s power to pick the PEAKS loan servicer.

The effort to keep the loan pools afloat fell apart when ITT’s auditors began to learn about information on the programs that had not been publicly disclosed. The revelations led ITT to restate its financials and pay $40 million to end claims by PEAKS participants who had questioned ITT’s POBOB plan. ITT also disclosed that it may need to pay $116 million of a total $144 million in added PEAKS payments in 2014. ITT’s stock soon fell 20 percent, deepening earlier price drops.

Accounting-focused charges. A key component of the SEC’s case includes charges that Modany and Fitzpatrick engaged in accounting-related violations. Both executives are alleged to have deceived ITT’s external auditor.

The SEC also is asking the court to invoke the Sarbanes-Oxley Act’s clawback provision regarding executive compensation Modany and Fitzpatrick failed to reimburse to ITT after it restated its financials. SOX Section 304 mandates reimbursement by executives whose misconduct resulted in an accounting restatement due to the issuer's material noncompliance with any financial reporting requirement under the federal securities laws.

The rest of the SEC’s allegations focus on fraudulent activities under both the Securities Act and the Exchange Act. ITT, Modany and Fitzpatrick also face charges that they violated books and records provisions, made false SEC filings, and falsely certified periodic reports. Likewise, Modany and Fitzpatrick are alleged to have aided and abetted many of these violations.

Although the possible total amounts that the court may order to be disgorged and the amount of any civil money penalties could be significant, there remains uncertainty over the exact amounts the SEC may seek. In reply to a reporter’s question, Ceresney said he could not estimate how much money the SEC may eventually recoup from ITT because the issue still must be litigated.

The case is No. 15cv00758.

Attorneys: Nicholas P. Heinke for the SEC.

Companies: ITT Educational Services, Inc.

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