Scathing Lawsuit Against ITT Colleges

WILMINGTON, Del. (CN) - ITT Educational Services concealed the nature of its exposure to mounting student loan defaults while assuring investors that its financial house was in order, shareholders claim in a derivative complaint.

Lead plaintiff Janice Nottenkamper claims in Federal Court that ITT Educational Services, operator of ITT Technical Institutes and Daniel Webster College, and its officers repeatedly made false and misleading statements about its liabilities relative to third-party financing of its students, and that its tenuous financial condition and lack of adequate cash reserves led it to engage in predatory lending practices that pushed students into high-cost private loans that were likely to default.

Nottenkamper claims that as ITT Educational Services' financial health deteriorated, the defendants failed to disclose that it was unlikely it would be able to secure a new third-party private lender to finance private student loans.

That, she says, left the company with no option but "to engage in increased direct student lending, which it was forced to do, wreaking havoc on ITT's financials - causing bad debt expenses to skyrocket, earnings to plummet, and profits to drop."

"Specifically, the defendants caused the company to be exposed to a massive risk that was material to ITT's bottom line and for which it was woefully under-reserved. Defendants concealed this by, among other things, ignoring basic and applicable accounting rules and SEC regulations and failing to disclose to investors that by engaging in increased direct student lending the company's bad debt expenses and reserves would in fact increase, thereby drastically reducing the company's free cash flow - the market's primary metric for valuing any company," Nottenkamper says in the 115-page complaint.

"In doing so, the defendants were able to inflate the company's balance sheet, by severely understating the company's liabilities and materially overstating its financial health and earnings."

While Nottenkamper lays the blame for a dramatic drop in shareholder value on the defendants, she also takes aim at the very concept upon which for-profit colleges are built.

"Whereas public or nonprofit colleges and universities operate independently of an ownership structure and are free to focus on providing quality education to students, for-profit institutions, like ITT, must provide an adequate financial return to their shareholders, making profit, rather than quality education, an absolute priority," she says in the complaint. "As a result, tuition at for-profit schools is much higher than tuition elsewhere. ITT's profit-centric approach is demonstrated by the fact that in 2009-2010, for-profit institutions spent $3,017 per student on instructional costs versus $15,321 per student on average at private nonprofit colleges, while average tuition costs at for-profit colleges was $31,000, compared with $26,600 for nonprofit colleges."

For years, Nottenkamper claims, ITT was not only one of the most expensive for-profit institutions in the country, it was also among the most profitable.

However, "beginning in or around 2008, government-funded student aid dropped and private student lenders were no longer interested in providing loans to students given the higher risk inherent in those loans," Nottenkamper says. "... As a result, private lenders, led by Sallie Mae, largely ceased their private student lending to for-profit institutions."

The complaint adds: "To continue its growth in revenue, earnings and cash flows in the face of a shrinking market, starting in 2007, the defendants caused the company to resort to a series of off-balance sheet financing programs that propped up ITT's declining enrollment rates while partially limiting ITT's business model from direct exposure to potential losses borne from student loan defaults.

"Specifically, in 2007, 2009 and 2010, the defendants caused ITT to secure a series of risk sharing agreements ('RSAs') with third-party lenders. The company used the agreements to incentivize private lenders to continue lending to ITT students despite the acknowledged risks associated with the rising national student loan default rates. Pursuant to each RSA, the third-party lenders established and funded dedicated trusts that, as far as the market was aware, provided capital for loans to ITT students and were independent of ITT's balance sheet. To induce lenders to provide loans to its students, the defendants caused ITT to provide substantial repayment guarantees to the trusts to ensure that lenders would be repaid in the event that student loan default rates exceeded a certain specified percentage."

In pursuing this course, Nottenkamper says, the defendants gambled that they could secure new RSAs when the old ones expired. "Without a new RSA, the defendants would be forced to increase the company's direct lending to students, and defendants knew what this meant for the company's financials. Without an RSA to protect the company, all of ITT's outstanding loan obligations would be forced back onto its books, and its liabilities would skyrocket as students continued to default on their loans, as would the company's debt expenses and its reserves."

This, she says, is precisely what happened in late July 2012. As a result, ITT's earnings plummeted and its precarious financial condition became public.

On July 26, 2014, Nottenkamper says, ITT issued a press release announcing that it had "increased lending to students directly and was therefore increasing its bad debt expense."

"Up to this point, much of ITT's exposure to losses arising from student loans issued under the RSAs had been kept off ITT's balance sheet. The July 26 press release was the first time the defendants revealed that its liability under the RSAs was substantially higher than it had previously represented. Moreover, on July 26, 2012, the defendants also finally disclosed that it had not secured a new RSA and was therefore increasing its use of 'internal financing' (i.e., direct student lending) to enrolled students." (Parentheses in complaint.)

Within days of these revelations, the U.S. Senate's Health, Education, Labor, and Pensions Committee published a scathing report on the for-profit educational industry that was particularly critical of ITT, she says.

"As the market absorbed and digested the significance of the Senate Report and ITT's true business model, the company's stock declined sharply," Nottenkamper says.

She seeks unspecified damages for breach of fiduciary duty, restitution of shareholder loses, and court-mandated reforms to ITT's corporate governance and internal procedures.

She is represented by Robert Goldberg of Biggs and Battaglia of Wilmington.

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