Fraud allegations against ITT Educational Services could be shaping up as another textbook case of what goes wrong when companies try to deal with bad news away from the eye of investors.

The Securities and Exchange Commission has filed a complaint in U.S. District Court accusing ITT Educational Services, along with its CEO Kevin Modany and CFO Daniel Fitzpatrick, of misleading investors by concealing mounting failures in two off-balance-sheet student loan programs. The SEC says the publicly traded for-profit higher education company formed two student loan programs in 2009 and 2010, on the heels of the credit crisis, that issued a combined $340 million in loans and quickly fell into extremely high default rates—all hidden from investors in off-balance-sheet entities. The company, Modany and Fitzpatrick “hid the poor performance of the programs and their impact on the company in numerous ways,” including by misleading auditors, the SEC said.

The allegations come a few months after the Consumer Financial Protection Bureau filed a lawsuit against ITT, accusing the company of predatory student lending. The CFPB says the company exploited students and pushed them into high-cost private student loans that were “very likely” to end in default. “Like the mortgage market in the lead-up to the financial crisis, the for-profit college industry may be experiencing misaligned incentives,” the Bureau wrote. “These colleges benefit when students take out large amounts of loans, regardless of the students’ long-term success.”

“I don’t believe this involves any kind of loophole in any GAAP reporting or SEC reporting requirements. The rules have been in place, and if properly acknowledged and complied with, were more than adequate to uncover the risks associated with these transactions.”
Brian Markley, Partner, SolomonEdwards

ITT issued a statement saying it was “deeply disappointed” in the SEC’s “mistaken decision” to pursue an enforcement action and is confident evidence will not support the SEC’s allegations. “Throughout the relevant time period, we repeatedly expanded our disclosures in an effort to present material information to investors,” the company said. “We also repeatedly conferred with outside experts, as well as our outside registered independent auditor. We shared extensive information with these experts to confirm that our accounting treatment was reasonable and appropriate. The company’s robust record of consultation and deliberation rebuts any allegation of wrongdoing.”


Below is the text of the complaint in SEC v. ITT Educations Services, Inc.
1. Beginning no later than the second quarter of 2012, ITT Educational Services, Inc. (“ITT”), an operator of for-profit colleges, its chief executive officer Kevin M. Modany, and its chief financial officer Daniel M. Fitzpatrick (collectively, the “Defendants”), engaged in a fraudulent scheme and course of business and made various false and misleading statements and omissions to defraud ITT’s investors by concealing the extraordinary failure of two off-balance sheet student loan programs, and the looming effect of that failure on ITT’s financial condition.
2. The “PEAKS” student loan program, formed in 2010 was structured as a trust that sold securities to investors and used the funds to make over $300 million in loans to ITT students. The “CUSO” student loan program, formed in 2009, was funded by a group of credit unions organized by ITT and made approximately $141 million in loans to ITT students. To induce the program participants to finance these risky loans, ITT provided guarantees that limited any risk of loss from the student loan pools. Default rates on the student loans had a key impact on these guarantees: if enough students defaulted, the guarantees were triggered and ITT would be responsible for payments to the loan program participants.
3. By 2012, the loans made through these programs had performed so abysmally, with extremely high default rates, that ITT’s guarantee obligations began to balloon. The Defendants knew ITT faced looming, massive payments on these guarantees. However, rather than disclosing the significant impact of these guarantee obligations to ITT’s investors, the Defendants engaged in a series of deceptive acts to hide the poor performance of the student loan programs and their financial impact on ITT. The Defendants also made numerous misstatements and omissions—in ITT’s public filings and in conference calls with financial analysts—that similarly concealed the condition of the student loan programs and ITT’s guarantee obligations.
4. ITT, Modany, and Fitzpatrick hid the poor performance of the programs and their impact on the company in numerous ways. For example, in October 2012, after ITT received its first demand for a multimillion dollar guarantee payment on the PEAKS program, Modany and Fitzpatrick devised a plan whereby ITT actually made payments on behalf of student borrowers who had failed to make timely payments, which had the effect of temporarily delaying further defaults. This practice—which ITT later innocuously titled “Payments on Behalf of Borrowers,” or “POBOB”—had the effect of delaying tens of millions of dollars of looming PEAKS guarantee payments ITT would otherwise have had to make. The Defendants concealed this practice from ITT’s investors (among others) and instead made statements in public filings that Case 1:15-cv-00758-JMS-MJD Document 1 Filed 05/12/15 Page 3 of 56 PageID #: 3 led investors to believe the PEAKS program and its composite student loans were performing relatively well.
5. ITT, Modany, and Fitzpatrick further misled investors about the condition of the PEAKS program by consistently “netting” the near-term PEAKS guarantee payments ITT projected making against speculative recoveries that were not projected to be realized until many years later. As a result, the net amount disclosed was tens of millions of dollars lower than the more than $100 million in near-term payments ITT projected making. The Defendants made numerous misstatements and omissions regarding this “netting” practice, including falsely claiming that this net amount represented the total amount of ITT’s future guarantee payments.
6. In addition, the Defendants made only the minimum payments required on ITT’s CUSO guarantee—a practice akin to making minimum payments on a high interest credit card—but failed to disclose that this payment choice would have the effect of significantly increasing the amounts ITT would ultimately owe. The Defendants also failed to consolidate the PEAKS program into ITT’s financial statements, which would have shown the declining value of PEAKS loans, despite having the sort of control over the program that should require consolidation.
7. Finally, Modany and Fitzpatrick routinely misled ITT’s external auditor regarding important information affecting the PEAKS and CUSO programs, including internal projections about future PEAKS and CUSO guarantee payments, a dispute with PEAKS program participants over the permissibility of POBOB, an unfavorable legal opinion regarding the permissibility of POBOB, and information about ITT’s ability to remove the PEAKS loan servicer. The Defendants’ actions to mislead ITT’s auditor also helped to further the Defendants’ fraudulent scheme.
8. In early 2014, the Defendants’ scheme began to unravel. ITT’s auditor began to learn previously undisclosed information regarding the PEAKS program, including the dispute with PEAKS program participants over the permissibility of POBOB. ITT ultimately restated 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 that ITT circumvented its guarantee obligations through POBOB. In its preliminary first quarter 2014 results, ITT disclosed that it was projecting $144 million of additional PEAKS payments, $116 million of which it expected to pay in 2014. ITT’s stock price dropped approximately 20% from already depressed prices. ITT has since paid millions of dollars in additional PEAKS guarantee payments, based on the poor performance of the program.
9. As a result of the conduct described herein, ITT, Modany, and Fitzpatrick violated numerous provisions of the federal securities laws and unless restrained and enjoined will continue to do so.
Source: SEC.

The company also vehemently denies the CFPB allegations. In an open letter to Sen. Richard Durbin (D-Ill.), Modany said both the SEC and CFPB complaints are unjust. “They are filled with factual inaccuracies and materially misrepresent the substance and reality of the matters that are the subject of these actions,” he wrote. “We anxiously await the opportunity to defend ourselves against these unsupported and misrepresented claims and remain confident and steadfast in our views that the facts will overwhelmingly support our positions.” Modany and Fitzpatrick both are continuing in their positions at the company.

Experts reviewing the complaints say there are some gray areas in ITT’s accounting that comes into play with the SEC’s fraud allegations, but the complaint itself seems to suggest the case is not about differences in judgment or interpretation of accounting rules. “I don’t believe this involves any kind of loophole in any GAAP reporting or SEC reporting requirements,” says Brian Markley, a partner at consulting firm SolomonEdwards. “The rules have been in place, and if properly acknowledged and complied with, were more than adequate to uncover the risks associated with these transactions.”

The accounting rules around consolidation of variable interest entities—such as the student loan programs that ITT apparently managed off its balance sheet—got a makeover by the Financial Accounting Standards Board in the aftermath of Enron and the Sarbanes-Oxley Act. The SEC identified off-balance-sheet transactions as an area of abuse that needed an accounting rule remedy. FASB adopted sections of Accounting Standards Codification Topic 810, Consolidations, to address weaknesses in consolidation rules.

Although the rules are complex, the SEC complaint doesn’t seem to suggest any disagreement over how to apply the rules, Markley says. ITT even disclosed problems with its internal controls over its consolidation assessment, the data around its loan programs, and the reporting of those activities, he says.

“The rules have been in place long enough. It looks like it really boiled down to the fundamental question in the VIE guidance of whether ITT had control over these VIEs or not,” he says. “I really think the problem here is a CEO and CFO who colluded to make up for and cover up some bad business decisions.”

Anne Eberhardt, senior director and forensic accountant at consulting firm Gavin/Solmonese, isn’t as direct in her assessment. She notes the rules around accounting for VIEs can be difficult to apply, and ITT is aggressively denying any wrongdoing. She also notes the company changed audit firms, from PwC at 2013 year-end to Deloitte for its 2014 audit. The company also restated its 2013 results to bring the ailing student loan programs onto the balance sheet, where ITT consolidated $156.8 million in losses and reported a net loss of $27 million. “I don’t want to connect the dots, but there does seem there was an issue,” Eberhardt says. (Neither Deloitte nor PwC replied to requests for comment.)

Michael Kessler, CEO of forensic accounting firm Kessler International, says the allegations against ITT are the kind that typically lead to the question: Where was the auditor? “The partner and senior-level people are not looking at the books and records,” he says. “That’s the junior-level people, to keep the costs down. My guess is they just didn’t know what they were looking at and couldn’t figure it out.”

Patricia Gorham, a partner and co-leader of the accountants’ liability practice at law firm Sutherland, says the for-profit education sector is on the radar with regulators, particularly after the effect of the credit crisis took a bit out of student loan funding. “That put a squeeze on the student loan situation for those schools in particular, and we see that in some of the actions those colleges took,” she says.

Corinthian Colleges, for example—recently accused by the Department of Education of inflating job placement data—has filed for bankruptcy. Although not facing any allegations of wrongdoing, Education Management Corp. said it would close 15 of its 52 art schools, and Career Education Corp. is planning a restructuring that includes selling all but two of its university holdings.

In Gorham’s view, the allegations against ITT look like the classic securities fraud case. “There will always be gray areas in these kinds of allegations,” she says. “We can’t tell from the face of it how it will turn out, but it contains very recognizable kinds of claims.”