In August, the Department Of Justice filed a law suit against Education Management Corporation (NASDAQ:EDMC) alleging massive fraud. The basis for the case is EDMC's practice of basing recruiter compensation on the number of students they enroll. For-profit schools may consider student enrollment in recruiters' compensation, but it cannot be the sole determinant of pay. The problem with paying recruiters solely based on the number of students they enroll is that the practice inevitably leads to the recruitment of underqualified students who then sign-up for and receive federal student aid. Because their chances of success are low, the default rate on the loans tends to be high. In fact, according to the NY Times, "for-profit colleges ... now serve more than 10% of the students enrolled in higher education, yet account for about half of all defaults on student loans." As such, the basis of the government's suit is the False Claims Act which allows "individual whistle-blowers [to] file suits charging that the government has been defrauded, leaving the government the option to intervene."
According to the NY Times, EDMC used "high-pressure sales techniques, ... inflated claims about career placement ... [and enrolled] applicants who were unable to write coherently, who appeared to be under the influence of drugs, or who sought to enroll in an online program but had no computer." These practices have been taking place at for-profit institutions for years and the lawsuit against EDMC notes that the company's CEO Todd Nelson was previously accused of fraudulent recruiting practices when he ran the University of Phoenix and paid nearly $10 million to the Department of Education to settle the claim.
Also announced in August were the results of an undercover government probe wherein investigators posing as prospective students found instances of lying and misrepresentation at all 15 for-profit schools they investigated. Among other things, the investigators documented instances of schools encouraging students to lie on the Free Application for Federal Student Aid, schools calling students nearly 200 times in a month in order to pressure them into enrollment, representatives lying about their organization's credentials and accreditations, recruiters lying about graduation rates and the likelihood of securing employment post graduation, and representatives telling students that they could not get information about federal student aid unless they enrolled in the college first.
Clearly, these charges do not bode well for proprietary schools. As their SEC filings make abundantly clear, they depend on federal loans for their very survival. If they are cut-off from federal money, they are unlikely to survive. Reading their 10Ks and 10Qs is liking walking through a mine field--it's hard to see the white paper for all of the red flags.
In the interest of time, I will focus on EDMC (all quotes from this point forward are taken from the company's most recent 10K and 10Q unless otherwise specified). The company 'indirectly' derived 90.3% of its revenues from Title IV programs in fiscal 2011, up 2% from 2010. In its 2011 annual report the company notes that it does not meet the government's 'quantitative standards of financial responsibility' and as such, is only 'provisionally certified' to receive Title IV funds and must post a letter of credit with the Department of Education to cover a portion of the amount its students receive in federal funds.
In its 2010 10K the company noted that they "expect[ed] to continue to not satisfy the U.S.['s] ... quantitative measure of financial responsibility for the foreseeable future [and] as a result, ... expect[ed] each of [its] schools to [remain] on provisional certification ... and [be] required to renew the letter of credit at the 10% level...although the U.S. could increase the amount substantially" (my italics). The U.S. did in fact increase the amount substantially in 2011. EDMC must now post 15% to remain provisionally certified--that amount was $361.5 million in 2011. Because this percentage could continue to be increased by the Department of Education and because failure to post the letter of credit could result in loss of access to Title IV funds which make up 90.3% of the company's revenue, the fact that EDMC believes it "may not have sufficient letter of credit capacity to satisfy the letter of credit requirement" in the future is a real problem.
Later in the 2011 10K the company notes that under the so-called 90/10 rule of the Higher Education Act (HEA), an institution which derives more than 90% of its revenue from Title IV programs for two consecutive fiscal years will be deemed ineligible to receive federal funds and cannot reapply for two years. In 2011, EDMC's 'weighted average' of revenue from Title IV funds was 78%. This seems to directly contradict the 90.3% reported in its most recent 10Q, but I'm sure there is some creative accounting work behind that.
In any case, EDMC's compliance with the 90/10 rule has been helped out over the past three years by a revision in the 2008 HEA reauthorization which provide for "relief through June 30, 2011 from a $2,000 increase in the annual Stafford loan availability for undergraduate students." Should this 'relief' not be extended, EDMC predicts that its "90/10 rate will increase substantially in 2012." Additionally, the company notes that "continued decreases in the availability of state grants, together with the inability of households to pay cash due to the current economic climate...also have adversely impacted [its] ability to comply with the 90/10 rule." Indeed the company predicts that some of its schools will not comply with the rule in fiscal 2012 and notes that "if any of its institutions violates the 90/10 rule, its ineligibility to participate in Title IV programs for at least two years would have a material adverse effect on ... net revenues."
Institutions can also lose access to Title IV funding if their so-called 'cohort default rate' reaches or rises above 25% for any three consecutive fiscal years. Unfortunately for EDMC, "beginning with the calculation of institutions' cohort default rates for the 2009 federal fiscal year which [will] be ... published in 2012, the period for which students' defaults will be included in an institutions cohort default rate will be extended by one year." This means that default rates will now include students who default on their loans within two years of the time they are scheduled to begin repayment as well as those who default in the first year. The company notes that "as a result of [this] extended default period, ... most institutions' respective cohort default rates are expected to materially increase," jeopardizing their access to Title IV funding.
All of this is on top of the fact that the company is facing a lawsuit filed by the Department of Justice which could, in the worst case scenario, cost the company a whopping $33 billion dollars (the suit alleges EDMC was not eligible for $11 billion it received in federal money and The False Claims Acts provides for 'triple damages). Incredibly, EDMC's stock price is above where it was in August when the government's suit was filed. Given the incredibly uncertain future of the company's access to Title IV funding which it relies upon for nearly all of its revenue combined with pending litigation, I believe there is a very good chance that this stock falls precipitously on bad news in the coming year. I would short, or buy puts on EDMC without hesitation.