Submitted: October 7, 2014
Draft Report: July 28, 2014
Kim E. Ayvazian Master in Chancery
Alden Walther, Jr., is a shareholder of ITT Educational Services, Inc. ("ITT"), a for-profit provider of postsecondary degree programs throughout the United States. Walther has made a demand for books and records from ITT under Section 220 of the Delaware General Corporation Law ("DGCL"), seeking to investigate, inter alia, possible mismanagement, waste, and breaches of fiduciary duty at ITT - specifically, ITT's compliance with federal Title IV eligibility requirements relating to ITT's primary source of revenue: federal Title IV student loans. As support for his suspicions, Walther cites ITT's public disclosures regarding its student cohort default rates for the years 2009 through 2012, and a Majority Committee Staff Report ("Staff Report") issued by the United States Senate Health, Education, Labor and Pensions Committee ("Senate HELP Committee") in July 2012, which stated that ITT had only recently begun to focus on bringing down its three-year default rate. Walther claims that his evidence is sufficient as a matter of law to support a Section 220 demand, and has moved for summary judgment under Court of Chancery Rule 56. ITT, in turn, claims that Walther's evidence is insufficient as a matter of law and has filed a cross-motion for summary judgment. For the reasons below, I find that Walther's evidence is sufficient to support his demand to investigate a potential mismanagement claim and, therefore, I recommend in this draft report that the Court grant Walther's motion for summary judgment as to four of the five categories of requested books and records.
ITT offers diploma, associate, bachelor, and master degree programs in various fields of study throughout the United States. It operates two main brands: Daniel Webster College and the ITT Technical Institutes. The Institutes account for 99 percent of ITT's students, and the majority of ITT's revenues come from Title IV Federal student aid programs. To be eligible to receive Title IV funds, ITT must fulfill certain eligibility requirements, one of which is based on student loan default rates.
From 1990 to 2011, student loan default rates were calculated by the United States Department of Education ("Department of Education" or "ED") using a cohort default rate ("CDR") measured over a two-year period. A two-year CDR is the rate at which students who are scheduled to begin repayment on their loans in year one have defaulted on their loans by the end of year two. From 1994 to 2011, if an institution was determined to have a two-year CDR of 25 percent or greater for three consecutive years, it would be ineligible to receive Title IV funds for three years beginning with the year in which the determination was made. An institution with a two-year CDR of 25 percent or more in any two of the three most recent years would be placed on provisional Title IV status.
In August 2008, the HEA was amended and changes were made to the CDR requirements for Title IV eligibility. Beginning in 2009, CDRs were measured over three years and the eligibility threshold was raised to 30 percent from 25 percent. The first official three-year CDRs were scheduled for release on September 24, 2012. Beginning in October 2009, the Department of Education released trial three-year CDRs for each year starting with the 2005 cohort. However, the first cohort to be monitored for the additional year consisted of borrowers who entered repayment between October 1, 2008 and September 30, 2009. Thus, an institution's 2009 three-year CDR would reflect the percentage of borrowers in the 2009 cohort who defaulted on their student loans on or before September 30, 2011.
On February 18, 2009, ITT filed its annual report for 2008 on Form 10-K with the Securities and Exchange Commission ("SEC"), disclosing that it derived approximately 73 percent of its revenues from federal student financial aid programs under Title IV, and disclosing the 2008 changes to the calculation of student default rates and the new threshold at which an institution could lose its Title IV eligibility. On October 28, 2009, the Department of Education promulgated regulations dealing with three-year CDRs, and on December 7, 2009, it released illustrative trial three-year CDRs to all institutions.
On August 6, 2010, ITT filed a Form 8-K with the SEC disclosing that the company had received a request for information and documents from the Senate HELP Committee. On October 22, 2010, ITT filed a Form 10-Q with its quarterly results for the third quarter of 2010, disclosing that the Senate HELP Committee was conducting hearings in connection with the for-profit education industry.
On February 17, 2012, ITT common stock closed at $75.52, its high for 2012. On February 24, 2012, ITT filed its annual report for 2011, disclosing that the average of its three institutions' two-year CDRs had risen from 11.5 percent in 2007 to 22.3 percent in 2009. In addition, the annual report disclosed:
We believe that the increase in the official Two-Year CDR average for FFY 2009 compared to the official Two-Year CDR average for FFYs 2008 and 2007 was primarily due to the servicing on the FFEL program loans that were purchased by the ED from the lenders (the "Purchased Loans"). The Purchased Loans were initially serviced by the FFEL program lenders that made those loans, until the Purchased Loans were sold to the ED. Upon receipt of the Purchased Loans, the ED transferred the servicing of those loans to the servicer of the FDL program loans. Shortly thereafter, the ED replaced the servicer of the FDL program loans with four different servicers, and servicing of the Purchased Loans was distributed among the new servicers of the FDL program loans. We believe that the changes in the servicers of the Purchased Loans had a negative impact on the servicing of those loans, which could have resulted in a higher Two-Year CDR average with respect to those loans. Our institutions' Two-Year CDR average for FFY 2009 with respect to the FFEL program loans that were not sold by the FFEL program lenders to the ED (the "Retained Loans") was approximately the same as our institutions' Two-Year CDR average for FFY 2008. We believe that this is primarily due to the absence of any disruption in the servicing of the Retained Loans.
We appealed the ITT Technical Institute institutions' official Two-Year CDRs for FFY 2009 on the basis that the Purchased Loans were improperly serviced. We have not yet received the ED's determination with respect to our appeals, but we believe that the average of our ITT Technical Institute institutions' official Two-Year CDRs for FFY 2009 should be lowered by the ED to between 13.8% to 19.0%, based on the loan servicing information on the Purchased Loans included in the Two-Year CDRs for FFY 2009 that we obtained from the servicers of those loans. Based on this same information, we believe that the Purchased Loans included in the Two-Year CDRs for FFYs 2010, 2011, and possibly, 2012 may also have been improperly serviced. As a result, we intend to appeal the ITT Technical Institute institutions' official Two-Year CDRs for FFYs 201, 2011 and, possibly, 2012 on the basis that the Purchased Loans were improperly serviced.
Beginning with the official Three-Year CDRs for FFY 2009 (which we believe will be published by the ED in September 2012), the cohort default rate for three consecutive FFYs that trigger loss of eligibility to participate in FDL and Pell programs increases from 25% to 30%. We believe that our institutions' Three-Year CDRs will likely be higher than our institutions' Two-Year CDRs, because of longer repayment and default histories, among other factors. We believe that the ITT Technical Institutes' Three-Year CDRs will exceed 30% for FFY 2009 and could exceed 30% for FFY 2010, in each case primarily due to the servicing on the Purchased Loans, as discussed above.
Since the same Purchased Loans are included in both the Two- and Three-Year CDRs for FFY 2009, we intend to appeal the ITT Technical Institute institutions' official Three-Year CDRs for FFY 2009 on the basis that those Purchased Loans were improperly serviced, unless the ED removes the improperly serviced Purchased Loans from the calculation of those rates as a result of our appeal of the ITT Technical Institute institutions' official Two-Year CDRs for FFY 2009 discussed above. Similarly, and for the same reason that we intend to appeal the Two-Year CDRs for FFYs 2010, 2011 and, possibly, 2012, as discussed above, we intend to appeal the ITT Technical Institute institutions' Three-Year CDRs for FFYs 2010, 2011 and, possibly, 2012.
On March 13, 2012, ITT's common stock closed at $63.57 per share. On April 26, 2012, ITT filed a Form 10-Q with the SEC, disclosing its results for the first quarter of 2012, and the following statement:
Beginning with the official Three-Year CDRs for FFY 2009 (which we believe will be published by the ED in September 2012), the cohort default rate for three consecutive FFYs that triggers loss of eligibility to participate in FDL and Pell programs increases from 25% to 30%. We believe that our institutions' Three-Year CDRs will likely be higher than our institutions' Two-Year CDRs, because of longer repayment and default histories, among other factors. The ITT Technical Institute institutions' preliminary average Three-Year CDR for FFY 2009 was 34.2%, and we believe that the ITT Technical Institute institutions' Three-Year CDRs could exceed 30% for FFY 2010, in each case primarily due to the servicing on the Purchased Loans, as discussed above.
On July 29, 2012, the Senate HELP Committee released the Staff Report entitled "For Profit Higher Education: The Failure to Safeguard the Federal Investment and Ensure Student Success." ITT was one of 30 companies examined by the Senate HELP Committee. The Staff Report included the following statements about ITT:
While the number of students leaving ITT with no degree is lower than some, the number of students defaulting on student loans is high. … The 3-year default rate across all 30 companies examined increased each fiscal year between 2005 and 2008, from 17.1 percent to 22.6 percent. This change represents a 32.6 percent increase over 4 years. ITT's default rate has similarly increased, growing from 21.1 percent for students entering repayment in 2005 to 26.3 percent for students entering repayment in 2009. ITT's most recent default rate is the sixth highest rate of loan default amongst the 30 schools. The company expects its 2009 draft 3-year cohort default rate to be approximately 34 percent.
It is likely that the reported default rates significantly undercount the number of students who ultimately face default, because of companies' efforts to place students in deferments and forbearances. Helping get delinquent students into repayment, deferment, or forbearance prior to default is encouraged by the Department of Education. However, for many students forbearance and deferment serve only to delay default beyond the 3-year measurement period the Department of Education used to track defaults.
Default management is primarily accomplished by putting students who have not made payments on their student loans into temporary deferments or forbearances. Default management contractors are paid to counsel students into repayment options that ensure that students default outside the 2-year, soon to be 3-year, statutory window, in which the Department of Education monitors defaults.
ITT has only recently begun to focus these efforts on bringing down their 3-year default rate. When discussing as to why the 3-year default rate was higher than the 2-year, ITT CFO Daniel Fitzpatrick stated:
I think that you do know that when we talk about adding that third year into the calculation, really that third year was not really worked at all, in the way the first two years are worked and so it is really hard to indicate what type of impact we can have there. We know that when we provided default management services there, we are able to mitigate losses.
At the close of markets on July 20, 2012, the first trading day after the release of the Senate Report, ITT common stock closed at $39.99 per share. On October 11, 2012, Walther served ITT with a written demand under oath to inspect ITT's books and records for the following purposes:
(1) to investigate corporate mismanagement, waste, or wrongdoing, including but not limited to, to determine whether the Company's officers and directors have properly discharged their fiduciary duties to the Company and its stockholders; (2) to obtain information to determine whether or not the Company's officers and directors are independent and disinterested, and ...