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Restructuring difficult when debtor a for-profit learning institution.

In many respects, the story of financial distress in the for-profit higher education industry has played out similarly to other regulated industries: consumer dissatisfaction, government investigation, loss of capital market credibility and an eventual liquidity crisis. Resolving this distress has proven to be fraught with risk, as there exists no mediated forum in which to negotiate the various parties' restructuring proceedings. The story of trouble in for-profit higher education starts with Title IV.

Title IV of the Higher Education Act of 1965 grants broad powers to the U.S. Department of Education (DOE) to regulate higher education, and it defines which institutions are eligible to receive the proceeds of federal student financial aid. Among various defining attributes, one is critical to this discussion: The school cannot be bankrupt:

   An institution shall not be considered to meet the
   definition of an institution of higher education in
   paragraph (1) if: (A) the institution, or an affiliate
   of the institution that has the power, by contract or
   ownership interest, to direct or cause the direction
   of the management or policies of the institution,
   has filed for bankruptcy. 20 U.S. Code [section] 1002(a)(4).


The implications of this definition are significant. If an institution files for bankruptcy, even Chapter 11, it will be barred from receiving any federal student aid funding. Given that for-profit institutions derive approximately 80% of their revenue from federal student aid programs, the loss of this revenue and these students would render the institution not viable as a going concern.

To appreciate the restructuring difficulties created by this definition, we consider some examples:

Lon Morris College

Lon Morris was a private nonprofit junior college in Jacksonville, TX. The Methodist-affiliated school was the oldest two-year college in Texas. After several years of operating losses, declining enrollments and diminishing donor support, Lon Morris filed for bankruptcy in July 2012, expecting to restructure its debts, continue as a going concern and serve its student population.

In August 2012, the U.S. Department of Education (DOE) notified the school's president that it had commenced an emergency action to revoke Lon Morris' Title IV status. Despite a plea to the Bankruptcy Court to stay the department's action, the court found that the department acted within its statutory authority. Without federal student aid, most students were unable to enroll that fall, rendering Lon Morris dead. As of the filing, the school was expecting to enroll 250 students for the next year. On an emergency basis, the school sought to transfer students to other schools while it suspended its fall semester. The school proceeded to liquidate.

While not a for-profit school, Lon Morris demonstrated that the DOE was unwilling to bankroll any students' attendance at a college that could not keep its own financial house in order. Not having to subject itself to the will of the Bankruptcy Court, the DOE signaled that it intended to uphold its mandate.

Corinthian Colleges

Corinthian Colleges Inc. once was among the nation's largest for-profit education providers with 12,000 employees and 72,000 students at 107 schools. It was organized under three brands: Wyotech, Heald and Everest. Consumer dissatisfaction with job placement combined with sizable debt-funded investments in Corinthian-issued degrees led to 20 attorneys' general, the Consumer Financial Protection Bureau, the Department of Justice and the Securities and Exchange Commission investigating and/or filing suits against the company.

Corinthian's very public problems resulted in a self-fulfilling prophecy, with fewer students applying for its programs. Before the DOE ever took action, private lenders that financed the operator's students curtailed their lending activities, partially as a result of broad scrutiny of private education loans and partially as a result of lenders having unacceptable default experience with Corinthian's graduates. To keep enrollments up, Corinthian extended discounts or loans of its own, both of which tied up precious capital.

As liquidity dried up, the DOE moved on June 2014 to put Corinthian on Heightened Cash Monitoring 1 (HCMI), extending the remittance period for loan proceeds to 21 days from one to three days. While the action was not related to Corinthian's financial condition--but in response to several attempts to get information regarding recruitment and marketing methods and designed to pressure it to comply with an investigation into its tactics--the delay of funding created a predictable cash hole. The disclosure rattled Corinthian's lenders and shareholders.

In July, Corinthian and the DOE entered into an operating agreement whereby Corinthian would sell 85 U.S. schools and its Canadian schools and facilitate the "teach out" of 12 schools (i.e., enable only enrolled students to complete their degrees) that the DOE had stipulated would not be eligible for Title IV funds for new students. In exchange for entering into the operating agreement, the DOE made available up to $42 million in advances on previously held loan proceeds.

Pursuant to the operating agreement, the DOE appointed a monitor to oversee progress of the company with plan implementation and compliance with pre-existing information requests. The operating agreement further stipulated that the company and DOE would work together to establish a reserve fund of no less than $30 million to cover full refunds to new students enrolling in schools subject to the teach-out (refunds that would reduce affected students' federal loan balances to zero).

With the sales process underway, the DOE took an increasingly involved role, eventually opting to supervise marketing of the schools directly. Also, the DOE chose to directly review any changes to compensation of the senior executives of Corinthian. Then, the DOE compelled the company to enter into an amendment to the operating agreement that codified the funding of an escrow agreement to protect student refunds (some proceeds of which would repay federal aid advances). The funding was a clear diversion of cash collateral that would ordinarily have been troublesome for the lenders, which already made $9 million available to the company to operate.

Once again, the DOE said it would withdraw from the operating agreement--and Title IV funding--to urge the lenders to go along. This ultimatum challenged lenders' stipulation that any modification of the operating agreement was a default, to say nothing of a unilateral change in payment priority from collateral. With only 12 days to decide, the lenders had little choice but to consent.

Corinthian agreed to sell 56 campuses, including its online campuses and 12 campuses subject to teach-out, to a newly formed unit of student loan guarantor, ECMC Group Inc., for $24 million. A portion of the proceeds would go to pay down the company's lenders, and $12 million would be paid to the DOE. The breakup of Corinthian is an example of the DOE's resolution of problems with Title IV-funded institutions. Without access to bankruptcy, the company and the secured creditors were unable to go forward. The DOE's interests stood apart from the providers of capital. The Corinthian example might be damaging to the ability of for-profit institutions to operate independently and access capital.

Education Management Corp.

It is hard to separate the difficulties faced by the next example from the market effects of Lon Morris and Corinthian cases. Pittsburgh-based Education Management (EDMC) operates the Art Institutes, Argosy University, Brown Mackie College and South University. EDMC is among the largest providers of for-profit postsecondary education in North America, based on student enrollment and revenue, with a total of 110 locations in 32 U.S. states and Canada as well as online instruction.

Education Management, which operates 50 Art Institutes and other postsecondary schools, said recently that new student enrollment fell by nearly 10% in the first quarter 2014, and enrollment overall was down 15.7%. In May 2014, it warned that it was likely to breach its loan agreement on June 30, potentially placing well over $1 billion in debt in default. The company announced in September 2014 that it had entered into a Restructuring Support Agreement with creditors holding in excess of 94% of the company's aggregate debt and the company's principal shareholders, pursuant to which the company's existing shareholders would retain 4% of the outstanding common stock after giving effect to the conversion of new preferred stock to be issued to creditors and receive warrants to purchase an additional 5% of the common stock.

Notwithstanding the success of the exchange offer, two note-holders holding $20 million of notes (out of more than $1 billion of funded debt), Marblegate Asset Management, LLC and Magnolia Road Capital LP, sued in federal court seeking to enjoin the restructuring. In its application for preliminary injunctive relief on Oct. 28, 2014, it argued that their notes be kept in place, with no change to principal and interest, while other holders exchange their debt claims for equity interests.

The court denied the injunction motion filed by Marblegate Asset Management, LLC and Magnolia Road Capital LP, basing its decision on, among other things, the balance of equities and the public interest. The court also concluded on a preliminary basis that the two funds were likely to succeed on the claim they have asserted under the Trust Indenture Act. EDMC disagreed, but proceeded to consummate its restructuring without the noteholders.

Since then, EDMC has completed step one of the restructuring, including the completion of its private offer to exchange in excess of $1.3 billion of outstanding indebtedness for the issuance of two first lien senior secured term loans due July 2, 2020 in the aggregate principal amount of $400 million, mandatorily convertible preferred stock, optionally convertible preferred stock and warrants for common stock. The company also repaid $150 million under its existing line of credit and obtained a new line of credit in the amount of $150 million that is presently undrawn. Despite having accomplished this, the company and its new restructuring sponsors intend to continue litigation with its holdout noteholders to protect the interests of those investors that did participate in the restructuring.

In any other industry, EDMC would seek to have its restructuring plan confirmed by a bankruptcy judge, over the objections of dissenting participants of a class. As we have seen, it was not an option. Holdout noteholders have argued their claims to be inviolable, and so far, have prevailed. Whether these claims are held to maturity or redeemed pursuant to some settlement with the company, the cost of the restructuring will be higher, a fact that will not be lost on future education restructuring participants.

It also begs the question: What if the dissenting noteholders were 20% of the debt, rather than 2%? What if the equity holders were public shareholders versus a prestigious private equity firm?

Need for Reform

Whether or not the political support exists to allow Title IV participating institutions to file for declare bankruptcy is a discussion for another article. However, the current paradigm where the restructuring process can be hampered by any of several parties tied to Title IV institutions is likely to continue having a daunting effect.

Sal Tajuddin is a managing director at Capstone Advisory Group in Washington, D.C., where he provides crisis management services to organizations and investors dealing with financial distress. Sal is a Chartered Financial Analyst and Certified Insolvency and Restructuring Advisor.
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Title Annotation:SELECTED TOPIC
Author:Tajuddin, Sal
Publication:Business Credit
Date:May 1, 2015
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