December 07, 2015
For-profit education, a sector that generates $30 billion in annual revenues, has become increasingly volatile, having fallen victim to a number of economic and legal pressures that have eroded enrollment in for-profit schools by 16 percent between 2007 and 2014, and continues to drop, with some companies facing enrollment declines up to 50 percent. Numerous companies in the sector are facing mounting assaults by regulators and alumni, with associated litigation adding significantly to operational costs. New regulatory requirements also have increased administrative burdens and frustrated innovation. It is not surprising that in a recent survey by Gallup of college and university business officers, only 64 percent of business officers strongly agreed or agreed that their institution's financial model was sustainable over the next five years. That level of confidence dropped to only 42 percent when considered over a 10-year horizon. It is against this backdrop that we must reassess the policies that have resulted in this precarious position.
Several for-profit giants suffered staggering setbacks over the past few years. Education Management Corporation, which serves more than 100,000 students nationwide, suffered a 97 percent drop in stock value amid negative press and investigations. ITT Educational Services faced legal and regulatory scrutiny, and its stock lost more than 70 percent of its value over the past year. Most famously, Corinthian Colleges collapsed altogether under a U.S. Department of Education directive to sell 85 of its 97 schools and to close the rest.
The shakeout in this sector will continue to build steam in the coming years, forcing more institutions into crisis and causing many to close their doors permanently. Companies are vulnerable to a number of threatening trends:
- Accumulation of considerable debt from acquisitions, real estate transactions and high-yield financing.
- Dropping enrollment and increasing reluctance of students to take on student loan debt in a sluggish economy.
- High unemployment rates and intense media focus have eroded the perceived value of degrees generally; the high loan default rate among for-profit school students casts additional doubt on the value of for-profit degrees.
- State and federal governments and regulatory bodies have launched a number of investigations looking into the industry's allegedly aggressive recruiting, marketing and lending practices.
- New gainful employment regulations, launched in October 2014, threaten federal aid for for-profits if they cannot improve economic outcomes for their students.
- Recent proposals from the White House would increase competition from heavily subsidized public community colleges.
These difficulties are only compounded by the sector's slow adoption of restructuring strategies to address the shifting landscape. The reluctance to restructure educational institutions derives in part from Title IV of the Higher Education Act of 1965. Under the HEA, federal funding to institutions of higher learning that file for Chapter 11 protection are automatically cut off from federal funding and participation in the Title IV program. Since many for-profits receive as much as 90 percent of their funding through Title IV programs, Chapter 11 often means liquidation for a filing institution. This prohibition on Chapter 11 has promoted an industry-wide stigma against workouts and financial restructuring generally.
Statutory limitations that make an institution restructuring in bankruptcy ineligible to receive federal funding were introduced to Title IV of the Act in 1992. At the time, the Department of Education was faced with a number of unscrupulous trade school operators that would use Chapter 11 and the resulting automatic stay to thwart the efforts of the regulators to enforce their authority. The working assumption therefore was that any educational institution that filed for bankruptcy was one not worthy of continuing in existence. However, when Congress enacted the changes to the law, it did not anticipate the future need for a workable restructuring statute, and made no provision for troubled educational institutions.
To declare bankruptcy is to lose funding, making Chapter 11 an effective death sentence for for-profit education providers. To make matters worse, the industry has responded by adopting a hostile stance toward crisis planning generally: For-profit educators tend to stigmatize non-Chapter 11 restructuring solutions as well, such as workouts and financial restructuring—even when exploring these alternatives is the prudent and responsible thing to do. This stigma, coupled with an institution's "mission" to educate the masses and free-flowing federal funding, has resulted in a focus on marketing for new students at all costs, rather than on efficient operations and economic rationalization of existing programs.
For a company in financial trouble, Chapter 11 affords the company with numerous tools to right-size its business and reduce its ongoing operating costs. These tools include, to name a few, the right to reject or disavow burdensome contracts and leases, the ability to cap damage claims for terminated employees and landlords, the power to sell assets free and clear of liens and claims, and the ability to delever the balance sheet by eliminating and equitizing debt. In many cases, the threat of a Chapter 11 filing is enough to compel creditors and contract counter-parties to agree to a consensual out of court restructuring without the need to rely on judicial intervention. For for-profit institutions this threat does not exist, therefore, obtaining creditor concessions is infinitely more difficult. In the case of Education Management Corporation, while the company was able to negotiate and implement a financial restructuring, the inability to bind hold-outs in a bankruptcy forum led to post-restructuring litigation by hold-outs insisting on full payment of their debt. Moreover, expectations of an operational restructuring that would reduce operating costs materially were not met as the company had little leverage to achieve the desired results. Accordingly, the company has not been able to optimize its cost structure.
There has been a keen focus in the media and in Congress on the proliferation of student loans that cannot reasonably be expected to be repaid in the face of the paltry job opportunities available for degree recipients. It is certainly true that the student loan industry is in crisis. Students are borrowing heavily to pay extremely high tuitions at schools that don't provide a clear path to a career that justifies the cost. But trying to fix the student loan problem in isolation is like trying to solve unemployment by building more homeless shelters. The root of the problem must be examined. Student loans are out of control because tuitions are too high. And tuitions are too high because there are too many schools, operating inefficiently, with no way to solve their financial predicament other than by enticing ever more students into its programs. Addressing the root of the problem leads one to the conclusion that the for-profit education sector needs a catalyst to consolidate and reform. Typically, Chapter 11 provides that catalyst. Creating a healthy and competitive educational system is the best way to reduce tuitions and the dependency on student loans.
Short of a congressional overhaul of the current system that would allow access to Chapter 11, for-profit educators need to change their basic attitude toward crisis planning and embrace thoughtful, thorough restructuring planning while trouble is still on the horizon. Institutions that take restructuring seriously will be positioned to unlock value and take advantage of opportunities and strategic alternatives. Even without Chapter 11 as a viable option, for-profit educators can implement a number of restructuring initiatives to help stabilize financial and operational performance.
Regular, basic reviews of costs and expenses, long-term business plan development and protective actions that anticipate possible shifts in regulation are all signs of a proactive management. For example, some for-profits now offer "nanodegree" products—short-term courses that reduce expenses for the institution while sidestepping the student debt burdens associated with traditional degrees.
When an institution faces more serious uncertainty, such as a government investigation, pursuit of a responsible out-of-court restructuring process can demonstrate good faith to regulators and creditors, and provide a more effective backdrop for negotiating settlements with government authorities and third-party litigants. However, as indicated above, the inability to take drastic measures to address serious challenges that require a full-blown judicial process to undertake a complete operational overhaul severely impairs the likelihood of success. This lack of a better alternative often leads to a decision by management to engage in a lengthy litigation ground war with no real ability to pay an ultimate judgment.
If closing a school or program outright is unavoidable, educators can implement "teach-outs" and other plans that minimize disruption to students and faculty and create avenues to settle bet-the-company litigation. A teach-out is a transfer of students to another institution that will allow students to complete their education while the school winds down. These strategies are designed to mitigate risks under Department of Education regulations, preserve all necessary licenses and accreditations, and ensure continuity of operations. But teach-outs are expensive and often are not in the best interest of lenders that would rather see a quick cessation of the problematic operations and a preservation of the remaining assets.
In some instances, a sale of assets is the path toward maximizing value. Chapter 11 provides a fertile environment for most distressed companies to maximize value in an expeditious sale process. Once again, due to the inability to transfer ownership of an educational institution that relies on federal funding in a Chapter 11 process and due to the large number of regulatory and accreditation approvals that are required to implement a sale, a school with limited liquidity can only expect to receive fire-sale prices for its assets in a rushed out-of-court transaction.
It is clearly time for a change. The Department of Education can no longer sit back and blame for-profit educators for the condition of the educational system. Instead, it needs to be at the forefront of encouraging colleges and universities to get their houses in order or transfer their assets to a more efficient operator. Restructuring and consolidation should be encouraged and not shunned.
Congress should reconsider the outright ban of Title IV funding in Chapter 11. This can be done while also addressing the Department of Education's need to monitor and shut down funding to schools that are not performing within acceptable standards. Amendments to Chapter 11 can easily provide the Department of Education with extraordinary powers to participate in Chapter 11 cases and to pull the plug without further court order on debtors that cannot demonstrate that they can operate within acceptable business norms during the Chapter 11 case and after a restructuring is completed. Other amendments could facilitate and streamline sales of distressed schools to put them in the hands of acceptable operators for the benefit of students, faculty and creditors. With minor adjustments to the Bankruptcy Code, for-profit educators can be protected during trying financial times without permitting evasion of appropriate government oversight.
Reprinted with permission from the December 7, 2015 edition of the New York Law Journal © 2015 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.