For-Profit Colleges

The Senate Report (S. Rep. No. 58(1991) did in fact find numerous instances of fraud and abuse in the Guaranteed Student Loan Program (the GSLP). But the Report repeatedly noted that the fraud and abuse was by far most prevalent in proprietary schools (i.e., for-profit schools). Section 1002, the automatic ineligibility statute, regrettably makes no distinction between for-profit and not-for-profit schools ' or any other distinction, for that matter. It is automatic, without exception, without differentiation, permanent and without regard to the specific facts causing financial distress for the school.

The types of fraud and abuse described in the Report varied. They ranged from unscrupulous school operators to incompetent regulators to ineffective accrediting bodies to careless guaranty agencies. For example, the Report found that in the case of American Career Training Corporation, a for-profit school for secretaries and travel agents, the school employed only 23 instructors, but 109 commission sales representatives. The accrediting bodies to which the Department of Education (DOE) in practice delegated most of the responsibility to evaluating compliance with DOE regulations depended for a majority of their revenues on membership dues. The more the number of schools accredited, the greater their income. Further, the accrediting bodies expressly disavowed any duty to see if Title IV funds were being administered properly ' yet the DOE testified to the Senate Subcommittee that it relied on the accrediting bodies for that very purpose. Other abuses included failure to timely fulfill the refund requirements (the obligation to refund to students tuition payments when students withdraw early), branching to avoid requirements that a school be in operation for two years before being able to participate in the GSLP, fraudulently misrepresenting to students the school's employment placement record, and many others.

It is entirely unclear and unexplained how automatic eligibility termination would address the fraud and abuse described in the Report.

Bankruptcy

There are only two references in the Report to bankruptcy. The first, at p. 23, quotes the DOE Inspector General's testimony:

By securing the protection of the [bankruptcy] court which has an interest in seeing that schools survive through reorganization, even a school that cannot make loan refund payments to former students may continue to admit new students who in turn incur student loan obligations [even though that] ' school may well close or otherwise cut back the student program.

And at p. 35 of the Report, it is stated that the then-recently enacted Default Reduction Initiative was designed to reduce loan default by including provisions to limit “the bankruptcy recourse used by schools trying to escape adverse action by accrediting agencies.”

Both these observations are singularly uninformed about the Chapter 11 process, which includes provisions for the appointment of a trustee in the case of fraud or gross mismanagement, the inapplicability of the automatic stay under certain circumstances and procedures for the prompt lifting of the stay in others, the duty of the trustee to pursue claims against wrongdoers for the benefit of creditors, the unique bankruptcy powers of the trustee to avoid certain transactions and recover transfers, and the ability of any party in interest to move to convert the case to one under Chapter 7. Further, to the extent additional or special provisions in the post-secondary school context might be necessary such could surely be adopted without wholesale abandonment of the rehabilitative option.

Beyond the adequacy of the existing bankruptcy law to deal with the fraud and abuse described in the Report, the automatic ineligibility provision destroys many good schools that operate sound academic programs but that have run into financial problems because of excessive leverage, declining enrollment, structural changes in the employment market, or a combination of these. These are the kind of issues Chapter 11 is designed to deal with while preserving the value of a going concern and protecting suppliers, employees, creditors, students ' the constituencies which suffer from the sudden closure of a school.

Post-Secondary School Bankruptcies

In point of fact, the Bankruptcy Code has provisions that make effective recourse for a post-secondary school to Chapter 11 relief challenging. Subsections 362(b)(15) and (b)(16) exclude from the automatic stay “any action by an accrediting agency regarding the accreditation status” and “any action by a guaranty agency ' or the Secretary of Education regarding eligibility of the debtor to participate in programs authorized by” the Higher Education Act (HEA). In addition, Section 541 of the Bankruptcy Code excludes from property of the debtor's estate “any eligibility of the debtor to participate in programs authorized under the [HEA] ' or any accreditation status or State licensure of the debtor as an educational institution.”

Even with these obstacles, reorganization under Chapter 11 would not be impossible but for the automatic ineligibility under section 1002. With respect to the inapplicability of the automatic stay, the debtor would not be without remedy. The procedural avenue to stop an action not automatically stayed and that threatens the bankruptcy reorganization is a request for an injunction using Section 105 of the Bankruptcy Code. As Professor Charles Tabb has written: “the bankruptcy court's injunctive power is not limited by the delineated exceptions to the automatic stay ' ” Charles Tabb, Ralph Brubaker, Bankruptcy Law: Principles, Policies and Practices (2010), LexisNexis.

Regarding the exclusion from “property of the estate,” such exclusion would not foreordain the value-destructive result in In Re Betty Owens Schools, Inc., 195 BR 23 (Bankr. S.D.N.Y. 1996). In Betty Owens, the school, a vocational institution, filed for Chapter 11 relief and was informed by the DOE that it was therefore immediately ineligible to participate in GSLP. The debtor sold its assets under Section 363 of the Bankruptcy Code. The buyer applied for certification of GSLP eligibility with the DOE under procedures that allow a buyer to receive provisional immediate certification based on the seller's eligibility. The DOE denied the buyer's request, asserting that since the seller had automatically and immediately lost its eligibility upon the Chapter 11 filing, the procedure for provisional certification was not available to the buyer. The buyer was left to apply through regular procedures, which entailed a two-year waiting list.

The result of the DOE's position is to destroy the going-concern value of an educational institution for no reason other than the filing of a Chapter 11 case. The parties who suffer from such loss of value are the creditors, the students, and the U.S. taxpayer.

Recent Rulings

In a more recent case, In re Lon Morris College , Case No. 12-60557-BP-11 (Bankr E.D.Tex. 2012), a 158-year-old nonprofit two-ear institution in Jacksonville, TX, was shuttered as a result of automatic ineligibility. The ruling by the bankruptcy court held that the anti-discrimination provision in the Bankruptcy Code, Section 525, was trumped by the automatic ineligibility statute.

Because of automatic ineligibility, the contortions, only partially successful, to which schools must resort in order to obtain value for the creditors are illustrated in In re FCC Holdings, Inc. et al., in what is known as the Anthem Education bankruptcy case. Case No. 14-11987-CSS (Bankr. D. Del. 2014).

In Anthem, the school (actually a number of entities owning a number of for-profit schools) developed a two-step structure to sell certain of the schools and avoid GSLP ineligibility. The first step, pre-Chapter 11, was to sell certain schools for which such eligibility needed to be maintained. Anthem then filed Chapter 11 and asked for court approval of step two ' the assumption and assignment of certain contacts that could not be assumed and assigned pre-Chapter 11, and the sale free and clear of liens of certain other schools for which GSLP eligibility was not an issue.

Analysis

The benefits of Chapter 11, whether rehabilitation or going concern sale, could have been much more easily and inexpensively achieved in the cases described above but for the automatic eligibility termination. Moreover, as recognized by all restructuring professionals, many restructurings occur “in the shadow of the bankruptcy court,” that is, with the availability of Chapter 11 looming over the negotiations. Parties, creditors, suppliers, shareholders and bondholders all measure the results they can obtain by negotiation against the result that might be imposed on them by court order. The power of holdouts, secured creditors and landlords is counter-balanced by the powers granted to the debtor under the Bankruptcy Code. If all parties identify the same risks and estimate the same outcome probabilities, then a negotiated restructuring is certainly possible. But when the debtor is stripped of the bankruptcy counter weight, any negotiation with the secured creditor at least turns into capitulation at the expense of other creditors and frequently the institution itself.

Order is better than chaos. Reorganization is better than closure. Planned closure is better than disruptive shut down. If Chapter 11 were available to post-secondary schools, rehabilitation for those schools whose problems are balance-sheet issues (excessive debt) but not academic or management, would be possible. The result, among others, would be to preserve the institution, the value of credits earned by students and the value of degrees confirmed to alumni. If the problems are not balance-sheet but do relate to mismanagement, the appointment of a trustee in a Chapter 11 could also accomplish value preservation strategies in addition to pursuing wrongdoers with the enhanced powers not available outside of bankruptcy.

If the schools' problems are such that rehabilitation is not possible, then a sale of assets as a going concern enhances recovery to creditors and benefits students. Finally, even if a shutdown is necessary, done with appropriate planning and teach out strategies to place students in other schools is far preferable than the chaos seen in the Corinthian case where 16,000 students have been left marooned with no lifeboat in sight.

Victor A. Vilaplana is of counsel and a litigation attorney with Foley & Lardner LLP, resident in the San Diego, CA, office. Mr. Vilaplana focuses his practice on the handling of insolvency matters, particularly complicated business bankruptcies and international transactions

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'

In 1992, Congress enacted a number of provisions as part of the Higher Education Act reauthorization in reaction to hearings held by the Senate Permanent Subcommittee on Investigations regarding abuses in the federal student aid program. One of the provisions is 20 USC 1002(a)(4)(A), which automatically makes any post-secondary school that files for bankruptcy ineligible to receive federal student financial aid (often referred to as Title IV funds) for its students. This automatic ineligibility is also set out in 34 CFR 600.7

The effect of the statute and the regulation is to deny to any post-secondary school suffering financial distress the rehabilitative opportunity available under Chapter 11 of the Bankruptcy Code. Instead, such school is left to liquidate its assets and, deprived of access to the government student loan program, frequently to abruptly and chaotically cease operations as in the recent case of Corinthian College, Inc. Why?

Background

The Senate Report (S. Rep. No. 58(1991) did in fact find numerous instances of fraud and abuse in the Guaranteed Student Loan Program (the GSLP). But the Report repeatedly noted that the fraud and abuse was by far most prevalent in proprietary schools (i.e., for-profit schools). Section 1002, the automatic ineligibility statute, regrettably makes no distinction between for-profit and not-for-profit schools ' or any other distinction, for that matter. It is automatic, without exception, without differentiation, permanent and without regard to the specific facts causing financial distress for the school.

The types of fraud and abuse described in the Report varied. They ranged from unscrupulous school operators to incompetent regulators to ineffective accrediting bodies to careless guaranty agencies. For example, the Report found that in the case of American Career Training Corporation, a for-profit school for secretaries and travel agents, the school employed only 23 instructors, but 109 commission sales representatives. The accrediting bodies to which the Department of Education (DOE) in practice delegated most of the responsibility to evaluating compliance with DOE regulations depended for a majority of their revenues on membership dues. The more the number of schools accredited, the greater their income. Further, the accrediting bodies expressly disavowed any duty to see if Title IV funds were being administered properly ' yet the DOE testified to the Senate Subcommittee that it relied on the accrediting bodies for that very purpose. Other abuses included failure to timely fulfill the refund requirements (the obligation to refund to students tuition payments when students withdraw early), branching to avoid requirements that a school be in operation for two years before being able to participate in the GSLP, fraudulently misrepresenting to students the school's employment placement record, and many others.

It is entirely unclear and unexplained how automatic eligibility termination would address the fraud and abuse described in the Report.

Bankruptcy

There are only two references in the Report to bankruptcy. The first, at p. 23, quotes the DOE Inspector General's testimony:

By securing the protection of the [bankruptcy] court which has an interest in seeing that schools survive through reorganization, even a school that cannot make loan refund payments to former students may continue to admit new students who in turn incur student loan obligations [even though that] ' school may well close or otherwise cut back the student program.

And at p. 35 of the Report, it is stated that the then-recently enacted Default Reduction Initiative was designed to reduce loan default by including provisions to limit “the bankruptcy recourse used by schools trying to escape adverse action by accrediting agencies.”

Both these observations are singularly uninformed about the Chapter 11 process, which includes provisions for the appointment of a trustee in the case of fraud or gross mismanagement, the inapplicability of the automatic stay under certain circumstances and procedures for the prompt lifting of the stay in others, the duty of the trustee to pursue claims against wrongdoers for the benefit of creditors, the unique bankruptcy powers of the trustee to avoid certain transactions and recover transfers, and the ability of any party in interest to move to convert the case to one under Chapter 7. Further, to the extent additional or special provisions in the post-secondary school context might be necessary such could surely be adopted without wholesale abandonment of the rehabilitative option.

Beyond the adequacy of the existing bankruptcy law to deal with the fraud and abuse described in the Report, the automatic ineligibility provision destroys many good schools that operate sound academic programs but that have run into financial problems because of excessive leverage, declining enrollment, structural changes in the employment market, or a combination of these. These are the kind of issues Chapter 11 is designed to deal with while preserving the value of a going concern and protecting suppliers, employees, creditors, students ' the constituencies which suffer from the sudden closure of a school.

Post-Secondary School Bankruptcies

In point of fact, the Bankruptcy Code has provisions that make effective recourse for a post-secondary school to Chapter 11 relief challenging. Subsections 362(b)(15) and (b)(16) exclude from the automatic stay “any action by an accrediting agency regarding the accreditation status” and “any action by a guaranty agency ' or the Secretary of Education regarding eligibility of the debtor to participate in programs authorized by” the Higher Education Act (HEA). In addition, Section 541 of the Bankruptcy Code excludes from property of the debtor's estate “any eligibility of the debtor to participate in programs authorized under the [HEA] ' or any accreditation status or State licensure of the debtor as an educational institution.”

Even with these obstacles, reorganization under Chapter 11 would not be impossible but for the automatic ineligibility under section 1002. With respect to the inapplicability of the automatic stay, the debtor would not be without remedy. The procedural avenue to stop an action not automatically stayed and that threatens the bankruptcy reorganization is a request for an injunction using Section 105 of the Bankruptcy Code. As Professor Charles Tabb has written: “the bankruptcy court's injunctive power is not limited by the delineated exceptions to the automatic stay ' ” Charles Tabb, Ralph Brubaker, Bankruptcy Law: Principles, Policies and Practices (2010), LexisNexis.

Regarding the exclusion from “property of the estate,” such exclusion would not foreordain the value-destructive result in In Re Betty Owens Schools, Inc., 195 BR 23 (Bankr. S.D.N.Y. 1996). In Betty Owens, the school, a vocational institution, filed for Chapter 11 relief and was informed by the DOE that it was therefore immediately ineligible to participate in GSLP. The debtor sold its assets under Section 363 of the Bankruptcy Code. The buyer applied for certification of GSLP eligibility with the DOE under procedures that allow a buyer to receive provisional immediate certification based on the seller's eligibility. The DOE denied the buyer's request, asserting that since the seller had automatically and immediately lost its eligibility upon the Chapter 11 filing, the procedure for provisional certification was not available to the buyer. The buyer was left to apply through regular procedures, which entailed a two-year waiting list.

The result of the DOE's position is to destroy the going-concern value of an educational institution for no reason other than the filing of a Chapter 11 case. The parties who suffer from such loss of value are the creditors, the students, and the U.S. taxpayer.

Recent Rulings

In a more recent case, In re Lon Morris College , Case No. 12-60557-BP-11 (Bankr E.D.Tex. 2012), a 158-year-old nonprofit two-ear institution in Jacksonville, TX, was shuttered as a result of automatic ineligibility. The ruling by the bankruptcy court held that the anti-discrimination provision in the Bankruptcy Code, Section 525, was trumped by the automatic ineligibility statute.

Because of automatic ineligibility, the contortions, only partially successful, to which schools must resort in order to obtain value for the creditors are illustrated in In re FCC Holdings, Inc. et al., in what is known as the Anthem Education bankruptcy case. Case No. 14-11987-CSS (Bankr. D. Del. 2014).

In Anthem, the school (actually a number of entities owning a number of for-profit schools) developed a two-step structure to sell certain of the schools and avoid GSLP ineligibility. The first step, pre-Chapter 11, was to sell certain schools for which such eligibility needed to be maintained. Anthem then filed Chapter 11 and asked for court approval of step two ' the assumption and assignment of certain contacts that could not be assumed and assigned pre-Chapter 11, and the sale free and clear of liens of certain other schools for which GSLP eligibility was not an issue.

Analysis

The benefits of Chapter 11, whether rehabilitation or going concern sale, could have been much more easily and inexpensively achieved in the cases described above but for the automatic eligibility termination. Moreover, as recognized by all restructuring professionals, many restructurings occur “in the shadow of the bankruptcy court,” that is, with the availability of Chapter 11 looming over the negotiations. Parties, creditors, suppliers, shareholders and bondholders all measure the results they can obtain by negotiation against the result that might be imposed on them by court order. The power of holdouts, secured creditors and landlords is counter-balanced by the powers granted to the debtor under the Bankruptcy Code. If all parties identify the same risks and estimate the same outcome probabilities, then a negotiated restructuring is certainly possible. But when the debtor is stripped of the bankruptcy counter weight, any negotiation with the secured creditor at least turns into capitulation at the expense of other creditors and frequently the institution itself.

Order is better than chaos. Reorganization is better than closure. Planned closure is better than disruptive shut down. If Chapter 11 were available to post-secondary schools, rehabilitation for those schools whose problems are balance-sheet issues (excessive debt) but not academic or management, would be possible. The result, among others, would be to preserve the institution, the value of credits earned by students and the value of degrees confirmed to alumni. If the problems are not balance-sheet but do relate to mismanagement, the appointment of a trustee in a Chapter 11 could also accomplish value preservation strategies in addition to pursuing wrongdoers with the enhanced powers not available outside of bankruptcy.

If the schools' problems are such that rehabilitation is not possible, then a sale of assets as a going concern enhances recovery to creditors and benefits students. Finally, even if a shutdown is necessary, done with appropriate planning and teach out strategies to place students in other schools is far preferable than the chaos seen in the Corinthian case where 16,000 students have been left marooned with no lifeboat in sight.

Victor A. Vilaplana is of counsel and a litigation attorney with Foley & Lardner LLP, resident in the San Diego, CA, office. Mr. Vilaplana focuses his practice on the handling of insolvency matters, particularly complicated business bankruptcies and international transactions