A CUSO Under Attack
A fierce legal battle is under way between a student loan CUSO's seven big credit union members and what was once one of the largest for-profit education companies in the nation that went bankrupt last year.
What's at stake in this controversial case is hundreds of millions of dollars that the CUSO claims it is owed.
Indianapolis-based trustee lawyer Deborah J. Caruso, who is representing ITT Technical Institute, claims the CUSO, Student CU Connect LLC, contributed to ITT's closure and bankruptcy and argues the $224 million in dispute should be withheld and/or recovered from the CUSO.
“The CUSO loan program scheme was, at a minimum, a colossal breach of ITT's former management's fiduciary duties, may have constituted outright fraud by such management and unquestionably resulted in a massive fraudulent transfer of ITT's assets to and/or for the benefit of the defendants (the CUSO and its credit union members),” Caruso wrote in court documents.
New York City-based attorney Richard J. Bernard, who is representing the CUSO, said Caruso's complaint has no merit.
“The defendants (the CUSO and its credit union members) at all times have acted properly and in good faith, and to the extent that ITT or its management has engaged in any wrongful conduct, the defendants are victims of, not accessories to, that misconduct,” Bernard said. “We will respond appropriately to – and defend vigorously against – the trustee's filing.”
On March 30, Caruso filed a 76-page adversary complaint against the CUSO. Bernard has not yet filed his answers to Caruso's adversary complaint. But in previous court documents, in which Caruso has made similar fraud accusations against ITT, the CUSO and its credit union members, Bernard has said those allegations are demonstrably false and contradictory.
What's more, he also wrote in court documents that Caruso “grossly mischaracterizes the facts” in one of her main arguments over a key provision in an agreement between ITT and the CUSO that required ITT to guarantee payments on defaulted loans that she contends led to the bankruptcy of the Carmel, Ind.-based education company.
The seven credit union members of Student CU Connect are the $1.3 billion Elements Financial Federal Credit Union (formerly Eli Lilly Federal Credit Union) in Indianapolis, the $3.7 billion Bellco Credit Union in Greenwood Village, Colo., the $2.3 billion CommunityAmerica Credit Union in Lenexa, Kan., the $730 million Credit Union of America in Wichita, Kan., the $670 million Directions Credit Union in Sylvania, Ohio, the $3.1 billion Veridian Credit Union in Waterloo, Iowa and the $1.5 billion Workers Credit Union in Fitchburg, Mass.
In February 2009, the CUSO inked a loan program agreement with ITT that Caruso claims was allegedly used to protect and enhance the compensation of ITT's former senior management, namely CEO Kevin M. Modany and CFO Daniel M. Fitzpatrick.
ITT generated the overwhelming bulk of its revenues, hundreds of millions of dollars annually, from Title IV loans, a U.S. taxpayer-funded student financial aid program. However, the 90/10 federal rule requires students to pay 90% of their tuition from Title IV loans, and the remaining 10% has to come from private sources. Following the financial crisis in 2008 and 2009, most private lending sources dried up. That meant ITT's ability to comply with the 90/10 rule over time would be jeopardized and threaten its main source of the company's revenue.
To address this looming crisis, senior management created a temporary credit program, which offered new students a zero-interest, short-term loan they were required to pay back by the end of the school year.
However, according to Caruso, a number of these students who received the short-term loans had poor credit and were unlikely to repay the loans. These accounts dragged down ITT's income and earnings per share. ITT was a publicly-traded company and its stock performance was tied to the compensation of senior executives.
In 2008, ITT and a consultant conceived the CUSO loan program that enabled ITT to offload the underperforming student loans into the loan program, which artificially boosted ITT's profits, earnings per share and ITT executives’ compensation.
According to Caruso, ITT students who got short-term loans became members of the originating credit union, Elements Financial. For a fee, Elements Financial originated the CUSO loans that were used to pay off the short-term loans. The 10-year loans these students received from the CUSO included a 10% origination fee with a 13.75% interest rate. For students taking out loans in 2011, the interest rate increased to 16.25%. By way of comparison, according to Caruso, the federal Stafford loans available under Tittle IV offered interest rates for all borrowers that were 3.4% for subsidized loans and 6.8% for unsubsidized loans and did not charge any origination fees.
Bernard, however, pointed out in court documents that Caruso ignored the fact that the origination fee was charged to students who had a credit score below 600, which is common for a high-risk loan, and that the interest rate loans were competitive for unsecured private loans. In addition, comparing the Stafford loan rate, guaranteed by the federal government, to the CUSO's loan rate was an apples to oranges comparison.
However, Caruso also claims that the underwriting criteria was allegedly undermined by a “temporary credit exception.” This exception allowed students who would not qualify for a CUSO loan to otherwise qualify so long as the student received an ITT-approved short-term loan, had graduated from ITT or was currently enrolled in an ITT program, and had not filed for bankruptcy over the last two years.
Bernard said ITT requested this exception and that the CUSO relied on ITT's representations that the exception would extend to only a small percentage of borrowers. In fact, he said, the CUSO was surprised and dismayed to learn of this unanticipated additional risk factor.
Nevertheless, Caruso alleges ITT and the credit unions knew that the temporary credit exception would likely result in higher default rates and trigger ITT's stop-loss guarantee obligation under a risk sharing agreement.
To induce Elements Financial to originate loans and the other six credit unions to purchase CUSO membership interest and participate in the CUSO's loan pools, the agreement required ITT to provide a stop-loss guarantee to the CUSO that was triggered when the number of defaulting loans reached 35% of the loan pool. That made ITT liable for payments on all defaulting loans that exceed the 35% threshold. The default rate for the 2009 CUSO loan pool was more than 70%. Moreover, up through 2011, the default rates were more than 60%.
However, in the agreement between ITT and the CUSO, the education company had the right to make a monthly minimal payment on the loan amounts in default or make a discharge payment that would pay off the balance of loans in default with discounted interest payments and other fees. Even though Caruso indicates in court documents that ITT and the CUSO “secretly agreed” that ITT would not make any discharge payments, Bernard said Caruso ignores the undisputable fact that ITT did make discharge payments of more than $12.7 million.
Nonetheless, Caruso claims ITT's former management almost always made the monthly minimum payments and that ITT, the CUSO and its credit union members knew or should have known that ITT's guarantee obligation on the CUSO loans would increase exponentially, create a liability bubble that would burst and lead to ITT's bankruptcy demise.
However, Bernard argued in court documents that Caruso “grossly mischaracterizes the facts” about ITT's liability for guarantee payments on all defaulting loans that exceeded 35%. That was her key argument.
Because credit unions are generally conservative, the risk sharing agreement provided the CUSO with a potential additional recovery source in the event of loan defaults, he said. The additional credit supported charging lower interest rates to student borrowers than they otherwise could have obtained based on their own credit scores and provided a potential backstop to limit the CUSO's losses.
Relying on information provided by ITT, the CUSO's credit unions believed that the loan default rates would generally be lower than 35% and there was no expectation that ITT would be required to make substantial and regular payments.
“On the other hand, ITT and the managers who were privy to the real make-up of the student borrower population, knowingly decided to commit and voluntarily agreed to guarantee the loans,” Bernard wrote.
In May 2015, the U.S. Securities and Exchange Commission filed a civil lawsuit alleging fraud against ITT executives Modany and Fitzpatrick. They have denied the SEC's fraud allegations. That lawsuit is still in litigation.
In February 2014, the CFPB filed a Truth in Lending civil lawsuit against ITT. That lawsuit has been delayed until May 31.
In both of these lawsuits, the CUSO and its credit union members have not been accused of any wrongdoing and have not been named as defendants.