Feds join lawsuit targeting company with ties to McKernan

Posted May 05, 2011, at 6:59 p.m.
Last modified May 05, 2011, at 8:30 p.m.

The Justice Department has joined an employee whistle-blower lawsuit against Education Management Corp., a for-profit college company that until recently was run by former Maine Gov. John McKernan.

The lawsuit alleges that Pittsburgh-based Education Management illegally paid recruiters based on the number of students they enrolled, the company said in a Securities and Exchange Commission filing Monday. The government, in most cases, forbids such incentive compensation for colleges accepting federal aid because of concern the practice will encourage companies to enroll unqualified students.

In a statement sent out on behalf of McKernan, who is chairman of the board of directors at Education Management Corp., the company said the lawsuit was “unwarranted and without merit.”

“The company denies any allegation of misconduct and plans to present a vigorous defense against this action.  The admissions compensation plan referenced in the claim was adopted in 2003 and was based on the advice of and good faith reliance on the opinion of outside counsel that EDMC’s compensation system was lawful,” the company said. “It also was assured that the plan complied with the safe harbor requirements of the U.S. Department of Education for compensation paid to admissions representatives.”

The Education Department plans, in July, to make all incentive compensation for college recruiters illegal, removing 12 types of exemptions, or “safe harbors,” that were put into place in 2002 under President George W. Bush. The exceptions allowed the practice when recruiters weren’t paid solely on the basis of enrollments. EDMC’s pay plan for admissions representatives in July 2003 was designed to comply with these “safe harbors,” the company said in its SEC filing Monday.

Education Management Corp. said it has provided the Justice Department with several statistical analyses performed by a nationally recognized firm demonstrating that admissions representatives were compensated using strict guidelines that considered other factors in addition to the enrollment of students, which it said was consistent with federal requirements.

“Because of the presentation of this statistical data and the opinion of counsel, the company is disappointed that the DOJ has decided to intervene,” the company said, noting that the DOJ has previously declined to intervene in some 25 court actions similar to the complaint.

McKernan, the chairman of the board, was CEO of the company from Sept. 2003 until 2007. He first joined the company in 1999 as vice chairman and a member of the board, according to the company.

McKernan, 62, was the governor of Maine from 1987 until 1995 and was one of the state’s congressmen from 1983 to 1987. He is the husband of U.S. Sen. Olympia Snowe, R-Maine, and remains an active part of Republican politics in Maine.

McKernan is not named individually as a defendant in the lawsuit.

Education Management Corp., which currently enrolls more than 148,000 students, operates the Art Institute chain, Argosy University, Brown Mackie College and South University. Analysts project the company will report revenue of $2.89 billion in the year ending in June, according to the average of estimates compiled by Bloomberg News.

A for-profit college differs from a traditional college or university in that it is operated by a private business.  For-profit colleges currently serve about 9 percent of the higher education population.

The Justice Department’s intention to join the suit as an intervener was disclosed by Education Management Corp. in a Securities and Exchange Commission filing made earlier this week. It marks the first time the Department of Justice has chosen to intervene in the student recruitment practices at for-profit colleges. The U.S. Attorney’s Office in Pittsburgh confirmed that it has filed to intervene in the case.

Harry Litman, the plaintiff’s attorney in this case, said the complaint basically alleges that Education Management Corp. knew it was against the law to pay its recruiters any sort of bonus commission or other incentive payments, but they did it anyway.

“It was at the heart of their whole business model,” Litman said.

He charged the company lied about the practice to federal and state governments when they promised they didn’t pay the bonus commissions in order for them to be eligible for their students to get financial aid.

That financial aid is the “vast majority” of their revenues, which Litman said was in excess of $2.5 billion annually.

“We allege in the complaint they ran a boiler-room-style telemarketing business where they relentlessly pushed their recruiters and paid them by the body. That’s fine in other professions, but that’s the very thing Congress said you can’t do if you’re a for-profit college, and they made billions of dollars doing it,” said Litman. “For them it was all about the numbers.”

Litman filed the whistle-blower complaint four years ago. As is the norm in these cases, it was sealed as the government began to investigate the allegations. This week, the federal government indicated some merit in the case by joining as an intervener, Litman said. Litman said Illinois and California have said they also want to intervene. The case was unsealed by the court earlier this week.

While McKernan is not named as a separate defendant in the suit, his name does appear in the body of the lawsuit.

In the lawsuit, the plaintiffs note that in order for the company’s colleges to be eligible to participate in student loan programs, the schools entered into “program participation agreements,” or PPAs, in which they assert they would obey the incentive compensation ban.

The suit goes on to charge that “in fact, the institution was not and is not in compliance with that ban, and the institution knew that its statements were false.” The suit also notes that “in December 2006, (company) Chairman and CEO John R. McKernan Jr. signed all PPAs for (company) institutions, certifying that (the company) is complying with (the) incentive compensation ban.”

“As the CEO, he was the person who actually executed and signed the annual participation agreements with the governments that promised that they wouldn’t do this forbidden practice, and that they were not paying their recruiters by the body, as it were,” Litman said.

In whistle-blower lawsuits, private citizens file fraud complaints on behalf of the federal government. If the government joins a case, the whistle-blower may get 15 percent to 25 percent of any money recovered.

At least 27 whistle-blower cases have been filed against for-profit colleges under the U.S. False Claims Act since the 1990s, primarily alleging violations of federal incentive- compensation rules, according to a December 2009 article by law firm Gibson, Dunn & Crutcher, which defends companies against such complaints.

In all but one case, the DOJ declined to intervene, the article said. In that case, prosecutors joined the lawsuit to address a different issue.

Education Management faces another pending whistle-blower complaint alleging incentive-compensation violations filed by Brian Buchanan, a former admissions representative. His suit, also filed in Pittsburgh, was unsealed in May 2010. In securities filings, Education Management calls the claims “without merit.” The Justice Department declined to intervene in that case.

The Justice Department action in federal court in Pittsburgh follows scrutiny by Congress and the federal Education Department of sales practices, student-loan defaults and job placement claims at for-profit colleges, which can receive as much as 90 percent of their revenue from federal financial aid. Several states intend to join the Justice Department’s civil action in federal court, Education Management said.

While McKernan was not named as a defendant in the whistle-blower lawsuit, he is one of nine Education Management directors or executives — along with the company itself — named in a separate class action shareholder lawsuit filed last August. Underwriters of the company’s 2009 public offering are also named in that lawsuit.

The shareholder lawsuit followed a Government Accountability Office report from last August that detailed the practices by for-profit colleges and their recruiters, though it didn’t name Education Management Corp. by name. The GAO report, and further investigations by Congress and other disclosures, revealed that “EDMC was systemically employing improper recruiting and enrollment practices,” the complaint alleges.

The company didn’t disclose those practices, the lawsuit alleges, and so the financial picture presented to potential investors “failed to disclose material information to the investing public.”

“Among defendants’ inaccurate representations and omissions of material facts were that EDMC had been regularly and systematically engaged in improper recruiting, enrollment, admissions and financial aid practices prior to and throughout the class period that subjected the company to risk of loss of its ability to receive (federal student aid) funds,” the suit charged.

The suit said that the company’s undisclosed practices included improper recruiting and enrollment practices such as misleading prospective students about tuition costs, academic program quality, graduation rates, graduate employment prospects and expected graduate salaries, and aggressively targeting low-income and vulnerable populations; using aggressive telemarketing practices in student recruiting; improperly compensating admissions staff; engaging in improper practices in connection with students’ and prospective students’ federal financial aid forms.

“Furthermore, the strong historic and continued growth reported by EDMC in connection with the IPO and throughout the class period was grounded upon these improper and inherently unsustainable practices, rendering EDMC’s reported financial performance materially untrue and misleading,” the suit said.

The lawsuit charges that McKernan, as chairman of the board, signed the registration statement for the public offering.

In the lawsuit, the plaintiffs – which include pension funds – said that “when the truth regarding EDMC was revealed, EDMC’s stock price plummeted from a Class Period high of $26.40 per share to $9.71 per share on August 16, 2010.”

That shareholder complaint, also filed in the federal court in Pittsburgh, remains active.

Material from the Bloomberg news service was used in this report.

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