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United States Securities and Exchange Commission v. ITT Educational Services, Inc.

United States District Court, S.D. Indiana, Indianapolis Division

April 19, 2018

United States Securities and Exchange Commission, Plaintiff,
ITT Educational Services, Inc., Kevin M. Modany, and Daniel M. Fitzpatrick, Defendants.


          Hon. Jane Magnus-Stinson, Chief Judge

         Plaintiff United States Securities and Exchange Commission (the "SEC") filed this lawsuit against Defendants ITT Educational Services, Inc. ("ITT"), [1] ITT's former Chief Executive Officer Kevin Modany, and ITT's former Chief Financial Officer Daniel Fitzpatrick, alleging that Defendants violated federal securities laws in connection with two student loan programs created by ITT for ITT students. The SEC on the one hand, and Mr. Modany and Mr. Fitzpatrick on the other, have filed numerous motions to exclude expert testimony in advance of the July 9, 2018 trial. Specifically, presently pending and ripe for the Court's consideration are: (1) Defendants' Motion to Exclude the Report, Testimony, and Opinions of Harvey L. Pitt, [Filing No. 197]; (2) the SEC's Motion to Preclude the Testimony of Defendants' Expert David B.H. Martin, [Filing No. 201]; (3) Defendants' Motion to Exclude the Report, Testimony, and Opinions of Kevin Kinser, Ph.D, [Filing No. 1991; (4) the SEC's Motion to Preclude the Testimony of Defendants' Expert Roger Meiners, [Filing No. 203]; (5) Defendants' Motion to Exclude Certain Testimony and Opinions of Anjan V. Thakor, Ph.D, [Filing No. 206]; and (6) Defendants' Motion to Exclude Certain Testimony and Opinions of R. Larry Johnson, [Filing No. 208].



         ITT was a for-profit higher education company whose stock was registered on the New York Stock Exchange. Mr. Modany was ITT's Chief Executive Officer and Mr. Fitzpatrick was ITT's Chief Financial Officer during the relevant time period. In 2009, ITT launched the Credit Union Service Organization student loan program (the "CUSO Program"). The CUSO Program involved a group of credit unions, acting through a Credit Union Service Organization ("CUSO"), making a total of approximately $141 million in private loans to ITT students. ITT and the CUSO entered into a risk sharing agreement whereby if more than 35% of the loans in any of the three annual pools defaulted, ITT guaranteed payment of the principal, interest, and fees on any loans that defaulted over the 35% threshold. Once ITT's guarantee obligation was triggered for one of the CUSO loan pools, ITT could either pay the monthly payments due on defaulted loans over the threshold (a minimum payment), or discharge its total future obligation by immediately paying the outstanding principal plus some additional interest.

         In 2010, ITT formed the Program for Education Access and Knowledge student loan program (the "PEAKS Program"). The PEAKS Program was structured as a trust (the "PEAKS Trust") that raised funds by issuing senior debt to institutional investors (the "PEAKS Noteholders"). The PEAKS Trust received the cash flow generated by payments on the student loans and used those funds to pay the principal and interest of the senior debt, and other fees and expenses. ITT made certain guarantees related to the PEAKS Program, including all of the principal and interest payments on the PEAKS senior debt, other financial obligations of the PEAKS Trust, and maintaining a "parity ratio" between the PEAKS Trust's assets and liabilities. If ITT failed to make the required guarantee payments on time, the PEAKS Noteholders could force ITT to immediately pay the entire amount of principal and interest remaining on the senior debt in advance of the 2020 maturity date.

         From the end of 2011 through the end of the third quarter of 2012, loans through the PEAKS Program and the CUSO Program were defaulting at high rates. At the same time, ITT's financial performance and stock price were declining due to decreasing enrollment at ITT, among other issues. In October 2012, ITT received a demand for a PEAKS guarantee payment of more than $8 million due to the parity ratio falling below its required level. ITT made a payment to the PEAKS Trust for $8 million. Mr. Modany and Mr. Fitzpatrick began devising a plan to avoid PEAKS Program guarantee payments.

         The alleged scheme involved ITT determining which students were about to default on their loans, and making the minimum payment necessary to avoid default on their behalf, without advising the students that these payments were being made. These "Payments on Behalf of Borrowers" ("POBOB") were to prevent PEAKS Program loans from defaulting so that ITT could avoid making parity ratio guarantee payments. At the end of October 2012, ITT made approximately $2.4 million in POBOB payments, which allowed ITT to avoid approximately $30 million in guarantee payments to the PEAKS Trust. Neither ITT, Mr. Modany, nor Mr. Fitzpatrick disclosed POBOB to investors.

         As for the CUSO Program, ITT calculated its liability for CUSO guarantee payments (triggered when loans defaulted over a 35% risk share threshold), and determined to pay the monthly minimum. Defendants did not disclose to investors in public filings that the method ITT used to calculate liability - which assumed that ITT would immediately discharge its obligation -was inconsistent with the method ITT actually used to pay its CUSO guarantee - which was to make minimum payments of the monthly amounts due on the high-interest loans. The decision to make only the monthly minimum payments resulted in increasing the amount that ITT would ultimately have to pay on the CUSO guarantee well beyond the amount of the liability disclosed in public filings.

         The SEC initiated this lawsuit in May 2015, alleging that Mr. Modany and Mr. Fitzpatrick failed to disclose certain information to investors and ITT's auditor, and engaged in other fraudulent behavior. The SEC asserts claims against Mr. Modany and Mr. Fitzpatrick under numerous provisions of the Exchange Act and the Securities Act. On March 23, 2018, the Court granted in part and denied in part the parties' Motions for Summary Judgment, [see Filing No. 259], leaving most of the SEC's claims pending for the upcoming July 9, 2018 trial. The parties' various Motions to Exclude are now ripe for the Court's decision.


         Applicable Law

         Federal Rule of Evidence 104 instructs that "[t]he court must decide any preliminary question about whether a witness is qualified.. .or evidence is admissible." Fed.R.Evid. 104(a). Federal Rule of Evidence 702 provides that expert testimony is admissible if: "(a) the expert's scientific, technical, or other specialized knowledge will help the trier of fact to understand the evidence or to determine a fact in issue; (b) the testimony is based on sufficient facts or data; (c) the testimony is the product of reliable principles and methods; and (d) the expert has reliably applied the principles and methods to the facts of the case." Fed.R.Evid. 702. A trial judge "must determine at the outset.. .whether the expert is proposing to testify to (1) scientific knowledge that (2) will assist the trier of fact to understand or determine a fact in issue. This entails a preliminary assessment of whether the reasoning or methodology underlying the testimony is scientifically valid and of whether that reasoning or methodology properly can be applied to the facts in issue.... Many factors will bear on the inquiry...." Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579, 592-93 (1993).

         The Court has a "gatekeeping obligation" under Rule 702, and "must engage in a three-step analysis before admitting expert testimony. It must determine whether the witness is qualified; whether the expert's methodology is scientifically reliable; and whether the testimony will 'assist the trier of fact to understand the evidence or to determine a fact in issue.'" Gopalratnam v. Hewlett-Packard Co., 877 F.3d 771, 779 (7th Cir. 2017) (quoting Myers v. III. Cent. R.R. Co., 629 F.3d 639, 644 (7th Cir. 2010)). Put another way, the district court must evaluate: "(1) the proffered expert's qualifications; (2) the reliability of the expert's methodology; and (3) the relevance of the expert's testimony." Gopalratnam, 877 F.3d at 779.



         The parties submitted over 450 pages in briefs and over 1, 500 pages in exhibits related to the six Motions to Exclude, and the Court has done its best to address the motions in a comprehensive yet manageable fashion. Below, the Court provides a brief summary of each expert's report and of the parties' arguments related to the report and anticipated testimony, before discussing the admissibility of the report and associated evidence. The Court notes that, although the parties provided lengthy discussions of the expert reports and testimony in connection with their motions, the issues involved are fairly discrete and simple and the Court discusses the issues accordingly.[3]

         A. Harvey Pitt

         1. Summary of Report

         Harvey Pitt, one of the SEC's expert witnesses, is the founder and Chief Executive Officer of Kalorama Partners, LLC, a global business consulting firm which "specializes] in providing strategic guidance - to independent board members, public companies and governmental entities - on corporate governance, disclosure, accounting, economic and risk-crisis issues." [Filing No. 197-3 at .1] Mr. Pitt was the SEC's Chairman from 2001 to 2003, where he "oversaw and directed the myriad functions performed by the SEC, including the establishment and interpretation of SEC regulatory requirements and disclosure policies, the creation of enforcement practices and oversight of SEC enforcement proceedings, and efforts designed to protect the fairness and orderly conduct of our Nation's securities markets." [Filing No. 197-3 at 2.]

         Mr. Pitt summarizes his engagement as follows:

I have been retained by the SEC to discuss long-standing understandings and customary practices, on the part of public companies and their advisors, regarding certain issues of particular relevance to this matter, including:
• Purpose and history of the disclosure obligations of public companies;
• Understandings, expectations, and industry practices with respect to issuer disclosures, particularly as they relate to trends and known uncertainties affecting a company's profitability, revenues, liquidity and future business metrics;
• Expectations of public investors regarding corporate disclosures, analyst assessments and corporate earnings calls;
• Responsibilities assumed by senior corporate managers for their company's formal and informal disclosures, including their certification of SEC filings and their need to update information that becomes stale, misleading or omits significant facts; and
• Commonly accepted management practices when seeking to rely on the advice of professional advisors.

[Filing No. 197-3 at 21-22.]

         Mr. Pitt summarizes his conclusions as follows:

• Market participants widely understand, and rely upon the fact that, public companies, such as ITT, are obligated to ensure that their disclosures - whether in the form of formal SEC filings or other forms of corporate communications - are accurate and not materially misleading;
• ITT ignored commonly accepted understandings and practices regarding its SEC filings and other corporate disclosures with respect to information regarding various of its student loan programs that reasonable investors would have considered important in deciding whether to buy, sell or hold ITT securities;
• Public companies and their advisors uniformly understand that public companies should inform their outside auditors of all significant developments affecting the accuracy and reliability of their financial statements;
• Market participants understand and rely on the fact that senior corporate managers are responsible for ensuring and certifying the accuracy of their company's SEC filings, and ensuring that any other public statements about their company, including regular earnings calls, must be honest, accurate and current; and
• Public companies and their advisors uniformly understand that full disclosure is the obligation of the companies (as well as their managers) themselves, and that, before they can justify relying on the advice of outside experts, they must
• Seek advice from knowledgeable and independent counsel, expert in the field to which the company's inquiry relates;
• Identify the specific issue (or issues) about which they seek an opinion;
• Fully inform counsel of all relevant facts related to the subj ect matter of the inquiry;
• Satisfy themselves the advice received is rational and logical; and
• Follow the advice received as provided.

         In this matter, ITT did not satisfy any, much less all, of these necessary preconditions to shifting the obligation to achieve full disclosure.

[Filing No. 197-3 at 22-23.]

         2. Defendants' Motion to Exclude

         Defendants argue that Mr. Pitt's report, testimony, and opinions should be excluded because they are improper, inadmissible, and unhelpful to a jury. [Filing No. 198 at 20-34.] Specifically, Defendants assert that Mr. Pitt offers improper and inadmissible legal opinions, including "that information concerning the CUSO and PEAKS student loan programs, including ITT's practice of making POBOB, would have been materially important to investors - a key legal element of various claims brought by the [SEC] in this case." [Filing No. 198 at 20.] Defendants also argue that Mr. Pitt's statement that ITT's POBOB payments were not contractually required is an impermissible legal conclusion. [Filing No. 198 at 27.] Defendants point to another case where Mr. Pitt's testimony was barred because the court found that it contained legal conclusions. [Filing No. 198 at 29-30.] Defendants contend that Mr. Pitt's testimony merely recites the SEC's allegations and invades the jury's province, and that any value in his testimony is outweighed by the risk of confusing the jury. [Filing No. 198 at 30-34.] Defendants also argue that Mr. Pitt's report, testimony, and opinions are unreliable because they rely on factual assertions that omit key information or are contrary to the established record, and his comments demonstrate his bias and unreliability. [Filing No. 198 at 34-40.]

         In response, the SEC argues that Defendants do not challenge many of Mr. Pitt's opinions, and that his opinions regarding common practices and understandings relating to corporate governance issues are proper expert testimony and helpful to the jury. [Filing No. 218 at 10-25.] The SEC contends that Mr. Pitt does not opine on the legal issues, nor on materiality or contract interpretation. [Filing No. 218 at 11-21.] It also asserts that Mr. Pitt's opinions are reliable. [Filing No. 218 at 25-31.]

         In their reply, Defendants argue that they challenge Mr. Pitt's report and testimony in their entirety. [Filing No. 240 at 6-9.] They assert that Mr. Pitt improperly offers legal opinions regarding the materiality of ITT's disclosures and whether POBOB was contractually required. [Filing No. 240 at 9-17.] Defendants reiterate their ...

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