Short-sellers get snagged in education litigation Eisman, the principal at FrontPoint Partners in Greenwich, Connecticut By David A. Kaplan, contributor

FORTUNE -- In his bestseller The Big Short, Michael Lewis cast Steve Eisman as the eccentric contrarian star. Now a nasty libel lawsuit in Florida is trying to make Eisman a villain in the raging economic and political battle between the for-profit education industry and the nonprofit sector. Whether he's a villain, or a well-intentioned citizen being used as a straw man, depends on whom you believe. The stakes in the case, though, involve not only Eisman, as well as the named litigants, but also the rules of engagement for all sides in what has become a central policy debate in higher education.

In the litigation, filed earlier this month, a privately held for-profit school called Keiser University sued a competing nonprofit public institution, Florida State College, for spreading "injurious falsehoods" about Keiser. In its formal complaint, Keiser -- which is based in Fort Lauderdale and has 21,000 students seeking degrees ranging up to doctorates -- claims FSC and two of its administrators aimed to "derail" the for-profit education sector through a "false and misleading campaign." That campaign, according to the complaint, was executed in part through a "conspiracy" with both advocacy groups and short-sellers like Eisman, who famously made a hedge-fund fortune by anticipating the housing-market crash in 2008 and betting against subprime mortgages. Along with FSC, the two administrators -- CEO Steven Wallace and vice president Susan Lehr -- are named as defendants in the suit. Eisman and two other institutional investors, Gilchrist Berg and Antal Desai, are cited only as "co-conspirators."

The lawsuit has been reported by other publications, but none have examined the trove of e-mails and documents -- 15,000 pages of them -- that Keiser obtained in a state freedom-of-information filing. (The documents are posted here.) Florida has a very broad public-records law, which makes many of FSC e-mails subject to public disclosure. That's how Keiser was able to obtain the 15,000 pages of records. Many of the e-mails disclosed, ironically, contain the "notice" that e-mail communications "may be subject to public disclosure."

The private e-mails -- a handful of which are included as exhibits in the lawsuit -- paint a vivid picture of combatants who personally can't stand each other. The documents also raise questions about the relationships between a nonprofit community college and other critics of the for-profit education industry, and the means used by those critics to go on the attack.

But on the other side of the debate, representatives of the for-profit industry have on occasion overreached to make the documents out to be more sinister than they are: Just because nonprofit colleges and organizations communicate with each other doesn't indicate misconduct; lobbyists for the for-profit industry have worked hard to convince congressional staffers and journalists that the documents reveal a cabal of corruption that simply isn't evident. Neither side in the disputes comes across looking so good. Altogether, it's a remarkably unattractive glimpse into how American regulatory sausage gets made and the tactics used behind the scenes among the butchers.

The regulators step in

The backdrop for the Florida fight is in Washington, where the Department of Education is finalizing regulations that are likely to toughen how the for-profits do business. The for-profits have come under heavy fire for alleged abuses in recruiting and marketing. The gist of the criticism is that they promise but don't deliver employment prospects related to the career-oriented and vocational degrees they grant. Under the DOE's complicated new rules on "gainful employment," for-profit colleges and universities could lose access to federal financial aid -- the bulk of their revenue -- if at least 35% of their former students aren't repaying principal on their loans. The for-profits face other restrictions if the typical student is spending more than 12% of income on loan debt. (Read the full 94-page government report on the regulations here.Good luck.)

The theory is that graduates who are in fact "gainfully employed" will be able to meet those repayment requirements. Last year, repayment rates were 36% at for-profits, compared to 56% at nonprofits and 54% at public colleges. The new regulations are scheduled to become final Nov. 1 and take effect in July. The rules do not apply to nonprofit colleges and public institutions, which has led critics of the rules to call them hypocritical and antibusiness. Because enrollment at for-profits has a significant proportion of low-income and minority students, the rules have also been called class- and race-biased by the for-profits and their supporters.

Over the past decade federal student aid to for-profit schools has more than quintupled, to $26.5 billion, according to the DOE. For-profits enroll 1.8 million, about a tenth of students in the U.S. Companies like Apollo Group (APOL) (which owns the University of Phoenix), ITT Educational Services (ESI), and Strayer Education (STRA) have been highly successful, and until the recent regulatory controversy have had attractive valuations. In 2009, students at for-profit schools received more than $20 billion in federal loans. Since 75% to 90% of revenue at most for-profit schools comes from the federal funds, being disqualified from those loans and grants would devastate the for-profits.

The DOE's proposed rules have been in the works since the early days of the Obama administration, under the direction of Bob Shireman. Until this past summer he was a deputy undersecretary at the U.S. Department of Education. He was long active in the public-policy arena and an outspoken advocate for reform in student lending practices. His lightning-rod status among interest groups helped make the gainful employment rules all the more controversial, even as Arne Duncan, the secretary of education, had said for-profit schools play a vital role in higher education. The language of the regulations was released to the public in two steps -- on June 16 and on July 23. That timing becomes key to understanding the context of the e-mails that are at the heart of the Florida suit brought by Keiser University against Florida State College. (Lawyers for Keiser declined to answer questions about the lawsuit.)

Short-sellers' stake

Steve Eisman, the principal at FrontPoint Partners in Greenwich, Conn. (a unit of Morgan Stanley), has been on a warpath against for-profit schools since the spring. In a highly publicized May 26 speech entitled, "Subprime Goes to College," he warned of $275 billion of defaults by students at for-profits schools over the next decade -- unless the DOE adopted new regulations. "Until recently," he said at the Ira Sohn Investment Research Conference, "I thought that there would never again be an opportunity to be involved with an industry as socially destructive and morally bankrupt as the subprime mortgage industry. I was wrong. The for-profit education industry has proven equal to the task."

He made that exact same remark a month later before the Senate education committee, citing three major for-profit education companies. After his June 24 testimony, over the course of that afternoon and the next day, the stock prices of those three companies declined between 6% and 8%; prices for other for-profit education companies went down as well. For-profit education stocks similarly declined shortly after Eisman's speech at the Sohn conference.

At the Senate hearing, Eisman acknowledged that his hedge fund has taken short positions on the stocks of various for-profit colleges. "Yes, I do have a stake," he said, when asked by Sen. Tom Harkin (D-Iowa) if he had a vested interest in the success or failure of the for-profit education sector. "Once in a blue moon an entire industry is a good short," Eisman testified. That, he explained, was true with the mortgage industry a few years earlier -- and was now true in the education business. In an interview, he said: "I've said it many times: 'I'm short -- and here's why.' "

No senator asked about why the committee was hearing from a short-seller in the first place. An organization in Washington immediately called Accountable America described Eisman's appearance before Congress as akin "to asking an arsonist whether a building will burn down."

Eisman also wasn't asked to disclose his specific short holdings, and he didn't. Eisman told Fortune that he didn't seek out the Senate appearance and was invited to appear because his Sohn speech was so widely reported. In an interview, Eisman declined to say how much the short positions in his hedge fund may have produced as a result of the price declines that occurred after both his speech and Senate testimony. "I'm not short so I can make a speech and drive the stock down and cover the stock," he says. "That's not what I do." He also emphasized, "I had no information about 'gainful employment' other than what the Department of Education had said publicly what it was trying to do." He said he did talk with DOE officials, including Shireman, before his speech at the Sohn conference -- to discuss the opinions he'd mention in the speech -- but that the subject of gainful employment regulations did not come up in "any way, shape, or form." Shireman could not be reached for comment.

A hero's testimony

Lehr, the FSC vice president, was thrilled about Eisman's remarks at the Sohn conference. "I read your speech and could just leap for joy," she wrote in an e-mail to him that evening. The for-profits "own the Florida legislature and even in these terrible fiscal times they still draw funds from our general revenue ... I am involved because I have seen firsthand hundreds of students whose lives are ruined by this abuse."

"You are welcome," Eisman wrote back. "Pls stay in touch." Eisman says that was the first and only time he had communicated with Lehr.

A month later, in an e-mail that is not cited in the complaint, Lehr obtained what she describes as a "confidential" advance copy of Eisman's prepared Senate testimony, which she sent to two friends in her church. "This guy," she wrote, referring to Eisman, "is my hero!" The advance copy in fact wasn't confidential. It apparently had been widely distributed on Capitol Hill and among journalists; an advocacy group sharing Lehr's views on for-profit schools had sent her a copy.

On July 21, Lehr e-mailed Wallace, her CEO at the Jacksonville college, to advise him that the last of the Department of Education's proposed rules were coming out the next day and that reporters would be briefed after the 4 p.m. close of the markets. In her e-mail, she wrote that her colleague, Jim Simpson, FSC's associate vice president, "met by phone with Eisman yesterday for a very interesting conversation. Fill you in tomorrow."

Citing the suit in which she's a defendant, Lehr declined to be interviewed by Fortune. Simpson did not respond to a request for an interview.

Eisman acknowledges that conversation with Simpson took place, but says it was only about how a DOE gainful-employment rule might calculate a debt-to-income-ratio requirement. Simpson apparently was a good person to ask since he had been involved earlier in DOE discussions as an official representative of community colleges.

In an interview, Wallace said he "did not recall" the July 21 e-mail from Lehr referring to Eisman and that he had never heard of Eisman until Keiser University filed its suit in early October. Still, the next morning-on July 22-Wallace e-mailed Berg, founder of the highly successful hedge fund Water Street Capital in Jacksonville. And that e-mail essentially tracked the substance of the e-mail Lehr had sent Wallace the night before.

"Breaking news, Gilchrist," Wallace wrote to Berg. "Reporters will be briefed ... on the proposed gainful employment regs. We expect lots of market churn." Wallace doesn't explain what he means by "market churn" or why he's saying it. In an interview, Berg said he didn't know why Wallace wrote either.

Berg's fund takes short and long positions, but is best known for the former. He says that at the time Wallace e-mailed him the fund had short positions in different for-profit educational companies, as well as long positions in some. But in response to journalistic inquiries, he says, "we checked" and "no trading took place within five days" of the Wallace e-mail. Berg, too, offered to open his books to prove it.

Wallace declined comment on the e-mail to Berg, refusing to acknowledge he sent it or to explain why he might have chosen to contact Berg with "breaking news" or his stated expectation about "lots of market churn." FSC's general counsel, Jeanne Miller, who sat in on the interview, challenged the authenticity of the e-mail and said she would look into it and get back to Fortune. She did not get back to Fortune by the time of publication. Wallace did not respond to subsequent requests to explain his e-mail to Berg.

Longtime friends

Wallace did explain that he had a long-standing friendship with Berg that had nothing to do with Berg's position as an investment professional. "I don't know what a short-seller is," Wallace says. They had started a local music school a few years ago and had served together on the Jacksonville symphony board. Both Wallace and Berg say they had what Berg describes as "a common interest" in rooting out the "bad actors" in the for-profit education sector. That mutual concern is demonstrated in an e-mail Wallace sent Berg in April 2009. Berg's interest in the for-profits was on the rise and he was looking to learn more.

"All right, my friend," Wallace wrote. "Here's a bunch of good stuff to get you started in your exploration of greed, corruption and predatory schemes among Florida's proprietary and for-profit career 'colleges.' It is a hideous spectacle, but one that really needs to be addressed."

"The new technical college we will launch," Wallace added, "is designed, in part, to drive the sleazebags out of our region." In the e-mail, Wallace refers to Lehr as "unquestionably the best higher ed lobbyist in Florida" and "the designated antagonizer of the privates."

The lawsuit in Florida alleges that, in addition to Eisman and Berg, Antal Desai -- with CPMG, a Dallas-based investment firm -- was part of the "conspiracy" to discredit Keiser University. According to the complaint, Lehr "traded information" with Desai, whose firm "had an apparent interest in seeing the value of 11 proprietary schools decline." E-mails in 2009 show that Lehr, as well as Simpson, were communicating with Desai about for-profit education. Before she talked to Desai, Lehr wrote to Barmak Nassirian, an executive at the American Association of Collegiate Registrars and Admissions Officers, to see if Desai is "legitimate ... before I forward stuff to him." Nassirian is named as a "co-conspirator" in the lawsuit.

He gave Lehr his seal of approval. "I know Antal and have been impressed," Nassirian wrote. "I don't care -- or fully understand -- what their financial interests in the matters might be, but have found [him and his firm] to be reliable."

Thereafter, according to the complaint, "Lehr began trading information with [Desai] to hurt proprietary schools." Yet the complaint offers no evidence of the information allegedly traded or how it might hurt the for-profit sector. All of the e-mails cited by Keiser are from 2009, long before the proposed gainful-employment rules were issued.

But Lehr's intent regarding for-profit schools seems clear from e-mail cited in the complaint. On Feb. 1 she was informed by another community-college lobbyist that the owner of Keiser University had written an op-ed piece against DOE regulations. "Squeals like a pig, doesn't he?" the lobbyist wrote to Lehr. "You guys have obviously done good work!"

Lehr replied: "Mrkts fell 1.5 b last week!"

Desai did not respond to several requests for an interview. In an interview, Nassirian called his inclusion in the complaint "weird."

On another occasion, Lehr got an e-mail in February from FSC's Simpson that he had obtained from a Berg employee a copy of a Credit Suisse analysis of "gainful employment." The analysis highlighted risks for the for-profits. "OH MY! OH MY, I know we did good but this is too good," Lehr replied in an e-mail with the subject line "I Love My Job -- MEE TOOO!" "Do you think it will stick? Will the big boys start divesting before the axe falls? Are we allowed to share if we redact their names on the documents?"

The advocacy groups' role

Besides the three traders, the complaint alleges that executives of several advocacy organizations were "co-conspirators." The most significant group -- mentioned six times in the complaint -- is The Institute for College Access and Success (TICAS), which had been founded by Shireman, the DOE deputy undersecretary who spearheaded the gainful-employment regulations. TICAS is a nonprofit in Oakland that aims to make higher education "more affordable."

The complaint alleges that TICAS personnel, including its vice president, Pauline Abernathy -- "in concert" with community colleges and other financial interconnected advocacy groups -- were "trading information with Eisman, whom they knew stood to profit if the value of proprietary schools declined." It's another instance of the complaint seeming to overreach, as it fails to recognize that Abernathy actually does appears sensitive to the potential issues of sharing information with a short-seller.

In a July 22 e-mail exchange with Lehr -- that the complaint never mentions -- Lehr informed Abernathy that Eisman earlier that week had talked to Simpson. "I was so happy for him to have such a cool conversation," Lehr wrote.

Replied Abernathy: [Eisman] and his folks have useful info but I try to be careful what I share since he has a financial interest we do not, and he may make money based on what happens in the market each day while we only care about the final outcome!"

But other Abernathy e-mails raise questions about possible communications she was having on the subject of the DOE gainful employment regulations. In April, various press discussed a Credit Suisse analyst report suggesting that an internal DOE draft would give more possible exemptions to for-profits. Shares in for-profit education companies rose on the news. E-mailing Lehr and others on April 15, Abernathy discounts the news. "I have been assured that the Credit Suisse description of the regulation is not accurate," she wrote. There's no indication who might have given Abernathy such "assurance." The DOE wasn't giving out information on internal discussions about the regulations.

Abernathy declined to discuss that e-mail. In an interview, Lauren Asher, the president of TICAS, said: "TICAS advocates for students and taxpayers -- and that's all these documents show. This lawsuit is clearly designed to intimidate people from raising concerns about documented problems in the for-profit college industry."

The lawsuit in Florida could play at over the course of years. The final Department of Education regulations, which won't take effect until July, could well be the subject of litigation. It is also possible that members of Congress or the DOE or other agencies will look into Keiser University's allegations of improper communications among groups advocating for tighter regulation of the for-profit education industry.

One thing, though, on which all sides might agree: The next time you want to say something in the form of e-mail, think twice.

Full disclosure: Until January 2009, David A. Kaplan was a long-time employee at Newsweek, which until recently was owned by the Washington Post Co. He also was the editor of the Kaplan-Newsweek College Guide until 2008. A percentage of his retirement-plan holdings is in Washington Post stock, granted when he worked at Newsweek. The lucrative Kaplan education division of the Post Co. would be hurt by the DOE's proposed "gainful employment" regulations. To top of page