Career Education 10-Q 2007
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2007
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
Commission File Number: 0-23245
(Exact name of registrant as specified in its charter)
Registrants telephone number, including area code: (847) 781-3600
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
Number of shares of registrants common stock, par value $0.01, outstanding as of May 1, 2007: 95,014,040
CAREER EDUCATION CORPORATION
CAREER EDUCATION CORPORATION AND SUBSIDIARIES
The accompanying notes are an integral part of these unaudited condensed consolidated statements.
The accompanying notes are an integral part of these unaudited condensed consolidated statements.
CAREER EDUCATION CORPORATION AND SUBSIDIARIES
The accompanying notes are an integral part of these unaudited condensed consolidated statements.
CAREER EDUCATION CORPORATION AND SUBSIDIARIES
The accompanying notes are an integral part of these unaudited condensed consolidated statements.
We are a dynamic educational services company committed to quality, career-focused learning and led by passionate professionals who inspire individual worth and lifelong achievement. Since our founding in 1994, we have progressed rapidly toward our goal of becoming the worlds leading provider of quality educational services. We are one of the worlds leading on-ground providers of private, for-profit, postsecondary education and have a substantial presence in online education. Our schools and universities prepare students for professionally and personally rewarding careers through the continuing operation of 75 on-ground campuses located throughout the United States and in France, Canada, Italy, and the United Kingdom and two fully-online academic programs.
Our schools and universities offer doctoral degree, masters degree, bachelors degree, associate degree, and non-degree certificate and diploma programs in the following core career-oriented disciplines:
· Culinary Arts: Programs within this discipline include culinary arts, hotel and restaurant management, and baking and pastry arts.
· Visual Communication and Design Technologies: Programs within this discipline include desktop publishing, graphic design, fashion design and merchandising, interior design, graphic imaging, web page design, animation, photography, game design, digital film and media, and visual journalism.
· Health Education: Programs within this discipline include medical assistance, medical billing and coding, massage therapy, pharmacy technician, diagnostic medical ultrasound, cardiovascular technician, surgical technician, dental assistance, and medical office administration.
· Business Studies: Programs within this discipline include business administration, business operations, merchandising management, business administration and marketing, paralegal studies, hospitality management, criminal justice, and education.
· Information Technology: Programs within this discipline include PC/LAN, PC/Net, computer technical support, computer network operation, computer information management, computer science, computer engineering, and computer programming.
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (GAAP) for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, the financial statements do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments, including normal recurring accruals, considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2007, are not necessarily indicative of the results that may be expected for the year ending December 31, 2007. The condensed consolidated balance sheet as of December 31, 2006, has been derived from the audited consolidated financial statements as of that date but does not include all of the information and notes required by GAAP for complete financial statements. For additional information, refer to the consolidated financial statements and notes to consolidated financial statements as of and for the year ended December 31, 2006, included in Part IV, Item 15 of our Annual Report on Form 10-K for
the year ended December 31, 2006, filed with the Securities and Exchange Commission (SEC) on March 1, 2007.
As used in this Quarterly Report on Form 10-Q, the terms we, us, our, and CEC refer to Career Education Corporation and our wholly-owned subsidiaries. The terms school and university refer to an individual, branded, proprietary educational institution, owned by us and including its campus locations. The term campus refers to an individual main or branch campus operated by one of our schools or universities.
The unaudited condensed consolidated financial statements presented herein include the accounts of CEC and our wholly-owned subsidiaries. All inter-company transactions and balances have been eliminated. The results of operations of all acquired businesses have been consolidated for all periods subsequent to the date of acquisition.
On January 25, 2007, we acquired 100% of the issued and outstanding stock of Istituto Marangoni for approximately $37.2 million. The purchase price was funded with cash generated from operating activities. Istituto Marangoni is a world-renowned private, for-profit, post-secondary fashion and design school with locations in Milan, Italy; London, England; and Paris, France. We acquired Istituto Marangoni primarily because of its potential for market leadership, the economic attractiveness of the educational markets that it serves, and its potential for strong returns on invested capital. The acquisition of Istituto Marangoni also provides us with a platform for additional expansion in Europe and represents our entry into the Italian educational market.
The purchase price of approximately $39.6 million, including acquisition costs of approximately $2.4 million, was allocated to the estimated fair values of acquired tangible and identifiable intangible assets of approximately $27.0 million and assumed liabilities of approximately $16.2 million as of January 25, 2007. Intangible assets acquired include, among others, trade names with a total estimated fair value of approximately $9.8 million and student contracts with an estimated fair value of approximately $1.5 million. Based on our preliminary purchase price allocation, we have recorded goodwill of approximately $28.8 million. We do not expect any portion of this goodwill balance to be deductible for income tax reporting purposes.
Subsequent adjustments may be made to the purchase price and the purchase price allocation. However, we do not believe that any such adjustments will be significant.
The following table summarizes the estimated fair values of assets acquired and liabilities assumed as of January 25, 2007 (in thousands):
Supplemental pro forma financial statement disclosures have not been included as this acquisition was not material to our consolidated financial position or results of operations.
Cash equivalents include short-term investments with a term to maturity of less than 90 days.
The postsecondary education industry includes approximately 6,500 institutions that participate in federally-sponsored financial aid programs authorized by Title IV of the Higher Education Act of 1965, as amended (HEA,), which we refer to as Title IV Programs. The U.S. Department of Education (ED) requires that Title IV Program funds collected in advance of student billings be kept in a separate cash account until the students are billed for the portion of their program related to those Title IV Program funds collected. The ED further requires that Title IV Program funds be disbursed to students within three business days of receipt. We do not recognize restricted cash balances on our consolidated balance sheet until all restrictions have lapsed. As of March 31, 2007, and December 31, 2006, the amount of restricted cash balances held in separate cash accounts was not significant. Restrictions on cash balances have not affected our ability to fund daily operations.
Investments, which primarily consist of municipal auction rate securities, are classified as available-for-sale in accordance with the provisions of Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities and are recorded at fair value. Any unrealized gains or temporary unrealized losses, net of income tax effects, are reported as a component of accumulated other comprehensive income on our consolidated balance sheet. Realized gains and losses are computed on the basis of specific identification and are included in miscellaneous other income (expense) in our consolidated income statement. As of March 31, 2007, our investments in municipal auction rate securities generally have stated terms to maturity of greater than one year. However, we classify such investments as current on our consolidated balance sheet because we are generally able to divest our holdings in municipal auction rate securities at auction 30 days from our purchase date. Cash and cash equivalents and investments consist of the following as of March 31, 2007, and December 31, 2006 (in thousands):
Changes in our student receivables allowance during the three months ended March 31, 2007 and 2006, were as follows:
As of March 31, 2007, we have outstanding under our $200.0 million U.S. Credit Agreement revolving loans totaling $11.6 million and letters of credit totaling $16.1 million. Credit availability under our U.S. Credit Agreement as of March 31, 2007, is $172.3 million.
As of March 31, 2007, we have no revolving loans outstanding under our $10.0 million (USD) Canadian Credit Agreement.
We have entered into agreements with Sallie Mae and Stillwater National Bank (Stillwater) to provide private recourse loans to qualifying students.
Sallie Mae. Our original recourse loan agreement with Sallie Mae was effective from July 1, 2002, to February 28, 2006. We entered into a new risk sharing agreement with Sallie Mae effective March 1, 2006, which has an expiration date of June 30, 2009. Under both our original and subsequent recourse loan agreements with Sallie Mae, we are required to deposit 20% of all recourse loans funded into a Sallie Mae reserve account.
Under our original recourse loan agreement, loans funded were intended for students whose credit scores were less than the credit score required under Sallie Maes non-recourse loan program for our students. A student was generally eligible for a Sallie Mae recourse loan under the original agreement if (1) the student demonstrated a specified minimum credit score, (2) any bankruptcy proceeding involving the student had been discharged for at least 18 months, and (3) the student was not in default or delinquent with respect to any prior student loan. Under the terms of the original agreement, we are obligated to purchase, with funds that have been deposited into the reserve account as discussed above, recourse loans funded under the original agreement (a) that have been delinquent for 150 days or (b) upon the bankruptcy, death, or total and permanent disability of the borrower. The amount of our repurchase obligation under the original agreement may not exceed 20% of loans funded under the original agreement, which also represents the amount that is withheld by Sallie Mae and deposited into the reserve account. Any balance remaining in the reserve account after all recourse loans have been either repaid in full or repurchased by us will be paid to us. Our new recourse loan agreement with Sallie Mae has substantially similar terms, with the exception that students and, if applicable, their qualified co-borrowers, must demonstrate a slightly higher specified minimum credit score than the credit score required under the original agreement to be eligible for a recourse loan.
We record amounts withheld by Sallie Mae in the reserve account as a deposit in long-term assets on our consolidated balance sheet. Amounts on deposit may ultimately be utilized to purchase loans in default, in which case recoverability of such amounts would be in question. Therefore, we establish a 100%
reserve against amounts on deposit through the use of a deposit contra-account. We believe that costs associated with our Sallie Mae recourse loan programs are directly attributable to the educational activity of our schools and the support of our students. Therefore, such costs are classified as educational services and facilities expense in our consolidated statement of income. Costs are recognized on a straight-line basis over the course of the instructional term for which the underlying loan was granted as the related revenues are earned. Upon purchasing Sallie Mae loans in default, we transfer an amount equal to the total balance of the loans purchased from the deposit account to a long-term recourse loan receivable account and transfer an offsetting amount from the deposit contra-account to a long-term recourse loan receivable contra-account, such that the net book value of the purchased loans is generally zero.
In October 2006, we negotiated an amendment to our risk sharing agreement that reduced the minimum credit score required for our students to qualify for non-recourse loans under Sallie Maes non-recourse loan program. The amendment also reduced loan fees and interest rates charged to our students for both non-recourse and recourse loans funded by Sallie Mae. Under the amendment, we are obligated to pay Sallie Mae a discount fee equal to 25% of all recourse loans funded under the agreement after March 1, 2007. Pursuant to the amendment, we will no longer be required to deposit a portion of loans funded under the agreement into a Sallie Mae reserve account. In addition, we are not required to repurchase any loans funded under the agreement.
Stillwater. The private student loans subject to the Stillwater purchase agreement are made by Stillwater to students at our schools if (1) the student demonstrates a specified minimum credit score, which is less than the minimum credit score required pursuant to our risk sharing agreement with Sallie Mae, (2) any bankruptcy proceeding involving the student has been discharged for at least 18 months, and (3) the student is not in default or delinquent with respect to any prior student loan. The loans are serviced by Sallie Mae. Under the terms of the purchase agreement, Stillwater retains 50% of the loan amounts disbursed and deposits this amount into a reserve account. Under the terms of the purchase agreement, Stillwater has an option, but not an obligation, to sell to us 100% of these private student loans on a monthly basis. We are required to purchase all private student loans offered for sale by Stillwater for a price equal to the current principal balance plus accrued interest. To date, we have purchased all private student loans offered for sale by Stillwater. Upon purchase of private student loans from Stillwater, we receive all funds that were placed into the reserve account with respect to the specific loans purchased.
Amounts held in reserve with Stillwater will be used to finance 50% of the principal balance of any loans that we are required to purchase pursuant to the agreement. We record such amounts as a deposit in long-term assets on our consolidated balance sheet. Based on our collection experience, we establish a 100% reserve against Stillwater funds on deposit. Due to the high level of uncollectible amounts expected under the Stillwater agreement, the associated costs are classified as a reduction of the related tuition revenue in our consolidated statement of income. Costs are recognized on a straight-line basis over the course of the instructional term for which the underlying loan was granted as the related revenues are earned. Upon purchasing Stillwater loans in default, we record the total balance of the loans as a long-term recourse loan receivable and transfer the reserve for recourse loans withheld by the lender, totaling approximately 50% of the related principal balance, from the deposit contra-account to the long-term loan receivable contra-account, such that the net book value of the purchased loans is approximately 50% of the related principal balance. Based on our collection experience, we believe that the 50% reserve is reasonable to provide for Stillwater loans that have been purchased or that may be purchased and that may be ultimately uncollectible. We evaluate the collectibility of our Stillwater loan receivables on a periodic basis and may adjust our reserve estimates in future periods based on collections experience.
On January 29, 2007, we provided Stillwater with a 90-day notice to terminate our purchase agreement. Pursuant to such notice, our purchase agreement terminated on April 29, 2007. However, we are still obligated to purchase any loans made by Stillwater prior to this termination date when offered by Stillwater for sale.
The following table reflects selected information with respect to each of our recourse loan agreements, including cumulative loan disbursements and purchase activity under the agreements from inception through March 31, 2007 (in millions, except for cumulative loan limits per student):
(1) Our original recourse loan agreement with Sallie Mae was effective from July 1, 2002 to February 28, 2006. We have entered into a new recourse loan agreement effective March 1, 2006, that has an expiration date of June 30, 2009.
(2) The Stillwater purchase agreement commenced in December 2003 and had no stated termination date. This agreement terminated effective April 29, 2007.
(3) Prior to the new agreement effective March 1, 2006, the Sallie Mae agreement had no stated limit for the amount of loans disbursed under the agreement. Loans funded prior to March 1, 2006, were subject to this previous agreement. Under the new agreement, the total amount of loans that may be funded may not exceed $180.0 million through June 30, 2008, with annual funding limits of $20.0 million for the period March 1, 2006, to June 30, 2006, $80.0 million for the period July 1, 2006, to June 30, 2007, and $80.0 million for the period July 1, 2007, to June 30, 2008. There is currently no stated loan funding limit for the period of July 1, 2008, to June 30, 2009. Instead, any funding limit must be negotiated by both parties prior to July 1, 2008.
(4) Under the Stillwater purchase agreement, the total amount of loans held by Stillwater under the agreement at any time cannot exceed $20.0 million.
(5) Loan limit per student generally represents the maximum loan amount available to an individual student during his or her complete academic program at one of our schools. Loan limits vary based on the length of the students academic program.
Costs associated with our recourse loan agreements as of and for the three months ended March 31, 2007 and 2006, are set forth below (in thousands). As discussed above, costs incurred in connection with our Sallie Mae agreements are classified as a component of educational services and facilities expense in our consolidated statement of income, and costs incurred in connection with our Stillwater agreement are classified as a reduction of tuition and registration fee revenue in our consolidated statement of income.
Outstanding recourse loan deposit, contra-deposit, loan receivable, and contra-loan receivable balances as of March 31, 2007, and December 31, 2006, are set forth below (in thousands).
Changes in the carrying amount of goodwill during the three months ended March 31, 2007, by reportable segment are as follows (in thousands):
On the first day of January of each year, our goodwill balances are reviewed for impairment through the application of a fair-value-based test. The results of the test as of January 1, 2007, indicated no goodwill impairment, as, for all reporting units, which we define as our school operating divisions, our estimate of reporting unit fair value exceeded the carrying value of the reporting unit. Our estimate of fair value for each of our reporting units was based primarily on projected future operating results and cash flows and other assumptions. Although we believe our projections and resulting estimates of fair value are reasonable, historically, our projections have not always been achieved.
7. COMMITMENTS AND CONTINGENCIES
We are, or were, a party to the following pending legal proceedings that are outside the scope of ordinary routine litigation incidental to our business.
Vander Vennet, et al. v. American InterContinental University, Inc., et al. As previously disclosed, on August 24, 2005, former admissions advisors of American InterContinental University (AIU) Online filed a lawsuit in the United States District Court for the Northern District of Illinois alleging that we, AIU Online, and the President of our University division violated the Fair Labor Standards Act (FLSA), the Illinois Minimum Wage Law, and the Illinois Wage Payment and Collection Act by failing to pay the plaintiffs for all of the overtime hours they allegedly worked. Plaintiffs seek unspecified lost wages, liquidated damages, attorneys fees, and injunctive relief. The plaintiffs are also seeking certification as a class under the FLSA. On December 22, 2005, and April 7, 2006, the court granted plaintiffs motions to send FLSA Notice, and plaintiffs counsel has distributed such notice to certain current and former admissions advisors. On April 7, 2006, the court granted the plaintiffs motion to expand the class to include temporary admissions advisors. The deadline for potential plaintiffs to opt-in to this lawsuit was June 23, 2006. Less than 10 percent of the persons to whom notice of the suit was sent, including current and former admissions advisors, have joined the litigation. Defendants deny all of the material allegations in the complaint and are vigorously defending the claims and opposing class certification. The parties are currently engaged in discovery.
Due to the inherent uncertainties of litigation, we cannot predict the ultimate outcome of this matter. An unfavorable outcome could have a material adverse impact on our business, results of operations, cash flows, and financial position.
In re Career Education Corporation Securities Litigation. As previously disclosed, In re Career Education Corporation Securities Litigation represents the consolidation into one suit of six purported class action lawsuits filed between December 9, 2003, and February 5, 2004, in the United States District Court for the Northern District of Illinois by and on behalf of certain purchasers of our common stock, against us, John M. Larson, a former officer of CEC, and Patrick K. Pesch, a current officer of the Company. The lawsuit alleged that, in violation of Section 10(b) of the Securities Exchange Act of 1934 (the Exchange Act) and Rule 10b-5 promulgated thereunder, the defendants made certain material misrepresentations and failed to disclose certain material facts about the condition of our business and prospects during the putative class period, causing the respective plaintiffs to purchase shares of our common stock at artificially inflated prices. The plaintiffs further claimed that Larson and Pesch were liable as control persons under Section 20(a) of the Exchange Act. On March 29, 2007, the court granted the defendants motion to dismiss for failure to state a claim and dismissed with prejudice the plaintiffs third amended consolidated complaint. Plaintiffs filed a notice of appeal on April 24, 2007.
Derivative Actions. As previously disclosed, on January 5, 2004, a derivative action captioned McSparran v. John M. Larson, et al. (McSparran) was filed in the United States District Court for the Northern District of Illinois on behalf of CEC against John M. Larson, Patrick K. Pesch, Wallace O. Laub, Keith K. Ogata, Dennis H. Chookaszian, Robert E. Dowdell, Thomas B. Lally, Nick Fluge, Jacob P. Gruver, and Todd H. Steele and CEC as a nominal defendant. Each individual defendant in this action is or was one of our officers or directors. The lawsuit alleged breach of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets, unjust enrichment, and breach of fiduciary duties for insider stock sales and misappropriation of information, generally based on allegations of conduct similar to that complained of in the In re Career Education Corporation Securities Litigation matter described above. On February 28, 2007, the court granted the defendants motion to dismiss for failure to plead demand futility and dismissed with prejudice the plaintiffs amended derivative complaint. Plaintiffs filed a notice of appeal on March 26, 2007.
As previously disclosed, on July 2, 2004, a derivative action captioned Xiao-Qiong Huang v. John M. Larson, et al., was filed in the Circuit Court of Cook County, Illinois, Chancery Division, on behalf of CEC against John M. Larson, Patrick K. Pesch, Wallace O. Laub, Keith K. Ogata, Dennis H. Chookaszian, Robert E. Dowdell, Thomas B. Lally, Nick Fluge, and Jacob P. Gruver and CEC as a nominal defendant. Each of the individual defendants is or was one of our officers or directors. The lawsuit alleges breach of fiduciary duty and misappropriation of confidential information for personal profit by the individual defendants and seeks contribution and indemnification on behalf of CEC. On September 12, 2005, the court granted defendants motion to stay the case until further order of the court in deference to the prior filed McSparran action.
As previously disclosed, on November 10, 2004, a derivative suit captioned Nicholas v. Dowdell, et al., was filed in the Chancery Court of New Castle County, Delaware, on behalf of CEC against John M. Larson, Patrick K. Pesch, Wallace O. Laub, Keith K. Ogata, Dennis H. Chookaszian, Robert E. Dowdell, Thomas B. Lally, Nick Fluge, and Jacob P. Gruver and CEC as a nominal defendant. The lawsuit alleges breach of fiduciary duty for insider stock sales and misappropriation of confidential information, breach of fiduciary duty of good faith, and unjust enrichment and seeks a constructive trust, disgorgement of profits, damages, costs, and attorneys fees. On March 17, 2005, the court granted the parties joint motion to stay the action pending final resolution of the McSparran action.
As previously disclosed, on June 3, 2005, a derivative suit captioned Romero v. Dowdell, et al., was filed in the Chancery Court of New Castle County, Delaware, on behalf of CEC against John M. Larson, Patrick K. Pesch, Wallace O. Laub, Keith K. Ogata, Dennis H. Chookaszian, Robert E. Dowdell, Thomas B. Lally and CEC as a nominal defendant. The court subsequently consolidated the Romero action with Neel v. Dowdell, et al., a case filed in the same court against the same defendants on May 15, 2006. Each of the individual defendants in the Romero and Neel actions is or was one of our officers or directors. On July 18, 2006, plaintiffs filed a consolidated derivative complaint under the caption In re Career Education Corporation Securities Litigation Derivative Litigation. The consolidated derivative complaint alleges conduct similar to that complained of in the lawsuits captioned In re Career Education Corporation Securities Litigation, McSparran, Huang, and Nicholas, described above, and seeks imposition of a constructive trust and disgorgement of profits, unspecified damages, and equitable relief and reimbursement of the plaintiffs costs and disbursement of the action. On March 8, 2007, the court held a hearing on the defendants motion to dismiss the consolidated derivative complaint or, in the alternative, to stay the case. Following the hearing, the court requested supplemental briefing from each party.
Due to the inherent uncertainties of litigation, we cannot predict the ultimate outcome of these matters. An unfavorable outcome of any one or more of these matters could have a material adverse impact on our business, results of operations, cash flows, and financial position.
Special Committee Investigation
As previously disclosed, in June 2004, our Board of Directors formed a Special Committee to conduct an independent investigation of allegations of securities laws violations against us. These allegations were asserted in the In re Career Education Corporation Securities Litigation matter described above (the Class Action). In July 2004, the Special Committee retained the law firm of McDermott, Will & Emery LLP, which in turn retained the forensic accounting firm Navigant Consulting, Inc., to assist in the investigation. Among other things, the investigation reviewed the allegations related to our accounting practices and reported statistics relating to starts, student population, and placement.
As previously disclosed, the Special Committee did not find support for the claims that CEC or its senior management engaged in the securities laws violations alleged in the Class Action. The Special Committee did find wrongful conduct by individual employees of CEC but specifically found that the wrongful activity was not directed or orchestrated by our senior management.
The Special Committee conducted a further investigation of assertions related to the claims of securities laws violations made for the first time, and not previously examined, in the second and third amended complaints filed in the Class Action on April 1, 2005, and May 1, 2006, respectively. The Special Committee completed its investigation of these new assertions and concluded that it did not find support for them. In so doing, the Special Committee reaffirmed its prior conclusion that it did not find support for the claims that CEC or its senior management engaged in the securities laws violations alleged in the Class Action.
We have undertaken a number of steps to improve our internal controls in the areas of finance and compliance, including the further development and expansion of our compliance, legal, and internal audit infrastructure processes. The Special Committee recommended additional improvements relating to our financial, compliance, and other controls. Our Board of Directors and senior management are continuing to evaluate the results and recommendations of the Special Committee. Our Board of Directors has requested that the Special Committee and its counsel remain in place and available, as needed.
Action against Former Owners of Western School of Health and Business Careers
As previously disclosed, on March 12, 2004, we filed a lawsuit in the U.S. District Court for the Western District of Pennsylvania against the former owners of Western School of Health and Business Careers (Western.). In the lawsuit, we allege that the former owners of Western made material misrepresentations of fact and breached certain representations and warranties regarding the accreditation and approval of several programs of study offered by Western and seek full indemnification for all resulting losses, costs, and damages, including attorneys fees. On July 12, 2004, we filed a similar complaint in the Court of Common Pleas of Allegheny County, Pennsylvania, and subsequently voluntarily dismissed the federal lawsuit. Subsequently, we amended our complaint to assert a claim for breach of contract against Westerns former accounting firm. Discovery is in progress.
The misrepresentations we allege in this matter came to light during a routine change of ownership review undertaken by the Accrediting Commission of Career Schools and Colleges of Technology (ACCSCT) subsequent to our acquisition of Western. On March 4, 2004, ACCSCT notified us of discrepancies in accreditation and approval documents related to several academic programs. Western suspended marketing, new enrollments, and disbursement of funds issued under Title IV Programs for all affected academic programs, and promptly applied for approval of all such programs. The diploma programs were approved in June 2004, and Western then resumed marketing, enrolling new students, and disbursement of Title IV Program aid to students in those programs. In July 2004, ACCSCT approved the degree programs effective upon Westerns satisfaction of certain stipulations. Western subsequently satisfied all stipulations and resumed marketing, enrollment of new students, and disbursing of Title IV Program funds to students in those programs. We are working in close cooperation with the ED and the U.S. Department of Justice to resolve any remaining issues in a manner that will best serve the interest of Westerns students. As a result of this matter, we expect that we will be required to reimburse the ED for a portion of Title IV Program funds improperly disbursed in relation to the effected programs, and we have recorded in our consolidated financial statements a reserve for the amount of the refund that we expect to pay to the ED. The pending lawsuit seeks to recover any such funds from the former owners of Western and its former accounting firm. Due to the inherent uncertainties of litigation, we cannot predict the ultimate outcome of this matter, but we do not expect such outcome to have a significant impact on our consolidated financial position or results of operations.
Laronda Sanders, et al. v. Ultrasound Technical Services, Inc,. et al. This action, filed on March 15, 2006, and currently pending in the United States District Court for the District of Maryland, Greenbelt Division, is brought by 21 current and former students of the Landover, Maryland, campus of Sanford-Brown Institute (SBI), one of our schools, on behalf of themselves and a putative class, against us and Ultrasound Technical Services, Inc. (UTS), one of our subsidiaries. Plaintiffs second amended complaint, filed on March 12, 2007, alleges that the defendants made fraudulent misrepresentations and violated the Maryland consumer fraud act by misrepresenting or failing to disclose, among other things, details regarding instructors experience or preparedness, availability of clinical externship assignments, and estimates for the dates upon which the plaintiffs would receive their certificates and be able to enter the work force. The complaint also alleges that defendants breached plaintiffs enrollment contracts by failing to provide the promised instruction, training, externships, and placement services. Plaintiffs seek actual damages, punitive damages, and costs. Discovery is ongoing.
McCarten, et al. v. Allentown Business School, Ltd. t/a Lehigh Valley College. As previously disclosed, on September 28, 2005, a complaint was filed against Allentown Business School, Ltd. (Allentown), one of our subsidiaries, in the Court of Common Pleas of Lehigh County, Pennsylvania. The complaint purports to be brought on behalf of all former students of Allentown, now known as Lehigh Valley College, who received allegedly high interest private loans, and alleges that Allentown violated Pennsylvanias Unfair Trade Practices and Consumer Protection Law and engaged in intentional misrepresentation, negligent misrepresentation, and negligence in connection with the enrollment and student loan information and application processes. The complaint seeks compensatory and punitive damages in an unspecified amount. On December 12, 2005, the plaintiffs filed an amended complaint asserting the same claims as set forth in the initial complaint. On December 14, 2005, Allentown moved to compel arbitration. The motion was granted by Order dated November 13, 2006. In December 2006, the plaintiffs made a Motion for Reconsideration of the Order compelling arbitration. The court denied the motion for reconsideration by Order dated December 27, 2006.
Bradley, et al. v. Sanford Brown-College, Inc., et al. As previously disclosed, this action, filed on August 25, 2005, and currently pending in the United States District Court for the Western District of Missouri, is brought against us, two of our subsidiaries, Sanford-Brown College (SBC) and Colorado Technical University, Inc., and Whitman Education Group, Inc. by eight former students of the radiography program at our Sanford-Brown College (SBC) school in Kansas City, Missouri. The complaint alleges that the defendants made fraudulent misrepresentations and violated the Missouri Merchandising Practices Act by misrepresenting or failing to disclose, among other things, details regarding instructors experience or preparedness, estimates for starting salaries of program graduates, that the curriculum would prepare the students for the state board exams for radiography, that credit hours earned at SBC were transferable, that SBC reported false expense estimates and false class credits in applications for federal and state grant and loan programs, and that admissions representatives had sales quotas for enrolling new students. The complaint also alleges that the defendants breached enrollment contracts with the plaintiffs by failing to provide the promised instruction, training, and placement services. Plaintiffs seek actual damages, punitive damages, attorneys fees and costs, and other relief. On July 13, 2006, plaintiffs filed a second amended complaint, adding Marlin Acquisition Corp. and CTU Corporation, Inc., both subsidiaries of CEC, as additional defendants. Our motions for summary judgment with respect to Colorado Technical University, Inc. and CTU Corporation, Inc. were granted. The parties have reached an agreement in principle to settle this matter and are in the process of finalizing settlement and general release agreements.
Thurston, et al. v. Brooks College, Ltd., et al. As previously disclosed, on March 21, 2005, a purported class action complaint was filed in the Superior Court for the State of California, County of Los Angeles, against Brooks College, one of our schools. The complaint was purportedly filed on behalf of all current
and former attendees of Brooks College. The complaint alleges that Brooks College violated the California Business and Professions Code and Consumer Legal Remedies Act by allegedly misleading potential students regarding Brooks Colleges admission criteria, transferability of credits, and retention and placement statistics and by engaging in false and misleading advertising. Plaintiffs seek injunctive relief, restitution, unspecified punitive and exemplary damages, attorneys fees, interest, costs, and other relief. On June 24, 2005, the Court ruled that this action was related to the case captioned Outten, et al. vs. Career Education Corporation, et al., which is described below. Brooks College filed an answer to the complaint on May 31, 2006. Plaintiffs filed a motion for class certification on December 18, 2006, and we filed our opposition motion on March 5, 2007. The court has not yet set a hearing date on the motion for class certification
Nilsen v. Career Education Corporation, et al. As previously disclosed, on February 4, 2005, three former students of Brooks Institute of Photography (BIP), one of our schools, filed a purported class action complaint in the Superior Court of the State of California, County of Santa Barbara, against us and BIP. The action was purportedly brought on behalf of all students who attended BIP from February 4, 2001, to the present.
Plaintiffs operative Third Amended Complaint states causes of action for (1) violations of the California Education Code, (2) violations of the Consumer Legal Remedies Act, (3) fraud, (4) false advertising in violation of California Business and Professions Code §17500, et seq, and (5) unfair competition in violation of California Business and Professions Code §17200, et seq. The plaintiffs primarily allege that BIP violated the California Education Code, the California Consumer Legal Remedies Act, and Californias Unfair Competition Law by allegedly misleading potential students regarding BIPs placement rates and by engaging in false and misleading advertising. The plaintiffs seek injunctive relief, disgorgement of profits, punitive damages, interest, and attorneys fees and costs. On October 11, 2006, the Court overruled the defendants demurrers and motion to strike a portion of the Third Amended Complaint.
Plaintiffs filed their motion for class certification on February 14, 2007. We have taken discovery from the class representatives. The hearing on the motion for class certification is set for September 11, 2007.
Outten, et al. v. Career Education Corporation, et al. As previously disclosed, a purported class action was filed in the Superior Court of the State of California, County of Los Angeles, against us and AIU, one of our schools. The operative complaint, which claims to have been brought on behalf of present and former students of AIU, alleges that AIU violated the California Unfair Competition Law (California Business and Professions Code), the California Consumer Legal Remedies Act, and the California Education Code and engaged in common law consumer fraud by purportedly misleading potential students regarding AIUs placement rates. The plaintiffs, on behalf of the putative class, seek injunctive relief, restitution, unspecified punitive and exemplary damages, attorneys fees and costs, interest, and other relief. On March 10, 2005, defendants filed an answer to the second amended complaint as well as a cross-complaint against one of the named plaintiffs for unpaid tuition. On June 24, 2005, the Court ruled that this action was related to another action captioned Thurston, et al. v. Brooks College, Ltd., et al., which is described above. A hearing on plaintiffs motion to certify a class is scheduled for May 25, 2007. No trial date has been set for this matter.
Due to the inherent uncertainties of litigation, we cannot predict the ultimate outcome of these matters. An unfavorable outcome of any one or more of these matters could have a material adverse impact on our business, results of operations, cash flows, and financial position.
In addition to the legal proceedings and other matters described above, we are also subject to a variety of other claims, suits, and investigations that arise from time to time in the ordinary conduct of our business, including, but not limited to, claims involving students or graduates and routine employment matters. While we currently believe that such claims, individually or in aggregate, will not have a material adverse impact on our financial position, cash flows, or results of operations, the litigation and other claims noted above are subject to inherent uncertainties, and managements view of these matters may change in the future. Were an unfavorable final outcome to occur in any one or more of these matters, there exists the possibility of a material adverse impact on our business, reputation, financial position, cash flows, and the results of operations for the period in which the effect becomes probable and reasonably estimable.
Our schools are subject to extensive regulation by federal and state governmental agencies and accrediting bodies. On an ongoing basis, we evaluate the results of our internal compliance monitoring activities and those of applicable regulatory agencies, and, when appropriate, record liabilities to provide for the estimated costs of any necessary remediation. The following is an update of selected recent regulatory and accreditation actions affecting us and certain of our schools.
Federal Regulatory Matters
As previously disclosed, the ED notified us in June 2005 that it was reviewing certain of our financial statements and annual compliance audit opinions and evaluating pending school program reviews at certain of our schools. The ED indicated that until these matters were addressed to its satisfaction, it would not approve any new applications for pre-acquisition review or change of ownership submitted by us. The ED further advised us that during this period, it will not approve applications for any additional branch campuses, which the ED refers to generally in its regulations as additional locations.
In a November 6, 2006, meeting, officials of the ED informed us that the ED would select 10 to 12 of our institutions for program reviews to be conducted before it would consider lifting the restrictions on new applications described above. During the months of November and December, 2006 and January and February 2007, the ED conducted site visits at 10 of our institutions as part of such program reviews.
The ED notified us in a January 19, 2007, letter that, based upon the preliminary results of these program reviews, it would remove the growth restrictions that it imposed in June 2005. The ED stated that any subsequent request by us to expand our operations would be considered in accord with the EDs standard operating procedures. The ED emphasized that the removal of the growth restrictions should not be construed to suggest that any Title IV compliance issues identified had been resolved or that program reviews currently in process would be concluded.
The following is an update on the status of pending ED program reviews:
As previously disclosed, an ED program review is currently pending for our Gibbs College school in Livingston, New Jersey, and the schools branch campus, Katharine Gibbs School in Piscataway, New Jersey. In January 2004, the school responded to the EDs initial findings report. In June 2005, the ED performed a follow-up review, and, in September 2005, the ED notified the school that additional information was required in response to its initial findings report. In November 2005, the school provided the ED with the requested additional information, and the school is awaiting a response from the ED.
As previously disclosed, in July 2006, our Briarcliffe College school was notified by the ED of the EDs intent to conduct a program review. The school provided the ED with all information requested pursuant to the program review and is awaiting the EDs program review report.
In November 2006, The Cooking and Hospitality Institute of Chicago, Gibbs College in Boston, MA, Katharine Gibbs School in New York, NY, Gibbs College in Vienna, VA, Lehigh Valley College, Brooks Institute of Photography, California Culinary Academy, Sanford-Brown Institute in Atlanta, and American InterContinental University were each notified by the ED of the EDs intent to conduct program reviews at the schools. In January 2007, our Western School of Health and Business Careers was notified by the ED of the EDs intent to conduct a program review at the school. The ED has begun but has not yet completed each of these program reviews.
We are committed to resolving all issues identified in connection with these program reviews to the EDs satisfaction and ensuring that our schools operate in compliance with all ED regulations.
We were advised that the Office of Inspector General of the ED (OIG) is conducting an investigation of our LCB-Atlanta school. In connection with this inquiry, LCB-Atlanta received a subpoena from the OIG seeking certain information. Generally, the subpoena calls for the production of information concerning the administration of Title IV Program funds at the school and related matters. We are in the process of providing documents and information in response to the subpoena, and intend to cooperate fully with the OIG in connection with this matter.
We cannot predict the outcome of these ED actions, and any unfavorable outcomes could have a material adverse effect on our business, results of operations, cash flows, and financial position.
SEC and Department of Justice Investigations. As previously disclosed, on January 7, 2004, we received notification from the Midwest Regional Office of the SEC that it was conducting an inquiry concerning us and requested that we voluntarily provide certain information. On June 22, 2004, the SEC staff notified us that it was conducting a formal investigation. On April 5, 2006, we disclosed that we were advised by the staff of the Midwest Regional Office of the SEC that the staff intends to recommend to the SEC that it terminate its investigation of us. The staff of the SEC also advised us that it will recommend that no enforcement action be taken against us. Recommendations by the SEC staff do not constitute final action by the SEC, as the SEC thereafter makes its own determination as to whether to follow the recommendations of the SEC staff.
The U.S. Department of Justice (Justice Department) in Chicago notified us on April 19, 2007 that it was declining prosecution and closing its grand jury investigation of us. We first became aware of and disclosed the investigation in 2004. With the notification from the Justice Department, the investigation has now been terminated with no action taken against us.
As previously disclosed, we received a letter from the Civil Division of the Justice Department in Washington, D.C., dated May 30, 2006, advising us that the Justice Department was reviewing allegations that certain of our schools may have submitted false claims or statements to the ED. The letter requested that we provide documents relating to various subject areas. The Justice Department has indicated that this review is informational in nature. We have voluntarily responded to the Justice Departments request for information and have cooperated fully with it. We believe this Civil Division informational review is ongoing.
Katharine Gibbs- New York (Gibbs-NY). In April, 2006, the Office of College and University Evaluation of the New York State Education Department (the Education Department) conducted a site visit to Gibbs-NY. The purpose of the visit was to examine Gibbs-NYs compliance with the regulations of the Education Department. On June 28, 2006, the Education Department issued a draft report relating to its site visit. The draft report included a number of findings and recommendations and indicated that Gibbs-NY may be out of compliance with Education Department regulations in several areas. Gibbs-NY was given until August 29, 2006, to comment on the draft report, point out factual errors, provide new information, and respond to the recommendations set forth therein. Gibbs-NY submitted a response to the draft report within the prescribed time period.
On January 25, 2007, the Education Department issued a final report stating that though the school had addressed many of the Education Departments recommendations, additional action was required. Gibbs-NY submitted a response to the Education Departments remaining concerns on March 23, 2007, and anticipates a follow-up review in the next several months. The Education Department stated that, absent a finding of substantial compliance with registration standards in the follow-up review, it will terminate the registration of all degree programs at Gibbs-NY. While the review remains pending, the Education Department has limited enrollments commencing with the April 2007 academic quarter to not more than 50% of entering first-time students enrolled in the comparable academic quarter of the preceding year. The Education Department has also required Gibbs-NY to show that not less than 65% of April 2007 entering first-time, full-time students remain as students into the following term, exhibiting satisfactory academic performance and progress.
Texas Culinary Academy (TCA). On October 21, 2005, the Texas Higher Education Coordinating Board (THECB) conducted an unannounced visit to TCA. Two follow-up visits were held in November 2005. On January 13, 2006, representatives from TCA and CEC met with the THECB to review the schools compliance with the Texas Success Initiative. The Texas Success Initiative is a state-legislated program designed to improve student success in college. The program requires that an institution assess (with a standardized test) entering students ability to perform freshman-level academic coursework and provide developmental instruction to strengthen academic skills for students who do not test at required minimum levels. TCA was given 90 days, until May 26, 2006, to have a system in place, that ensured compliance with the Texas Success Initiative. In March 2006, TCA submitted a remediation plan to the THECB and, the school has since been in the process of implementing such plan. To date, the school has addressed the findings of the THECB and has implemented changes intended to minimize the risk of future noncompliance. Additionally, the school has corrected a majority of the deficiencies outstanding as of the date of the submission to the THECB of its remediation plan and continues to address the remaining deficiencies. On March 13, 2007, the THECB informed the school that it had discontinued its audit of the school and agreed that TCA could submit new program applications at this time.
Lehigh Valley College (Lehigh). As previously disclosed, on July 20, 2005, the Bureau of Consumer Protection of the Office of Attorney General in Pennsylvania (Pennsylvania AG) notified Lehigh that it had begun a review into the business practices of the school. The Pennsylvania AG requested certain documents, including information relating to Lehighs recruitment practices, student complaints, and financial aid policies and procedures, which we provided in August 2005.
In a May 31, 2006, subpoena, the Pennsylvania AG requested that Lehigh provide additional documents and information and appear to answer certain inquiries. Lehigh has produced documents responsive to the Pennsylvania AGs additional requests and has made a former senior administrator available to answer the Pennsylvania AGs inquiries. In October 2006, the Pennsylvania AG alleged that Lehigh and CEC engaged in conduct that violates the Pennsylvania Unfair Trade Practices and Consumer Protection Law. The Pennsylvania AG has offered us and Lehigh the opportunity to resolve this matter by entering into an assurance of voluntary compliance and paying a fine. We are currently engaged in discussions with the Pennsylvania AG regarding the resolution of its concerns and allegations. If a resolution cannot be reached, the Pennsylvania AG may commence a civil litigation for injunctive relief, costs, and fines.
Brooks Institute of Photography (BIP). On April 19, 2007, the California Bureau for Private Postsecondary and Vocational Education issued a full five-year license renewal for Brooks Institute of Photography.
We cannot predict the outcome of pending state regulatory matters, and an unfavorable outcome of any one or more of these matters could have a material adverse effect on our business, results of
operations, cash flows, and financial position. We have evaluated these matters in connection with our ongoing evaluation of goodwill and indefinite-lived intangible assets for impairment, when applicable.
Accrediting Body Matters
American InterContinental University (AIU). As previously disclosed, at SACS December 11, 2006, meeting, SACS extended AIUs Probation status through December 2007. On January 9, 2007, AIU was notified that seven of the 15 previous recommendations from SACS remained unresolved to the commissions satisfaction and that another special committee visit to AIU had been authorized. AIU is scheduled to submit a second monitoring report in September 2007 responding to these seven open recommendations, and the special committee visit is scheduled to occur in October 2007. AIU remains accredited during this probationary period and committed to resolving all issues identified by SACS. Under the SACS rules, an institution may only remain on Probation status for two consecutive years, after which Probation status must either be lifted or the institutions accredited status must be terminated.
American InterContinental University London (AIULondon). AIULondon has been authorized by the applicable U.S. and United Kingdom agencies to grant academic credentials. AIULondon is authorized to grant academic degrees by the Nonpublic Postsecondary Education Commission of the State of Georgia. U.S. students that attend AIULondon are eligible to participate in Title IV Programs through AIULondons status as a branch campus of AIUBuckhead. As previously disclosed, on December 12, 2005, AIULondon entered into an accreditation agreement with London South Bank University (LSBU), which has currently validated student degrees in AIU Londons interior design, visual communication, fashion design, fashion marketing, and fashion design with marketing programs and is currently reviewing AIU-Londons other programs in order to validate student degrees in those programs. AIULondons prior accreditation agreement with The Open University has terminated. As previously reported, on June 23, 2006, AIULondon filed a lawsuit against The Open University alleging wrongful termination of the accreditation agreement and wrongful denial by The Open University of its obligations to confer degrees on AIULondon students. AIULondon and the Open University signed a confidential settlement agreement on March 23, 2007, settling the proceedings and all claims between them, and a consent order was filed with the court.
We cannot predict the outcome of any pending accreditation matters, and an unfavorable outcome of any one or more of these matters could have a material adverse effect on our business, results of operations, cash flows, and financial position. We have evaluated these matters in connection with our ongoing evaluation of goodwill and indefinite-lived intangible assets for impairment, when applicable.
8. STOCK REPURCHASE PROGRAM
Since July 2005, our Board of Directors has authorized the use of a total of $500.2 million to repurchase outstanding shares of our common stock. Stock repurchases under this program may be made on the open market or in privately negotiated transactions from time to time, depending on factors, including market conditions and corporate and regulatory requirements. The stock repurchase program does not have an expiration date and may be suspended or discontinued at any time.
During the first quarter of 2007, we repurchased 1.6 million shares of our common stock for approximately $50.0 million at an average price of $30.42 per share.
Since the inception of the program, we have repurchased 12.4 million shares of our common stock for approximately $416.3 million at an average price of $33.53 per share. As of March 31, 2007, we are authorized under the program to use an additional $83.8 million to repurchase outstanding shares of our common stock.
The repurchase of shares of our common stock reduces the amount of cash available to pay cash dividends to our stockholders. We have never paid cash dividends on our common stock.
9. SHARE-BASED COMPENSATION
Under our 1998 Employee Incentive Compensation Plan, as amended, (the Employee Plan) and our 1998 Non-Employee Directors Stock Option Plan (the Directors Plan), non-employee members of our Board of Directors, officers, and other employees may receive grants of incentive stock options, nonqualified stock options, shares of non-vested stock, stock appreciation rights, and other awards. We are authorized to grant up to approximately 27.5 million shares of common stock under the plans. As of March 31, 2007, we have reserved approximately 5.8 million shares of common stock for the exercise of stock options outstanding as of March 31, 2007, approximately 0.8 million shares for awards of non-vested stock, and approximately 2.8 million additional shares of common stock for future share-based awards under the plans.
Stock Options. The exercise price of stock options granted under the plans is equal to the fair market value of our common stock on the date of grant. Employee stock options become exercisable ratably over a four-year service period beginning on the date of grant and expire ten years after the date of grant, unless an earlier expiration date is set at the time of the grant. Non-employee directors stock options expire ten years after the date of grant and generally become exercisable as follows: one-third on the grant date, one-third on the first anniversary of the grant date, and one-third on the second anniversary of the grant date. Both employee stock options and non-employee director stock options are subject to possible earlier vesting and termination in certain circumstances. If a plan participant terminates his or her employment for any reason other than by death or disability during the vesting period, he or she forfeits the right to unvested stock option awards. Since the inception of the plans, grants of stock options have only been subject to the service conditions discussed previously. No stock option grants have included performance or market conditions that affect stock option vesting or other pertinent factors.
Non-vested Stock. Shares of non-vested stock become vested three years after the date of grant. If a plan participant terminates his or her employment for any reason other than by death or disability during the vesting period, he or she forfeits the right to all shares of non-vested stock. The vesting of shares of non-vested stock is subject to possible acceleration in certain circumstances. Certain of the shares of non-vested stock that we have granted to plan participants are subject to performance conditions that may affect the number of shares of non-vested stock that will ultimately vest at the end of the requisite service period. These awards are referred to as performance-vesting non-vested stock.
Stock option activity during the three months ended March 31, 2007, under all of our share-based compensation plans was as follows:
The following table summarizes information with respect to all stock options outstanding under all of our share-based compensation plans as of March 31, 2007:
Non-vested stock activity during the three months ended March 31, 2007, under the Employee Plan was as follows:
Each of the share-based awards granted under the plans, including stock options and shares of non-vested stock, is subject to a change in control provision included in our share-based compensation plans. As defined by the plans, a change in control is deemed to have occurred if, among other things, any corporation, person, or other entity (other than CEC, a majority-owned subsidiary of CEC or any of CECs subsidiaries, or an employee benefit plan sponsored or maintained by CEC), including a group as defined in Section 13(d)(3) of the Securities Exchange Act of 1934 (the Exchange Act), becomes the beneficial owner of our common stock representing more than 20 percent of the combined voting power of our then outstanding common stock.
Under the Employee Plan, in the event of a change in control:
· Any stock options outstanding as of the date of the change in control and not then exercisable would become fully exercisable to the full extent of the original grant.
· The restrictions applicable to any outstanding shares of non-vested stock awards would lapse, and the shares of non-vested stock would become fully-vested and transferable to the full extent of the original grant.
· The performance goals and other conditions with respect to any performance-vesting non-vested stock or stock options subject to performance vesting conditions would be deemed to have been satisfied in full, and such awards would generally become fully distributable.
· Plan participants holding stock option awards as of the date of the change in control would have the right, by giving notice to us during the 60-day period from and after the date of a change in control, to elect to surrender all or part of a stock option award to us and receive, within 30 days of such notice, cash in an amount equal to the amount by which the per share change of control price, as defined below, exceeds the per share amount that the employee must pay to exercise the stock
option award, multiplied by the number of stock options for which the employee has exercised this right.
Under the Director Plan, in the event of a change in control, any stock options outstanding as of the date of such change in control and not then exercisable will become fully exercisable to the full extent of the original grant. In addition, our Board of Directors will have full discretion to do, among other things, any or all of the following with respect to outstanding stock option awards:
· Cause any stock option award to be cancelled, provided notice of at least 15 days thereof is provided before the date of cancellation;
· Grant the director participants, by giving notice during a pre-set period, the right to surrender all or part of a stock option award to us and to receive cash in an amount equal to the amount by which the change in control price per share on the date of such election exceeds the per share amount that the plan participant must pay to exercise the stock option award, multiplied by the number of shares of our common stock for which the director has exercised this right; and
· Take any other action our Board of Directors determines to take.
In the event of a change in control, as described above, the change in control price is defined by the plans as the highest reported sales price of a share of our common stock in any transaction reported on the principal exchange on which our shares are listed during the 60-day period prior to and including the date of the change in control event.
As of March 31, 2007, we are not aware of any person or entity, including a group, who beneficially owns, or at any point previously owned, 20% or more of the combined voting power of our outstanding common stock. As of March 23, 2007, no individual shareholder owned more than 11.6% of the combined voting power of our then outstanding common stock, and, based on existing facts and circumstances, we do not believe it is probable that the change in control provisions will be triggered.
If any person or entity, including a group, beneficially owned 20% or more of the combined voting power of our then outstanding common stock as of March 31, 2007, triggering the change in control provisions discussed above, we would have recognized additional share-based compensation expense of approximately $30.4 million during the first quarter of 2007. The estimated additional share-based compensation expense represents, for each outstanding share-based award, the greater of (a) the unrecognized grant date compensation expense for the share-based award as of March 31, 2007, or (b) the fair value of the cash redemption value of the share-based award as of March 31, 2007, less share-based compensation expense previously recorded under SFAS 123R or disclosed as pro forma compensation expense under SFAS 123, based on a change in control price of $32.23 per share, the highest reported share price of a share of our common stock in a transaction reported on the NASDAQ Global Select Market during the 60-day period prior to and including March 31, 2007.
Additionally, if the change in control provisions had been triggered as of March 31, 2007, or if we determined that the occurrence of a change in control event was probable, we would have recognized a liability of $24.6 million as of March 31, 2007, representing the estimated fair value of the obligation that would be due to participants who are eligible to surrender all or part of a stock option award to us in exchange for cash. Our estimation of this cash liability assumes that participants would elect to redeem for cash all stock options outstanding as of March 31, 2007, with an exercise price less than the change in control price.
As discussed above, a participant in the plans has the right, or may be granted the right, upon the occurrence of a change in control event, to surrender all or part of his or her stock option awards to us in exchange for cash. As required by SFAS No. 123 (revised), Share-Based Payment (SFAS 123R), the
grant-date cash redemption value of each outstanding stock option award is recorded as Share-based awards subject to redemption on our consolidated balance sheets on a pro rata basis over the requisite service period. Total grant-date cash redemption value for each outstanding stock option award represents the intrinsic value of the award as of the grant date, assuming that a change in control event occurred on the grant date. Share-based awards subject to redemption as of March 31, 2007, recorded as a reduction of retained earnings with no affect on net income, represents the portion of the total grant-date cash redemption value for all stock option awards outstanding as of March 31, 2007, earned by plan participants as a result of services rendered through such date. The adoption of SFAS 123R resulted in the cumulative effect recorded in this manner as of January 1, 2006, of $11.2 million. The balance increased during 2006 by $2.3 million, resulting in a balance of $13.5 million as of December 31, 2006, and decreased by $1.4 million during the first quarter of 2007, resulting in a balance of $12.1 million as of March 31, 2007.
On January 1, 2006, we adopted the provisions of SFAS 123R, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123), and replaces our previous method of accounting for share-based awards under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (Opinion 25) for periods beginning in 2006. SFAS 123R requires that all share-based payments to employees, including grants of stock options, shares of non-vested stock and the compensatory elements of employee stock option plans, be recognized in the financial statements based on the estimated fair value of the equity or liability instrument issued.
We previously accounted for share-based compensation using the intrinsic value method as defined in Opinion 25. Prior to January 1, 2006, no share-based employee compensation cost, other than the insignificant costs associated with infrequent issuances of shares of non-vested stock, was reflected in our consolidated statement of income. SFAS 123R requires that we report the tax benefit from the tax deduction related to share-based compensation that is in excess of recognized compensation costs as a financing cash flow rather than as an operating cash flow in our consolidated statement of cash flows. Prior to January 1, 2006, Opinion 25 required that we report the entire tax benefit related to the exercise of stock options as an operating cash flow.
We adopted SFAS 123R using the modified prospective transition method. Under this method, employee compensation cost recognized during 2006 includes (1) compensation cost for all share-based payments granted prior to, but not yet vested, as of January 1, 2006, based on grant date fair value estimated in accordance with the provisions of SFAS 123 and (2) compensation cost for all share-based awards granted on or subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. Under the modified prospective transition method, the provisions of SFAS 123R were not applied to periods prior to adoption, and, thus, prior period financial statements have not been restated.
In accordance with SFAS 123R, the fair value of each stock option award is estimated on the date of grant using the Black-Scholes-Merton option pricing model. Consistent with our approach under the disclosure only provisions of SFAS 123, we will continue to recognize the value of share-based compensation as expense during the vesting periods of the underlying share-based awards using the straight-line method. SFAS 123R requires companies to estimate forfeitures of share-based awards at the time of grant and revise such estimates in subsequent periods if actual forfeitures differ from original projections. Consistent with our approach under the disclosure-only provisions of SFAS 123, we will continue to estimate forfeitures at the time of grant.
The fair value of each stock option award granted during the three months ended March 31, 2007 and 2006, was estimated on the date of grant using the Black-Scholes-Merton option pricing model. Our determination of the fair value of each stock option is affected by our stock price on the date of grant, as
well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, our expected stock price volatility over the expected life of the awards and actual and projected stock option exercise behavior. The weighted average fair value per share of stock option awards granted during the three months ended March 31, 2007 and 2006, and assumptions used to value stock options are as follows:
Volatility is calculated based on the actual historical daily prices of our common stock over the expected term of the stock option award. During the three months ended March 31, 2007, we utilized a range of expected volatility assumptions for purposes of estimating the fair value of stock options awarded during the period. Such volatility assumptions ranged from 51.29% to 51.61%.
The expected life of each stock option award is estimated based primarily on our actual historical director and employee exercise behavior.
The fair value of each share of non-vested stock is equal to the fair market value of our common stock as of the date of grant.
All shares of performance-vesting non-vested stock granted during the three months ended March 31, 2007, are subject to performance conditions based on the results of school-level independent compliance audits and the compliance of our schools with federal, state, and accrediting body regulations. Share-based compensation expense associated with performance-vesting non-vested stock awards is recognized only to the extent that we believe performance conditions attributable to such awards will ultimately be satisfied. As of March 31, 2007, we believe performance conditions attributable to our performance-vesting non-vested stock awards will be satisfied.
As of March 31, 2007, we estimate that pre-tax compensation expense for all unvested share-based awards, including both stock options and shares of non-vested stock, in the amount of approximately $25.7 million will be recognized in future periods. We expect to satisfy the exercise of stock options and future distribution of shares of non-vested stock by issuing new shares of common stock.
10. WEIGHTED AVERAGE COMMON SHARES
The weighted average numbers of common shares used to compute basic and diluted income per share during the three months ended March 31, 2007 and 2006, were as follows:
During the three months ended March 31, 2007 and 2006, we issued 468,356 and 148,258 shares, respectively, of our common stock upon the exercise of employee stock options and the purchase of common stock pursuant to our employee stock purchase plan.
Included in stock options outstanding are options to purchase 4.3 million shares and 3.1 million shares, respectively, of our common stock as of March 31, 2007 and 2006, that were not included in the computation of diluted net income per share because the options exercise prices were greater than the average market price of our common stock during the three-month period then ended and, therefore, the effect would have been anti-dilutive.
Based on our interpretation of SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information (SFAS 131), we have identified six school reportable segments, including the Academy segment, the Colleges segment, the Culinary Arts segment, the Health Education segment, the International segment, and the University segment.
The Academy segment includes our International Academy of Design and Technology (IADT) campuses that collectively offer academic programs primarily in the career-oriented discipline of visual communications and design technologies in a classroom setting.
The Colleges segment includes schools that collectively offer academic programs in each of our core career-oriented disciplines of business studies, culinary arts, health education, information technology, and visual communications and design technologies in a classroom or laboratory setting.
The Culinary Arts segment includes our Le Cordon Bleu and Kitchen Academy schools that collectively offer culinary arts academic programs in the career-oriented disciplines of culinary arts, pastry arts, and hotel and restaurant management primarily in a classroom or kitchen setting.
The Health Education segment primarily includes our Sanford-Brown schools that collectively offer academic programs in the career-oriented disciplines of health education, business studies, visual communication and design technologies, and information technology in a classroom or laboratory setting.
The International segment includes our INSEEC Group schools and Istituto Marangoni schools located in France, Italy, and the United Kingdom, which collectively offer academic programs in the career-oriented disciplines of business studies, health education, and visual communication and technologies in a classroom or laboratory setting.
The University segment includes our AIU and CTU universities that collectively offer academic programs in the career-oriented disciplines of business studies, visual communication and design technologies, health education, information technology, criminal justice, and education in an online, classroom, or laboratory setting.
Our chief operating decision maker evaluates segment performance based on pretax segment profit or loss. This measure of profit or loss includes the University segments share of affiliate earnings and excludes interest income, interest expense, miscellaneous income and expense, and any unallocated corporate expenses. Adjustments to reconcile segment results to consolidated results are included under the caption Corporate and other, which primarily includes unallocated corporate activity and eliminations.
The accounting policies of each segment are consistent with those described in the summary of significant accounting policies in Note 2 Significant Accounting Policies of the notes to our consolidated financial statements in Part IV, Item 15 of our Annual Report on Form 10-K for the year ended December 31, 2006. Transactions between segments, which are not significant, are consummated on a basis
intended to reflect the market value of the underlying products or services. A majority of corporate expenses have been charged to the segments as part of a general allocation.
The results of operations of our schools on-ground campuses fluctuate on a quarterly basis, primarily as a result of changes in the level of student enrollment. Our schools on-ground campuses typically experience a seasonal increase in student population in the fall, traditionally when the largest number of new high school graduates begin postsecondary education. Furthermore, although our schools encourage year-round attendance at all campuses, certain programs at certain schools include summer breaks. As a result of these factors, total student population and revenue at our schools on-ground campuses are typically highest in the fourth quarter (October through December) and lowest in the second quarter (April through June). The operating costs of our schools on-ground campuses do not fluctuate as significantly on a quarterly basis, except for admissions and advertising expenses, which are typically higher during the second quarter and third quarter (April through September) in support of seasonally high enrollment. We anticipate that these seasonal trends will continue.
The results of operations of AIU Online, which is included in our University segment, fluctuate on a quarterly basis, primarily as a result of AIU Onlines academic calendar and, more specifically, the number of instructional days in each quarter. Historically, the number of revenue-generating instructional days has been highest during the first and second quarters (January through June), lower in the third quarter (July through September), and lowest in the fourth quarter (October through December). Operating costs for AIU Online do not fluctuate as significantly on a quarterly basis. We anticipate that these seasonal trends will continue.
The results of operations of CTU Online, which is included in our University segment, are not significantly impacted by seasonal trends, as, historically, the number of revenue-generating instructional days during each quarter has not fluctuated significantly.
Summary financial information by reportable segment is as follows (in thousands):
(1) University segment profit includes share of affiliate earnings of $1.7 million and $0.9 million for the three months ended March 31, 2007 and 2006, respectively.
The negative corporate and other segment asset balance as of March 31, 2007, and December 31, 2006, is primarily attributable to the elimination of intercompany receivable activity between corporate and our schools and campuses, which is reflected within Corporate and other.
Start-up campuses include our branch campuses that have been instructing students for less than 12 months, including those campuses that have not yet opened for instruction. The following supplemental financial information illustrates the impact of our start-up campuses on segment revenues, operating results, and capital expenditures during the three months ended March 31, 2007 and 2006 (in thousands):