Tuition Payments by Insolvent Parents (Likely) Constitute Fraudulent Transfers

Bankruptcy trustees in some parts of the country are filing fraudulent transfer suits to recover tuition payments that insolvent parents made on behalf of their children over age 18.

In March, Chief Bankruptcy Judge Carla E. Craig of Brooklyn, N.Y., notched a victory for colleges and universities by holding that concepts borrowed from structured finance will insulate educational institutions from fraudulent transfer liability. To read ABI’s report on Judge Craig’s decision, click here.

The trustee appealed, and District Judge Allyne R. Ross of Brooklyn reversed and remanded in an opinion on November 27.

Although upholding Judge Craig’s legal construct, Judge Ross made a critical factual distinction that may end up making the universities automatically liable, even though they had no inkling that the parent was insolvent or making fraudulent transfers.

Because a child’s higher education supposedly confers no value on the parent, some courts find fraudulent transfers to the schools while others do not, as Judge Craig said in her March 28 opinion. In assigning liability or not, it is this writer’s view that some courts are making dubious law on who is a “mere conduit” and in deciding whether the school is the initial or subsequent transferee.

Instead, the courts and Congress should starkly confront this fundamental question: Does an insolvent parent make a fraudulent transfer by paying typical, reasonable expenses of a child over the age of 18?

Although schools are normally the defendants, not the children, nothing prevents trustees from suing the kids. Would society countenance holding children liable for receipt of fraudulent transfers when the parents have done nothing more than provide an education? If contemporary society believes that parents have a duty to educate children over the age of 18, should fraudulent transfer law adopt the same presumption?

As soon as possible, schools can and should tweak their student accounts to obviate the chance of being liable under Judge Ross’s opinion. But that leads to another question: Should astute structured finance change the result when the underlying economic reality remains the same?

This writer also recommends that state legislatures adopt family laws to protect innocent educational institutions whose only sin is providing an education.

The Facts

In the lawsuit before Judge Craig, an insolvent parent had paid tuition for his children both before and after he filed a chapter 11 petition. After conversion to chapter 7, the trustee filed fraudulent transfer suits to recover the tuition payments.

Holding that the universities were not the initial transferees and were therefore entitled to the good faith defense as subsequent transferees under Section 550(b), Judge Craig granted summary judgment to the universities dismissing the adversary proceedings.

Judge Craig based her decision on the structure of student accounts created by the universities to pay tuition.

The accounts were in the name of the students. Payments by parents went into the accounts and were applied toward tuition when the students registered for classes. Even though they may have supplied the funds, parents had no right to access the accounts without the students’ permission. If the students were to withdraw, refunds went to the students, not to the parents.

Judge Craig ruled that the students, not the universities, were the initial transferees because undisputed facts showed that the parent-debtor did not have dominion or control over the students’ accounts when the parent made transfers into the accounts. After the initial transfers, she said, the debtor could not access the accounts without the students’ authorization. Rather, she said, the students had dominion and control over their accounts.

Since the universities were subsequent transferees, Judge Craig ruled that the schools were entitled to dismissal because they had the good faith defense in Section 550(b). The trustee did not question the universities’ good faith.

The Opinion by Judge Ross

In her 21-page opinion on appeal, Judge Ross said that Judge Craig’s “analysis of this thorny issue was sound.” Still, she reversed and remanded because Judge Craig had not “grappled with a key factual question” of whether the parent funded the student account before or after the child had registered for classes.

The trustee conceded that the schools took the payments in good faith. The only question, Judge Ross said, was whether the universities were the initial or subsequent transferees.

In the Second Circuit, Judge Ross said that an initial transferee is someone who can exercise dominion and control to put the funds to “his own purposes” and is not a “mere conduit.”

Before a student registers for classes, Judge Ross said that any refunds must be made to the students. Before registration, she said the schools did not have “dominion over the tuition payments” because the students could withdraw from the university “and take the money with them,” thus preventing the schools from being the initial transferees who would be liable automatically.

On the other hand, Judge Ross held that the schools would be the initial transferees, and thus deprived of the good faith defense, if the parent funded the student account “after [the tuition] was already due.”

Judge Ross reversed and remanded the case for the bankruptcy court to determine whether the parent funded the accounts before or after tuition payments were due. She said that Judge Craig “did not discuss the timing of the payments in detail.” Instead, she said that Judge Craig appeared to assume that the debtor funded the students’ accounts before they registered for classes.

Although the schools may be liable after remand, Judge Ross did make rulings in favor of the universities, although not on issues that would absolve them of liability. She rejected the trustee’s contention that the children were “mere conduits,” evidently if the accounts had been funded before tuition was due for payment. Were the children “mere conduits,” the schools would have been liable had they received the funds before or after the students registered.

Judge Ross went on to say that the outcome did not depend on the existence of the student accounts. Even if the funds were held by the schools in a commingled account, Judge Ross indicated that the result would be the same as long as the student had the contractual right to direct the disposition of refunds before tuition was due for payment.

Because Judge Craig must perform more than ministerial functions on remand, Judge Ross’s decision is probably not a final order bestowing a right of appeal to the Second Circuit.

While the litigation grinds forward, the New York legislature should consider legislation to protect colleges, universities and perhaps, also, private secondary and elementary schools.