College Tuition Payments for Adult Children Are Recoverable as Constructively Fraudulent Transfers

Bankruptcy Code § 548 allows creditors and trustees to avoid transactions that unfairly or improperly deplete the bankruptcy estate.[1] Transfers made within two years[2] preceding a bankruptcy filing can be clawed back if either (1) the debtor attempted to defraud creditors, or (2) the debtor did not receive “reasonably equivalent value” in return.

The Bankruptcy Code does not specifically define “reasonably equivalent value.”[3] In recent years, courts have grappled with whether a trustee can claw back college tuition payments made by parents on behalf of an adult child on the theory that they are constructively fraudulent transfers.[4] The issue is “culturally and socially charged,”[5] and in these cases, the outcome depends on how the court defines “reasonably equivalent value.”

DeGiacomo v. Sacred Heart Univ. Inc. (In re Palladino)

This issue was at the heart of the First Circuit’s opinion in Palladino. The First Circuit reversed the decision of the bankruptcy court, holding that parents do not receive reasonably equivalent value when they make payments for their adult child’s education.[6]

While operating a multimillion-dollar Ponzi scheme, the Palladinos paid $64,696.22 in tuition to Sacred Heart University for their 18-year-old daughter’s education. Following fraud convictions and a $9.7 million civil judgment brought by the Securities and Exchange Commission, the Palladinos filed a chapter 7 bankruptcy petition. The trustee filed an adversary proceeding against Sacred Heart seeking to claw back the tuition payments, arguing that the debtors had not received reasonably equivalent value. The Palladinos argued that a self-sufficient child conferred an economic benefit to them by enhancing the financial well-being of their daughter. The bankruptcy court granted summary judgment in favor of the university, finding that there was a reasonable quid pro quo, and certified its ruling to the First Circuit.

Explaining the issue as “straightforward,” the First Circuit reversed and found that any economic benefit to the parents was not concrete or quantifiable, and offered no direct benefit to creditors.[7] According to the court, reasonably equivalent value should be assessed from the creditors’ view because they are “the central concern of the code provisions at issue.”[8] Relying on statutory textualism, the court looked at the five classes of transactions that confer value to creditors^[9] and found none present. In a footnote, the court stated that parents are under “no legal obligation” to support adult children, and that any societal expectation that parents should pay for college tuition “does nothing for the creditors.”[10] As other courts similarly have recognized, the First Circuit noted that Congress had already made the “trade-off,” and until Congress acted otherwise, the Court was obligated to enforce the statute.^[11]

Implications

This is the first circuit court to consider whether colleges can be compelled to refund tuition paid by insolvent parents, but lower courts are divided. Courts finding that tuition payments provide a reasonably equivalent value give weight to the fact that the federal financial aid system and tax incentives are premised on a parent’s obligation to pay for college expenses and that parents receive some indirect value by paying for college costs.^[12] Other courts adopt a more rigid approach to reasonably equivalent value. These cases stress that parents have no legal obligation to pay college tuition for their adult children, and give preference to creditors, who are the central concern of clawback actions.[13]

The Palladino case left many questions unanswered. First, can a trustee claw back college tuition payment if the parent is obligated to pay under a divorce agreement? Generally, parents have no legal obligation to pay for the education of their children beyond the age of 18. However, if a parent must pay tuition costs under a divorce settlement, it would seem more difficult to argue that the paying parent had no legal obligation to do so. And what if a child is a minor, or a student is denied federal aid because of expected family contribution?^[14]

Recovery from a university also depends on whether the university is an initial transferee under § 550(a) or a subsequent transferee under § 550(b). An initial transferee refers to something more than just an initial recipient. An initial transferee is the first entity “for whose benefit such transfer was made” and who is not just a “mere conduit,” such as a bank who holds transferred funds for its customer.[15] A subsequent transferee is an entity for whose benefit the transfer was made after the initial transferee.[16] Generally, a trustee may recover from both initial and subsequent transferees.[17] The outcome may ultimately depend on the school’s accounting method.

For example, in In re Hamadi, the university placed funds received for a student’s tuition into an account controlled by the student.[18] The student could use the funds in his account to pay for tuition. If the student did not register for classes, the student would be entitled to a refund of a portion of the funds on deposit. The court found that the trustee could not claw back the refundable portion of the tuition paid to the university by the insolvent parent because the university was a “mere conduit,” and thus not an initial transferee from which the trustee could recover fraudulent transfers. As to the nonrefundable portion, the court found that the university was the initial transferee because “it exercised complete dominion and control over the nonrefundable portion of the Debtors’ payments.”[19]

For a trustee to recover tuition payments, the property must of course be property of the estate. Can a trustee claw back tuition payments withdrawn from a qualified tuition savings plan, otherwise known as a “529 Plan”?[20] Generally, 529 Plans are excluded from the bankruptcy estate under § 541(b)(6) and cannot be clawed back under § 548, subject to the exceptions in § 541(b)(6). Should a parent fund a 529 Plan far enough in advance and use those funds to make college payments, the tuition likely is not property of the bankruptcy estate. As such, payment would not be considered a fraudulent transfer under § 548.

Conclusion

Now that the First Circuit has weighed in, Palladino will be cited by trustees across the country seeking to claw back tuition payments made by parents for their adult children. As evidenced by the inconsistent holdings in the lower courts, the facts, jurisdiction and parties involved will lead to different outcomes. Given the increased frequency with which trustees are seeking to recover tuition payments, attorneys should consult with their clients about any payments or steps taken to secure their children’s education.