Bankruptcy Trustee Avoidance of Tuition Payments

Introduction

In recent years, an interesting trend has developed in which bankruptcy trustees, using their “strong-arm” powers[1] are seeking to avoid or claw back tuition payments made to colleges and universities on behalf of their adult children for the benefit of creditors of the bankruptcy estate.  The source of these payments made to these institutions often stems from student loan disbursements.  While to some, the idea of a bankruptcy trustee seeking to force a school to turnover tuition payments to a trustee may seem abhorrent, a Chapter 7 trustee has a fiduciary duty to investigate the financial affairs of the debtor which includes pre-petition transfers and recover those transfers for the benefit of creditors.[2]  The primary theory the trustees are relying on is that the payments to the institutions were made without receiving reasonably equivalent value and are therefore constructively fraudulent. With the ever increasing costs of tuition, trustees are increasingly on the lookout for cases in which sizable recoveries could be made for the bankruptcy estate.   Colleges and universities have generally chosen to settle these adversary complaints with the trustees rather than face costly litigation in bankruptcy court, later seeking to be reimbursed by the student for the loses the schools have incurred.  Some schools have gone so far as to threaten to withhold college transcripts and refuse to verify graduation to future employers or educational institutions unless they recover payments they are forced to turnover.[3]    Increasingly, these schools are choosing to contest such avoidance actions.

Fraudulent Transfers and Avoidance of Tuition Payments by Trustees

Although trustees have recovered payments in bankruptcy cases in which tuition was paid within 90 days prior to a bankruptcy filing pursuant to Bankruptcy Code Section 547 on a preference theory, the more common approach involves the trustee utilizing  Section 548 of the Bankruptcy Code. Section 548 allows a trustee to avoid pre-bankruptcy transfers either on an actual fraud theory in which the trustee must show that the transfers were made with intent to hinder, delay or defraud creditors, or, as is usually the argument in these tuition claw back cases, that the debtor made the transfer while insolvent or became insolvent as a result and that the debtor received less than reasonably equivalent value. Under the constructive fraudulent transfer theory, the trustee’s case hinges on a showing that the parent(s) or debtor-transferor did not receive “reasonably equivalent value” in the exchange and that therefore the trustee may avoid the transfer. 11 USC Section 548 allows a bankruptcy trustee to avoid any transfer incurred by the debtor, that was made or incurred on or within 2 years before the date of the filing of the petition and, as incorporated in the bankruptcy code, up to six years under applicable state fraudulent transfer law depending on the state in which the bankruptcy was filed. [4]

Reasonably Equivalent Value/Split in Authority

The litigation in these cases primarily revolves around the meaning of “reasonably equivalent value” and whether there is a direct economic benefit to the debtor-parent-transferor(s).  Unfortunately, the Bankruptcy Code does not define the term and hence the courts are left to interpret it and, as in many other areas of bankruptcy law, a split of authority has developed.

Cases Permitting Trustee’s Avoidance of Transfers

Gold vs. Marquette University (In re Leonard).[5] In re Leonard, is a significant case stemming from the Eastern District of Michigan in which the court held that tuition payments made by debtor parents on behalf of their adult child constituted avoidable transfers because the debtors themselves did not receive economic value in exchange for the payments. In this case, most of the money used to pay the university was derived from a student loan taken out by the adult child-student and his father, who, along with his wife, was a debtor in the bankruptcy. The university argued that the student loan funds that were transferred were never debtor’s property and therefore never property of the bankruptcy estate but instead were held in trust for the education of their child. The court rejected this argument due to the fact that the student loan check was made payable to debtor and his son and the funds were deposited into debtor’s joint checking account.  The court next focused on whether the debtors received “reasonably equivalent value” which would negate an essential element of all of the trustee’s fraudulent transfer theories under both the Bankruptcy Code § 548 and Michigan law. In this case, the court found in favor of the trustee and allowed the trustee to recover tuition payments that debtor-parents had made on behalf of their adult (18 year-old son).  The University argued the position that although the debtors were insolvent at the time the transfers were made as they were made within months of the bankruptcy filing, the debtors did nevertheless receive reasonably equivalent value because the transfers enabled the debtor’s son to attend the school and receive the benefit of a college education and the associated peace of mind of the parents in knowing that their child was receiving a quality education and would one day become financially independent. Hence there exists the equivalent value exchange.  The court saw otherwise.  Looking to 6^th Circuit precedent, the court found that value cannot simply be an indirect benefit to the debtor and therefore cannot be reasonably equivalent value unless it is (1) an economic benefit; (2) concrete;  and (3) quantifiable.  Applying this standard, the court found that the debtors did not receive reasonably equivalent value for their tuition payments.

Banner v. Lindsay (In re Lindsay).[6] In this case, debtor parents used proceeds stemming from the sale of a car and motorcycle to pay their adult child’s tuition. The appointed trustee sued seeking to avoid the transfers as fraudulent conveyances under both Section 548 and the State of New York’s version of the Uniform Fraudulent Conveyance Act which allows the trustee to rely on state law pursuant to Bankruptcy Code section 544.  The bankruptcy court found that the debtor-parents must turn over to the trustee the amounts used to pay their son’s tuition which came to over $35,000.00. The trustee alleged that the tuition payments were fraudulent transfers because the debtors received no fair consideration in return.  Debtor parents argued that they had a moral obligation to pay for their adult child’s education, yet the court found that they failed to offer any authority in support of that argument.  The court also found that defendant-parents produced no evidence of their alleged legal obligation to pay for their adults son’s tuition, such as a promissory note in favor of the university or lender and the court was not aware of any law requiring a parent to pay for a child’s college education.  Unlike other cases in which the trustee is able to claw back tuition payments from the university itself as transferee, in Lindsay, the court ordered the debtor parents themselves to pay the trustee the amount transferred.

Cases Denying Trustee’s Avoidance of Transfers

DeGiacomo vs. Sacred Heart University, Inc. (In re Palladino).[7] In this case the bankruptcy court ruled against the trustee’s attempts to recover over $60,000 in tuition and fees paid to a university and found that these payments were made in exchange for reasonably equivalent value because the debtors believed that a college degree would directly contribute to their child’s financial self –sufficiency and that this was an economic benefit to the debtors.  The court emphasized the term “reasonably” and, using music lessons in comparison, found that future outcome cannot be the standard for determining whether one receives reasonably equivalent value at the time of payment.  The court held that “A parent can reasonably assume that paying for a child to obtain an undergraduate degree will enhance the financial well-being of the child which in turn will confer an economic benefit on the parent. This, it seems to me, constitutes a quid pro quo that is reasonable and reasonable equivalence is all that is required.” This case has been appealed to the United States Court of Appeals for the First Circuit and is currently pending.[8]

Sikirica v. Cohen (In re Cohen).[9] Here, the trustee’s theory was that because underlying state law did not require parents to pay for their adult child’s post-secondary education, that such education is not a necessity and that therefore the bankruptcy trustee may recover those payments. The court disagreed finding that such expenses are reasonable and necessary for the maintenance of the debtor’s family.

Shearer v. Oberdick (In re Oberdick).[10] The trustee in this case also argued that parents have no legal obligation to provide for the education of their children past the age of 18.  The parent-debtors countered by stating that they viewed the educational expenses as a family obligation.  The court agreed with the parents recognizing that there is something of a societal expectation that parents will assist with such expense if they are able to do so and found that the expenditures in this case were made out of a reasonable sense of parental obligation.

A case presently pending in the US Bankruptcy Court for the District of Connecticut (New Haven), parents Robert and Jean DeMauro[11] paid approximately $47,000 in tuition to a university on behalf of their adult daughter.  This case differs from the others in that the source of the funds used to pay the tuition were derived from the Federal Direct PLUS Loans Program, also known as Parent Plus Loans, and were disbursed directly from the U.S. Department of Education and were not comprised of funds owned or controlled by the Debtors. The university’s position is that they were therefore third party funds and were never property of the bankruptcy estate because they never constituted an interest of the debtor’s in property for purposes of 11 U.S.C. § 548(a)(1).  The trustee, on the other hand, argues that because the debtor-parent was the sole obligor on the Master promissory note, and not merely a guarantor or co-maker, he has an interest in the property under state law.  Trustee further argues that because the promissory note allowed the debtor to use the transferred funds for things such as books, supplies, equipment, transportation, a personal computer and the like, the debtor had an interest in them and they therefore can be avoided for benefit of the bankruptcy estate.  In a recent decision out of the Eastern District of Pennsylvania[12], the Bankruptcy court, in a trustee action seeking to recover Parent Plus loan funds paid directly by the U.S. Department of Education to Penn State, found that the debtor nor his estate ever held an interest in the proceeds of the loans and that the debtor-parent-transferor received reasonably equivalent value in exchange for the transfers and dismissed the trustee’s complaints.  The court found that applicable non-bankruptcy law (i.e. the Higher Education Act), expressly prevented the loan proceeds from becoming property of the debtor or his estate, and because debtor never had possession of, control over, or an interest in, the loan proceeds, that those proceeds could not have been available to pay debtor’s creditors. The judge found that the purpose of the fraudulent transfer provisions in the Bankruptcy Code and other state uniform fraudulent transfer acts is to protect creditors by preventing a debtor from placing assets otherwise available to pay creditors out of the reach of those creditors. The court agreed with the reasoning in Oberdick and Cohen above and found that a parent’s payment of a child’s undergraduate college expenses is a reasonable and necessary expense for the maintenance of the family and for preparing family members for the future and the parent therefore receives reasonably equivalent value in exchange for the tuition payment.  At the end of his opinion, the judge pointed out what he felt were critical issues left unaddressed by the litigants that were rendered moot by his ruling but that nevertheless he felt were important had the trustee been successful in his efforts to recover funds from the university.  He outlined eight issues that he felt were troubling:

1. If the Trustee is successful, does someone owe Penn State the avoided tuition?
2. Under any result in this litigation, does [debtor] owe the bank non-dischargeable debt?
3. What happens if PSU files a claim against [debtor]?
4. Does [debtor] face BOTH (1) non-dischargeable liability to the bank for the loans AND (2) the avoided tuition payments owed to PSU?
5. Can PSU somehow bootstrap the status of the bank and have the debt be non-dischargeable?
6. If Debtor’s debt to PSU is dischargeable or uncollectible, can PSU undertake collection efforts against [debtor]’s son and daughter?
7. Does that make [debtor] and his son and daughter necessary parties who must have been joined in the complaint as party defendants?
8. Can PSU refuse to give [debtor]’s son and daughter transcripts, etc., until paid in full by someone for all money avoided by the Trustee?

Conclusion

The case law continues to develop in this controversial area with bankruptcy court decisions at opposite ends of the spectrum.  The bankruptcy courts must wrestle with an apparent dichotomy between the centuries long standing debtor-creditor laws regarding fraudulent conveyances and the benefits realized by today’s society when parents financially assist their children beyond the traditionally recognized age of adulthood.  Proposed legislation seeking to amend the Bankruptcy Code to prevent trustees from avoiding tuition payments made by debtors has lingered in Congress and eventually died, but it is likely that more bills will be forthcoming.[13]

[1] 11 U.S. Code § 544

[2] 11 U.S.C. §§ 704, 726.

[3] http://www.abi.org/feed-item/usc-in-tuition-battle-former-students-will-face-consequences

[4] See 11 U.S.C. § 544(b)

[5] Gold vs. Marquette University (In re Leonard), 454 B.R. 444, 460 (E.D. Mich.2011)

[6] Banner v. Lindsay (In re Lindsay), No. 06-36352 (CGM), 2010 WL 1780065, at *8(Bankr. S.D. N.Y. May 4, 2010)

[7] DeGiacomo vs. Sacred Heart Univ., Inc. (In re Palladino), 556B.R. 10 (Bankr. D. Mass. 2016)

[8] U.S. Court of Appeals for the First Circuit, Docket#: 17-1334, Docketed 04/05/2017

[9] Sikirica v. Cohen (In re Cohen), No. 05-38135-JAD, 2012 WL 5360956

[10] Shearer v. Oberdick (In re Oberdick), 490B. R. 687 (Bankr. W.D. Pa. 2013)

[11] Robert R. DeMauro and Jean M. DeMauro, U.S. Bankruptcy Court, District of Connecticut, New Haven Division, Chapter 7 Case no.: 14-32312(JAM) Adversary Proceeding #: 15-03011

[12] In re: David Alan Lewis and Donna Lynn Lewis, United States Bankruptcy Court for the Eastern District of Pennsylvania, David Alan Eisenberg, as Chapter 7 Trustee, v. Pennsylvania State University Case no. 16-12372REF. Opinion Date: April 7, 2017  2014 WL 1344622

[13] H.R.2267 — 114th Congress (2015-2016) PACT (Protecting All College Tuition) Act of 2015