The Trend Reverses: College Tuition Payments Shielded from Avoidance in Bankruptcy

HIGHLIGHTS:

• It has become increasingly common for trustees administering individual bankruptcy cases to take the position that tuition payments paid by a parent to a college on an adult child's behalf prior to the parent's bankruptcy are avoidable as "constructively fraudulent" transfers.
• Bankruptcy courts that have considered the merits of litigation involving suit by a trustee to recover tuition payments from colleges and universities have reached disparate rulings. However, a recent ruling by the U.S. Bankruptcy Court for the District of Massachusetts in a pending Chapter 7 bankruptcy case has tipped the scales ever so slightly in favor of institutions of higher education.
• In the case of In re Steven and Lori Palladino, et al., the Bankruptcy Court accepted Sacred Heart University's argument that the Palladinos' payments to the university were made in exchange for "reasonably equivalent value" because the Palladinos believed that paying for their daughter's undergraduate degree would contribute to her financial independence and, in turn, provide the parents with economic benefit.

It is the start of a new semester, and all across the country, parents are writing tuition checks to the colleges and universities that their children attend. Colleges accept the checks on behalf of the students, the tuitions are marked paid and the students are enrolled. Nothing unusual or improper about this scenario, right? Bankruptcy trustees may disagree: When the parents who wrote those checks are in Chapter 7 bankruptcy, trustees may view those checks as fraudulent transfers. (See Holland & Knight's alert, "Reversing the Trend: Will Congress Act to Except College Tuition Payments from Clawback in Bankruptcy?," July 21, 2015.)

Background

It has become increasingly common for trustees administering individual bankruptcy cases to take the position that tuition payments paid by a parent to a college on an adult child's behalf prior to the parent's bankruptcy are avoidable as "constructively fraudulent" transfers. The trustee's theory is based on the premise that, while the matriculating student receives consideration from a college or university in the form of education, the parent writing the check to that college or university receives nothing of "value" in exchange, let alone the required "reasonably equivalent value." So long as the trustee can meet his or her burden of proof on the remaining elements of the governing avoidance statute, there is risk that a defending university will be required to refund up to four years' worth of tuition and housing payments to the trustee to pay the parent/debtor's creditors, even though the debtor's child was educated at the university. According to a Wall Street Journal analysis, colleges and universities have been the subject of demand or suit in more than 31 instances in the past 18 months. Most colleges and universities, however, appear to have elected to compromise the trustee's claims – and refund a portion of the tuition paid on behalf of a student – rather than bear the cost of litigating these suits in the bankruptcy courts.

Bankruptcy courts that have considered the merits of litigation involving suit by a trustee to recover tuition payments from colleges and universities have reached disparate rulings. Two bankruptcy courts have held tuition payments to be avoidable fraudulent transfers on the basis that parents without a legal obligation to support their children past the age of adulthood or without proof of receipt of indirect consideration did not receive the necessary "reasonably equivalent value" from the college or university that received the tuition payments at issue. Two Pennsylvania bankruptcy courts, on the other hand, have denied such claims, finding "reasonably equivalent value" to have been received by the debtor/parents since the tuition payments were made out of a reasonable sense of parental obligation based on societal expectation that parents will assist with such expense if they are able to do so.

Palladino Ruling in Favor of Sacred Heart University

A ruling by Chief Judge Melvin Hoffman of the U.S. Bankruptcy Court for the District of Massachusetts in the pending Chapter 7 bankruptcy case of In re Steven and Lori Palladino, et al., U.S.B.C. District of Massachusetts, Case No 14-11482, has tipped the scales ever so slightly in favor of institutions of higher education. In the Palladino case, the acting Chapter 7 trustee, Mark G. DeGiacomo (Trustee), sued Sacred Heart University (SHU) to avoid and recover a series of tuition payments totaling $64,696.22 funded by the Palladinos for their daughter's college tuition on the alternate theories of "actual"¹ and "constructive" fraud. The Trustee urged that the tuition payments were avoidable given that the Palladinos had no legal obligation to pay for their adult daughter's college education and there was no evidence of any other direct or indirect economic value having been received from SHU, as that term is defined in the Bankruptcy Code.

While SHU urged that the Palladinos received direct economic benefit in exchange for the payments to SHU in the form of development of a "financially self-sufficient daughter," its primary argument was that the evidence established that the required "reasonably equivalent value" took the form of "indirect benefit" to the Palladinos resulting from payment of the tuition to the university. SHU argued that this "indirect benefit" took the form of satisfaction by the Palladinos of their "reasonable sense of parental obligation" as well as of societal expectation. SHU submitted affidavits of the Palladinos and their daughter, demonstrating that the daughter qualified as a "dependent" for purposes of applying for financial aid using the Free Application for Federal Student Aid form distributed by the U.S. Department of Education, a form that required the collection of the details of the Palladinos' own financial information. Additionally, over objection of the Trustee, SHU submitted the expert testimony of the former director of financial aid services of the State of Connecticut, who opined through affidavit regarding how colleges compute federal need-based financial aid for a dependent student, and a higher education consultant who separately opined on which students receive financial aid, why parents choose to pay for their children's college education, and the societal benefits of parental financial support and of attending college.² Having established the factual evidence of "value," SHU urged that the Massachusetts Bankruptcy Court to conclude that "reasonably equivalent value" includes the indirect value that flows to a parent and that the payments received by SHU, therefore, were not avoidable fraudulent transfers on any theory.

On Aug. 10, 2016, Judge Hoffman issued his Memorandum of Decision on Cross Motions for Summary Judgment, Docket No. 76 (Decision). For SHU and other colleges and universities, it was a decision worth waiting for. After finding that the transfers to SHU were not per se avoidable merely based on the Palladinos' involvement in a Ponzi scheme, Judge Hoffman expressed that the central issue in the case before him was really about "value" – whether the tuition payments were avoidable "because the Palladinos did not receive reasonably equivalent value from SHU in exchange for the payments?" Decision at p. 6. While noting that the Trustee was correct to point out that under Massachusetts law, a parent has no legal obligation to support an adult child and so, as the Trustee suggested, the only possible justification the Palladinos could have had for paying their daughter's college costs were of a "recondite variety," the Court nonetheless found the Trustee's approach to valuing the Palladinos' payments to SHU to be "overly rigid." Decision at p. 7.

Instead, the Court accepted SHU's argument that the Palladinos' payments to SHU were made in exchange for "reasonably equivalent value" because the Palladinos believed that a financially self-sufficient daughter offered them an economic benefit and that a college degree would directly contribute to her financial self-sufficiency. In doing so, 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.

Decision at p. 8

     The Trustee filed a swift notice of appeal of the Decision on Aug. 15, 2016. The Massachusetts Bankruptcy Court countered with a rarely invoked right of the bankruptcy courts to certify an appeal of its order for direct appeal to the U.S. Court of Appeals for the First Circuit³ under 28 U.S.C. §158(d)(2). In his certification, Judge Hoffman urged that direct appeal is warranted as the Decision involves questions of law as to which there is no controlling decision in the First Circuit or from the Supreme Court, involves a matter of public importance and involves questions of law that have resulted in conflicting decisions among lower courts around the country.⁴ The Trustee will likely attempt to challenge this certification, but it is not likely that those efforts will be fruitful.

Conclusion and Considerations

Judge Hoffman's certification may have cleared an expeditious path for the Court of Appeals to establish the controlling law on an issue that, one way or another, will have an impact on providers of higher education, at least those with a student population that have a permanent residence in any of the states comprising the First Circuit.

Predicting the outcome of the Trustee's appeal is difficult given the lack of guidance within the Bankruptcy Code and the conflict between 1) use of avoidance powers to recover assets transferred pre-petition for the benefit of unpaid creditors of a bankrupt debtor and 2) the pro-education policies that generally encourage and support higher education.

In the meantime, a proposed bill to amend Bankruptcy Code Section 548 to preclude trustees from avoiding a good-faith payment by a parent for a child's post-secondary education tuition has languished in Congress.⁵ Given this stalled legislative effort, there will likely be no shortage of amicus briefs filed by major players in the higher education field desiring to shape Judge Hoffman's reasoning and ruling. Holland & Knight attorneys are prepared and willing to help with this critical process or answer any questions about the legal issues and their importance to the higher education sector. We will provide further updates as events unfold. 

Notes

¹ The Trustee asserted that the payments were presumed to have been made with actual intent to hinder or delay the Palladinos' creditors given that the Palladinos had admitted involvement in a Ponzi scheme.

² The Connecticut Conference of Independent Colleges and the Association of Independent Colleges & Universities of Rhode Island moved for permission to file a brief in support of SHU's summary judgment motion as amici curiae, urging that they had an interest in the suit given that the type of fraudulent transfer claim at issue "had serious implications [on the colleges they represented], the financial aid programs they administer, and the students they are educating" and that the Court should consider these implications in making its ruling. Palladino Case, Docket at No. 62. Ultimately, over objection of the Trustee, this motion was denied.Id. at Docket No. 65.

³ The traditional course of an appeal is to the Bankruptcy Appellate Panel or the U.S. District Court.

⁴ Certification, Palladino Case Docket No. 85.

⁵ Rep. Chris Collins (R-N.Y.) has introduced legislation known as "The PACT (Protecting All College Tuition) Act of 2015" (Congressional Bills 114th Congress H.R. 2267).

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.