The Hidden Chapter of the Financial Aid Handbook:Tuition Payments Subject to Fraudulent Transfer Liability

by Jason Angelo

By Jason D. Angelo

The cost of a college and professional education has, as most attorneys know all too well, skyrocketed over the course of the past few decades. Some students graduate with tens or even hundreds of thousands of dollars in student loan debt. Bankruptcy practitioners know the high hurdle of obtaining a discharge of student loan debt in a personal bankruptcy. But what happens when a student’s parents pay for their son’s or daughter’s tuition and then end up filing a chapter 7 or chapter 13 petition?

There is an emerging trend in bankruptcy cases across the country in which some trustees are attempting to recover pre-petition tuition payments made to educational institutions by debtors (parents) on behalf of their children (students). The Wall Street Journal reports that trustees have recovered over $276,000.00 from at least 25 educational institutions since 2014.1 The rationale is that the student, not the parents, received the reasonably equivalent value of the tuition payments – that is, the child, not the parents, received the actual benefit of the tuition payments, and so those payments are recoverable as fraudulent transfers. Some trustees have even attempted to recover payments made for private elementary and high school education, although with far less success.2

While educational institutions begin to battle these claims, many have opted to settle with trustees rather than see an adversary proceeding through to the end. Some students, however, have been hit with dire consequences: institutions, such as the University of Southern California – currently battling a lawsuit to recover nearly $200,000.00 in tuition payments – have threatened to withhold transcripts, refuse certification of a degree, recover the funds from the students themselves and bar them from registering for classes.3 Institutions also argue that allowing trustees to claw back such funds is inconsistent with the principles of federal financial aid and that, because the student will still owe the tuition to the institution (and the parents will still be on the hook for any loan they co-signed or guaranteed given the difficulty of discharging such loans), this is simply a windfall of funds to creditors – funds that they have no right to receive.

While some courts have agreed with the trustees’ position that the parents did not receive reasonably equivalent value, others have rejected the attempt to recover tuition, relying on a “moral obligation” of parents to pay for higher education. There is little consensus among bankruptcy courts on this issue. This post surveys some recent bankruptcy court decisions on this controversial tactic.

No Reasonably Equivalent Value Received?

The Michigan case of In re Leonard4 is significant because the Bankruptcy Court determined that the debtors did not receive reasonably equivalent value for the tuition payments made on behalf of their son. The Chapter 7 trustee sought to avoid and recover, as fraudulent transfers, four payments totaling $21,527.00 that the debtors made to Marquette University to pay for their 18–year old son’s tuition. The payments were made by checks from debtors’ joint checking account. However, the funds transferred were from a $35,000.00 private student loan from J.P. Morgan-Chase taken out by the student and his father. While the trustee argued that the transfers should be avoided, the University responded that the funds were never debtors’ property and instead had been held in trust for the education of their son. Relying on a theory that an express oral trust was created regarding the use of the loan proceeds, the University contended that debtors held legal, but not equitable, title in the funds, barring them from ever becoming property of the estate.

The Court determined that, because the check for the loan proceeds from J.P. Morgan-Chase was actually made payable to both the student and the father, no express oral trust could be created as to half of the funds. Further, the deposit of the funds into debtors’ joint checking account created a rebuttable presumption under state law that the money was debtors’ property, and cast further doubt upon the claim that an express trust was created given the commingling of the funds. The Court rejected the notion that a constructive trust had been created and hence was not property of the estate. Ultimately, the matter came down to who received reasonably equivalent value for the transfers: the debtors’ son, or the debtors who received value in the form of intangible benefits, such as: (1) the son’s education “bestowed peace of mind” on the debtors in that their son “will be afforded opportunities” in life that would not have come but for the education; and (2) debtors “anticipate that they will not remain financially responsible” for their son. The Court rejected Marquette’s argument and found that the debtors received no economic value in exchange for the transfers. However, the trustee’s summary judgment motion was ultimately denied because there was a still a genuine issue of material fact regarding the creation of an express oral trust and whether the loan proceeds were ever property of the estate.

Recovery of Federal Loan Proceeds

 In a case pending in the District of Connecticut5, the Chapter 7 trustee sought disgorgement of tuition payments from Johnson & Wales University. Slated for trial this year, the trustee seeks to claw back $46,909.00 in payments made from March 2011 to December 2013. According to the University and the amici curiae, the trustee’s argument essentially transforms federal loans into a government subsidy to pay off the debtors’ creditors, leaving educational institutions, which are not able to protect themselves from parents who apply for Federal Loans and later file a bankruptcy petition, incredibly vulnerable.

The key issue here is the source and control of the payments: while the tuition payments were federal dollars, they were never in the debtors’ possession or control. Rather, the government made payments directly to the university for restricted purposes. Thus, according to the University, the funds never were and never could have been property of the estate; the funds were not “fungible cash” that could actually have been utilized by the debtors to pay their creditors. Moreover, as the amici curiae point out, diversion of federal PLUS Loan funds to the debtors’ estate would be deemed “misuse” of the funds, causing the loans to be accelerated and made immediately due. The proper relief, according to the University, is to avoid the debtors’ obligations to repay the loans for which they are solely liable rather than claw back the funds from an educational institution.

In response, the trustee asserts that the debtors are liable as the sole obligor on the master promissory note related to the funds, thereby providing debtors a clear and unequivocal interest in the funds. Where there is a direct transfer to a third party resulting in an increase in a debtor’s liability and no increase in a debtor’s assets, the trustee argues that there has clearly been a transfer of the debtor’s interest in property. The trustee further claims that, had Congress intended to exempt federal loan proceeds as property of the estate, they would have done so when passing BAPCPA – in which they exempted Education IRAs (529 plans), and that this omission demonstrates an intent that proceeds of federal loans be available for recovery. See 11 U.S.C. § 541(b)(5) and (6). By incurring nearly $50,000 in new debt and receiving no corresponding benefit, the trustee believed the transfers to be fraudulent and thus recoverable. The Bankruptcy Court has not ruled yet on these issues, and the case is scheduled for trial later this year.

A “Moral Obligation” As Reasonably Equivalent value

In two separate cases6 in the Western District of Pennsylvania, the bankruptcy court determined that debtors did in fact receive reasonably equivalent value for tuition payments. Specifically, the courts held that undergraduate expenses fit within the definition of “necessities” under Pennsylvania’s Uniform Fraudulent Transfer Act.

In In re Cohen, the trustee challenged a total of $102,573.00 in tuition payments, including $46,059.97 for their son’s undergraduate education, $7,562 for their daughter’s undergraduate education, and $39,205 for their daughter’s graduate education. The Court refused to accept the trustee’s argument that because Pennsylvania law does not require parents to pay for post-secondary education, it is not a necessity and is therefore avoidable. The Court held that post-secondary educational expenses are reasonable and necessary for the maintenance of the debtor’s family for purposes of the fraudulent transfer statutes only. However, the ruling was limited to undergraduate expenses only, with the Court expressly noting that “children in graduate school are well into adulthood.” Similarly, in In re Oberdick, the trustee challenged $82,536.22 used to pay for the college education of debtors’ children at the University of Chicago and Robert Morris University. Citing to Cohen, the Court relied on debtors’ testimony that “they viewed college tuition and related educational expenses for the children as a family obligation” to deny the trustee’s claim.

Willing to Settle

Unlike Johnson and Wales, Marquette and the University of Chicago, other institutions have elected to settle these fraudulent transfer actions rather than incur the costs of litigation. The University of Hartford, Quinnipiac University7, the University of Bridgeport, Pace University, Post University, the University of Arizona and the University of Michigan8 each paid more to the trustee to avoid the risks of litigation.  According to the trustee’s attorney, many similar adversary proceedings have settled, and there are “about a dozen pending” in the Connecticut bankruptcy courts as of May 2, 2016.9

A Potential Solution?

In response to the willingness of some trustees to go after tuition dollars, Congressman Chris Collins (R-NY) introduced H.R. 2267 – PACT (Protecting All College Tuition) Act of 2015. The legislation would amend Section 548 of the Bankruptcy Code to explicitly provide that “payment of tuition by a parent to an institution of higher education . . . for the education of that parent’s child is not a transfer” that is recoverable as fraudulent. While seemingly supported by legislators on both sides of the aisle, including Rep. Blake Farenthold (R-Tex.) and Sen. Richard Blumenthal (D-Conn.), the legislation has been languishing in the House Judiciary Committee’s Subcommittee on Regulatory Reform, Commercial and Antitrust Law since June 1, 2015.10 In the meantime, as educational institutions continue to settle these fraudulent transfer actions, expect to see more filings from trustees across the country in an attempt to claw back tuition payments for distribution to creditors.          

Jason D. Angelo is an Associate in McElroy, Deutsch, Mulvaney & Carpenter, LLP’s Bankruptcy, Restructuring & Creditors’ Rights Practice Group and is admitted to practice in Delaware and New Jersey.

[1] http://www.ctlawtribune.com/id=1202756519162/Bankruptcy-Attorneys-Sue-Colleges-to-Demand-Return-of-Tuition-Payments?slreturn=20160418124233; http://www.wsj.com/articles/bankruptcy-trustees-claw-back-college-tuition-paid-for-filers-kids-1430869820.

[2]               See, e.g., In re Akanmu, 2013 WL 6283582 (Bankr. E.D.N.Y. Dec. 4, 2013) (Debtors legally obligated under New York Law to provide their minor children with an education, and the fact that they chose to do so by sending their children to private or parochial school, rather than public school, did not render the tuition payments avoidable. Debtors received reasonably equivalent value by satisfying their legal obligation to educate their children and because parents and children are viewed as a single economic unit for purposes of a constructive fraudulent conveyance analysis).

[3]                    http://blogs.wsj.com/bankruptcy/2015/11/17/usc-in-tuition-battle-former-students-will-face-consequences/

[4]               In re Leonard, 2011 WL 1344732 (Bankr. E.D. Mich. Apr. 8, 2011)

[5]               Roumeliotis v. Johnson & Wales Univ., No. 15-03011 (Bankr. D. Conn. Apr. 8, 2015)

[6]                  In re Cohen, 2012 WL 5360956, at *9-10 (Bankr. W.D. Pa. Oct. 31, 2012), aff’d in part, vacated in part, remanded sub nom. Cohen v. Sikirica, 487 B.R. 615 (W.D. Pa. 2013); In re Oberdick, 2013 WL 1289152 (Bankr. W.D. Pa. Mar. 27, 2013).

[7]              Roumeliotis v. Univ. of Hartford, No. 15-03006 (Bankr. D. Conn. Mar. 11, 2015); Roumeliotis v. Quinnipiac Univ., No. 15-03017 (Bankr. D. Conn. Apr. 15, 2015).

[8]                       http://www.wsj.com/articles/bankruptcy-trustees-claw-back-college-tuition-paid-for-filers-kids-1430869820.

[9]                       http://www.ctlawtribune.com/id=1202756519162/Bankruptcy-Attorneys-Sue-Colleges-to-Demand-Return-of-Tuition-Payments?slreturn=20160418124233

[10]             http://www.ctlawtribune.com/id=1202756519162/Bankruptcy-Attorneys-Sue-Colleges-to-Demand-Return-of-Tuition-Payments?slreturn=20160418124233; http://blogs.wsj.com/bankruptcy/2015/05/12/bill-proposes-ban-on-tuition-clawbacks-in-bankruptcy/.