Trustee Litigation Trend: Tuition Clawback

For parents paying their adult child's college education costs, however, this investment may not be worth (to them) the cost of tuition — at least according to some bankruptcy courts. With increasing frequency, Chapter 7 trustees are looking to insolvent parents as well as colleges and universities to avoid and recover for estate creditors payments made by insolvent debtors for the benefit of the debtors' dependents. These cases are premised on the theory that the tuition payments being made by insolvent parents for the benefit of their children are avoidable as constructively fraudulent transfers because the parents do not receive reasonably equivalent value in exchange for the payment of such tuition. The principal issue in these cases is whether the payment of a child's tuition provides reasonably equivalent value to the insolvent parents. Courts are divided, with some holding that parents do receive reasonably equivalent value for the tuition payments and others holding that the parents do not. The courts that find reasonably equivalent value do so by finding economic value conferred upon the parents. See, e.g., Sikirica v. Cohen (In re Cohen), 2012 Bankr. LEXIS 5097 28-29 (Bankr. W.D. Pa. 2012) (“While the Pennsylvania legislature has not yet enacted a statute that requires parents to pay for their children's post-secondary education, this [c]ourt holds that such expenses are reasonable and necessary for the maintenance of the Debtors' family for purposes of fraudulent transfer statutes only”); see also, DeGiacomo v. Sacred Heart Univ., Inc. (In re Palladino), 556 B.R. 10 (Bankr. D. Mass. 2016) (“A parent can reasonably assume that paying for a child to obtain an undergraduate degree will enhance 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.”). In contrast, the courts that do not find reasonably equivalent value do so based on the absence of legal responsibility on the part of the parents to educate their child. See, e.g., Gold v. Marquette Univ. (In re Leonard), 454 B.R. 444 (Bankr. E.D. Mich. 2011) (allowing tuition clawback because parents' payment of tuition for adult child, in the absence of a legal obligation to do so, did not provide reasonably equivalent to debtor-parent); see also, Banner v. Lindsay (In re Lindsay), 2010 Bankr. LEXIS 1554 (Bankr. S.D.N.Y. 2010) (finding no reasonably equivalent value in absence of a law requiring parents to pay for child's college education). Recent decisions in the Second Circuit adopt the reasoning of the latter line of decisions and hold that the value analysis turns whether there is a legal obligation to educate. See, e.g., Mangan v. Univ. of Conn. (In re Hamadi), 597 B.R. 67 (Bankr. D. Conn. 2019); Pergament v. Brooklyn Law Sch. (In re Adamo), 595 B.R. 6 (E.D.N.Y. 2019); In re Sterman, 594 B.R. 229 (Bankr. S.D.N.Y. 2018). Another issue that arises in tuition clawback litigation cases, particularly where the universities are defendants, is whether, and to what extent, the educational institutions may be considered initial transferees or mere conduits.

Tuition Payments as Constructively Fraudulent Transfers

Section 548(a)(1)(B) of the Bankruptcy Code empowers a trustee to avoid a transfer of an interest in property of the debtor under a constructive fraud theory to set aside transactions that improperly deplete a debtor's estate. See, 11 U.S.C. §548(a)(1)(B) (“the trustee may avoid any transfer … if the debtor voluntarily or involuntarily … received less than reasonably equivalent value in exchange for such transfer or obligation [and] was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation.”). A constructive fraudulent transfer has two basic elements: 1) whether reasonably equivalent value was received by the debtor; and 2) insolvency. The Bankruptcy Code does not define “reasonably equivalent value”; however, the term “value” is defined and is given an economic meaning. Specifically, the Bankruptcy Code provides that “value” means “property, or satisfaction or securing of a present or antecedent debt of the debtor, but … not … an unperformed promise to furnish support to the debtor or to a relative of the debtor.” 11 U.S.C. §548(d)(2)(A). (Similarly, courts have held that bonds of love and affection do not constitute reasonably equivalent value. See, e.g., Harris v. Burrell (In re Burrell), 159 B.R. 365, 370 (Bankr. M.D. Ga. 1993) (“Love and affection is not reasonably equivalent value under section 548”); see also, Kramer v. Mahia (In re Khan), 2015 U.S. LEXIS 133241 42 (E.D.N.Y. 2015) (“love and affection do not amount to consideration for transfers among family members”).) Whether the debtor received “reasonably equivalent value” is unique in the tuition clawback cases because when a parent pays tuition of a child, the child receives the direct benefits of an education, a degree, and eventual employment. Thus, it must be determined whether: 1) the parent receives any value at all for paying tuition for an adult child; and 2) whether that value constitutes “reasonably equivalent value.” The courts that have examined the issue have considered whether the parents had a legal obligation to provide financial support or an education for their children as dispositive of value being provided.

Educating a Minor Child May Provide Reasonably Equivalent Value But Educating an Adult Child May Not

Tuition payments made to or for the benefit of an adult child may change the analysis and may be deemed to be less than reasonably equivalent value. Last year, the Bankruptcy Court for the Southern District of New York rejected the debtor-parents' argument that they received an economic benefit from paying the education costs of their adult children because paying for an adult child to obtain an undergraduate degree will enhance such child's financial well-being which will in turn confer an economic benefit on the parents. See, Sterman, 594 B.R. 229. In Sterman, the bankruptcy court held that such asserted economic benefit did not constitute value under the New York Debtor Creditor Law or the Bankruptcy Code. The court in Sterman explained that arriving at this value conclusion was not a simple matter. 594 B.R. 229, 236 (“Whether insolvent parents receive reasonably equivalent value for college tuition payments made for the benefit of their adult children is a culturally and socially charged issue. With the greatest respect for the courts that have found reasonably equivalent value for such tuition payments, the [c]ourt is constrained by the language of the Bankruptcy Code and the NYDCL — those states define the terms 'value' and 'fair consideration' to require either the transfer of property or the satisfaction of an antecedent debt in return for an insolvent debtor's payments. 11 U.S.C.A. §548(d)(2)(A); NYDCL §272. The Debtors received neither in this case with respect to transfers made to or for the benefit of the [defendants' children] after they reached the age of majority — 21 years old in New York State”). In contrast, tuition payments made to or for the benefit of minor children differ in that the parents satisfy their legal obligation to educate their child and in doing so they received reasonably equivalent value and fair consideration. The age of majority is determined by applicable state law and, therefore, a different result may have been reached had the facts of Sterman been governed by Connecticut law, providing that the age of majority is 18 as opposed to New York law under which the age of majority is 21. 594 B.R. 229, 236.

Mere Conduit Defense Available to Universities to Extent Tuition Payments Remain Refundable

Once a transfer has been successfully avoided under section 548 of the Bankruptcy Code, “the trustee may recover, for the benefit of the estate, the property transferred” from either “the initial transferee of such transfer” or “any [subsequent] transferee of such initial transferee.” 11 U.S.C. §550. A trustee may not, however, recover from a subsequent transferee “that takes for value …, in good faith, and without knowledge of the voidability of the transfer avoided.” 11 U.S.C. §550(b)(1). Thus, even where the court finds there was less than reasonably equivalent value, a trustee's recovery of tuition from universities under a constructive fraud theory may turn on whether the universities are initial transferees or immediate transferees of initial transferees. See, 11 U.S.C. §550(a). To qualify as an initial transferee, existing caselaw distinguishes between the initial recipient — the first entity to touch the transferred funds — from the initial transferee. Courts have held that the minimum requirement for status as a “transferee” is dominion over the money or other asset and the right to put the money to one's own purposes. See, Bonded Fin. Servs., Inc. v. European Am. Bank, 838 F.2d 890 (7th Cir. 1988) (in explaining the dominion and control or “mere conduit” test for determining whether a transferee is an initial transferee, the court remarked that “[s]o far as the Bank was concerned, … [its customer, the principal,] was free to invest the whole $200,000 in lottery tickets or uranium stocks”); Christy v. Alexander & Alexander Inc. (In re Finley, Kumble, Wagner, Heine, Underberg, Manley, Myerson & Casey), 130 F.3d 52 (2d Cir. 1997). Courts in the Second Circuit have held that an entity is not an initial transferee if it was a “mere conduit” of the funds. Finley, 130 F.3d 52; Bear, Stearns Sec. Corp. v. Gredd (In re Manhattan Inv. Fund Ltd.), 397 B.R. 1 (S.D.N.Y. 2007); Authentic Fitness Corp. v. Dobbs Temp. Help Servs., Inc. (In re Warnaco Group., Inc.), 2006 U.S. Dist. LEXIS 4263 18-19 (S.D.N.Y. 2006) (“A 'mere conduit' … has no dominion or control over the asset; rather, it is a party with actual or constructive possession of the asset before transmitting it to someone else. Mere conduits can do no more than transmit a transferor-debtor's funds to a transferee.”).

Applying this definitional framework to the context of tuition clawback cases, courts have held that for a university to qualify as an initial transferee, it must have exercised dominion over the money or other asset and the right to put the money to its own purpose. See, e.g., Hamadi, 597 B.R. 67; see also, Adamo, 595 B.R. 6. In January, the United States Bankruptcy Court for the District of Connecticut ruled that to the extent a university receives tuition payments made through a university's payment portal and prior to the time when such payments are applied to a student's tuition costs and are deemed non-refundable, the university acts as a mere conduit of such payments and not an initial transferee subject to the clawback provisions of sections 548 and 550 of the Bankruptcy Code. See, Hamadi, 597 B.R. 67.