Tuition Payments may be Deemed Fraudulent Transfers in Bankruptcy

Suits by bankruptcy trustees seeking to claw back tuition payments received by colleges and universities have recently garnered public attention.1   Section 548 of the Bankruptcy Code permits bankruptcy trustees to recover generally two types of pre-bankruptcy transfers:

(A) those made with actual intent to hinder, delay, or defraud creditors, and
(B) those for which the debtor received less than reasonably equivalent value in exchange, when he or she was insolvent.2

11 U.S.C. § 548(a)(1)(A)–(B).

Under the former provision, the trustee must prove the transfer was “actually” fraudulent; under the latter provision, the trustee need only prove that the transfer was “constructively” fraudulent.  “Actual” fraud is more difficult to prove and is less likely to be factually supportable in a tuition-payment context.  But a parent’s tuition payment for a child’s education neatly fits as a “constructively” fraudulent transfer because the parent does not receive “reasonably equivalent value” in exchange for the tuition payment—their child does.  If the parent subsequently files for bankruptcy, his or her bankruptcy trustee may sue the college or university that received tuition payments in the four years pre-bankruptcy to recover the payments.3  The transferee-university needn’t have any fraudulent or otherwise wrongful intent.

Many balk at the notion that colleges and universities, after educating a student in exchange for tuition paid by the student’s parents, are confronted with the prospect of having to return that same tuition when the parents file for bankruptcy years later.  And there is a societal expectation that parents should pay for their children’s educations if they can afford to do so.  On May 12, 2015, New York representative Chris Collins even introduced a bill to amend the Bankruptcy Code to create an exception in section 548 to prevent trustees from recovering tuition paid by parent-debtors to higher learning institutions.  H.R. 2267, PACT (Protecting All College Tuition) Act of 2015.4

As of this writing, the bill has not progressed, but this author questions the wisdom of adding an exception to section 548 preventing trustees from clawing back tuition payments.  The “problem” of trustee suits is hyped for now, but colleges and universities can protect themselves (in most or all cases) by requiring the student to pay for tuition him or herself directly.  (The student’s potential liability for repaying the tuition to the bankruptcy trustee remains, but a college student or recent grad is less likely to have deep pockets or be a target.)  Creating an exception in the Bankruptcy Code to protect tuition payments from avoidance might function in practice as a new “exemption” used for the benefit of a debtor’s children, limited only by the highest tuition costs of whatever institution the debtor’s children can get into.  As parents slide toward bankruptcy, they could channel remaining resources into tuition payments, deciding it better to benefit a child’s education than creditors.5

We should be cautious about any Code revision that shields transactions benefiting a debtor’s adult children.  And shielding tuition payments raises underlying policy questions.  Should a parent’s purchase of a new car for a child’s high school graduation be shielded?  What about money provided as a down-payment on a house for the adult child?  A better Code revision would be to provide a defense under section 548 to any person (e.g., universities, or the car dealership or home seller in my examples) who receives a transfer from a debtor and who in good faith provided reasonably equivalent value in exchange (i.e., the education, the car, or the house), even if that value did not flow directly to the debtor.

1 The Wall Street Journal recently published an article exploring the issue.  Stech, Katy, Bankruptcy Trustees Claw Back College Tuition Paid for Filers’ Kids, The Wall Street Journal, May 5, 2015.
2 Or when certain other statutory conditions are met.
3 A two-year pre-bankruptcy “look-back” period applies under section 548, but under section 544(b) of the Bankruptcy Code, the trustee can avoid transfers avoidable under state law, and Washington’s Uniform Fraudulent Transfer Act permits avoidance of transfers up to four years after they occur. RCW 19.40.091. Whether the parents were insolvent at the time of the transfer generally becomes more difficult for a trustee to prove the longer back in time, pre-bankruptcy, that the payment was made.
4 The Protecting All College Tuition Act appears to only target avoidance of tuition payments as constructively fraudulent transfers. If there was evidence of actual intent to hinder, delay, or defraud creditors, the tuition payment would still be avoidable—but this would need to be clarified if the bill progresses. (PACT, creating exception for tuition transfers under “paragraph (1)(B),” which is probably meant to read “paragraph (a)(1)(B).”)
5 Intent to hinder, delay, or defraud creditors may still support avoidance of tuition payment transfers in these circumstances, but would be difficult to prove.

Author:  Hilary Mohr