Each year, millions of parents across America write checks to institutions of higher learning, in payment of tuition and charges for their children to pursue a college degree. Inevitably, some of those parents end up in the bankruptcy courts. In recent years, trustees have found an attractive potential source of estate recovery: pursuing the colleges and universities to recover tuition and related payments as constructive fraudulent transfers. The argument is that a parent has no legal obligation to provide a college education to a child over 18 and therefore, that the parents did not receive “reasonably equivalent value” for the tuition payments.
A recent decision by a New York bankruptcy court examines a structure adopted by several educational institutions in an effort to avoid bankruptcy exposure. In Pergament v. Hofstra University (In re Adamo), Judge Craig examined a case where the trustee sought to avoid education payments made both pre-petition and post-petition, pre-conversion by a debtor parent who filed a Chapter 11 that was later converted to a Chapter 7 liquidation.
The court began by exploring the growing list of cases on whether a trustee can avoid educational expenses paid by the parents of the students. The court noted that the cases were inconsistent and that the question of “reasonably equivalent value” was an interesting one. The court noted that decisions had utilized a number of factors in their decisions, including (i) whether the student was a minor, (ii) whether the payment was for education or extracurricular activities, (iii) whether the education was primary, undergraduate or post-graduate, and (iv) whether the payments satisfied a legal or moral obligation, or some other societal expectation.
Ultimately however, the court concluded it did not need to reach the question of “reasonably equivalent value.” In this case, each of the defendant educational institutions had established an account in the name of the student. Payments made by the parents went into that account and the student then authorized the educational institution to apply the funds in payment of the educational expenses. After funds were deposited in the student account, the parents no longer had control over the monies. Also, in the event there were unused funds remaining in the account, those funds were dispersible only to the student and not to the parents, despite the fact the parents may have made the initial deposit.
After exploring the student account structure, the court pointed out that all transfers that are avoidable may not also be recoverable. Section 550 of the Bankruptcy Code differentiates between initial transferees and subsequent transferees of the property. A non-initial transferee has the availability of a good faith defense under section 550(b), a defense that is not applicable to the initial transferee.
In this instance, the court held that the parents did not maintain dominion over the funds once they were transferred into their children’s accounts. They were unable to recover the funds directly and had no right to unused balances. As such, the court felt that the child was the initial transferee and that the educational institutions in question, as subsequent transferees, had the availability of the good faith fence.
The court felt that the accounts maintained for the students were similar to a bank account and that the educational institutions were merely a conduit for the payment of funds by the parent to their child. The payments made by the children from their accounts were received by the institutions in good faith in exchange for providing classes and other educational services. Based on its analysis, the court granted the defendants’ motions for summary judgment, finding that the payments were not avoidable by the trustee.
This case provides an example where careful structuring can prevent the risk of what might seem to be harsh application of the fraudulent transfer laws. However, it does contain its own perverse aspect. Based on the court’s finding that the child was the initial transferee of the funds, those funds would presumably be avoidable and recoverable from the child without respect to good faith. The schools thus may have succeeded in shifting the bankruptcy risk from themselves to their students. Presumably, college students will not present as an attractive a target for avoidance actions as the educational institutions themselves. Thus, in most instances, the issue should be resolved without significant individual exposure. It may also provide the setting for a new set of interesting issues as to what “reasonably equivalent value” the child might provide in return for college payments from their parents.