Appeals Court rules bankruptcy trustee can recover tuition payments from college

On November 12, 2019, the First Circuit Court of Appeals ruled that bankruptcy trustees may sue colleges and universities to recover pre-bankruptcy tuition payments received from parents of adult children. This is the first case decided by a court of appeals on an issue that has divided the lower courts for several years.

Eighteen year-old Nicole Palladino, who was an adult under the law of the state of her residence, enrolled at Sacred Heart University. For two years, Ms. Palladino’s parents paid her tuition to Sacred Heart, amounting to about $65,000. In 2014, however, her parents pled guilty to operating a multi-million dollar Ponzi scheme. Shortly thereafter, the parents filed a Chapter 7 bankruptcy case.

The parents’ bankruptcy trustee then sued Sacred Heart for return of the tuition payments because they were avoidable fraudulent transfers. The bankruptcy code generally permits a trustee to recover for the benefit of the bankruptcy estate any payments made by a debtor within two years of the bankruptcy filing if the debtor (a) was insolvent at the time of the payment and (b) did not receive reasonably equivalent value in exchange for the payment. The bankruptcy trustee argued the parents did not receive “reasonably equivalent value” in exchange for their payment of their adult daughter’s college tuition.

Sacred Heart acknowledged state law imposed no direct legal obligation on parents to pay for the education for their adult children, but argued that the parents received value from a “financially self-sufficient daughter.” Sacred Heart also argued that there is a “societal expectation” that parents will pay the tuition for their adult children.

The bankruptcy court granted Sacred Heart’s motion for summary judgment, but the First Circuit Court of Appeals reversed, holding that Sacred Heart must return the payments.

The Court of Appeals noted the purpose of the fraudulent transfer statute is to preserve assets to pay creditors’ claims, so potential fraudulent transfers should be evaluated from the creditors’ perspective, i.e. did the transfer deplete the universe of assets that would have otherwise been available to pay creditors. The Court of Appeals held that the tuition payments clearly depleted the assets available for creditors and that the parents received nothing of direct value in exchange for the payments.

The Court construed the words “reasonably equivalent value” narrowly. The Court noted the parents were under no legal obligation to pay for their adult daughter’s tuition. The court also rejected the idea that “reasonably equivalent value” includes intangible, emotional and non-economic benefits. Since the parents were under no legal obligation to pay the tuition and the supposed non-economic benefits were insufficient as a matter of law, the Court of Appeals ordered Sacred Heart to refund the tuition payments to the trustee.

There are at least five key takeaways from this decision:

1. The result might differ in states that have an age of majority different from age 18. For instance, the age of majority is 21 in some states.
   
    
2. The result arguably might differ if the parent paid the tuition pursuant to a court approved settlement decree that obligated the parent to pay for an adult child’s education.
   
    
3. A college or university that is forced to return tuition payments to the parents’ bankruptcy trustee may still have a claim against the adult student.
   
    
4. The Palladino case is not binding on any other court of appeals, but it evidences a clear trend in recent cases to find for the trustee in similar situations.
   
    
5. It is not difficult to imagine a similar argument being made in other circumstances, such as a bankrupt parent’s payment of healthcare obligations of an adult child.

David Warfield is the co-chair of Thompson Coburn’s Financial Restructuring Group. You can reach David at (314) 552-6079.