Bankruptcy and College Tuition (ReBroadcast)

January 30, 2017

In 1600, a financially distressed English farmer named Pierce gave away his sheep herd to Twyne before Pierce’s creditors could close in. An English court said Twyne had to give the sheep to Pierce’s creditors.

Four hundred years later, the same legal principles lie at the heart of a number of cases today where bankruptcy trustees have demanded that colleges and universities return tuition paid by parents who later filed bankruptcy.When people are able to pay their debts as they become due, what they do with their money is pretty much their own business. When people become insolvent, their creditors now have a very concrete stake in how they spend their money. Every dollar spent is one less dollar for creditors

Thus, when people are solvent and give away their money, they have made a gift. When people are insolvent and give away their money – well, that’s just it. They are not giving away their money. They are being generous with what is essentially their creditors’ money.These were the basic ideas that were behind the 17th-century decision of that English court. The law already prohibited debtors from committing a fraud on their creditors. But, courts have to judge after the fact, and people will rarely admit they intended to commit a fraud.

What the courts did was to develop factors the courts believed indicated that fraud was present. These factors came to be called badges of fraud. For example, courts are more suspicious of transfers that occur in secret or with close friends and family. If a court believes a prebankruptcy transfer has enough badges of fraud, it will order the recipient to surrender the money so it could be shared among all the creditors. Perhaps the most important badge of fraud is whether the debtor received fair value in exchange for the transfer. The modern-day Bankruptcy Code reflects that rule. The trustee in bankruptcy can recover any transfer of property for which the debtor did not receive reasonably equivalent value. Because of the rule’s history, such transfers are known as fraudulent transfers. Whatever the bankruptcy trustee recovers from a fraudulent transfer gets shared among all of the creditors.

With that legal background, we can come back to the college tuition cases. When mom and dad pay Sally or Bobby’s tuition, Sally or Bobby receives a college education. The child has received reasonably equivalent value but have mom and dad? If not, it is a fraudulent transfer, and the bankruptcy trustee will win a lawsuit to force the college to give up the tuition payment. The courts have split over whether the parents have received value. Legally, parents have no financial obligation toward their adult children. To some courts, that answers the question. Without any obligation to pay for their adult child’s college tuition, parents do not receive any value when they do so.

Other courts have struggled to protect the tuition payments, undoubtedly influenced by the consequences to an adult child who may suddenly find that either they have to come up with a few years of tuition or quit college. The traditional rule has been that value must be economic. The reciprocal affection of family and friends may be priceless, but it is not value within the meaning of the bankruptcy laws.Thus, some courts have gone hunting for something to call value. A Pennsylvania court decided that, for purposes of the fraudulent transfer law only, college tuition for an  adult child was a necessary household expense. Within the past month, a Massachusetts court ruled that the self-sufficiency college will bring to the adult child is a financial benefit to the parents.

The tuition payment issue has just begun to percolate up through the federal court system. It may be that the appeals courts eventually will settle on a rule, but I suspect that it will be an issue that Congress eventually will resolve by amending the Bankruptcy Code itself.