Bankruptcy Trustees Sue to Recover Tuition Payments

Keyboard with student loan buttons

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Does a parent have a legal or moral obligation to pay for a child’s college education? That question is being played out in, of all places, bankruptcy courts across the nation. With the cost of higher education soaring, and student loan debt at an all-time high exceeding a trillion dollars, parents who can afford to help their children pay the cost of higher education likely do. But what about those parents who try to help but are not in a very stable financial position to do so? When their precarious financial position later becomes acute, and they choose to file a bankruptcy case, the college may find itself a defendant in a lawsuit by a bankruptcy trustee to recover those tuition payments.

Fairness in Bankruptcy

Why would a bankruptcy court have the right to go after tuition payments made before - as much as two years before - a bankruptcy case is filed? It's all based on a concept that is designed to make the bankruptcy process as fair as possible and to ensure that similar creditors are treated the same. And this extends not only to the bankruptcy case itself, but it recognizes that creditors may have been treated unequally when the person in financial difficulty was insolvent and contemplating filing a bankruptcy case. 

The Fundamentals of Bankruptcy

In a Chapter 7 bankruptcy case, the court appoints a trustee whose job includes the identification, marshaling, and liquidation of the filer’s excess assets for distribution to creditors. A debtor - the person who files a bankruptcy case - does not surrender all their assets when they file for bankruptcy. The debtor is allowed to keep certain assets of a certain value so that they can enjoy a “fresh start” once the case is concluded. These are called exemptions or exempt assets. The trustee takes charge of the property that is not exempt and liquidates it if necessary. In the meantime, the debtor’s creditors file claims with the court. Once the trustee has completed the task of liquidating the non-exempt assets, the trustee will make sure that the claims are properly and adequately supported. Then, the trustee will distribute the pool of cash accumulated to satisfy the claims according to a priority schedule set forth in the bankruptcy code. If the trustee does not have enough to pay the creditors 100%, the creditors each receive a pro-rata share of the pool.

Preferences and Fraudulent Transfers

A guiding principle in bankruptcy is the equal treatment of similar creditors. This extends beyond the distribution of assets by the trustee. When a debtor is approaching insolvency, sometimes the debtor will use scarce resources to pay favored creditors. These are called preferential transfers. Preference payments are made during the 90 days preceding a bankruptcy filing, or as long as a year if made to or for the benefit of an insider, like a relative.

Likewise, a debtor may use dwindling assets to pay for goods or services without obtaining a reasonable equivalent value in return. Or the debtor may outright transfer an asset as a gift. These are considered fraudulent transfers. While actual fraud is not necessarily involved, the effect is similar. The debtor lost assets that were not replaced by equivalent value.

The bankruptcy code grants a trustee extraordinary powers to undo those payments, and “clawback” those assets. These are often called the trustee’s “strong-arm” powers. In certain cases, the trustee can reach back as far as two years to bring assets back into the bankruptcy estate. In some cases, the trustee can go back even further under state law. In addition, the trustee is given especially broad leeway when the payments are to or for the benefit of an “insider.” Insiders can include partners and employees, but they can also include relatives.

For this very reason, debtors are also required to disclose financial transactions that have taken place during the two years before a bankruptcy case is filed, although a trustee is within their rights to investigate independently to determine if the debtor made payments that were potentially preferential or were made without an equivalent exchange of value to the debtor.

The Tuition Claw Back

Enter the tuition clawback. Only recently have trustees starting using their strong-arm powers to recapture tuition payments made by debtors on their children’s behalf. According to an article in the Wall Street Journal a search of public records since 2008 turned up suits filed against at least 25 different colleges. More than a dozen colleges capitulated and returned at least some of the tuition to the trustee. The recoveries range from a few thousand dollars to tens of thousands. Many colleges quickly settle to avoid the uncertainty and expense of protracted litigation.

The reasoning behind the lawsuits goes something like this:

  • The child is over the age of majority.
  • The parents no longer have a legal obligation to provide for the child.
  • The tuition payments are gifts made to the child or made to the college on the child’s behalf.
  • Although the child is presumably receiving value in exchange for the tuition payments, that value does not flow to the parents.
  • The child is an “insider” of the debtor parents, therefore, the trustee can search back one year before the bankruptcy case was filed for a preferential transfer, longer for a fraudulent transfer.

Tuition payments made on behalf of a child who has not reached the age of majority may also be avoided as either a preferential or fraudulent transfer. The law of most states requires that the parent provides nothing more than basic necessities like food, water, clothing, medical care, education and a roof over their heads. The education requirement will not include private school or college unless the child has special needs that can't be addressed in a less expensive way.

The College's Position

Some courts presented with this issue have sided with the colleges. These courts have often cited a moral or societal expectation that parents will help their children with the costs of higher education when they are able to do so. At least one court has held that the payments did not qualify as preferences or fraudulent transfers because they were reasonable and necessary for the maintenance of the family. Another potential argument pins the value to the parents as the greater likelihood that the child will leave college ready to make a living and will be less likely to boomerang home. 

Do Nondischargeable Tuition Payments Remain Nondischargeable?

What about tuition payments made pursuant to an agreement incident to divorce or a property settlement agreement? A parent may have no legal obligation to pay child support, but parents often enter into agreements to provide for such items as medical care and college educations for their children. Property settlement agreements are generally not dischargeable in a Chapter 7 case, although they can be discharged in a Chapter 13 repayment plan case. But nothing in the bankruptcy code would suggest that these payments are not subject to the trustee’s strong-arm powers.

The question on nondischargeable debts is not whether they can be clawed back, but whether the debt that is reinstated will retain its status as nondischargeable. This appears to be an unanswered question. When the trustee avoids a preference or fraudulent transfer, the debt is reinstated. So, if the creditor pays $1,000 over to the trustee, the creditor is then owed the $1,000 again. The question seems to be who owes the debt. Is it the bankruptcy estate or is it the debtor personally? If it is the debtor personally, the debt will survive the bankruptcy. There is a split of authority on this issue. Therefore, it may depend on what jurisdiction you live in.

How Does a Claw Back Affect the Student’s Status?

Even more problematic than the ability to discharge issue may be the relationship between the student and the school after the trustee’s successful suit. The student has received value for the money that was put up on her behalf. When a student owes tuition or fees, colleges often have policies that deny transcripts or other privileges to the student. Most colleges appear to be taking a reasonable course and are recognizing that the student had no control over the outcome and should not be held responsible for her parents’ financial issues or the trustee’s choice to seek turnover of the funds.