Tuition as a Fraudulent Transfer

• Publication year: 2020

Tuition as a Fraudulent Transfer

David Gray Carlson

TUITION AS A FRAUDULENT TRANSFER

David Gray Carlson^*

Bankruptcy trustees are suing universities because the insolvent parent of an adult student has written a tuition check while insolvent. The theory is that the university is the initial transferee of a fraudulent transfer that has provided benefit to the student but not to the parent debtor. This Article claims that the university is never the initial transferee of tuition dollars. Rather, the student is. Where the university has no knowledge of parent insolvency, the university can count educating the student as a good faith transfer for value, thus immunizing the university from liability. The unpleasant side effect is that the student is liable as the initial transferee of a fraudulent transfer, and this liability is not dischargeable should the adult student seek refuge in bankruptcy.
Fraudulent acts are as varied as fish in the sea.¹

Parents frequently cover the tuition expense of their adult children. Sometimes they do so when insolvent.

Bankruptcy trustees have started to claim that the colleges and graduate schools that receive tuition from insolvent parents are fraudulent transferees in the parents' bankruptcy proceeding.² Tuition payments can be sizable—six-figure numbers stretching over a few years, in some cases.³

Until recently, the issue has been whether the school gives value directly to the parents when their adult children are elevated to the determination of thinking reason.⁴ Some courts have found that the insolvent parent receives a reasonably equivalent value. Accordingly, no fraudulent transfer occurs when the insolvent parent pays the tuition bill.⁵ Other courts have found no benefit to

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the parent.⁶ Accordingly, the schools must return tuition dollars to the parent's bankruptcy trustee.

Recently, the district court in Pergament v. Brooklyn Law School⁷ assumed that tuition payments by an insolvent parent are fraudulent transfers. But it outlined a legal fiction under which the school may or may not be liable to the bankruptcy trustee of the parent. According to this fiction, when a school takes tuition in advance of fall registration and promises a refund if the student does not register, the school is a "mere conduit" of the tuition and therefore not a transferee of the tuition dollars. Under this fiction, the adult child becomes the initial transferee of the tuition dollars, not the school. Later, when the school delivers an education, the school is a transferee of the student's dollars. If the school in good faith later delivers the education, the school is a transferee of fraudulently transferred tuition dollars, but it avoids liability by virtue of the bona fide transfer defense in Bankruptcy Code § 550(b)(1). Under § 550(b)(1), the bankruptcy trustee may not recover from "a transferee that takes for value, including satisfaction . . . of a present . . . debt, in good faith, and without knowledge of the voidability of the transfer avoided . . . . "⁸

Weirdly, under the Brooklyn Law School reasoning, if tuition payments are overdue when the education commences, the school is the initial transferee of the tuition dollars. The § 550(b)(1) defense is not available to "initial transferees."⁹ The university's only defense is provided by § 548(c): a transferee of a transfer fraudulent under § 548(a) that "takes for value and in good faith . . . may retain any interest transferred . . . to the extent that such transferee . . . gave value to the debtor in exchange . . . ."¹⁰ As a result, the school can defend itself only by proving that it gave value directly to the insolvent parent. If the school gives value to the student but not to the parent, the school has received a fraudulent transfer and so must regurgitate tuition to the parent's bankruptcy trustee.

Under the Brooklyn Law School test, timing determines whether a school is the initial transferee of the student and thus the transferee of a transferee of the bankrupt parent (no liability), or whether the school is the initial transferee of

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the parent (strict liability).¹¹ If payment precedes registration day, the school is safe. If payment occurs after registration day, the school must disgorge:

Whether the schools exercise dominion and control over tuition payments immediately upon receipt thus depends on when each particular payment is made . . . . [I]n the case of any tuition paid early enough that the recipient school would have been obligated to refund it to the student if he or she then withdrew, the school must be classified as a mere conduit and the student an initial transferee, regardless of whether the student actually withdrew from school. But as for tuition paid so late that the student could never have had any right to obtain it, even had he or she withdrawn from school immediately, the school had dominion and control from the outset and thus is properly considered the initial transferee.¹²

How could the district court in Brooklyn end up articulating such an absurd rule? The answer is that the court relied on Bonded Financial Services v. European American Bank,¹³ the leading case in tripartite fraudulent transfers cases. In such cases, a debtor (whom I shall call D) wishes to enrich a third party (X). D does so by sending funds to a creditor of X (CX) or vendor (V) of X. In the context of tuition, D is the parent, X is an adult child, and V is an institution of higher learning. If D is delinquent on tuition payments, the school is CX.

In my view, the Bonded court missed a major point about tripartite fraudulent transfer cases. According to this missed point, subrogation and agency doctrines identify the child as the initial transferee of the fraudulent transfer in all cases.¹⁴ The educational institution therefore either gives clear value to the parent (subrogation) or the parent gives the tuition to the child and subsequently, as agent of the child, pays the child's tuition dollars to the child's school. In such case, the school bestows value on the child (not the parent). If the school is in good faith—if the school has no knowledge that the parent is insolvent—the school has a good faith transferee defense that prevents school liability to the parent's bankruptcy trustee.¹⁵

This Article proposes that good faith schools are never liable for fraudulent transfers when they accept checks from an insolvent parent of an adult student. In pursuit of this proposition, Part I of this Article briefly states what a fraudulent

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transfer is, and how a bankruptcy trustee of the parent is entitled to recover it from an initial transferee or transferee of a transferee.

Part II describes tripartite fraudulent transfer cases, where an insolvent debtor conveys funds to a creditor or vendor of a person the debtor wishes to enrich. It is a bizarre and indefensible aspect of the Bankruptcy Code that a good faith initial transferee that bestows value on a third party is absolutely liable for the fraudulent transfer. A transferee of a transferee, however, is defended by such bestowal. The statutory wreckage, irrational and indefensible, can be rendered harmless through the doctrines of subrogation and agency.

Part III reviews the "mere conduit" fiction employed in the Brooklyn Law School case and finds it analytically incorrect. Schools receive tuition from the student, even when the insolvent parent writes the tuition check. The school's always the transferee of a transferee.

Part IV warns that, if indeed tuition is a fraudulent transfer, and if schools are defended as good faith bestowers of value, then the adult student has received a fraudulent transfer by the very fact of being educated. Worse, if the adult student is driven into bankruptcy by the bankruptcy trustee of the parent, discharge of that obligation could be denied to the student under the recent case of Husky International Electronics v. Ritz.¹⁶ Even if this is not the case, receipt of a fraudulent transfer means that the student has received a "student loan," as the Bankruptcy Code defines that term, and student loans are not dischargeable unless repayment constitutes an undue hardship on the student.¹⁷ Letting the university off the hook implies that the student received the fraudulent transfer, and for this liability there can be no bankruptcy discharge.

I. FRAUDULENT TRANSFERS

It is my contention that, if the underlying property regime implied by fraudulent transfer law is carefully analyzed, schools would rarely be liable simply because a parent paid the tuition bill of an adult child. If the school has no knowledge of the parent's insolvency, the school is a bona fide transferee for value and therefore has the defense against liability spelled out in Bankruptcy Code § 550(b)(1).¹⁸

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Fraudulent transfer law emanates from state law, but the Bankruptcy Code also governs fraudulent transfers quite independently of state law. Furthermore, the Uniform Fraudulent Transfer Act (enacted in most states) imports purely federal ideas (some of which are regrettable) back into state law. Thanks to the UFTA, serious errors of legislative judgment in the Bankruptcy Code are now present in state law.

A. State Law

In the classic fraudulent transfer, a debtor (D) makes an absolute transfer of property to a transferee (X) with the intent of preventing D's creditors from getting it. According to the time-honored phrase in the Uniform Fraudulent Transfer Act (UFTA), inherited from the Act of Elizabeth,¹⁹ D conveys to X with the "actual" intent to "delay, hinder or defraud creditors."²⁰ When this intent is present, it doesn't matter whether D was solvent at the time of the conveyance or whether D received value in return. If D's bad intent is present, D's creditor (CD) may obtain a remedy with regard to the very property that D conveyed to X. Passing over the considerable controversy that exists with regard to fraudulent transfer remedies,²¹ it...