Congress Weighs Legislation that May Preclude Suit by Bankruptcy Trustees Against Colleges and Universities to Recover a Bankrupt Parent's Tuition Payments for a Student

HIGHLIGHTS:

  • An increasing number of colleges and universities find themselves defending litigation initiated by Chapter 7 trustees administering bankruptcy cases of the parents of past or present students of that college or university.
  • Rep. Chris Collins, R-N.Y., has introduced legislation known as the PACT (Protecting All College Tuition) Act of 2015 that would preclude trustees from clawing back tuition money from universities.
  • While the PACT proposal represents progress in achieving consistency within the Bankruptcy Code as to treatment of prepetition tuition payments toward a dependent child’s college education, colleges and universities as well as students and parents affected by Chapter 7 debt remain exposed.

A trend emerging in consumer bankruptcy cases around the U.S. is causing concern for many parents, students and undergraduate schools. As was reported by The Wall Street Journal in an article published on May 5, 2015, an increasing number of colleges and universities find themselves defending litigation initiated by Chapter 7 trustees administering bankruptcy cases of the parents of past or present students of that college or university.

These trustees seek to recover from the college or university the value of tuition payments received from debtor-parents on behalf of an adult child at a time when the debtor-parents were "insolvent," on the basis that the tuition payments are avoidable "constructively fraudulent" transfers under either Section 544 or Section 548 of the U.S. Bankruptcy Code, codified at 11 U.S.C. §§ 101 et seq.

Bankruptcy Trustee Theory

The bankruptcy trustees' theory is based on the premise that, while the matriculating student receives consideration from a college or university in the form of an education, the parent writing the check receives nothing. The defending universities typically assert that even without direct consideration flowing to the debtors, the parents received indirect consideration in the form of peace of mind in knowing that their child was getting an education, or the love and affection of their children.

Bankruptcy courts ruling in favor of Chapter 7 trustees explain, however, that while parents may feel a moral obligation to pay their child's tuition, if the debtor-parents do not hold a legal obligation to support their children past the age of adulthood under applicable state law ­– or otherwise prove concretely that indirect consideration reached the parents ­– the parents did not receive the necessary "reasonably equivalent value" (whether in satisfaction of a legal obligation of the parents or otherwise) for the tuition payments they funded for their children. As long as the trustee can meet his or her burden of proof on the remaining elements of this type of fraudulent transfer case, the trustee is entitled to judgment and the university must write a check to the trustee in an amount equal to up to four years’ worth of tuition and housing payments – even though the debtors' child was educated at the college.

Implications of Avoidance Litigation

The implications of this type of avoidance litigation on third parties are potentially profound. If the student at issue has not yet graduated, the college or university could take steps to suspend the student's access to courses after the deadlines for applying for financial aid have passed, forcing the student to scramble to secure alternate sources of funding or, worse, necessitating that the student stop taking courses entirely.

The college or university is impacted as well, particularly once the student has graduated and received a diploma, as it has to either sue a present or former student to recover the unpaid and overdue tuition, or spread its loss of tuition revenue across the entire student body. Such present and anticipated financial losses will likely lead to even higher costs of securing a college degree for all future students.

PACT Legislation

One congressman seeks to reverse this trend. Rep. Chris Collins, R-N.Y., has introduced legislation known as the PACT (Protecting All College Tuition) Act of 2015 (114th Congress H.R. 2267). The bill, if passed, would amend Bankruptcy Code Section 548 to preclude trustees from avoiding a good-faith payment by a parent of post-secondary education tuition for that parent's child. The stated purpose of the proposed law is to prevent bankruptcy trustees from clawing back tuition money from universities.

While the proposal of PACT may provide colleges and universities some much needed comfort, an amendment to Section 548 alone does not go far enough. Trustees will arguably still hold the ability to sue to recover a debtor's tuition payments under the applicable state fraudulent transfer statutes if the prerequisites of Section 544 can be satisfied by the trustee, as plaintiff. This leaves a gaping hole in the protections PACT appears intended to provide.

Although it is difficult at present to predict whether Congress will be as equally concerned with shielding prepetition tuition payments from clawback as Rep. Collins is, approval of PACT or a modified version that closes the unintended gap left by omission of a reference to Section 544 would arguably be consistent with certain other policy-based amendments to the Bankruptcy Code from prior years that relate to tuition or family expenses.

Bankruptcy Code Provisions

Perhaps the best example of protection, albeit limited, of monies set aside to fund the cost of a college education can be found in the current provisions of Bankruptcy Code Section 541(b). In 2005, Congress amended Section 541 to provide that certain education savings plans up to defined thresholds are no longer included in the otherwise broad and seemingly creditor-friendly scope of a debtor's "property of the estate" in a section of the bill that was aptly titled, "Protection of Education Savings in Bankruptcy." Section 541(a)'s definition of "property of the estate" excludes "funds placed in an education individual retirement account [or "education savings account"] not later than 365 days before the date of the filing of the petition in a case under this title... if the designated beneficiary of such account was a child, stepchild, grandchild or stepgrandchild of the debtor … to the extent that such funds for the taxable year for which funds were placed in such account … are not pledged …[and] are not [Internal Revenue Code defined] excess contributions."

Protected contributions per beneficiary funded between the first and second year preceding a bankruptcy cannot exceed $6,225. There is no limit within the Bankruptcy Code (other than for Internal Revenue Code (IRC) defined "excess contributions") on the amount exempted under Section 541(b)(5) if funded outside of the two years preceding the case filing.

In addition, pursuant to Section 541(b)(6), those funds used by a debtor to purchase a tuition credit or a tuition certificate for a child, stepchild, grandchild or stepgrandchild outside of the year preceding a bankruptcy filing are excluded from Section 541's definition of "property of the estate" up to the per beneficiary limits set forth in IRC Section 529(b)(6), as adjusted to reflect the governing Consumer Price Index. Similarly excluded are those funds contributed to an IRC-qualified Section 529(b)(1) tuition program or plan outside of the year preceding the bankruptcy petition date for beneficiaries that were children, stepchildren, grandchildren or stepgrandchildren. Exempted contributions per beneficiary funded between the first and second year preceding a bankruptcy case are capped at $6,225. As with Section 541(b)(5), funds contributed by a debtor, as account owner, more than two years prior to a petition date are fully exempt, as long as the contributions were in amounts that comply with IRC Section 529(b)(1).

Theoretically, then, a parent could fund $10,000 into a 529(b) plan for a child outside of the two years preceding his or her bankruptcy case at a time of insolvency, and those funds would not be included in his or her bankruptcy estate. However, in the current state of the law, if those same funds were paid directly to a college or university, they are potentially recoverable in a bankruptcy as constructively fraudulent under the theories mentioned above. To be internally consistent, then, a Bankruptcy Code amendment is appropriate. To avoid the gap between intent and drafting currently evident in PACT, that amendment would best be placed in Section 550 through providing an exception from avoidance for amounts paid by a debtor on behalf of a parent, stepchild, grandchild or stepgrandchild for tuition paid directly to a college or university prior to a bankruptcy filing in amounts calculated in accordance with Sections 541(b)(6) and (7).  

Congressional Post-Secondary Education Protective Philosophy

There are signs, though, that this is as far as Congress may be willing to go in protecting payments that fund an adult child's college education. When it had the opportunity to fully implement a post-secondary education protective philosophy in 2005, Congress chose not to, declining to exclude post-petition contributions to 529(b) plans from the calculation of "disposable income" in a Chapter 13 bankruptcy case. This exclusion was not implemented despite Congress having done so for retirement plans when it excluded post-petition payments to qualified IRC. Section 401(k) plans with the addition of Section 541(b)(7) and the hanging paragraphs contained therein.

As a result, while a Chapter 13 debtor can reduce the disposable income he or she must dedicate to plan payments through post-petition 401(k) contributions as a matter of right, payments towards a child's tuition can reduce the debtor's "disposable income" only to the extent "reasonably necessary to be expended for the maintenance or support of the debtor or a dependent of the debtor."

For above-median debtors, Bankruptcy Code Section 707(b)(2)(A)(ii)(IV) tells us that Congress only considers the cost of educating a child though the age of 18 at the amount of $1,875 (as periodically adjusted) per year to be "reasonably necessary." The Bankruptcy Code's silence as to whether a Chapter 13 debtor can indeed confirm a plan that complies with the Bankruptcy Code – yet permits a parent-debtor to pay for an adult child's college tuition when unsecured creditors will not be paid in full – speaks volumes. 

Next Steps for Colleges, Universities and Parents

While the PACT proposal certainly represents progress in achieving consistency within the Bankruptcy Code as to treatment of prepetition tuition payments towards a dependent child's college education, colleges and universities that received payments funded by Chapter 7 debtors remain exposed.

Until PACT becomes law, colleges and universities are left to their own determinations on how to best structure the parent-student-university relationship to protect tuition payments from avoidance and enable collection from students, even after graduation, if previous payments are avoided. Parents may consider funding 529(b) Plans rather than paying tuition directly, and colleges and universities may benefit from insisting that they do so. For now, it remains to be seen whether PACT is a step in the right direction for defending colleges and universities, but it clearly is a step toward effecting textual support for already evidenced, but only partially implemented, policy.