In In re Palladino, 942 F.3d 55 (1st Cir. 2019), the U.S. Court of Appeals for the First Circuit addressed whether a debtor receives “reasonably equivalent value” in exchange for paying his adult child’s college tuition. The Palladino court answered this question in the negative, thereby contributing to the growing circuit split regarding the avoidability of debtors’ college tuition payments for their adult children as constructively fraudulent transfers.

Background

In 2012, Steven and Lori Palladino began paying tuition for their 18-year-old daughter to enroll as an undergraduate at Sacred Heart University. From 2012 to March 2014, the Palladinos made a total of $64,656.22 in tuition payments to Sacred Heart. Unfortunately, while they were making these tuition payments, the Palladinos were in the midst of operating a multimillion-dollar Ponzi scheme through Viking Financial Group, their closely held company. Consequently, the Palladinos were charged with and pleaded guilty to fraud, after which the Securities and Exchange Commission obtained a $9.7 million civil judgment against them for securities violations. In April 2014, the Palladinos filed for bankruptcy relief under Chapter 7 of the Bankruptcy Code, and Viking filed its own Chapter 7 petition shortly thereafter. The U.S. Bankruptcy Court for the District of Massachusetts consolidated the two Chapter 7 cases, and appointed Mark DeGiacomo as bankruptcy trustee.

In July 2015, DeGiacomo filed a complaint against Sacred Heart to avoid and claw back the tuition payments that the Palladinos had made on their daughter’s behalf. Two counts of the four-count complaint alleged that these payments constituted constructively fraudulent transfers under Section 548(a)(1)(B) of the Bankruptcy Code because, according to DeGiacomo, the Palladinos had not received “reasonably equivalent value” in exchange therefor.

As there was no material factual dispute in the case, the parties filed cross-motions for summary judgment. The bankruptcy court ultimately granted summary judgment in favor of Sacred Heart on all counts of the complaint. With respect to the “constructively fraudulent transfer” claims, the bankruptcy court justified its holding on the finding that the Palladinos had paid their daughter’s tuition because “they believed that a financially self-sufficient daughter offered them an economic benefit.” The court concluded that the Palladinos’ belief satisfied Section 548(a)(1)(B)(i)’s “reasonably equivalent value” standard. It then acted sua sponte to certify its decision for direct appeal to the U.S. Court of Appeals for the First Circuit. The sole issue on appeal was whether the Palladinos received “reasonably equivalent value” in exchange for their tuition payments.

Constructively Fraudulent Transfers

Section 548(a)(1)(B)(1) of the Bankruptcy Code provides that any transfer of an interest of the debtor in property that is made within two years of the debtor’s bankruptcy filing may be avoided if the debtor: voluntarily or involuntarily received less than “reasonably equivalent value” in exchange for such transfer, and was insolvent when the transfer was made or became insolvent as a result of the transfer. Thus, a transfer is avoidable as “constructively fraudulent” when an insolvent debtor makes such transfer for less than reasonably equivalent value, irrespective of the debtor’s intent to defraud its creditors.

The term “reasonably equivalent value” is not defined in the Bankruptcy Code. However, courts have agreed that “reasonably equivalent value” does not include intangible, emotional or non-economic benefits. Courts instead look for some realized commercial value in exchange for the value that was transferred.

In applying this standard to virtually identical fact patterns, bankruptcy courts throughout the country diverge on the question of avoiding college tuition payments as constructively fraudulent transfers; their disagreement is rooted in the question of whether parents receive “reasonably equivalent value” when paying the college tuition of an adult child. Compare In re Sterman, 594 B.R 229 (Bankr. S.D.N.Y. 2018) (finding tuition payments are avoidable), In re Knight, Case No. 15-21646 (JJT), Adv. Pro. No. 15-02064 (JJT), (Bankr. D. Conn. Sept. 29, 2017) (same) and In re Leonard, 454 B.R. 444 (Bankr. E.D. Mich. 2011) (same) with In re Oberdick, 490 B.R. 687 (Bankr. W.D. Pa. 2013) (holding that trustee failed to establish lack of reasonably equivalent value) and In re Lewis, 574 B.R. 536 (Bankr. E.D. Pa. 2017) (same). Most courts that have addressed the issue have ruled in favor of avoidance, holding that such tuition payments can constitute constructively fraudulent transfers.

The Court’s Analysis

The First Circuit concluded that the answer to whether parents’ college tuition payments for their adult children may constitute constructively fraudulent transfers “is straightforward.” The court explained that the purpose of fraudulent transfer law is “to preserve the debtor’s estate for the benefit of unsecured creditors,” so courts evaluate transfers “from the creditors’ perspective.” The court concluded that the tuition payments made for their daughters’ benefit depleted the Palladinos’ estate and “furnished nothing of direct value to the creditors who are the central concern of [Section 548(a)].”

The Palladino court looked to the “five classes of transactions that confer value” recognized by the Bankruptcy Code: the exchange of property; the satisfaction of a present debt; (3) the satisfaction of an antecedent debt; the securing or collateralizing of a present debt; and (5) the granting of security for the purpose of securing an antecedent debt. (citing 11 U.S.C. Section 548(d)(2)(A)).The court found that the tuition payments did not fall within one of these five categories; it went on to point out that parents are not under any legal obligation to pay the college tuition of their adult children.

The appellate court readily recognized that many payments ultimately deemed to constitute constructively fraudulent transfers are actually made for “worthy causes,” such as to elderly parents or needy siblings. However, it underscored the fact that unless these payments fall within one of the five classes of transactions discussed above, they will be subject to claw-back under fraudulent transfer law. The court emphasized that Congress enacted these “constructively fraudulent” transfer laws, and it is the duty of the courts to enforce these laws.  It concluded that, when confronted with a “clear statutory demand” such as the one contained in section 548(a)(1)(B) of the Bankruptcy Code, “that is the end of the matter.” Based on this rationale, the court held that the Palladinos’ tuition payments could be clawed back as constructively fraudulent transfers.

Conclusion

The decision of the First Circuit Court of Appeals in Palladino adds to the growing circuit split regarding whether parents’ tuition payments for their adult children are avoidable as constructively fraudulent transfers, and it may well lead to a grant of certiorari by the U.S. Supreme Court (as of the date of this publication, no petition for a writ of certiorari has been filed). Until then, with a growing number of courts holding that these tuition payments are not made for reasonably equivalent value, educational institutions—especially those accepting payments from parents of adult children—should be aware of the risk that they may be compelled to return tuition payments well after a student has completed his studies

Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors’ rights.

Elisa Hyder, an associate with the firm, practices in the area of business reorganization and financial restructuring.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.