In a striking blow to colleges and universities across the country, on Nov. 12, 2019, the First Circuit Court of Appeals reversed a decision by the United States Bankruptcy Court for the District of Massachusetts, DeGiacomo v. Sacred Heart Univ. (In re Palladino), 556 B.R. 10 (Bankr. D. Mass. 2016), and held that parents did not receive "reasonably equivalent value" in exchange for the college tuition payments they made to educate their child. DeGiacomo v. Sacred Heart Univ. (In re Palladino), 942 F.3d 55 (1st Cir. 2019). Reasoning that because parents have no obligation to provide for a child's educational costs once the child reaches legal adulthood, parents receive no benefit from the payment of tuition and associated costs and thus, parents receive no "value" for the payments as the term is used in Section 548 of the Bankruptcy Code.  As a result, the Court of Appeals concluded that the payments in question were voidable by the trustee as constructive fraudulent transfers under 11 U.S.C. § 548(a)(1)(B). This long-awaited decision represents the first instance in which a Federal Court of Appeals addressed the issue of whether a debtor-parent receives "reasonably equivalent value" for the payment of a child's tuition once the child has attained the age of 18.

'Palladino' and the Bankruptcy Court Decision

The facts of the Palladino case are relatively straightforward. In 2012, Steven and Lori Palladino's daughter began her first year of college at Sacred Heart University. Over the next several years, the Palladinos made $64,696.22 in tuition payments. In 2014, after experiencing an onslaught of financial problems stemming from their involvement in a Ponzi scheme, the Palladinos filed joint voluntary petitions for relief under Chapter 7 of the Bankruptcy Code. The Chapter 7 trustee commenced an action against Sacred Heart, seeking, inter alia, to recover the tuition payments as constructive fraudulent transfers under 11 U.S.C § 548(a)(1)(B) and Uniform Fraudulent Transfer Act as enacted in Massachusetts, Mass. Gen. Laws ch. 109A §5(a)(2), on the basis that the debtors, having no obligation to pay for their adult daughter's tuition, received no benefit from having made the payments.

In addressing whether the payments were avoidable under §548(a)(1)(B), the Bankruptcy Court focused on the meaning of the phrase "reasonably equivalent value" as used in the Bankruptcy Code, and acknowledged that decisions in other districts have offered differing guidance on the interpretation of the phrase. Courts that have found "reasonably equivalent value" to support payment of tuition have identified value received by parents in satisfying a societal expectation and alleviating a family's overall financial burdens by helping their children become financially independent. See, e.g., Sikirica v. Cohen (In re Cohen), No. 05-38135-JAD, 2012 Bankr. LEXIS 5097, *28–29 (Bankr. W.D. Pa. 2012) (concluding that tuition expenses are reasonable and necessary for the maintenance of the debtor's family). In contrast, other courts have found that tuition payments made for an adult child do not provide "reasonably equivalent value" because any value received is not sufficiently economic, concrete or quantifiable, and there is no legal obligation to support an adult child. Gold v. Marquette Univ. (In re Leonard), 454 B.R. 444, 457 (Bankr. E.D. Mich. 2011).

The Bankruptcy Court concluded that although "ethereal or emotional rewards, such as love and affection, do not qualify as 'value' for the purposes of defeating a constructive fraudulent conveyance claim," the use of the term "reasonably" allows parents some degree of speculation or assumption in applying the phrase in practice. Reasonably equivalent value would be received by the parent who makes a tuition payment because, a parent can, "reasonably assume that paying for a child to obtain an undergraduate degree will enhance the financial well-being of the child which in turn will confer an economic benefit on the parent." This "reasonable equivalence" while certainly not a guarantee that the parents' investment will ultimately have been worthwhile, is sufficient to avoid claw back of a tuition payment as a constructive fraudulent transfer. The Trustee appealed to the First Circuit.

The First Circuit Decision

On appeal, the First Circuit reversed. In a succinct opinion, the court observes that any definition of reasonably equivalent value "does not include intangible, emotional, and non-economic benefits." In support of this conclusion, the court points to the statute's purpose of preserving the debtor's estate for the benefit of unsecured creditors and goes on to explain that value must be evaluated from the perspective of creditors and measured at the time of the transfer.

The court notes that the age of majority in Massachusetts is 18, and there is no legal obligation for the parents to make tuition payments on behalf of a child. Thus, because there was no legal obligation for the debtors to support their adult child, the payment of tuition conferred no benefit upon the creditors. Accordingly, the tuition payments depleted the estate and furnished nothing of direct value to the creditors who are the central concern of the code provision at issue. The court further notes that §548(d)(2)(A) recognizes only five classes of transactions that confer value, and none of these classes are applicable to the college tuition payments made by the debtors. Therefore, the transfers were avoidable by the trustee.

The First Circuit's Misplaced Focus on Creditor Benefit

At first blush, the First Circuit decision appears to be tied directly to statutory intent and, to some degree, the text of §548(d)(2)(A). However, by focusing on value solely with an eye to preserving the debtor's estate for the benefit of creditors, the First Circuit ignores a very significant reality—that not all pre-bankruptcy transfers add value to the estate for the ultimate benefit of creditors. There are countless examples of pre-bankruptcy transfers that are made for value, and thus not avoidable, which have the effect of depleting the estate and yet furnish nothing of direct value that is available to creditors.

For example, consider a debtor who, prior to his bankruptcy filing, has spent money on a vacation, a gym membership, a salon treatment or a language skills course. As long as the debtor paid a market price for the purchase, there is no question that these transfers are not fraudulent conveyances under the constructive standard. In each of these examples, the transfers in question have furnished nothing of value to the estate or the debtor's creditors. It is indeed difficult to imagine that a debtor would, in a sense, be justified in spending $5,000 on a vacation within the year prior to a bankruptcy filing without any risk of avoidance, while, according to the First Circuit, the debtor apparently cannot use the same funds to pay tuition for his 18-year old child, without the risk of payment avoidance.

The Aftermath for Colleges and Universities

Unquestionably, the decision unreasonably exposes universities to loss. Universities typically invoice tuition payments to students and have no control over whether it is the student, one of the student's parents, or even another relative who makes the tuition payments. Long lookback periods under both §548 and applicable state fraudulent transfer statutes also disfavor universities, as by the time the avoidance action is commenced, students may have already graduated from the university, leaving the university with little practical recourse other than to seek recovery against the student.

At the outset of a student relationship, universities should consider measures to counter the risk of avoidance of tuition payments made by insolvent parents. Some commentators have suggested that universities could require parents to guaranty tuition payments. The rationale behind this approach is that the guarantee provides the parent with a contractual obligation at the outset of the relationship to pay tuition to the university, and the obligation is satisfied, in part, each time the parent makes a tuition payment. Thus, even though the parent may not have had an underlying legal obligation to pay the tuition, as a matter of law, it becomes contractually obligated once it signs the guaranty.

Not so fast. If the guaranty is provided within a lookback period while a parent is insolvent (or, more likely, rendered insolvent by the giving of such a large guaranty), the guaranty itself may likewise be susceptible to avoidance as a constructive fraudulent transfer, on the theory that the parent received no "value" in exchange for giving the guarantee. It is true that this approach may have the advantage of timing; as perhaps a guaranty given at the outset of a student relationship will place the transfer outside of the lookback period.

Alternatively, universities should consider a requirement that students make all tuition payments directly. The advantage of this approach is that if parents or other family members wish to contribute to a student's educational costs, these family members may arrange to contribute to student-controlled accounts, but the student would ultimately be responsible for making the tuition payments to the university. Using this structure, the university would only be a recipient of funds directly from the student. In the event of the student's insolvency, the transfer from the student to the university would not be subject to avoidance, as the issue of value as between the student and the university would be established. Further, in the event of a parent insolvency, the university would be entitled to the protections of Section 550 of the Bankruptcy Code, to the extent applicable, which provides additional protection to transferees for value and good faith transferees.

Amy A. Zuccarello is a partner with Sullivan & Worcester in Boston. She practices in the areas of corporate finance, corporate trust, financial restructuring, business bankruptcy and litigation. Aaron J. Staudinger is a litigation associate at the firm.