Caught in the Cross-Fire: Student Loan Lenders and Servicers’ Risks  in the Bankruptcy Fight over College Tuition ClawbacksMany parents hope to fund, in some part, their children’s college educations, and the federal government has created a system of incentives, including tax advantaged 529 plans, to support that expectation. Recent research shows that approximately 78% of parents plan to help pay for their children’s college educations, usually through a combination of savings, grants, and student loans.

Robert and Jean DeMauro did just that. They paid approximately $47,000 in tuition to Johnson & Wales University to secure their daughter’s attendance. The DeMauros’ tuition payments were paid entirely via Federal PLUS loans, and payments were made directly from the U.S. Department of Education to the university.

In December 2014, the DeMauros filed for bankruptcy. The Chapter 7 Trustee assigned to their case, in keeping with his duty to recover as much money as possible to repay the DeMauros’ creditors, has filed an adversary proceeding seeking to claw back these tuition payments to the DeMauros’ bankruptcy estate.

The DeMauros’ case is unique in that it involves tuition payments made via Federal PLUS loans, but the case is part of a larger bankruptcy trend toward clawing back college tuition payments paid by parents on behalf of their children. The Wall Street Journal estimates that such disputes have affected at least 49 colleges and universities, and that these institutions have returned $276,434.80 in tuition payments to the bankrupt parents’ estates. While historically, colleges and universities have opted to settle these disputes quietly, the institutions have increasingly hired high-profile counsel in an attempt to contest the merit of these lawsuits. Student loan lenders and servicers must be aware of these issues, as they act as intermediaries between the borrower (and potentially bankrupt) parents, universities, and the Bankruptcy Trustees.

The legal theory underlying these cases is that Bankruptcy Trustees are entitled to avoid, or unwind, transactions that occurred up to two years prior to the bankruptcy that are thought to unfairly deplete a debtor’s assets as fraudulent transfers. Trustees may also avoid fraudulent transfers that occurred up to six years prior to the bankruptcy, depending upon state law of the jurisdiction where the parent filed bankruptcy.

The Trustee may avoid such transfers on the grounds of actual or constructive fraud, and Trustees often plead both causes of action in tuition recovery cases. In the case of actual fraud, the Trustee must show that the transfers were made with “actual intent to hinder, delay or defraud creditors,” as evaluated by a list of factors indicating probable fraud known as the “Badges of Fraud.”

For constructive fraud, the Trustee must show (1) that the debtor received less than a reasonably equivalent value in exchange for the transfer and (2) that the debtor was insolvent on the date of the transfer or became insolvent as a result of the transfer.

In the context of college tuition recovery, constructive fraud is the more litigated claim. Trustees argue that the debtor-parents were insolvent at the time they were making tuition payments and did not receive reasonably equivalent value in exchange for those payments – instead, the child received that value. Even where the university has argued that the debtor-parents received value in the form of their child’s education, which “bestowed peace of mind” and afforded the child career opportunities that meant that the parents would not remain financially responsible for the child, courts have held that these were only indirect benefits to the debtor-parents’ bankruptcy estate and did not present any economic, concrete, or quantifiable benefits that could be used to pay creditors.

The DeMauros’ case is novel, however, because it involves tuition paid from Federal PLUS loans, money that was arguably never part of the debtors’ estate. Johnson & Wales University contends that because those funds were disbursed directly from the U.S. Department of Education to the university and could only be used for qualifying educational expenses, they were third party funds, never made property of the debtors’ estate. The Trustee contends that because the debtor is the sole obligor on the Master Promissory Note, he has an interest in the property under applicable state law akin to when a person finances a car purchase and the lender sends the check directly to the car dealer. The Trustee also argues that the funds’ uses are not as restricted as the university contends, noting that the Master Promissory Note allows Federal PLUS loans to be used beyond tuition, room, and board. The case is set for trial this fall, and although most fact discovery is wrapped up, expert discovery is presently ongoing.

This wave of lawsuits caught the attention of Congress and last year, Representative Chris Collins (R – NY) introduced a bill titled Protecting All College Tuition (PACT) (H.R. 2267). The PACT legislation is intended to create an exception to the Trustee’s avoidance powers for tuition payments made in good faith by parents. The bill has been criticized, however, as being toothless, given that it only protects clawbacks brought under the Bankruptcy Code and would not extend to indirect claims brought under state law. The bill was referred to the House Subcommittee on Regulatory Reform, Commercial and Antitrust Law in June 2015.

In light of this bankruptcy litigation trend, it may be time for student loan lenders and servicers to revisit best practices for tuition payments. To mitigate the risk of a potential clawback demand, lenders and servicers should consider implementing the following business practices:

  • Require tuition payments to be paid directly by the student
  • Revisit processes to ensure that third party payor/guarantors are solvent
  • Develop policies and procedures designed to timely and accurately respond to Bankruptcy Trustee’s clawback demands
  • Allocate additional litigation reserves for potential lawsuits or settlements

In the meantime, the Bradley team will monitor these issues and publish updates as available.