Over Four Hundred Years of Law on Fraudulent Transfers, Flushed Down the Drain

Bryan Cave Leighton Paisner

In 1571, Parliament enacted a law, sometimes known as the Statute of 13 Elizabeth, creating one of the greatest means of creditor protection – the proscription of fraudulent transfers.  As Professors Baird and Jackson stated, the law prevents an “Elizabethan deadbeat [from selling] his sells his sheep to his brother for a pittance.”[1]  The law has progressed, covering not just intentional acts to hinder, delay, or defraud creditors, but also “constructively fraudulent transfers” in which a third party who is not in on any con nonetheless gets something from an insolvent debtor for less than reasonably equivalent value.

These are simple, straightforward principals, with which no bankruptcy professional (or really, anyone) could quibble.  You got stuff and you didn’t pay for it, so you need to give it back.  There are some exceptions.  Voiding transfers in the securities industry, for instance, could up-end financial markets.  So Congress added Sections 548(d)(2)(B) – (E) of the Bankruptcy Code to protect various securities-related transfers from avoidance as constructively fraudulent transfers.  Likewise, Congress has excluded some charitable contributions and tithes from attack. 11 U.S.C. § 548(a)(2).

Now, a Bankruptcy Judge (which is not, the last time we checked, a Congressional body which can change the law), has grafted another exception to Section 548: transfers by a parent to help an adult child, where the adult child might (or might not, who knows) return the favor sometime in the future.  This is the law under DeGiacomo, as Chapter 7 Trustee v. Sacred Heart Univ. (In re Palladino), Case No. 15-01126, Bankr. D. Mass., Docket No. 76 (August 10, 2016).  In Palladino, the Chapter 7 Trustee sued a university, which had received tuition money from the insolvent Debtors.  But the Debtors didn’t get anything for the payments – it went to pay the tuition of the Debtors’ adult child.  Thus the Chapter 7 Trustee sought to get the money back from the university, and distribute it to rightful creditors.

In Palladino, one of the parents / debtors defended the payments on moral grounds, stating “I am her mother and she shouldn’t have to come out of [Sacred Heart University] saddled with thousands of dollars in loans.”  Morality has nothing to do with constructively fraudulent transfers, and so we don’t know why this statement made it in the opinion.  Instead, the Bankruptcy Judge ruled against the Chapter 7 Trustee by holding that future, entirely speculative benefit can somehow provide “reasonably equivalent value” such that a transfer is not voidable.  As the Court held, “[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, it seems to me, constitutes a quid pro quo that is reasonable and reasonable equivalence is all that is required.”  Wow.  No caselaw is cited by the Court for this proposition.  Indeed, none of us at the Bankruptcy Cave have ever heard of future, speculative benefits serving as a defense to a constructively fraudulent transfer action.  As to children taking care of parents, we suggest a review of King Lear (you know, “how sharper than a serpent’s tooth . . .”).

Future debtors, please take note of this remarkable opinion.  If you want to help a family member, then give them money before bankruptcy, for any plausible (or implausible reason).  Sick relative?  Down on their luck relative?  Relative that wants to invest in uranium stock, purchase the Brooklyn Bridge, or bail a Nigerian prince out of jail?  The Palladino ruling creates a debtor-friendly “it tugs on your heartstrings” / “blood is thicker than water” defense to fraudulent transfer actions.  And preferences too!  Why not?  Palladino is a safe haven for most or all of these wrongful actions.

Now, we understand the basis for the Palladino ruling.  Palladino was one of those “every possible ruling seems unfair” cases, in which a Chapter 7 Trustee was suing the child’s university, seeking to recover pre-petition tuition payments made by the insolvent parents for the benefit of the innocent child.  These cases are awful.  The child did nothing wrong.  The university did nothing wrong.  Indeed, the university really can’t police against this, unless it enacts a rule that every tuition payment must come from a check written on the student’s account.[2]  And even then, that would just make the innocent child / student the defendant.  That sticks in some people’s craw.[3]  On the other hand, creditors are unpaid – why should a kid get free or subsidized college when creditors have to lick their wounds? In any event, a bill is now kicking around Congress to exempt payments like these from fraudulent transfer attack under Section 548 of the Bankruptcy Code, as Lynne Xerras of Holland and Knight has written here.

So we understand the ruling.  But we still don’t like it.  Bankruptcy judges are not legislative bodies.  Bankruptcy judges can’t change the law, or create exceptions based on subjective principles of fairness.  If lawsuits like Palladino shouldn’t be allowed, it is up to Congress to make that decision, and not bankruptcy judges.  We are afraid that the Bankruptcy Code, the Statute of 13 Elizabeth, and creditor protections of all sort, all just got a little weaker through Palladino.

[1]           Baird & Jackson, Fraudulent Conveyance Law and Its Proper Domain, 38 Vand. L. Rev. 829, 852 (1985)); a full copy of this classic is located here.

[2]           And even then, would the school be automatically immune from attack as an immediate transferee under Section 550(a)(2)?  Ug.  More briefing on legal issues is not the solution to this problem.

[3]           The WSJ’s bankruptcy blog has covered this issue a lot.  See http://blogs.wsj.com/bankruptcy/2015/05/06/whats-behind-bankruptcy-lawsuits-over-college-tuition/; for Friday’s coverage of Palladino, if you have a WSJ subscription, you can click here.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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