In the November 2009 issue of Basis Points, we reported that the courts had recently been trending toward a consistent position that negative equity for a trade-in was part of the secured creditor’s purchase-money security interest in Bankruptcy. The Seventh Circuit joined the other federal Circuits on March 1, 2010, in In re Aubrey (Aubrey v. Americredit Financial Services), 2010 U.S. App. LEXIS 4168 (Bankr. N.D. Ill.) March 1, 2010). Citing the other federal Circuits, the Seventh Circuit joined the other courts in ruling that “negative equity can be part of a purchase money security interest and if thus secured is not subject to the cramdown power of the bankruptcy judge in a Chapter 13 bankruptcy.”
To refresh your memory, recall that the 2005 Bankruptcy Code amendments introduced the anti-cramdown provision in the “hanging paragraph” at the end of 11 U.S.C. § 1325(a), shoring up protection for secured creditors who perfected their security interests within 910 days after the creation of the security interest. Debtors began to argue that vehicle-secured creditors who financed negative equity were not entitled to the protection under the anti-cramdown provision, even though they financed vehicle purchases for personal use within 910 days of the car buyer’s bankruptcy filing, because the buyer did not finance only the purchase price. Initially, the courts split. Some found that negative equity was not a purchase-money obligation because it was not part of the price of the collateral or value to enable the buyer to acquire rights in the collateral. These courts concluded that a creditor that finances negative equity is not eligible for protection from “cramdown” under the Bankruptcy Code.
Other bankruptcy courts disagreed. They found that “price” was a broad enough concept under retail installment sales acts and the Uniform Commercial Code to include negative equity, and that the purchase of a car and the financing of negative equity on the buyer’s trade-in in connection with that purchase were a single transaction. These courts concluded that a creditor that finances negative equity is still eligible for protection from cramdown under the Bankruptcy Code. The Eleventh Circuit was the first federal circuit court to take one of these negative equity financing cases, and in In re Graupner (Graupner v. Nuvell Credit Corporation), it held that a creditor does not lose its status as the holder of a purchase-money security interest by financing negative equity. The Fourth Circuit (in In re Price (Wells Fargo Financial Acceptance v. Price) and the Tenth Circuit (in In re Ford (Ford v. Ford Motor Credit Corp), followed suit agreeing that negative equity is part of a creditor’s purchase-money security interest. The Eighth Circuit, Fifth Circuit and Second Circuit (via the N.Y. Court of Appeals) also concluded that negative equity financing, when coupled with a car sale, is part of a creditor’s purchase-money security interest where the parties, as in this case, agreed to include the negative equity as part of the price of the newly purchased vehicle in the cases In re Mierkowski (Ford Motor Credit Company v. Mierkowski); In re Callicott (Nuvell Credit Company, LLC v. Callicott); and In re Dale (Ford Motor Credit Company LLC v. Dale); In re Peaslee (Reiber v. GMAC, LLC).
The facts of the Aubrey case were run-of-the-mill for this kind of case. The debtor financed $8,000 in negative equity in connection with the purchase of a new vehicle financed by Americredit, and then filed a Chapter 13 bankruptcy case within 910 days. The court noted that Illinois law controlled, because the debtor lived in and purchased the vehicle in Illinois. The Illinois Motor Vehicle Retail Installment Sales Act specifically contemplates the inclusion of negative equity in the amount financed in a new retail installment contract, which lead the court to conclude that financing negative equity was “indeed a common element of a credit purchase of a car.” The court also looked to Illinois’ version of the Uniform Commercial Code § 9-103, and a comment clarifying that the “price” of collateral subject to a purchase money security interest can include “obligations for expenses incurred in connection with acquiring rights in the collateral, sales taxes, duties, finance charges, interest, freight charges, costs of storage in transit, demurrage, administrative charges, expenses of collection and enforcement, attorney’s fees, and other similar obligations…”. The court noted that “wrapping negative equity into the purchase money security interest is often necessary to enable the purchase of the car, given the impediment to financing car purchases that Chapter 13’s cramdown provision would otherwise create.” The court weighed the interpretation that the security interest should be limited to the amount actually spent to purchase collateral against the potential impact on the auto sale (and finance) industry of a holding that effectively disincentivized creditors from financing negative equity. The Seventh Circuit found that the interest in supporting the “important market that consists of the sale of cars on credit” (as long as doing so did not upset the applicable state laws) was too crucial to interpret the definition of “purchase money security interest” literally.
There are not many federal circuit courts left to weigh in on the question. With consensus building as it has among the federal circuit courts that have decided this question, it seems that the path is clear for creditors to finance negative equity without concern that, if it does so in connection with a purchase that is within 910 days of a consumer’s bankruptcy filing, it will retain its perfected creditor status in the bankruptcy and not have to settle for a crammed-down amount on its debt.
Chuck Dodge is a partner in the Maryland office of Hudson Cook, LLP. Basis Points readers can reach Chuck at (410) 865-5427 or by email at cdodge@hudco.com.