Creditors Making Secured Auto Loans Win A Big One In Fourth Circuit Bankruptcy Case

The Fourth Circuit today settled a nationwide debate, in this Circuit anyway, about an important issue involving automobile loans in Chapter 13 proceedings.  That's whether a lender can have a purchase money security interest for the portion of its financing which includes "negative equity" or other items associated with the loan, like "gap insurance." 

The answer, according to the Fourth Circuit in the case of In re Price, is "yes."  The case drew amicus briefs from a group of bankruptcy law professors, the National Association of Consumer Bankruptcy Attorneys, and GMAC; and was argued for the creditors by noted bankruptcy lawyer and former Professor David Epstein.

This issue arises when a borrower who owes money on the car that he or she is trading in rolls the amount of the unpaid debt (the negative equity) into the loan for the new car.  An "upside down" borrower like this also has to take gap insurance for the loan.  That's additional insurance covering the difference between the amount owed and the amount that would be paid if the car were totaled, because the lender is lending more than the car is worth.  According to the Fourth Circuit, this type of borrowing is involved in about 38% of new car loans. 

The financing of this additional debt becomes important in a Chapter 13 proceeding, because a Chapter 13 debtor has to repay in full a creditor's "allowed secured claim."  That ordinarily is the present value of the collateral, and that is often less than the loan amount.  So in the non-car loan situation, this results in a bifurcation of a Chapter 13 creditor's claim into two components -- a secured claim for the value of the collateral, and an unsecured claim for the remainder.

But in 2005 Congress added something called the "hanging paragraph" to the Bankruptcy Code, which the Fourth Circuit said was designed "to protect secured car lenders." The hanging paragraph, at the end of 11 U.S.C. §1325(a), says that there won't be bifurcation if the claimant has a purchase money security interest involving a motor vehicle. 

This statutory addition has resulted in a variety of different results in courts around the country:

  • Some courts have held that a lender is entitled to a purchase money security interest in the entire amount of the car loan, even if the lender financed negative equity and gap insurance.
  • Other courts hold that a lender can't have a purchase money security interest in the portion of a car loan relating to negative equity or gap insurance. 
  • Then, some of these courts apply the "transformation rule," and treat the entire debt as non-purchase money if it includes any negative equity.
  • Other courts apply the "dual status rule," which grants the lender a purchase money security interest for the portion of the claim that doesn't include negative equity and an unsecured claim for the remainder.

The Fourth Circuit took the side of the lenders on this one, looking to the Uniform Commercial Code definition of "purchase money security interest," and holding that "negative equity financing gives rise to a purchase money security interest under the UCC -- and, thus, under the hanging paragraph as well." 

The Court held that the debtors "could not have traded in their old car unless they also extinguished their negative equity; car dealers are generally unwilling to accept a trade-in with an outstanding lien because the lien makes it difficult for the dealer to resell the car."  It rejected arguments of amici that this result would "make it more difficult for the chapter 13 debtor to retain his or her car" in the bankruptcy proceeding.

The result reached by the Fourth Circuit is consistent with an Eleventh Circuit decision, In re Graupner, 537 F.3d 1295 (11th Cir. 2008).

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