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Bankruptcy judges split on negative equity

By: dmc-admin//November 17, 2008//

Bankruptcy judges split on negative equity

By: dmc-admin//November 17, 2008//

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Suppose a lender finances the purchase of a new automobile by means of negative equity financing -– the new car loan includes payment of the loan balance on a trade-in, and the loan balance exceeds the trade-in value.

Bankruptcy courts around the country have divided roughly equally on whether the lender has a purchase money security interest (PMSI) in the entire loan, or only a partial one.

Until last month, the only courts in Wisconsin to address the issue have held that the lender has a PMSI in the whole loan, but that changed with an Oct. 28 opinion by Judge Susan V. Kelley to the contrary.

At issue is 11 U.S.C. 1325(a) of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. The statute provides that a debtor may not bifurcate a loan into secured and unsecured portions, if the lender has a PMSI securing debt incurred to purchase a motor vehicle.

However, PMSI is not defined in the code, but is determined by reference to state law.

Negative Equity

The facts in the recent case are straightforward. Shante D. Crawford bought a 2006 Honda, trading in a 2005 Nisssan. The trade-in value of the Nissan was only $15,000, and the outstanding balance owed on the Nissan was more than $18,300.

Thus, roughly $3,300 of the total loan -– almost $31,000 -– is considered “negative equity.”

The negative equity is not part of the PMSI, Judge Kelley concluded, relying on Article 9 of the Uniform Commercial Code.

Sec. 9-103 defines “purchase-money obligation” as an obligation “incurred as all or part of the price of the collateral or for value given to enable the debtor to acquire rights in or the use of the collateral if the value is in fact so used.”

Kelley concluded that the requirement that the value be “in fact so used” to acquire the collateral means that the PMSI cannot secure antecedent debt in the form of negative equity.

“By its nature, antecedent debt that existed prior to the purchase of the collateral is not a right in the collateral,” Kelley wrote. “And negative equity, as a debt owed on a previous purchase, is clearly antecedent debt.”

The lender argued that sec. 9-103 should be read in context with the Wisconsin Consumer Act, which includes negative equity in the definition of “amount financed,” but Kelley disagreed.

“The consumer finance laws … are not intended to govern the creation or perfection of security interests, but rather to mandate various disclosures and address how finance charges may be computed,” Kelley wrote. “Accordingly, this Court concludes that these statutes should not be read together.”

Applying that holding to Crawford’s loan, Kelley calculated 89 percent of the outstanding loan as attributable to the PMSI, and thus secured, and classified the 11 percent negative equity as a general unsecured claim.

Conflicting Law

The opinion conflicts with two prior opinions from bankruptcy courts in the Eastern District of Wisconsin. In re Dunlap, 383 B.R. 113 (Bankr.E.D.Wis. 2008); and In re Smith, 2008 Bankr. LEXIS 2525 (Bankr.E.D.Wis. June 25, 2008).

Smith actually involved interpretation of Illinois law, but the applicable statutes are not materially different.

Dunlap, however, involved the same Wisconsin statutes as in Crawford’s case.

In Dunlap, Judge James E. Shapiro rested his holding on the same definition as Kelley — “purchase-money obligation” means an obligation “incurred as all or part of the price of the collateral or for value given to enable the debtor to acquire rights in or the use of the collateral if the value is in fact so used.”

By emphasizing different terms in the definition, however, the two reached different results.

Kelley placed the emphasis on the language, “is in fact so used” -– the negative equity part was not used to buy the new car, so it is not secured debt.

However, Shapiro found the controlling language, “to enable.”

Shapiro concluded, “In light of the close nexus between debtors’ acquisition of the new car and the negative equity financing enabling them to purchase this new car, negative equity financing is entitled to be included as part of the PMSI.” In re Dunlap, at 119.

Shapiro also noted that the legislative purpose in enacting 11 U.S.C. 1325(a) was to expand, not diminish, the rights of secured creditors, a purpose served by including negative equity as part of the PMSI.

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