Negative equity in car is secured

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The Seventh Circuit has finally resolved an issue that has plagued and divided Wisconsin bankruptcy courts since the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 – whether negative equity used to buy a new car is included as part of the lender’s security interest.

Negative equity exists when a debtor trades in one car to buy another, while owing more on the first car than its trade-in value, and the lender pays off the difference.

The court joined every other circuit to have considered the issue, and held that negative equity is fully secured debt.

According to Eliza Reyes, a bankruptcy attorney at von Briesen & Roper, SC, this has been a big issue for quite some time, and now that it is settled it will make a difference in how debtors craft Chapter 13 plans.

Debtors will have to make larger payments to creditors, if they want to keep their cars, and in cases where there is money to distribute to unsecured creditors, they will get less.

Reyes questioned whether the opinion will make it easier for consumers to obtain loans, however, because the practice is already so common.

Negative equity

Prior to enactment of the 2005 Act, only the value of a car was secured debt when a debtor filed for bankruptcy under Chapter 13. Any remaining amount on the loan was classified as unsecured.

11 U.S.C. 1325(a)(5)(B), enacted as part of the Act, forbids the reduction of a security interest if it was incurred within 910 days of filing bankruptcy, and the security was a car acquired for the debtor’s personal use.

Several Wisconsin courts have held that negative equity is included in collateral. (In re Dunlap, 383 B.R. 113 (Bankr.E.D.Wis.2008); In re Smith, 401 B.R. 343 (Bankr.S.D.Ill.2008); and In re Morey, 414 B.R. 473 (Bankr.E.D.Wis.2009).) Although the Smith case was from Illinois, it was heard by U.S. Bankruptcy Judge Pamela Pepper.

In contrast, Judge Susan V. Kelley held that a creditor does not have a security interest in the entire amount of the loan, but only a partial percentage of it. (In re Crawford, 397 B.R. 461 (Bankr.E.D.Wis.2008).)

Judge Kelley concluded that because a purchase money security interest cannot secure an antecedent debt, and negative equity is an antecedent debt, the security interest cannot include negative equity.

The Seventh Circuit’s opinion rejects that analysis.

The debtor in the case, Aubrey Howard, bought a car from a dealer for roughly $30,000, making a down payment of $4,500. He also traded in his old car, valued at $14,500, even though he still owed $22,500 on it. Thus, he had “negative equity” in the old car of $8,000 at the time of the purchase. The lender paid off the $22,500 as part of the transaction.

Less than 910 days later, Howard filed for Chapter 13 bankruptcy but wanted to keep the car. He argued that the new lender, AmeriCredit Financial Services, did not have a security interest in the debt. The bankruptcy court disagreed.

He appealed, but the Seventh Circuit affirmed, in an opinion by Judge Richard Posner.

The court began, as have the lower courts that have considered the issue, by noting that the Bankruptcy Code does not define “purchase money security interest,” and thus looking to state law for a definition.

In this case, that was Illinois. As the lower courts have noted, however, the relevant Wisconsin statute, sec. 409.103, is identical.

Finding that the statute neither prohibits nor compels any result, the court looked to public policy to support its holding that a creditor can have a secured interest in negative equity.

Citing a study indicating that almost 40 percent of all car sales involve a trade-in with negative equity, the court concluded that negative equity may be essential to the market.

The court also noted the rapid depreciation of cars as a justification.

Posner wrote, “had the creditor been forbidden to wrap the $8,000 in negative equity into its purchase money security interest, it would have had a secured interest of only $27,500 in a car worth $30,000 on the day of sale but probably no more than $24,000 a year later.”

Posner concluded, “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.”

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