Negative Equity – The Tale Continues

By Michael A. Benoit

A couple months ago, we discussed a situation where two courts addressing the same issue somehow managed to reach opposite conclusions on essentially identical facts. As you may recall, the issue in the Kansas bankruptcy courts was whether negative equity financed in a retail installment sale transaction is protected by a “Purchase Money Security Interest” (PMSI) in the vehicle being financed for purposes of the U.S. Bankruptcy Code. Judge A held that the negative equity was protected (i.e., the creditor’s full claim was secured); Judge B held that it was not.

This is a hot issue, being made all the more so by a pattern of higher delinquencies. In fact, at least four courts addressed the issue during a three-week period in July; two favored including negative equity in the PMSI, and four opposed it. Not a good score for creditors.

The confusion lies in the interpretation of the so-called “hanging paragraph” added to the Bankruptcy Code in 2005 to stem “cram-down” abuses in the auto finance industry (i.e., the practice of limiting the value of a secured creditor’s claim to the actual value of the vehicle secured, as opposed to the full amount of the debtor’s obligation). In a world of 72- and 84-month financing, where a significant percentage of vehicle owners owe more for their cars than they’re actually worth, limiting a secured creditor’s claim to the actual value of the vehicle securing the claim only adds stress to an already stressed industry. The hanging paragraph was intended to give relief to the auto finance industry by making clear that, under certain conditions, the full amount of a debtor’s obligation would be secured.

One of the requirements that must be satisfied to take advantage of the hanging paragraph is that the creditor must have a PMSI in the vehicle securing the debt. Courts attacking the hanging paragraph have focused on whether a creditor can have a PMSI in negative equity.

Until now, only lower courts (i.e., the U.S. Bankruptcy Courts or Federal District Courts) have had the opportunity to weigh in on this issue. But on Aug. 6, the 11th Circuit Court of Appeals (covering Florida, Georgia and Alabama) gave a resounding victory to secured auto finance creditors, holding that negative equity is indeed protected by the PMSI.

The 11th Circuit started by recognizing that the hanging paragraph’s legislative history, “leaves little doubt that its architects intended only good things for car lenders and other lienholders.” That said, the court felt that the hanging paragraphshould be interpreted in a manner that achieved that purpose.
The Court defined its issue simply – “whether negative equity constitutes purchase money” — and noted that, in this case, the answer turned on Georgia law. It found that Georgia law required the inclusion of negative equity in the PMSI at issue because it was “debt for the money required to make the purchase” of the new vehicle.

According to the Court, the negative equity portion of the financing was part of the new car financing transaction. Payment of the trade-in debt was a prerequisite to consummating the sales transaction, and utilizing the negative equity financing was a necessary means to accomplish the purchase of the new vehicle. In short, without the negative equity financing, the transaction would not have occurred.

As for the hanging paragraph, the Court noted that the practice in automobile financing over the years has been to extend the repayment period over longer time frames: from three years in the past to as long as five or more years now. As a result, having negative equity in a vehicle is common. This is true now, and it was true when Congress enacted the hanging paragraph in 2005. So, it seems nonsensical that Congress would have enacted the hanging paragraph to “do good things” for auto lenders if it intended to carve out a significant percentage of transactions because they contain negative equity

So, the good news in the 11th Circuit is that there now is appellate support for protecting negative equity financing. But the tale continues. The 10th Circuit is soon to rule on a case with similar facts and identical issues, and it is entirely possible that the 10th Circuit could reach the opposite conclusion. Stay tuned — this tale may take us all the way to the Supreme Court.

Michael Benoit is a partner in the Washington, D.C., office of Hudson Cook LLP. He is a frequent speaker and writer on a variety of consumer credit topics. He can be reached at 202-327-9705 or mabenoit@hudco.com. Nothing in this article is intended to be legal advice and should not be taken as such. All legal questions should be addressed to competent counsel.