What happens to a car’s negative equity in bankruptcy?
Lately I’ve been pondering a strange imperfection in the bankruptcy code. If you’re a bankruptcy attorney (as you must be if you make it to the end of this post), you already know about the ‘hanging paragraph’ at 11 U.S.C. 1325(a) of the code. If you’re not an attorney, you might have asked yourself what happens if you’re ‘upside down’ on your car note (i.e. the car is worth less than you owe) when you file for bankruptcy. Unsurprisingly, bankruptcy courts around America do not completely agree about how to interpret this unfortunate paragraph of law. In this post, I’m going to make sense of this fabled piece of law by discussing a few cases involving Washington bankruptcy courts and cars with negative equity. Buckle up.
For reference, here’s the paragraph. In essence, it’s an anti-cramdown rule that congress clumsily included in its 2005 overhaul of the bankruptcy code. (Just skip it if you hate boring stuff.) For purposes of paragraph (5), section 506 shall not apply to a claim described in that paragraph if the creditor has a purchase money security interest securing the debt that is the subject of the claim, the debt was incurred within the 910-day period preceding the date of the filing of the petition, and the collateral for that debt consists of a motor vehicle (as defined in section 30102 of title 49) acquired for the personal use of the debtor, or if collateral for that debt consists of any other thing of value, if the debt was incurred during the 1-year period preceding that filing. 11 U.S.C. 1325(a)
So, to trigger the ‘anti-cramdown’ powers of the hanging paragraph, four things must be true:
The creditor must have a purchase money security interest (“PMSI”); and
The debt was incurred within 910-days prior to the bankruptcy filing; and
The collateral is a car; and
The car was acquired for the debtor’s personal use.
First, let’s talk about things in the context of Chapter 13 Bankruptcy.
In re Wear, Case No. 07-42537 (Bankr. W.D.Wash. 1/23/2008), TLDR: Negative equity from a previous car note which has been rolled into a new car note is not a purchase money security interest, which means the original negative equity is subject to cramdown. In English, the secured part of the debt does not include the negative equity from the previous car note. Zing!
In Wear, the debtors filed for Chapter 13 bankruptcy five months after purchasing two new cars secured by two new notes, which means that element 2 is satisfied. Also, we’re talking about cars the debtor’s bought for themselves, which means elements 3 and 4 are satisfied. The crucial point here is that the debtors traded in their two existing cars and rolled the negative equity from those vehicles into their new car note. [Now, why they didn’t just sell their cars outright, which would have netted them more money than they got from the dealer and avoided this debacle, is beyond the scope of this post.] At any rate, the issue for the court was whether the lender held a purchase money security interest on the entirety of both notes, or just the portions of the notes that did not include negative equity. [Wear at 4.]
The court looked to the provisions of the Uniform Commercial Code as well as an Oregon case called In re Johnson, No. 07- 31717-rld13, 2007 WL 4510288 (Bankr. D. Or. Dec. 19, 2007) to determine how to decide the issue above. Long story short, the court decided that the negative equity from the prior note does not get the same PMSI status as the rest of the note, which means the negative equity from the previous car note is now subject to the almighty cramdown rule of § 506. Let the cramming begin!
The court stayed true to its reasoning in In re Bunge, Case No. 17-44245 (Bankr. W.D. Wash. Apr 16, 2018), where it reaffirmed that negative equity from a previous transaction does not magically become secured by its attachment to a new debt instrument. On the other hand, the court said that all those dodgy aftermarket items dealers like to throw into the deal cannot be crammed down.
What all this means in a Chapter 13 Bankruptcy is that a debtor may not ever have to pay (1) the value of the negative equity from a prior car note, (2) the deficiency balance of a repossessed car, nor (3) the unsecured portion of a current note. Joy.
Now, in the context of Chapter 7 Bankruptcy, the consequences of the hanging paragraph are somewhat different. For one thing, remember that negative equity from an antecedent debt is treated like an unsecured claim. Think about that for a moment. That negative equity was secured up until it was refinanced into the new car note, at which point it became unsecured. So you might be tempted to ask why a car dealer would make a deal like that, and why a lender would accept such a risk. As to the former, trade-ins are typically appraised by a used-car manager who really doesn’t care whether the lender (i.e. creditor) makes money or loses money, while the risk of default is typically analyzed by the lender. This disconnect gives the rare, but painful situation (if you’re the creditor) where wine (a secured claim) is turned into water (an unsecured claim), i.e. where money is potentially lost.
