Positive Treatment for Negative Equity

By: Vitaly Libman
St. John's Law Student
American Bankruptcy Institute Law Review Staff

In the first appellate decision on point, the Eleventh Circuit Court of Appeals held in In re Graupner[1] that the anti-bifurcation protection granted to certain purchase money security interests by BAPCPA’s “hanging paragraph” applies even though the loan includes negative equity. The Second Circuit, meanwhile, opted to defer determination of this issue by certifying the question of whether negative equity is to be included in such purchase money security interests to the New York Court of Appeals.[AA]   In Graupner, the debtor traded in a vehicle with negative equity as part of his purchase of a new car.[2]  Both the purchase price of the new car and the negative equity from the earlier loan were included in the amount financed by the dealer.[3]  Rejecting the debtor’s argument that the inclusion of negative equity meant that the security interest was not a purchase money security interest, the court held that the entire unpaid balance was deemed to be a secured claim, including the negative equity.[4]

The lower courts have split on the proper interpretation of the “hanging paragraph” in section 1325, which was added to the Bankruptcy Code as part of the 2005 BAPCPA amendments.[5] Before the addition of the hanging paragraph, a debtor could bifurcate an allowed claim of a creditor into its secured and unsecured portions in those cases where the collateral (usually an automobile) was worth less than the outstanding debt amount.[6]  This was accomplished under section 506(a), which states that a secured creditor’s claim is an allowed secured claim only to the extent of the value of the collateral and an allowed unsecured claim for the remainder of the allowed claim.[7]  The BAPCPA hanging paragraph changes this result in Chapter 13 cases by treating the entire debt as a secured claim if several conditions are satisfied, specifically: 1) the lien is a “purchase money security interest”; 2) the debt was incurred within 910 days before the filing of bankruptcy; 3) the collateral for the debt was a motor vehicle; and 4) the vehicle was acquired for personal use.[8]  The courts disagree whether negative equity is part of purchase money security interest and thus qualifies for the anti-bifurcation protection of the hanging paragraph.[9] One line of cases views the financing of the new vehicle and negative equity as “two separate transactions memorialized on a single retail installment contract.”[10]  Under this view, the financing of negative equity does not constitute a purchase money security interest.  Other courts view the negative equity as a component of a purchase money security interest because it is part of a package transaction inextricably intertwined with the sales transaction and the financing of the purchase.[11] The Graupner court followed that view and held that the hanging paragraph prevents bifurcation even where negative equity is included in the transaction.[12]

The court relied on Congress’ intent in BAPCPA to curb the abuse of the bankruptcy process.[13]  Since the practice of rolling negative equity into the financing of new vehicle purchases was such a common practice, the court reasoned that Congress would not have intended to exclude this large segment of automobile financings from the anti-bifurcation protection of the hanging paragraph.[14]  Other courts have agreed that one of BAPCPA’s goals was to afford additional protection to creditors, primarily automobile lenders.[15]  However, some courts contend that the hanging paragraph should be narrowly construed since it is an exception to one of the core principles of bankruptcy law, which is equal distribution among like creditors.[16]  Extending anti-bifurcation protection to the negative equity from a prior loan, converts that unsecured debt into secured debt, resulting in a windfall to automobile lenders.[17]  Hence, the court’s decision may have extended statutory protection for automobile lenders beyond Congress’ intentions and practical fairness.