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Auto Lenders Are Now Better Protected in Consumer Bankruptcies

August 1, 2009

By: Catherine K. Hopkin

With the Bankruptcy Abuse Prevention and Consumer Protection Act's (BAPCPA) sweeping revisions to the bankruptcy code came a new provision that had caused uncertainty for auto lenders nationwide.  This provision, which prohibits consumer debtors from breaking down claims for certain auto loans into unsecured and secured portions, was intended to provide more favorable treatment for auto lenders.  The provision applies to debtors who financed motor vehicles within 910 days of their bankruptcy filings, and was supposed to prevent debtors from loading up secured debt on expensive vehicles that they could later reduce in their Chapter 13 bankruptcy proceedings.  However, inconsistent application of the provision resulted in uncertainty for many auto lenders who engage in consumer auto financing until recently, when the U.S. Court of Appeals for the Fourth Circuit issued a ruling that will limit a consumer debtor's ability to break down auto loans into secured and unsecured claims.  The Fourth Circuit includes courts in Maryland, Virginia, West Virginia, South Carolina, and North Carolina, and its decision is binding on bankruptcy claims in these states.

Before BAPCPA was enacted, a debtor could take an auto lender's secured claim and break it into two parts:  a secured claim for the value of the vehicle, and an unsecured claim for the remainder owed to the lender.  This was commonly referred to as a "cramdown" of the claim.  For example, a debtor who owned a vehicle valued at $10,000 with $15,000 of debt on the vehicle could break the lender's claim into a secured claim for $10,000 and an unsecured claim for $5,000.  This was very favorable to the debtor, because he or she could then lump the unsecured claim in with all of the other unsecured claims, which were typically paid only a fraction of the claim amounts.  On the other hand, the debtor had to pay the secured claim in its entirety, with interest.

BAPCPA introduced a new provision that prohibits cramdown of a lender's claim if the claim is a purchase money security interest ("PMSI") in a motor vehicle that was purchased for the debtor's personal use within 910 days of the bankruptcy filing.  Generally stated, a PMSI arises where the money lent is used to purchase the same collateral securing the loan.  This provision seemed fairly straightforward and was intended to provide relief for auto lenders in Chapter 13 bankruptcy proceedings.

However, soon after BAPCPA was enacted, a new issue arose.  Often, auto lenders will allow a customer to trade in an old vehicle with the value assigned to the trade-in being applied to the purchase price on the new vehicle.  In many cases, the customer owes more on the trade-in vehicle than it is worth, and the auto lender pays off the lien on the old vehicle and rolls that amount into the sale price, and consequently the financing, for the new vehicle.  The amount the lender pays off on the trade-in vehicle above the value of the vehicle is referred to as "negative equity."

There was disagreement about whether this negative equity is part of the auto lender's PMSI that is protected from cramdown.  Some courts have found that it is part of the lender's PMSI in the vehicle, and have allowed auto lenders full protection of their claim from cramdown.  Other courts have found that the negative equity itself is not protected from cramdown, but that the rest of the lender's claim is still protected.  And yet other courts find that the negative equity component of the lender's interest destroys the nature of the claim, and that the entire claim may be crammed down just as it could be under pre-BAPCPA law.

Maryland courts have not yet ruled on this issue, but in April 2009, the Fourth Circuit held that a claim including negative equity cannot be bifurcated into secured and unsecured debt.  In its ruling, the Fourth Circuit found that state law governs the definition of a PMSI, and most states define a PMSI as an interest in collateral where the obligor gave value to enable the debtor to acquire rights in or use of the collateral.  Auto financing that includes negative equity does, in fact, enable a debtor to acquire rights in a vehicle; therefore the Fourth Circuit found that a claim including negative equity is a PMSI in its entirety.  Consequently, no portion of an auto lender's claim can be crammed down by a consumer debtor, as long as the vehicle was purchased within 910 days of the debtor's bankruptcy filing.

Maryland auto lenders can now breathe a collective sigh of relief.  Allowing customers to trade in old vehicles and roll negative equity into a new loan will not destroy the lender's status as a fully secured creditor if the customer later files for bankruptcy within 910 days of his or her purchase.

If you have any questions regarding BAPCPA revisions or any other bankruptcy-related issues, please contact Catherine Hopkin at 410.752.9768 or via email at chopkin@tydingslaw.com.

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