Congress added a provision to BAPCPA that appeared to be designed to protect auto lenders who financed cars for debtors within 910 days of the bankruptcy filing. This provision sought to prevent the cramdown of these so-called “910-day loans” in chapter 13 cases and was included in a section of the legislation entitled “Giving Secured Creditors Fair Treatment in Chapter B.” H.R. Rep. No. 109-31 at 72 (2005). Unfortunately, this provision was unnumbered and simply added at the end of §1325(a). Now known as the “hanging paragraph,” the apparent misplacement of this provision, together with its confusing language, has created extensive litigation on a number of issues.
To qualify for the statutory protection from cramdown in chapter 13, a 9l0-day loan must, among other things, constitute a purchase money security interest (PMSI). Some debtors have argued that lenders do not hold the requisite PMSI when the loan also finances debts unrelated to the “price” of the financed car, such as (1) a roll-over of negative equity owed on a trade-in car, (2) pre-payment of “gap” insurance covering the difference between the new car’s value and the total amount financed and/or (3) prepaid extended warranty contract premiums. Several courts have adopted this argument and found that 910 day loans that finance these additional items are no longer PMSI and thus not protected from cram-down by the “hanging paragraph.” This article will explore the different positions taken by Florida bankruptcy courts on the issue.
The term “purchase money security interest” is not defined in the Bankruptcy Code. Courts have looked to the definition of PMSI in state law and more specifically, the Uniform Commercial Code. Bankruptcy courts that have looked at Florida law on this issue have come to different conclusions. In In re Blakeslee, 377 B.R. 724 (Bankr. M.D. Fla. 2007), a car loan was incurred within 910 days of filing. The loan included financing of negative equity in the debtor’s trade-in vehicle. Judge Funk of Jacksonville, Fla., found that the “hanging paragraph” was inapplicable and the debtor could cramdown the secured claim. Judge Funk adopted the reasoning of a New York bankruptcy court in In re Peaslee, 358 B.R. 545, 551 (Bankr. W.D. N.Y. 2006), which held that the inclusion of negative equity in a loan means the loan is no longer a PMSI. In Peaslee, the bankruptcy court looked to New York law and found that a PMSI exists where the collateral secures an obligation “incurred as all or part of the price of the collateral or for part of the price of the collateral or for value given to enable the debtor to acquire rights in or the use of the collateral if the value is in fact so used.” Judge Funk agreed and found the term “price of the collateral” to equal the amount the collateral cost to buy—his price does not include the payoff of negative equity. Judge Funk noted that “negative equity is not used to enable a debtor to acquire rights in the collateral.” Instead, financing negative equity is merely an “accommodation” to facilitate the sale. In other words, there are two separate transactions and the payoff of the old loan is not a prerequisite to the new loan. [ED. NOTE: - as set out below, the bankruptcy court’s holding in Peaslee has been reversed].
Once Judge Funk in Blakeslee determined the obligation to be partially a PMSI and partially a non-PMSI (based on the inclusion of negative equity), the court considered the next step—how to apply the hanging paragraph to a claim that is only partially secured by a PMSI. The court found under well established commercial law, that it had discretion to determine the extent of the PMSI by applying either the “dual status rule” or the “transformation rule.” The dual status rule provides that the secured lender has a purchase money security interest to the extent that the amount financed relates to the purchase price for the collateral. In re Price, 363 B.R. 734, 745 (Bankr. E.D. N.C. 2007). The transformation rule, however, “transforms” the entire secured obligation to non-PMSI (i.e. the non-purchase money component transforms the entire claim into a non-purchase money security interest). Id.
In Blakeslee, Judge Funk found that when a debtor finances negative equity in a 910-day loan, the entire security interest is transformed into a non-PMSI loan. The court reasoned:
While the court agrees that it does have the discretion as to whether to apply the dual status or the transformation rule to a partial purchase money security interest, the court finds that with respect to negative equity, the transformation rule is the appropriate rule to be applied. As the court in Price pointed out, notwithstanding the fact that a sales contract may clearly state the amount of the purported purchase price of a vehicle, a vehicle’s true purchase price and the amount of negative equity is difficult to compute and is in fact a “mystery,” with the actual purchase price being affected by an unreasonably low allowance on a traded in vehicle. Price, 363 B.R. at 745. A creditor’s burden of establishing the difference between the purchase price and advances to pay the debt on the traded in vehicle is “a virtually impossible task.” Id. Moreover, a court is burdened with the task of the allocation of prebankruptcy payments to the purchase money and non¬purchase money portions of the secured debt. Id. The court declines the task of “unwind[ing] the manipulations” which would be foisted upon it were it to apply the dual status rule to the financing of negative equity in retail installment contracts. See Peaslee, 358 B.R. at 560. Accordingly, the court will apply the transformation rule to such situations. [footnote omitted] [The creditor] is not secured by a purchase money security interest in any amount. Consequently, the prohibition against strip down in §1325(a) does not apply and debtor may therefore bifurcate [The creditor’s claim] into secured and unsecured components pursuant to 11 V.S.C. §506(a)(1).
On the same day he issued Blakeslee, Judge Funk issued a decision on a similar issue in In re Honcoop, 377 B.R. 719 (Bankr. M.D. Fla. 2007). In Honcoop, the debtor financed the purchase of a vehicle for $12,000 less than 910 days prior to filing bankruptcy. The debtor also financed an additional $500 for “gap” insurance. The debtor later filed chapter 13 and filed a motion to value the creditor’s secured claim at $4,570. The creditor opposed the valuation motion, arguing that its claim could not be modified based upon the protections of the hanging paragraph.
In Honcoop, Judge Funk applied the same analysis from Blakeslee and adopted the bankruptcy court’s analysis in Peaslee. Judge Funk found that “gap” insurance was not part of the “price of the collateral.” In Honcoop, however, Judge Funk applied the “dual status” rule and not the “transformation rule” because the court found that the contract clearly allocated a specific amount paid for the “gap” insurance. The court was able to calculate the creditor’s PMSI by simply subtracting the cost of the “gap” insurance from the contract amount. Ironically, while the debtor prevailed in Honcoop, the debtor gained very little in the end. The PMSI portion of the secured claim turned out to be $11,500, which was protected by the hanging paragraph and had to be fully paid (with interest) in the plan.
In January 2008, Judge May in Tampa faced the same issues as in Blakeslee and Honcoop, but came to the opposite conclusion. In In re Schwalm,—B.R. uu, 2008 WL 162933 (Bankr. M.D. Fla. January 16, 2008), Judge May rejected the analysis used by Judge Funk in Blakeslee and Honcoop. In particular, Judge May was persuaded by the recent District Court opinion in In re Peaslee, 373 B.R. 252 (W.D. N.Y. 2007), where the district court reversed the bankruptcy court decision relied upon by Judge Funk (i.e. the inclusion of negative equity in the loan took the vehicle out of the 91O-day protections of the hanging paragraph). [Ed. Note: The Peaslee case currently is on appeal to the 2nd Circuit Court of Appeals.] Judge May cited the following from the district court opinion in Peaslee:
It is not apparent why a refinancing of rolled-in negative equity on a trade-in as part of a motor vehicle sale could not constitute an ‘expense incurred in connection with acquiring rights in’ the new vehicle. If the buyer and seller agree to include the payoff of the outstanding balance on the trade-in as an integral part of their transaction. . . it is in fact difficult to see how that could not be viewed as such an expense.
In Schwalm, Judge May pointed out that items such as negative equity and “gap” insurance are specifically authorized to be included in motor vehicle financing. not only under state law, but under the Federal Truth in Lending Law (15 D.S.C. §1601, et seq.) and Regulation Z (12 C.F.R. §226.l8) (these specific items can be included in the “amount financed” in a motor vehicle retail installment contract). Taking a straight-forward approach to the issue, Judge May found that the debtors negotiated a package financing in compliance with state law:
[In 2005] it was already common industry practice, sanctioned by state motor vehicle finance law and the Federal Truth in Lending Law, for automobile dealers to offer buyers packaged financing, which includes the payoff of debt on the trade-¬in vehicle, GAP insurance to protect repayment of that amount and the cost of a service contract. These obligations, by the parties’ negotiation and sanctioned by Florida finance laws (as in other states), have the requisite ‘close nexus’ to the acquisition of the collateral and the secured obligation as explained by Comment 3 to §679-1031 [the Florida DCC].
Judge May found further support for his decision in the legislative history of BAPCPA. Many courts have opined that there is scant, if any, legislative history regarding the 2005 BAPCPA amendments (e.g. there is no Conference Report accompanying the legislation). These courts, however, tend to overlook the apparent intent behind the change in the law to give additional protections to auto lenders who made loans to debtors within 910 days of the bankruptcy filing. As an example of this apparent intent, Judge May pointed to the title of the provision containing the hanging paragraph—Giving Secured Creditors Fair Treatment in Chapter 13” and concluded:
[T]he ‘hanging paragraph’ was adopted to give favored treatment to a limited class of potentially under-secured creditors - those holding a purchase money security interest in a motor vehicle acquired for personal use within the 910 days preceding the bankruptcy petition date. 11 U.S.C. §1325(a). The debtors’ argument carries with it the implicit conclusion that Congress intended the ‘hanging paragraph’ to be inoperative as to a substantial number of lawful auto finance transactions that were industry practice when BAPCPA was enacted. Such an interpretation is not compelled by the text of the ‘hanging paragraph,’ or by its legislative history.
The negative equity issue decided in Blakeslee and Schwalm is currently on appeal before the 1st Circuit in a Georgia case, Graupner v. Nuvell Credit Corp., 2007 WL 1858291 (M.D. Ga. 2007). In Graupner, the creditor argued that under state law, the “price of the collateral” included the negative equity that was included in the total amount financed. The bankruptcy court agreed. The district court affirmed, holding that the price of the collateral included the negative equity:
The trade-in of the vehicle was an integral part of the sales transaction. The value of that trade-in along with its accompanying debt affected the ultimate price that was paid for the new pick-up truck. The negative equity is inextricably intertwined with the sales transaction and the financing of the purchase. This close nexus between the negative equity and this package transaction supports the conclusion that the negative equity must be considered as part of the price of the collateral. [footnote omitted] Accordingly, the court finds that the creditor has a purchase money security interest for the full amount of its debt. Thus, §506 shall not apply to modify the amount of the secured obligation.
Like Schwalm, the district court in Graupner supported its conclusion by referring to the official comments of the drafters of the UCC, which indicate that the price of collateral includes negative equity. See UCC §9-103 cmt. 3 (price of collateral includes “obligations for expenses incurred in connection with acquiring rights in the collatera1”). The district court in Graupner also referred to other statutory authority defining “sales price” in consumer transactions, such as the Federal Truth in Lending Act, 15 U.S.c. §1601, et seq., as implemented by Regulation Z, 12 CFR Pt. 226 (negative equity treated as part of total sales price) and the Georgia Motor Vehicle Sales Finance Act (“cash sales price” includes negative equity).
As these cases show, courts across the country will continue to wrestle with the PMSI issue related to the hanging paragraph until the Circuit Courts of Appeal or the Supreme Court, hopefully, decide the issue.