The most litigated provision of the Bankruptcy Abuse Prevention and Consumer Protection Act of  2005 (the “Act”) is the hanging paragraph under § 1325(a).  The purpose of this provision under the Act is to prevent debtors from cramming down a secured claim on a vehicle that was purchased within 910 days of the bankruptcy filing, which was purchased for the debtor’s personal use and for which the creditor retained a purchase money security interest.  In spite of the new provision, debtors continue to bifurcate secured claims on automobiles, treating the secured part of the claim as the amount of the value of the vehicle, leaving the remainder to be treated as unsecured.  Because debtors have continued to attempt to bifurcate such 910 claims, creditors have resorted to filing objections to confirmation in courts all over the United States in order to have their claim properly treated as fully secured.

The three North Carolina Bankruptcy Districts have received their fair share of these objections to confirmation.  All three of the bankruptcy districts have issued at least one opinion on the issue of whether the financing of negative equity into a purchase of a vehicle within 910 days of the bankruptcy filing destroys the purchase money security interest of the creditor, which allows for modification and bifurcation of the claim.  Interestingly, these three courts have reached three completely different outcomes. 

The sole issue in these cases is whether the secured claim meets § 1325(a)’s “purchase money” requirement.  The question that is addressed is whether § 1325(a) applies if a secured lender finances negative equity from a buyer’s previous vehicle loan along with the purchase price of the new vehicle.   Debtors generally contend that the secured creditor’s security interest was not “purchase money” because the amount financed usually includes obligations separate from, and in addition to, the purchase price of the vehicle, such as gap insurance and the trade-in value of the car which had negative equity.  The reason for the negative equity is that the amount that the debtor owed on the car was greater than the trade-in allowance given by the seller. 

Creditors argue that the language, plain meaning, and context of § 1325(a) support the position that the negative equity and gap insurance components of the amount financed are included in the purchase money security interest, which the Act protects from “strip down.”  Creditors cite the meaning of purchase money security interest from governing state law statutes and the North Carolina Uniform Commercial Code.  Creditors contend that this gap insurance and negative equity are an integral part of the price of the new vehicle, and the financing of this negative equity enables the debtor to acquire rights in the new vehicle.

There are many opinions across the country which have held that negative equity financing does not destroy the creditor’s purchase money security interest, and other cases which hold the exact opposite, that the negative equity financing does destroy the creditor’s purchase money security interest for purposes of having a fully secured claim. Under the latter scenario, when a security interest includes components that relate to the purchase of the collateral and components that do not, the extent of the secured creditor's purchase money security interest is determined by the application of either the dual status rule or the transformation rule.  The dual status rule takes the approach that a secured debt is comprised of both a purchase money component, representing the collateral’s price, and a non-purchase money component, representing any other additional debt associated with the transaction.  The dual status rule provides that the portion of the claim attributable to the financing of the negative equity may be crammed down because it is not part of the purchase money security interest; however, the remaining portion may not be bifurcated.  Under the dual status rule, the secured lender has a purchase money security interest to the extent that the amount financed relates to the purchase price.  However, under the transformation rule, the secured creditor has no purchase money security interest because the non-purchase money component transforms the entire claim into a non-purchase money security interest.  Where the item is a consumer good, it is within the court's discretion to apply either the dual status rule or the transformation rule. 

The Eastern District of North Carolina Bankruptcy Court published the decision of In re Price in March 2007, and the Court applied the transformation rule in determining that the negative equity financing destroyed the creditor’s purchase money security interest so that it could not retain a fully secured claim for a vehicle purchased within 910 days of the bankruptcy filing.  The Court found that the debtor was able to bifurcate the claim because the purchase money security interest had been destroyed, since the funds advanced to pay the negative equity in the trade-in were not part of the purchase price of the vehicle.  The creditor appealed the Court’s decision, and in November 2007, the District Court reversed the Bankruptcy Court’s decision, and ruled that the dual status rule should govern in a situation in which negative equity has been financed.  This decision is being appealed to the Fourth Circuit Court of Appeals. 

The Middle District of North Carolina Bankruptcy Court entered the decision of In re Conyers in November 2007, and the Court applied the dual status rule, which permits a debtor to bifurcate a claim secured by a 910 vehicle, but only to the extent of the pro rata portion the negative equity represented in the remaining outstanding balance of the loan.  The Court decided that only the portion of the claim that is purchase money is subject to the hanging paragraph and must be paid in full.  This decision is being appealed by the creditor to the District Court.  In July 2008, the District Court entered an order stating that a decision will be rendered once the Fourth Circuit Court of Appeals case of In re Price is decided.

The Western District of North Carolina Bankruptcy Court has issued two identical opinions that reach the opposite result from the In re Price and In re Conyers decisions, finding neither the transformation or dual status rule to apply to negative equity financing of a 910 claim.  In September 2007, the Court found in In re Wall and In re Craig that the financing of a motor vehicle that includes negative equity in a trade-in vehicle may constitute a purchase money security interest that is not subject to modification by the debtor’s Chapter 13 plan.  The Court reasoned that the line of cases that do not permit modification of a secured creditor’s claim is the correct holding in such a circumstance where negative equity is financed.  The Court stated that this conclusion is consistent with the two District Court decisions and one Circuit Court decision that have most recently addressed this issue on appeal.  Furthermore, the Court found that this holding was consistent with the apparent intention of Congress in enacting the language in the hanging paragraph, noting that the intent of Congress in enacting the hanging paragraph seems to be to protect creditors from the abuse of “cram down.”  The Wall case has been converted to Chapter 7, but the Craig decision is being appealed by the Debtors to the District Court.  Subsequent to the appeal being filed, the In re Craig case was dismissed from the District Court because the Debtors converted to Chapter 7.

The interpretation of the hanging paragraph has been contested in many courts across the country, just as it has been litigated in North Carolina bankruptcy courts.  Likewise, the decisions at the national level are just as inconsistent as the results in North Carolina.  Therefore, it is difficult to predict what will be the ultimate interpretation of this provision of the Act.  We will likely see this issue come before the Supreme Court, in order to have a final reconciliation of Congress’ intended effect of the relief afforded by the hanging paragraph.

For more information on this alert, or other bankruptcy law issues please contact Deborah Crowder at 704.342.5316 or dcrowder@poynerspruill.com.