« One-Way ARMs: Stacking the Deck. | Main | Hobson's Choice »

The Case of the Upside-Down Trade-In

posted by Tara Twomey

The more times I read section 1325(a), the more I am convinced that not even Leroy “Encyclopedia” Brown, the wonder boy detective, could solve the mysteries of the “hanging paragraph.” The latest chapter, in what is sure to be a very long series, involves the case of the upside-down trade-in.

An upside-down car is one in which in which the value of the car is less than the amount owed on it. It is not unusual for owners with longer-term loans, low or no down payments, and/or cars that are depreciating rapidly to be “upside-down.” According to J.D. Power and Associates, more than one-third of U.S. car buyers who traded in for a new car in 2005 were upside-down. When an owner of an upside-down car goes to buy a new car, not only must he pay the purchase price of the new car, he must also payoff the negative equity on the old car. Is a loan that includes refinancing of negative equity a purchase money loan, in whole or in part? Does the “hanging paragraph” cover claims in which only a portion of the debt is purchase money? These were the puzzlers faced by the court in the recent case of In re Price, 2007 WL 664534 (Bankr. E.D.N.C. Mar. 6, 2007).

The hanging paragraph in section 1325(a) covers certain claims including those in which the “creditor has a purchase money security interest securing the debt that is the subject of the claim.” The Code does not define the term “purchase money security interest.” Under North Carolina law, and the law of many other states, a “purchase money obligation” is defined as an obligation incurred “as all or 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…” N.C. Gen. Stat. § 25-9-103(a)(2). The creditor in Price argued that the funds used to satisfy the negative equity on the trade-in were part of the purchase money obligation because those funds “enabled” the debtors to purchase the new vehicle. (In other words, we wouldn’t let them finance the car if they didn’t pay off the negative equity). The court disagreed finding that refinancing the negative equity, may have been a convenient option for the consumer and lender, but it was not value given to enable the debtor to acquire rights in the new car.

Next, the creditor argued that if it did not have a purchase money security interest for the full amount, then under the “dual status” rule, it had at least a purchase money security interest in the portion of the debt attributable to the actual purchase price. The court found that the hanging paragraph could apply even where the entire debt was not purchase money, but then rejected the creditor’s argument finding that the near impossibility of determining the actual purchase price precluded the use of the dual status rule. Instead, the court applied the transformation rule and concluded that the creditor’s claim was not secured by a purchase money security interest in any amount. Consequently, the hanging paragraph did not apply.

The two other cases to address this issue have reached different conclusions: In re Peaselee, 2006 WL 3759476 (Bankr. W.D.N.Y. Dec. 22, 2006) held that only claims in which the entire debt was purchase money were covered the hanging paragraph, and In re Graupner, 356 B.R. 907 (Bankr. M.D. Ga. 2006) held that funds used to refinance the negative equity were considered part of the purchase price under Georgia law. All three cases are currently on appeal.

At the end of each Encyclopedia Brown book are the solutions to all the mysteries, “just in case you don’t crack the case.” Unfortunately, when it comes to the hanging paragraph Congress did not give us the same kind of guidance for cracking the Code. It looks like we won’t know how this one ends for quite some time.


Many debtors have loans financing the purchase of warranties, gap insurance and other items on a new car loan. I wonder how the court would analyze those circumstances.

The comments to this entry are closed.


Current Guests

Follow Us On Twitter

Like Us on Facebook

  • Like Us on Facebook

    By "Liking" us on Facebook, you will receive excerpts of our posts in your Facebook news feed. (If you change your mind, you can undo it later.) Note that this is different than "Liking" our Facebook page, although a "Like" in either place will get you Credit Slips post on your Facebook news feed.



  • As a public service, the University of Illinois College of Law operates Bankr-L, an e-mail list on which bankruptcy professionals can exchange information. Bankr-L is administered by one of the Credit Slips bloggers, Professor Robert M. Lawless of the University of Illinois. Although Bankr-L is a free service, membership is limited only to persons with a professional connection to the bankruptcy field (e.g., lawyer, accountant, academic, judge). To request a subscription on Bankr-L, click here to visit the page for the list and then click on the link for "Subscribe." After completing the information there, please also send an e-mail to Professor Lawless ([email protected]) with a short description of your professional connection to bankruptcy. A link to a URL with a professional bio or other identifying information would be great.