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Calling All Article 9 Supernerds--Negative Equity and State Law

posted by Jean Braucher

What’s a blog for?  For law professors, a key attraction is to float a question you don’t have time to write a law review article about.

As a matter of state (not bankruptcy) law, should a loan be considered all purchase money if the lender makes a consolidation loan for purchase of collateral and also for paying off an old obligation, all secured by the collateral being purchased?  In particular, what are the policy implications for Article 9 purposes of defining purchase money obligation that broadly?

In bankruptcy, the definition of “purchase money security interest” determines the scope of the “hanging paragraph” in chapter 13--specifically, if “negative equity” on an old loan is rolled into a new purchase money loan, whether the whole loan should be treated as a purchase money obligation so that it can’t be crammed down (assuming that is the treatment under the hanging paragraph).

Under state law, the question of the meaning of “purchase money obligation” is not confined to car loans or even consumer loans.  The definition sets the scope of special purchase money provisions in Article 9 that extend to commercial finance for purchase of equipment and inventory.  Should the leap-ahead priority for purchase money obligations apply to rolled in negative equity?   Could this have perverse effects?  In the case of consumer loans for items outside certificate of title laws’ reach (i.e., collateral other than cars and boats), should automatic perfection extend to “negative equity” on some other old loan the balance of which is rolled into a loan for purchase of a washing machine or a diamond ring?

In bankruptcy, there are competing policy arguments about the proper scope of the hanging paragraph.  The car lender argument is that it is unfair for debtors to be able to cram down recent car loans, and a lot of car loans (maybe as high as 40 percent, and growing, of new car loans) involve paying off the unpaid balance on the last car loan.  Another way the argument has been put is that Congress intended only good things for car lenders in the 2005 law.  The opposing argument is that the slight of hand of turning an undersecured loan into a fully secured one should be limited as much as possible because it prejudices (other) unsecured lenders, encourages risky, highly leveraged loans and makes it hard for debtors to afford to hold on to collateral in chapter 13 (that's why we are talking about mortgage cramdown).   Under this view, since the old negative equity isn’t used for purchase of the new car, one can draw a line and exclude negative equity from the reach of the hanging paragraph (and maybe the whole loan, under the “transformation rule” as opposed to the “dual status” rule, but let’s not go there in the interests of getting to the basic state law issue as cleanly and quickly as possible).

So what are the full state law implications of treating as purchase money the negative equity on an old loan when it is rolled into a purchase money loan?  Could this be problematic in commercial secured lending? Could it be troublesome in consumer purchase money lending outside bankruptcy?

These questions are likely to be on the minds of the justices of the New York Court of Appeals when they decide later this year whether, as a matter of state law, a “purchase money obligation” under U.C.C. section 9-103(a)(2) includes old negative equity.  The U.S. Court of Appeals for the Second Circuit certified the question to that court in In re Peaselee  (and also said that the bankruptcy law question should be resolved by interpretation of state law)      http://www.ca2.uscourts.gov:8080/isysnative/RDpcT3BpbnNcT1BOXDA3LTM5NjItYmtfb3BuLnBkZg==/07-3962-bk_opn.pdf .  The NY court accepted the question late last year.  http://www.law.cornell.edu/nyctap/I08_0165.htm  Briefing will be coming up in a few months.

One could argue that using state law on this question in bankruptcy is a mistake.  The state law issue does not involve questions about the extent of cramdown; that is a pure bankruptcy concern.  But the Bankruptcy Code does not define “purchase money security interest,” and using the Butner principle, the Second Circuit said state law determines the definition for bankruptcy purposes.  So let’s assume that state law will control.

So, supernerds, you know who you are.  If you got this far, you probably qualify.  What’s the right policy answer under state law?  As a technical matter, it seems pretty clear that the bankruptcy courts that have treated negative equity as part of purchase money obligations have not understood Article 9.  The history of the definition of purchase money obligation is that it covered credit sales and third-party financing.  The language “incurred in connection with acquiring rights in” the collateral was used to refer to the latter (that is, loans incurred from a third party and used to purchase the collateral from the seller), and not in order to cover paying off old loans by rolling them into a new purchase money loan. See http://www.nacba.org/s/45_50fc1f2acc4e329/  But beyond that technical legal argument, what policy arguments are there that bear on the interpretation issue under state law?


I argued the negatve equity issue in the Fourth Circuit on Tuesday (Janurary 28). (Wells Fargo Finacial Acceptance v. Price) My opponent proposed that the court adopt a federal definition of PMSI, contrary to the holding in Butner. This should be a hard sell since just last June the Fourth Circuit cited Butner in Tidewater Finance v. Kenney in construing the hanging paragraph to not allow a debtor to surrender a vehicle in full satifaction. I began my oral argument by asserting that the court should adopt a state law definition of PMSI. (In my case, the state of NC.) Judge Gregory asked if adopting a state definition of PMSI would result in a non-uniform application of the hanging paragraph. The answer was two-fold. No, it will not, because every state has adopted the "Uniform" Commercial Code, which defines PMSI. Secondly, even if it would result in non-uniformity, that situation would not be unique, since the practice has been to allow states to define claims and interests in property in bankruptcy. Furthermore, the most likely scenario in which non-uniformity will result is the adoption of the rationale of the courts in Graupner (Eleventh Circuit and Georgia district court and bankruptcy courts), Peaslee (New York district court, and GMAC v. Horne (Virginia district court) in which the courts have looked beyond the UCC to state motor vehicle financing laws to define PMSI. There is nothing uniform about these laws. They usually apply only to consumer transactions, and some only apply to seller financing, not third-pary financing.

Billy Brewer
Raleigh, NC

Lets face it--allowing lenders to essentially securitize negative equity as PSMI secured debt is going to encourage them to do it. Maybe not as much in this credit market, but down the road. And, on the mortgage side of things--using refis and seconds and Helocs to cover unsecured debt--we see how well that worked out from a policy perspective.

We will be hearing one next Monday. This helps a lot, as I have to prep the litigating attorney. Will post as soon as we get word... I have word that its before the 5th cir. also.

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