Trade-in Value and Auto Loans After Bankruptcy Reform

In 2005, when Congress enacted PL 109-8, significant changes were in store for the automobile finance industry. Under the prior law, automobile financiers faced the prospect of cram-down or lien stripping, whereby a portion of the amount due on an automobile sales contract could be bifurcated and then treated as unsecured. The effect of this procedure was to substantially reduce the likelihood of the auto lender being repaid the full amount due under the sales contract. PL 109-8 was specifically drafted to prevent this from occurring if a vehicle was purchased within two and one-half years (910 days) prior to the bankruptcy filing and the debt resulted from a purchase money security interest.

Real-World Consequences

Four years after the enactment of PL 109-8, there is as yet little literature on the real-world financial consequences of the 910 provision. However, the literature that does exist indicates the 910 provision has lowered borrowing costs in certain states. According to the staff of the Federal Reserve Bank of New York, in states with high bankruptcy exemptions, interest rates for auto loans declined after 2005. According to this study, auto loan interest spreads declined after PL 109-8 in these states specifically due to the prohibition on cram-down.

Congress intended this prohibition to provide broad protection for automobile lenders. As the precise text of the 910 provision evolved over time, it was modified in ways that make it clear Congress intended the 910-day provision to provide an absolute prohibition on lien stripping within 910 days for debt incurred to purchase an automobile. Thus, the current controversy over whether “negative equity” and other charges associated automobile financing should somehow defeat a portion or all of the protection afforded by the 910-day provision arises from a misreading of, or disregard of, Congressional intent.

Tellingly, even the Congressional opponents of the 910-day provision, who sharply criticized the provision during floor debates, acknowledged that it covered all components of debt incurred to purchase an automobile. The debate in Congress was whether it was wise as a matter of policy to create such an absolute shield. With the enactment of PL 109-8, the debate has shifted from policy to statutory interpretation to implement policy. This article is intended to provide a complete and exhaustive review of the legislative record to assist market actors and courts in this task.

The Automobile Finance Industry

Automobile financing is a crucial part of the American economy. The price for a new car or light truck is typically too high for most consumers to make an outright purchase. The financial system has accordingly developed a variety of different financing options to enable the purchase of a new car or light truck on credit. Many prospective car buyers have a trade-in automobile, the value of which can be part of the down payment for a new car. Rather than attempt to sell it directly, most consumers prefer to trade in a used car or truck to the dealer, who offers an accessible way to dispose of used vehicles.

In many cases, the trade-in vehicle will be subject to an existing lien arising out of a previous financing. In most cases, the debt secured by the existing lien exceeds the value of the vehicle. This difference between value and indebtedness is commonly referred to as “negative equity.” See Wilson & DiChiara, The Changing Landscape of Indirect Automobile Lending, FDIC Supervisory Insights, Summer 2005, at 29. When the trade-in vehicle is subject to an existing lien, the lien must be satisfied before for the purchase of the new vehicle can occur. The attempted sale of a trade-in vehicle without the approval of the prior lienholder will permit that creditor to repossess the vehicle and/or sue the borrower and finance company and the trade-in vehicle will have a cloud title.

A typical consumer can either roll the negative equity into the debt for a new car, or borrow money to pay off the negative equity. For most consumers, the most efficient choice in this circumstance is to roll the negative equity into the new car or trade because this arrangement is cheaper and easier than the alternative of borrowing to eliminate the old debt. Thus, the ability to roll negative equity into the price paid for a new automobile is crucial to the efficient functioning of the auto finance market.

Effects of PL 109-8

Assessing the impact of limiting cram-down in the credit market so soon after enactment is difficult. According to a recent study from the staff of the Federal Reserve Board of New York, auto loan interest rate spreads declined after PL 109-8 in certain states. Thus, based on the research actually available to date, passage of the anti-cramdown provisions in PL 109-8 lowered risk to lenders who have therefore lowered interest rates for borrowers. See Morgan et al., Seismic Effects of the Bankruptcy Reform, FRB Report No. 358 (Feb. 2009).

Overview of Selected Legal Issues

As noted earlier, prior to PL 109-8, the bifurcation of automotive loans was permitted in Chapter 13 Bankruptcy proceedings by virtue of 11 U.S.C. ' 506(a). This procedure permitted an obligation to be treated as secured only to the market value of the collateral, while the remainder of the claim would be treated as an unsecured claim that would be extinguished at the completion of a Chapter 13 bankruptcy plan. PL 109-8 sought to end this practice by inserting an unnumbered paragraph to 11 U.S.C. ' 1325(a), commonly described in court decisions as the “hanging paragraph.” The hanging paragraph generally prohibits debtors from utilizing Section 506 to
bifurcate a creditor's claim on certain motor vehicles into secured and unsecured claims.

Specifically, the hanging paragraph exempts claims from Section 506 bifurcation if:

• the creditor has a purchase money security interest (“PMSI”) securing the debt;
• the debt was incurred within 910 days preceding the date of the bankruptcy filing; and
• the collateral for that debt consists of a motor vehicle the acquired for the personal use of the debtor.

The scope of the hanging paragraph is the topic of much litigation. One of the most litigated questions concerns whether so-called negative equity (debt on a prior vehicle), rolled into a new auto loan, should be treated as part of the PMSI for purposes of the hanging paragraph. Federal courts are presently split into various schools of thought on this question. In order to clarify Congressional, intent, this paper exhaustively reviews the legislative history of the anti-modification provision.

Legislative History

In PL 109-8, Congress prohibited claim bifurcation for certain automobiles by enacting an unnumbered paragraph known as the hanging paragraph. The hanging paragraph provides:

For purposes of paragraph (5), section 506 shall not apply to a claim described in that paragraph if the creditor has a purchase-money security interest securing the debt that is the subject of the claim, the debt was incurred within the 910-day preceding the date of the filing of the petition, and the collateral for that debt consists of a motor vehicle (as defined in section 30102 of title 49) acquired for the personal use of the debtor '

PL 109-8 was under consideration by Congress for nearly a decade. The evidence from the legislative record clearly and unambiguously leads to the conclusion that Congress intended all debt related to the financing of a new vehicle would be protected from bifurcation if incurred within 910 days. The hanging paragraph simply determines how much of that committed disposable income goes to the secured creditor, that enabled the debtor to purchase the new vehicle shortly before bankruptcy, and how much goes to unsecured creditors, such as credit card companies. See Elizabeth Warren, Bankruptcy Reform Then and Now, 12 Am. Bankr. Inst. L. Rev. 299, 318-19 (2004). During Congressional consideration, the House and Senate Judiciary Committees received evidence and testimony on a variety of abuses of the Bankruptcy Code, including the opportunistic use of bifurcation. See Whitford, A History of the Automobile Lender Provisions of PL 109-8, 2007 U. Ill. L. Rev. 143 (2007); Carlson, Cars and Homes in Chapter 13 After the 2005 Amendments to the Bankruptcy Code, 14 Am. Bankr. Inst. L. Rev. 301 (2006); Jensen, A Legislative History of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, 79 Am. Bank. L.J. 485 (2005).

105th Congress

The earliest response in Congress to secured creditor concerns about abuses in the bifurcation and cram-down process was a provision in H.R. 3150, the first version of bankruptcy reform. Unlike the hanging paragraph, Section 110 of this bill amended Section 506 of the Bankruptcy Code. Section 110 was not limited to motor vehicles but was otherwise narrowly focused as to the types of claims that would be immune from bifurcation:

1) [Section 506] subsection (a) shall not apply to an allowed claim to the extent attributable in whole or in part to the purchase price of personal property acquired by the debtor within 180 days of the filing of the
petition ' ;

2) if such allowed claim attributable to the purchase price is secured only by the personal property so acquired, the value of the personal property and the amount of the allowed secured claim shall be the sum of the unpaid principal balance of the purchase price and accrued and unpaid interest and charges at the contract rate ' .”

See H.R. 3150, 105th Cong. ' 128 (1998) (emphasis added).

Section 110 as drafted would have exempted from bifurcation categories of debt other than purchase money security debt. Also, Section 110 would not have protected any secured transaction that was completed more than six months prior to the filing of the bankruptcy petition. Most importantly, the “to the extent” and “in whole or in part” language would have limited the application of the anti-bifurcation rule to the portion of the claim related only to the purchase price, which is but one element of a purchase money security debt. Section 110 was thus very different than the final proposal enacted in PL 109-8.

The companion Senate legislation in the 105th Congress took a different approach. The original version of S. 1301 contained no provision concerning lien stripping or bifurcation. After conducting a hearing during which Congress was asked to address the issue, the Senate Judiciary Committee amended S. 1301 by changing Section 1325 of the Bankruptcy Code to state that Section 506 would be inapplicable to secured indebtedness of any sort or vintage. See S. 1301, 105th Cong. ' 302(a) (1998); Hearing on The Consumer Bankruptcy Reform Act, 105th Cong. 40 (2008).

Section 124 of the conference agreement, which passed the House but was filibustered in the Senate, did not contain the text of the hanging paragraph. See S. Rep. No. 105-794 (1998). Instead, the conference agreement included a five-year look back that applied to all collateral and which retained the limited language of the House bill. This provision reads:

See Sec. 124. Restraining Abusive Purchases On Secured Credit. Section 506 of title 11, United States Code, is amended by adding at the end of the following: (e) In an individual case under chapters 7, 11, 12, or 13 ' (1) subsection (a) shall not apply to an allowed claim to the extent attributable in whole or in part to the purchase price of personal property acquired by the debtor within 5 years of the filing of the petition, except for the purpose of applying paragraph (3) of this subsection;

(2) if such allowed claim attributable to the purchase price is secured only by the personal property so acquired, the value of the personal property and the amount of the allowed secured claim shall be the sum of the unpaid principal balance of the purchase price and accrued and unpaid interest and charges at the contract rate;

(3) if such allowed claim attributable to the purchase price is
secured by the personal property so acquired and other property, the value of the security may be determined under subsection (a), but the value of the security and the amount of the allowed secured claim shall be not less than the unpaid principal balance of the purchase price of the personal property acquired and unpaid interest and charges at the contract rate; and

(4) in any subsequent case under this title that is filed by or against the debtor in the 2-year period beginning on the date the petition is filed in the original case, the value of the personal property and the amount of the allowed secured claim shall be deemed to be not less than the amount provided under paragraphs (2) and (3).

The Joint Explanatory Statement indicated only that this outcome was a compromise between the House and Senate. See Rep. No. 105-794, at 122 (1998).

Conclusion

Part Two of this article discusses additional legislation and provides an overview of what it means to the bankruptcy practitioner.

John McMickle is a partner in Winston & Strawn LLP's federal governmental relations and regulatory affairs practice group, practicing in the firm's Washington, DC, office. McMickle represents clients before Congress and administrative agencies. He may be reached at [email protected]. The author gratefully acknowledges Financial Services Roundtable's Anthony T. Cluff Research Fund for support in writing this article.

In 2005, when Congress enacted PL 109-8, significant changes were in store for the automobile finance industry. Under the prior law, automobile financiers faced the prospect of cram-down or lien stripping, whereby a portion of the amount due on an automobile sales contract could be bifurcated and then treated as unsecured. The effect of this procedure was to substantially reduce the likelihood of the auto lender being repaid the full amount due under the sales contract. PL 109-8 was specifically drafted to prevent this from occurring if a vehicle was purchased within two and one-half years (910 days) prior to the bankruptcy filing and the debt resulted from a purchase money security interest.

Real-World Consequences

Four years after the enactment of PL 109-8, there is as yet little literature on the real-world financial consequences of the 910 provision. However, the literature that does exist indicates the 910 provision has lowered borrowing costs in certain states. According to the staff of the Federal Reserve Bank of New York, in states with high bankruptcy exemptions, interest rates for auto loans declined after 2005. According to this study, auto loan interest spreads declined after PL 109-8 in these states specifically due to the prohibition on cram-down.

Congress intended this prohibition to provide broad protection for automobile lenders. As the precise text of the 910 provision evolved over time, it was modified in ways that make it clear Congress intended the 910-day provision to provide an absolute prohibition on lien stripping within 910 days for debt incurred to purchase an automobile. Thus, the current controversy over whether “negative equity” and other charges associated automobile financing should somehow defeat a portion or all of the protection afforded by the 910-day provision arises from a misreading of, or disregard of, Congressional intent.

Tellingly, even the Congressional opponents of the 910-day provision, who sharply criticized the provision during floor debates, acknowledged that it covered all components of debt incurred to purchase an automobile. The debate in Congress was whether it was wise as a matter of policy to create such an absolute shield. With the enactment of PL 109-8, the debate has shifted from policy to statutory interpretation to implement policy. This article is intended to provide a complete and exhaustive review of the legislative record to assist market actors and courts in this task.

The Automobile Finance Industry

Automobile financing is a crucial part of the American economy. The price for a new car or light truck is typically too high for most consumers to make an outright purchase. The financial system has accordingly developed a variety of different financing options to enable the purchase of a new car or light truck on credit. Many prospective car buyers have a trade-in automobile, the value of which can be part of the down payment for a new car. Rather than attempt to sell it directly, most consumers prefer to trade in a used car or truck to the dealer, who offers an accessible way to dispose of used vehicles.

In many cases, the trade-in vehicle will be subject to an existing lien arising out of a previous financing. In most cases, the debt secured by the existing lien exceeds the value of the vehicle. This difference between value and indebtedness is commonly referred to as “negative equity.” See Wilson & DiChiara, The Changing Landscape of Indirect Automobile Lending, FDIC Supervisory Insights, Summer 2005, at 29. When the trade-in vehicle is subject to an existing lien, the lien must be satisfied before for the purchase of the new vehicle can occur. The attempted sale of a trade-in vehicle without the approval of the prior lienholder will permit that creditor to repossess the vehicle and/or sue the borrower and finance company and the trade-in vehicle will have a cloud title.

A typical consumer can either roll the negative equity into the debt for a new car, or borrow money to pay off the negative equity. For most consumers, the most efficient choice in this circumstance is to roll the negative equity into the new car or trade because this arrangement is cheaper and easier than the alternative of borrowing to eliminate the old debt. Thus, the ability to roll negative equity into the price paid for a new automobile is crucial to the efficient functioning of the auto finance market.

Effects of PL 109-8

Assessing the impact of limiting cram-down in the credit market so soon after enactment is difficult. According to a recent study from the staff of the Federal Reserve Board of New York, auto loan interest rate spreads declined after PL 109-8 in certain states. Thus, based on the research actually available to date, passage of the anti-cramdown provisions in PL 109-8 lowered risk to lenders who have therefore lowered interest rates for borrowers. See Morgan et al., Seismic Effects of the Bankruptcy Reform, FRB Report No. 358 (Feb. 2009).

Overview of Selected Legal Issues

As noted earlier, prior to PL 109-8, the bifurcation of automotive loans was permitted in Chapter 13 Bankruptcy proceedings by virtue of 11 U.S.C. ' 506(a). This procedure permitted an obligation to be treated as secured only to the market value of the collateral, while the remainder of the claim would be treated as an unsecured claim that would be extinguished at the completion of a Chapter 13 bankruptcy plan. PL 109-8 sought to end this practice by inserting an unnumbered paragraph to 11 U.S.C. ' 1325(a), commonly described in court decisions as the “hanging paragraph.” The hanging paragraph generally prohibits debtors from utilizing Section 506 to
bifurcate a creditor's claim on certain motor vehicles into secured and unsecured claims.

Specifically, the hanging paragraph exempts claims from Section 506 bifurcation if:

• the creditor has a purchase money security interest (“PMSI”) securing the debt;
• the debt was incurred within 910 days preceding the date of the bankruptcy filing; and
• the collateral for that debt consists of a motor vehicle the acquired for the personal use of the debtor.

The scope of the hanging paragraph is the topic of much litigation. One of the most litigated questions concerns whether so-called negative equity (debt on a prior vehicle), rolled into a new auto loan, should be treated as part of the PMSI for purposes of the hanging paragraph. Federal courts are presently split into various schools of thought on this question. In order to clarify Congressional, intent, this paper exhaustively reviews the legislative history of the anti-modification provision.

Legislative History

In PL 109-8, Congress prohibited claim bifurcation for certain automobiles by enacting an unnumbered paragraph known as the hanging paragraph. The hanging paragraph provides:

For purposes of paragraph (5), section 506 shall not apply to a claim described in that paragraph if the creditor has a purchase-money security interest securing the debt that is the subject of the claim, the debt was incurred within the 910-day preceding the date of the filing of the petition, and the collateral for that debt consists of a motor vehicle (as defined in section 30102 of title 49) acquired for the personal use of the debtor '

PL 109-8 was under consideration by Congress for nearly a decade. The evidence from the legislative record clearly and unambiguously leads to the conclusion that Congress intended all debt related to the financing of a new vehicle would be protected from bifurcation if incurred within 910 days. The hanging paragraph simply determines how much of that committed disposable income goes to the secured creditor, that enabled the debtor to purchase the new vehicle shortly before bankruptcy, and how much goes to unsecured creditors, such as credit card companies. See Elizabeth Warren, Bankruptcy Reform Then and Now, 12 Am. Bankr. Inst. L. Rev. 299, 318-19 (2004). During Congressional consideration, the House and Senate Judiciary Committees received evidence and testimony on a variety of abuses of the Bankruptcy Code, including the opportunistic use of bifurcation. See Whitford, A History of the Automobile Lender Provisions of PL 109-8, 2007 U. Ill. L. Rev. 143 (2007); Carlson, Cars and Homes in Chapter 13 After the 2005 Amendments to the Bankruptcy Code, 14 Am. Bankr. Inst. L. Rev. 301 (2006); Jensen, A Legislative History of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, 79 Am. Bank. L.J. 485 (2005).

105th Congress

The earliest response in Congress to secured creditor concerns about abuses in the bifurcation and cram-down process was a provision in H.R. 3150, the first version of bankruptcy reform. Unlike the hanging paragraph, Section 110 of this bill amended Section 506 of the Bankruptcy Code. Section 110 was not limited to motor vehicles but was otherwise narrowly focused as to the types of claims that would be immune from bifurcation:

1) [Section 506] subsection (a) shall not apply to an allowed claim to the extent attributable in whole or in part to the purchase price of personal property acquired by the debtor within 180 days of the filing of the
petition ' ;

2) if such allowed claim attributable to the purchase price is secured only by the personal property so acquired, the value of the personal property and the amount of the allowed secured claim shall be the sum of the unpaid principal balance of the purchase price and accrued and unpaid interest and charges at the contract rate ' .”

See H.R. 3150, 105th Cong. ' 128 (1998) (emphasis added).

Section 110 as drafted would have exempted from bifurcation categories of debt other than purchase money security debt. Also, Section 110 would not have protected any secured transaction that was completed more than six months prior to the filing of the bankruptcy petition. Most importantly, the “to the extent” and “in whole or in part” language would have limited the application of the anti-bifurcation rule to the portion of the claim related only to the purchase price, which is but one element of a purchase money security debt. Section 110 was thus very different than the final proposal enacted in PL 109-8.

The companion Senate legislation in the 105th Congress took a different approach. The original version of S. 1301 contained no provision concerning lien stripping or bifurcation. After conducting a hearing during which Congress was asked to address the issue, the Senate Judiciary Committee amended S. 1301 by changing Section 1325 of the Bankruptcy Code to state that Section 506 would be inapplicable to secured indebtedness of any sort or vintage. See S. 1301, 105th Cong. ' 302(a) (1998); Hearing on The Consumer Bankruptcy Reform Act, 105th Cong. 40 (2008).

Section 124 of the conference agreement, which passed the House but was filibustered in the Senate, did not contain the text of the hanging paragraph. See S. Rep. No. 105-794 (1998). Instead, the conference agreement included a five-year look back that applied to all collateral and which retained the limited language of the House bill. This provision reads:

See Sec. 124. Restraining Abusive Purchases On Secured Credit. Section 506 of title 11, United States Code, is amended by adding at the end of the following: (e) In an individual case under chapters 7, 11, 12, or 13 ' (1) subsection (a) shall not apply to an allowed claim to the extent attributable in whole or in part to the purchase price of personal property acquired by the debtor within 5 years of the filing of the petition, except for the purpose of applying paragraph (3) of this subsection;

(2) if such allowed claim attributable to the purchase price is secured only by the personal property so acquired, the value of the personal property and the amount of the allowed secured claim shall be the sum of the unpaid principal balance of the purchase price and accrued and unpaid interest and charges at the contract rate;

(3) if such allowed claim attributable to the purchase price is
secured by the personal property so acquired and other property, the value of the security may be determined under subsection (a), but the value of the security and the amount of the allowed secured claim shall be not less than the unpaid principal balance of the purchase price of the personal property acquired and unpaid interest and charges at the contract rate; and

(4) in any subsequent case under this title that is filed by or against the debtor in the 2-year period beginning on the date the petition is filed in the original case, the value of the personal property and the amount of the allowed secured claim shall be deemed to be not less than the amount provided under paragraphs (2) and (3).

The Joint Explanatory Statement indicated only that this outcome was a compromise between the House and Senate. See Rep. No. 105-794, at 122 (1998).

Conclusion

Part Two of this article discusses additional legislation and provides an overview of what it means to the bankruptcy practitioner.

John McMickle is a partner in Winston & Strawn LLP's federal governmental relations and regulatory affairs practice group, practicing in the firm's Washington, DC, office. McMickle represents clients before Congress and administrative agencies. He may be reached at [email protected]. The author gratefully acknowledges Financial Services Roundtable's Anthony T. Cluff Research Fund for support in writing this article.