In our update of October 20, 2008, we reported on whether "negative equity" can be part of a purchase money security interest. ( "Negative equity" is the excess of the amount owed on a trade-in item over the market value of the item. If the item is traded-in, the seller of the new, replacement item, will usually pay the entire balance owed on the trade-in item, including the "negative equity." If the buyer later goes into bankruptcy, should this "negative equity" be counted as part of the seller's purchase money security interest or should it be considered an unsecured claim?

Initially, it appeared courts were coming down on the side of treating "negative equity" as not part of the purchase money security interest. However, more recently, higher courts of appeal are allowing creditors to treat "negative equity" as part of the purchase money security interest. (See, for example, In re Ford, 574 F.3d 1279 (10th Circuit Court of Appeals 2009) and In re Mierkowski, 2009 WL 28353586 (8th Circuit Court of Appeals 2009))

The vast majority of cases, so far, have dealt with trade-ins of automobiles to finance the purchase of a new automobile. In this regard, the cases can be viewed narrowly as interpreting the infamous "hanging paragraph" of the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act ("BAPCPA"). The "hanging paragraph" basically protects creditors holding a purchase money security interest from certain adverse treatment in bankruptcy. (U.S. Bankruptcy Code Section 506) So a creditor holding a purchase money security interest is in a better position in the event of a bankruptcy. Conversely, competing creditors and the bankrupt debtor will be in a more favorable position to the extent an obligation is not considered a purchase money security interest in bankruptcy.

A related law is Article 9 of the Uniform Commercial Code (the law governing sales) which, as the name implies, is generally uniform among all the states. Although BAPCPA does not define "purchase money security interest," Article 9 does. So most courts look to Article 9 to interpret BAPCPA's reference to "purchase money security interest." Basically, a purchase money security interest is the security for the "enabling loan" that enables the debtor to acquire the collateral. A dealer who finances the purchase of an automobile is an example of a creditor making an "enabling loan" permitting the debtor to acquire the automobile. But Article 9 also permits other amounts loaned to be part of the purchase money security interest, such as sales taxes, finance charges, expenses of collection and enforcement, and similar charges.

So whether negative equity should be included as part of the purchase money security interest requires close review of two statutes and courts have not answered the question consistently. This is why the trend toward treating negative equity as part of the purchase money security interest is significant.

But there is more at stake. One judge noted that, "Admittedly, in today's market an agreement to finance negative equity is frequently part of the transaction. . . . The fact [is] that financing negative equity has become a customary industry practice, and [the] practical reality necessary to many motor vehicle sales transactions . . ." (In re Mierkowski, Id at 11).

So the treatment of negative equity is not just a narrow issue of interpreting an unclear statute. Permitting creditors to include negative equity in their purchase money security interest will encourage financing and sales. For example, take a creditor accepting a trade-in with negative equity. If the negative equity is not treated as part of the purchase money security interest, the creditor has a dilemma. If the creditor does not pay off the entire loan balance of the trade-in, the sale will probably not take place. If the creditor pays the entire amount of the loan balance, the creditor is in a riskier position, as some of its payoff will be an unsecured obligation.

But there are competing interests. As we noted, creditors with a purchase money security interest will not be forced to accept unfavorable treatment in a bankruptcy, making it more difficult for bankrupt consumers. On the other hand, creditors with confidence that their entire loan amount is entitled to purchase money priority may more readily lend money to consumers and provide more financing to encourage the economic recovery. So, in this respect, the courts of appeal that are protecting the security interest of creditors are adding their own contribution to the "stimulus plan."

Given the differences in the courts on the treatment of "negative equity," a final decision may end up with the U.S. Supreme Court. But that is a long way in the future. No one knows what the economic situation will be at that time and what role, if any, it will play in any final decision.