In our October 5, 2009 update, we reported on the line of "negative equity" cases that were especially spawned by the recession. "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, the seller of the new item will assert that the "negative equity" should be counted as part of the seller's purchase money security interest.

In our October 5, 2009 update, we reported that cases, especially at the circuit courts of appeal level, were allowing creditors to treat negative equity as part of the purchase money security interest. This trend has continued.

So it is something of a surprise to find the 9th Circuit Court of Appeals, a circuit generally known as being more liberal and consumer friendly, to come down on the other side. (In re Penrod, 611 F.3d 1158, 9th Cir. 2010)

In re Penrod is a classic negative equity case. The debtor, Marlene Penrod, purchased a Ford Taurus for approximately $25,600 in September 2005. At the time, Penrod traded in her 1999 Ford Explorer, on which she owed over $13,000. She received $6,000 credit on the Ford Explorer, thereby leaving $7,000 in negative equity. Penrod filed for bankruptcy about a year and a half later. The dealer's assignee, AmeriCredit Financial Services, claimed that the $7,000 should be included as part of the purchase money security interest in the Ford Taurus. Penrod took the expected debtor's position, trying to limit the purchase money security interest of AmeriCredit, thereby leaving more equity for other creditors.

In its opinion, the 9th Circuit acknowledged that, "[E]ight circuits have held that a creditor has a purchase money security interest in the negative equity of a debtor's trade-in vehicle." But the court went on," We decline to adopt the reasoning of our sister circuits. We acknowledge that our decision creates a circuit split, and we do not do this lightly."

The court did not break new ground in its opinion. Basically, it adopted the reasoning given in the dissenting opinions of other circuits. Some of the key reasons the court gave for its opinion are:

  • Unlike other circuits, the court did not agree that negative equity could be included in the definition of "purchase money obligation" found in UCC 9-103.  
  • Like other circuits, the court closely reviewed UCC 9-103, Official Comment 3 for examples of "price of collateral" or of "value that is given" to acquire the collateral (an essential element of purchase money). These examples include sales taxes, duties, finance charges, and "other similar obligations." These are examples of "value given to enable" the debtor to acquire the collateral. But, unlike other circuits, the court determined that negative equity was not like the examples in Comment 3. Those examples were transaction costs. In contrast, negative equity is usually much larger and more readily separated from the transaction itself.  
  • Other circuits had looked on negative equity as included within the definition, reasoning that, unless the seller paid off the negative equity of the trade-in, there would likely be no sale. (The opinion cited studies indicating that over a third of vehicle purchases in the United States involve negative equity.) But the 9th Circuit opinion took a different view, seeing negative equity as a form of antecedent debt that could not be included with the purchase money security interest.  
  • "In sum," the court concluded, "we find that a creditor does not have a purchase money security interest in the "negative equity" of a vehicle traded in during a new vehicle purchase."

In our October, 2009 update we discussed the financial implications of these opinions. Courts that permit negative equity to be included as part of the purchase money security interest are favoring new and future creditors who are assured that their entire loan amount is entitled to purchase money priority and these creditors may more readily lend money and provide financing. At that time, the recession's impact was still being severely felt and courts may have been reluctant to issue an opinion that discouraged new financing and credit.

In contrast, the 9th Circuit's opinion was issued in July, 2010. While the recession's effects were not (and are still not) over with, the 9th Circuit could have been more willing to issue a narrower and more conservative opinion in a less severe business climate, particularly in view of the recovery of the auto industry, (the vast majority of the negative equity cases being auto-related).

So now with the clear split on negative equity in the circuit courts of appeals, it seems more likely that a final decision will be with the U.S. Supreme Court. Not only will the result be interesting, but it will also be interesting to speculate on the effect of the then-prevailing economic situation on any opinion issued by the U.S. Supreme Court.