Aubrey Howard v. AmeriCredit Financial Services ( 2010 )

In the
United States Court of Appeals
For the Seventh Circuit
No. 09-3181
IN RE:
A UBREY H OWARD ,
Debtor-Appellant.
A MERIC REDIT F INANCIAL S ERVICES,
Creditor-Appellee.
Appeal from the United States Bankruptcy Court
for the Northern District of Illinois, Eastern Division.
No. 08-B-32998—Jacqueline P. Cox, Bankruptcy Judge.
A RGUED JANUARY 12, 2010—D ECIDED M ARCH 1, 2010
Before P OSNER, F LAUM, and W ILLIAMS, Circuit Judges.
P OSNER, Circuit Judge. This direct appeal from the
bankruptcy court, pursuant to 28 U.S.C. § 158(d)(2)(A),
requires us to consider an issue that is new in this
court. It is whether the bankruptcy court’s “cramdown”
power in a Chapter 13 bankruptcy (the counterpart, for
an individual, to corporate reorganization in bank-
ruptcy—Chapter 11) extends to an automobile dealer’s, or
2 No. 09-3181
other creditor’s, taking a security interest in a customer’s
“negative equity” in his traded-in vehicle. (Often as in
this case the financing of the purchase of a car is done by
a finance company rather than by the dealer who sells
the car. So when we refer to the “creditor,” it is to the
finance company rather than to the dealer.)
The issue presented by the appeal requires some ex-
plaining, beginning with “cramdown,” which means
forcing a secured creditor to take cash in lieu of his collat-
eral. The bankruptcy judge first determines the market
value of the collateral. The creditor’s claim is treated as
a secured claim to the extent of that value. If the value
is less than the unpaid balance of the secured loan, the
difference is demoted to being an unsecured claim of
the creditor. 11 U.S.C. § 506(a)(1). In a Chapter 13 bank-
ruptcy, the debtor gets to keep the collateral over the
objection of his creditor, provided that the plan requires
him to make payments (for example, monthly) to the
creditor equivalent to the market value of the collateral,
as calculated by the court. 11 U.S.C. § 1325(a)(5)(B).
If the bankruptcy judge values the collateral accurately
and the debtor makes the payments that the plan
requires, the creditor is no worse off than he would be
had he foreclosed his secured interest. But if the judge
undervalues the collateral, the creditor is worse off,
while if the judge overvalues it the debtor will surrender
the collateral to the creditor (for if it is overvalued, this
means that the monthly payments that the debtor is
required to make to retain the collateral will exceed its
value), who will not be able to sell it for more than the
No. 09-3181 3
market price. Bankruptcy judges sometimes misvalue
collateral. If we assume that their errors are unbiased,
in half the cases of misvaluation the creditor is made
worse off by cramdown and in the other half he is made
no better off, and thus he is systematically disadvantaged
by the availability of cramdown. In re Wright, 492 F.3d
829, 830 (7th Cir. 2007). Heads he loses, tails he wins
nothing.
The creditor is further disadvantaged because the
debtor may default on his payment obligations,
forcing the creditor to repossess the collateral at a time
when it may have greatly depreciated in value. Associates
Commercial Corp. v. Rash, 520 U.S. 953, 962-63 (1997). It is
only a small consolation to the creditor that he retains
an unsecured claim to the difference between what he
is owed and what he retains of his secured interest after
cramdown, because unsecured claims in bankruptcy
are usually worth little.
Both the asymmetric consequences of misvaluation by
bankruptcy judges and the risk of second defaults (the
debtor’s defaulting on his payment obligations under
the plan) operate to the special disadvantage of car
dealers because cars depreciate in value so rapidly (often
by as much as 20 percent in the first year), with the result
that the effect of cramdown is to shrivel the dealer’s
(or, as in this case, a finance company’s) secured interest.
In response to complaints from dealers and their finan-
ciers, Congress added (as part of the Bankruptcy Abuse
Prevention and Consumer Protection Act) a paragraph
at the end of 11 U.S.C. § 1325(a), which is the section that
4 No. 09-3181
authorizes cramdowns in Chapter 13 bankruptcies. The
paragraph (confusingly referred to in the cases as the
“hanging paragraph” because it doesn’t have a sub-
section designation) forbids the use of the cramdown
power to reduce a purchase money security interest if
the debt secured by that interest was incurred within
910 days before the declaration of bankruptcy and the
security was a motor vehicle that had been acquired for
the debtor’s personal use. The worry behind the para-
graph is that a car buyer who has financed his purchase
will declare bankruptcy under Chapter 13 and propose,
and obtain approval of, a plan that allows him to keep
the car by paying the creditor, in installments, just its
depreciated value as determined by the bankruptcy judge.
The debtor in this case bought a car from a dealer in
Illinois (and so their contractual relation is governed by
Illinois law). The purchase was financed by a purchase
money security interest—and sure enough, within
910 days the debtor declared bankruptcy under Chapter 13.
The price of the car was $30,000 (we round off all
figures to the nearest $500). The debtor made a cash
down payment of $4,500 and in addition traded in his
old car, which was valued in the contract of sale for the
new car at $14,500. But he had not paid off the loan
that had financed the purchase of that car; he still owed
$22,500, making his equity in the old car a minus $8,000.
In other words, he had “negative equity” in the old car.
“Equity” is the difference between the value of a
property and the debt on it, and if the debt is greater
than that value the equity is a negative number.
No. 09-3181 5
The financing of the purchase of the new car included
the $8,000. So instead of borrowing $25,500 (the purchase
price of $30,000 minus the down payment of $4,500) to
finance the purchase (plus $2,000 to cover taxes and fees,
for a total of $27,500), the plaintiff borrowed $35,500:
$27,500 plus the $8,000 in negative equity. The loan on
the plaintiff’s old car came due when it was sold, as a
trade-in, to the new dealer, whose finance company
discharged the lien on the trade-in by paying the old
dealer (or its finance company) the $22,500 that the
buyer owed on the old car.
The question is whether the $8,000 paid to cover the
negative equity on the trade-in is subject to the bank-
ruptcy judge’s cramdown power. The plaintiff says it is
because the car is the only thing (aside from some or all
of the $2,000 in taxes and fees, as we’ll see) in which a
creditor has a purchase money security interest. The
creditor claims it isn’t because the purchase money
security interest includes the negative equity. The bank-
ruptcy judge sided with the creditor, ruling, in agree-
ment with all the reported appellate decisions to date,
see In re Peaslee, 585 F.3d 53, 57 (2d Cir. 2009) (per curiam);
In re Mierkowski, 580 F.3d 740, 742-43 (8th Cir. 2009);
In re Dale, 582 F.3d 568, 573-75 (5th Cir. 2009); In re
Ford, 574 F.3d 1279, 1283-86 (10th Cir. 2009); In re
Price, 562 F.3d 618, 624-29 (4th Cir. 2009); In re Graupner,
537 F.3d 1295, 1300-03 (11th Cir. 2008), that a purchase
money security interest in a car includes negative equity.
The Bankruptcy Code does not define purchase
money security interest, and generally and in the present
6 No. 09-3181
setting the rights enforced in bankruptcy are rights
created by state law. Travelers Casualty & Surety Co. v.
Pacific Gas & Electric Co., 127 S. Ct. 1194, 1204-05 (2007);
Butner v. United States, 440 U.S. 48, 54-57 (1979); In re
Wright, supra, 492 F.3d at 832-33; In re Carlson, 263 F.3d
748, 750-51 (7th Cir. 2001); In re Dale, supra, 582 F.3d at
573; In re Price, supra, 562 F.3d at 624. So we go to
Article 9 of the Uniform Commercial Code, in force in
Illinois as in every state, 810 ILCS 5/9-101 et seq., which
defines security interests in personal property, including
cars, and so is the natural place to look for the answer
to our question. But the Code does not mention negative
equity. It does, however, define a “purchase-money
obligation”: it is “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 col-
lateral if the value is in fact so used.” UCC § 9-103(a)(2).
The “value given” part of the definition is intended
to make clear that the obligation can be to a finance
company, as in this case, rather than to the seller.
A “purchase-money security interest” is a security
interest in the item purchased. UCC §§ 9-103(a)(1), (b)(1).
But it does not include just the price of the item, in
this case the new car bought by the plaintiff. A comment
to UCC § 9-103(a)(2) (comment 3) says that “the ‘price’ of
the collateral or the ‘value given to enable’ includes
obligations for expenses incurred in connection with
acquiring rights in the collateral, sales taxes, duties,
finance charges, interest, freight charges, costs of storage
in transit, demurrage, administrative charges, expenses
of collection and enforcement, attorney’s fees, and other
No. 09-3181 7
similar obligations . . . . [But] a security interest does not
qualify as a purchase money-security interest if a
debtor acquires property on unsecured credit and sub-
sequently creates the security interest to secure the pur-
chase price.” So if the purchaser’s promissory note pro-
vides that in the event of default he shall owe, in addi-
tion to unpaid principal and accrued interest, an
attorney’s fee of 15 percent of the amount due, and he
does default, the purchase money security interest
includes the attorney’s fee. At the other extreme,
suppose the purchaser has unsecured credit card debt
which he offers to roll over to the creditor who is
financing his car purchase. The creditor pays off the
debt, which the purchaser then owes the creditor. That
additional debt would not be part of the purchase
money security interest and so would be subject to the
cramdown power of the bankruptcy court.
Where does negative equity fit in this spectrum?
The creditor emphasizes that Illinois like other states
has a statute specifically regulating the sale of cars on
credit. (These statutes have figured prominently in the
reasoning of some of the courts that have held that nega-
tive equity can be part of a purchase money security
interest.) The Illinois Motor Vehicle Retail Installment
Sales Act provides that the “amount financed” by the
dealer or the finance company includes not only the
“cash sale price” but also “all other charges individually
itemized, which are included in the amount financed,
including the amount actually paid or to be paid by the seller
pursuant to an agreement with the buyer to discharge a security
8 No. 09-3181
interest, lien interest, or lease interest on the property traded
in, but which are not part of the finance charge, minus the
amount of the buyer’s down payment in money or goods.”
815 ILCS 375/2.8. Another section defines “deferred
payment price” as the “total of (1) the cash sale price . . .,
(2) all other charges individually itemized which are
included in the amount financed but which are not a part
of the finance charge, and (3) the finance charge.” 815 ILCS
375/2.10. The portion of the statute that we have
italicized is an exact description of the transaction in-
volving the negative equity in the plaintiff’s trade-in.
The creditor paid to discharge the security interest in
the trade-in and included the payment in the credit
extended to the plaintiff to enable him to buy the car.
The negative equity was part of the “deferred payment
price,” just as if the dealer had charged $8,000 more for
the car.
Article 9 of the UCC states that transactions governed
by it are subject to statutes that establish “a different rule
for consumers,” UCC § 9-201, which in Illinois includes
the Motor Vehicle Retail Installment Sales Act. 810 ILCS
5/9-201(b)(2). (We cite Illinois’s version of the UCC here
because it refers specifically to the Motor Vehicle
Retail Installment Sales Act.) The Act, read literally,
allows a car dealer or financier to include negative
equity in the amount of the price of the car that he
finances, just as he can include an attorney’s fee. End of
case? Probably not; probably the Act shouldn’t be read
literally as encompassing our case. It’s a consumer-pro-
tection statute, intended to require disclosure of the
charges that make up the total price that a consumer pays
No. 09-3181 9
for the car, rather than to prescribe what is and is not
included in the purchase money security interest. But it
is at least evidence that negative equity is indeed a com-
mon element of a credit purchase of a car, and this will
turn out to be important in our analysis.
If we set the Motor Vehicle Retail Installment Sales Act
to one side, we are left with the UCC comment that says
that a purchase money security interest includes “obliga-
tions for expenses incurred in connection with acquiring
rights in the collateral”—and that seems a pretty good
description of negative equity. It is an obligation
assumed by the buyer of the car in connection with his
acquiring ownership.
But we should consider the effect on other creditors
of including negative equity in the purchase money
security interest. That security interest enjoys priority
should the purchaser default, and is thus an exception
to the general rule that existing secured debt has
priority over new secured interests in the same goods.
UCC § 9-324(a); 4 James J. White & Robert S. Summers,
Uniform Commercial Code § 33-4, pp. 320-21 (6th ed. 2010).
The concern behind the general rule is that new ex-
tensions of credit increase the risk of default on the old.
See Hideki Kanda & Saul Levmore, “Explaining Creditor
Priorities,” 80 Va. L. Rev. 2103, 2111-14 (1994). The pur-
chase money security interest is therefore limited, as
the name implies, to newly purchased property, so that
the effect on the debtor’s existing secured creditors is
limited even if their credit agreements with the debtor
include “after-acquired property” clauses, which would
10 No. 09-3181
give them a security interest in the debtor’s subsequently
acquired property. Salem National Bank v. Smith, 890
F.2d 22 (7th Cir. 1989). Such clauses do not generally
extend to consumer goods, UCC § 9-204(b)(1), but neither
are purchase money security interests limited to such
goods; and so the effect of such interests in the com-
mercial as distinct from consumer context is relevant to
understanding the concept of such a security interest
and helps us see why such interests are given priority.
Even the debtor’s unsecured creditors are harmed less
by the priority of a purchase money security interest
than they would be by the debtor’s borrowing against
his existing assets, because the debt created by the pur-
chase money security interest is partially offset by the
value of the property bought with it. This isn’t
true when the debtor, having acquired property
with unsecured credit, grants the unsecured creditor
a security interest in the property. The comment to UCC
§ 9-103 that we cited earlier is explicit that in such a
case the new security interest does not qualify as a pur-
chase money security interest. That is our example of the
rollover of credit-card debt.
The difference between that example and this case is that
wrapping negative equity into the purchase money secu-
rity interest is often necessary to enable the purchase of
the car, given the impediment to financing car purchases
that Chapter 13’s cramdown provision would otherwise
create. That necessity—which is underscored by the
fact that in almost 40 percent of all car sales the consider-
ation includes a trade-in with negative equity, James A.
No. 09-3181 11
Wilson, Jr. & Sandra L. DiChiara, “The Changing Land-
scape of Indirect Automobile Lending,” 2 FDIC Supervisory
Insights 29, 30 (Summer 2005), www.fdic.gov/regulations/
examinations/supervisory/insights/sisum05/si_
summer05.pdf (visited Feb. 7, 2010)—is the justification
for allowing the creditor to enlarge his secured interest
to the prejudice (though the prejudice is less than it
would be were it not limited to a new asset of the debtor)
of the debtor’s other creditors. The enlargement eliminates
the misvaluation problem because the entire car loan is
secured. It also goes some distance toward solving the
depreciation problem; given the plaintiff’s modest down
payment, had the creditor been forbidden to wrap the
$8,000 in negative equity into its purchase money
security interest, it would have had a secured interest of
only $27,500 in a car worth $30,000 on the day of sale
but probably no more than $24,000 a year later.
So on the one hand purchase money security interests,
because they are limited to newly acquired assets of the
debtor, need not be narrowly limited in order to protect
creditors, and on the other hand allowing the purchase
money security interest to include negative equity—a
permission that does no violence to the language of
Article 9, though neither is it compelled by it—may be
essential to the flourishing of the important market
that consists of the sale of cars on credit.
Of course the dealer or finance company can always tell
a prospective buyer to go pay off the negative equity
himself. At argument the plaintiff’s lawyer gave us the
hypothetical case of a shopper for a pricy BMW. Wealthy
12 No. 09-3181
people usually don’t finance their purchase of a car, but
if they do they can borrow from a bank, or dig into
their savings for, the money needed to pay off any
negative equity on their trade-in. But the automobile
industry is understandably not content with selling cars
only to wealthy people. And Article 9 does not seek to
discourage credit transactions. We therefore join the
other courts in ruling that negative equity can be part of
a purchase money security interest and if thus secured
is not subject to the cramdown power of the bankruptcy
judge in a Chapter 13 bankruptcy. The decision of the
bankruptcy court denying cramdown of a Chapter 13 plan
that excludes negative equity from a purchase money
security interest is therefore
A FFIRMED.
3-1-10