In Re Aubrey Howard

• Citation: 597 F.3d 852
• Decision Date: 01 March 2010
• Docket Number: No. 09-3181.,09-3181.
• Parties: In re Aubrey HOWARD, Debtor-Appellant. AmeriCredit Financial Services, Creditor-Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (7th Circuit)

597 F.3d 852

In re Aubrey HOWARD, Debtor-Appellant. AmeriCredit Financial Services, Creditor-Appellee.

No. 09-3181.

United States Court of Appeals, Seventh Circuit.

Argued Jan. 12, 2010.

Decided March 1, 2010.

Brian R. Zeft (argued), Semrad & Associates, Chicago, IL, for Debtor-Appellant.

William M. Burke (argued), Costa Mesa CA, David J. Frankel, Sorman & Frankel Chicago, IL, for Creditor-Appellee.

Craig A. Varga, Varga, Berger, Ledsky Hayes & Casey, Chicago, IL, for Amicus Curiae.

Before POSNER, FLAUM, and WILLIAMS, Circuit Judges.

POSNER, 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 bankruptcy— Chapter 11) extends to an automobile dealer's, or 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 thefinance company rather than to the dealer.)

The issue presented by the appeal requires some explaining, beginning with "cramdown, " which means forcing a secured creditor to take cash in lieu of his collateral. 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 bankruptcy, 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 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, 117 S.Ct. 1879, 138 L.Ed.2d 148 (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 financiers, 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 authorizes cramdowns in Chapter 13 bankruptcies. The paragraph (confusingly referred to in the cases as the "hanging paragraph" because it doesn't have a subsection 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 paragraph 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 allowshim 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.

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 plaintiffs 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 tradein is subject to the bankruptcy 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 bankruptcy judge sided with the creditor, ruling, in agreement 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 setting the rights enforced in bankruptcy are rights created by state law. Travelers Casualty & Surety Co. v. Pacific Gas & Electric Co., 549 U.S. 443, 127 S.Ct. 1199, 1204-05, 167 L.Ed.2d 178 (2007); Butner v. United States, 440 U.S. 48, 54-57, 99 S.Ct. 914, 59 L.Ed.2d 136 (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 collateral 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 financecompany, 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)(l), (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 similar obligations.... [But] a security interest does not qualify as a purchase money-security interest if a debtor acquires property on unsecured credit and subsequently creates the security interest to secure the purchase price." So if the purchaser's promissory note provides that in the event of default he shall owe, in addition to...