Fourth Circuit Rules That The “Hanging Paragraph” Protects Negative Equity

13 Apr Fourth Circuit Rules That The “Hanging Paragraph” Protects Negative Equity

Today, the Fourt Circuit Court of Appeals (Virginia, West Virginia, North Carolina, South Carolina, Maryland) ruled that the “hanging paragraph” of Section 1325 of the Bankruptcy Code protects negative equity financing in motor vehicles.

Negative equity financing is when you trade in your vehicle but you owe more on the vehicle than the dealer will give you to trade.  The dealer will pay to satisfy the lien on your old vehicle but will put the additional amount required to satisfy that lien onto the new vehicle that you are purchasing.  For example, if the dealer will allow you $4,000 on the trade but you owe $6,000 on the vehicle, the dealer will put $2,000 additional dollars into your new car purchase that you finance with the bank.

Under prior bankruptcy law, vehicles could be bifurcated or split into two separate components or claims (called a “cram-down”) if the vehicle was worth less than what was owed on it.  There was a secured claim representing the value of the collateral or vehicle.  This amount was paid in full through a debtor’s chapter 13 plan with interest.  Then, a second component was the negative equity or the amount owing on the vehicle less the value of the vehicle (owes $14,000 and car worth $9,000) which was treated as an unsecured claim.  Lenders sought to change this procedure through the 2005 amendment to the Bankruptcy Code by prohibiting “cram-downs.”

Because of poor drafting of the statute (it is called the “hanging paragraph” because it was not correctly numbered), prior court decisions in the Eastern District of North Carolina, held that debtors could “bifurcate” or split into two components the secured claims on their vehicles with one component representing the negative equity rolled into the new car transaction and the other component representing the price of the new car.  This could often result in significant savings to the debtors because, at times, several thousands of dollars in “negative equity” were financed in new car transactions.

These decisions are now overruled and if a car is obtained within 910 days of filing bankruptcy, bifurcation is no longer an option.  This also means that for chapter 13 cases that were conditionally confirmed based on the lower court opinions, debtors are going to be hit with requests for increased plan payments so that the plan will comply with the In re:  Price decision.

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Adrian Lapas, Esq.

I've been practicing bankruptcy law in North Carolina since 1993, and am certified as a specialist in consumer bankruptcy law by the North Carolina State Bar.

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