Fifth Circuit Goes All In On Hanging Paragraph

Joining several other courts, the Fifth Circuit has ruled that the entire debt created by a purchase money transaction is protected from modification under the hanging of section 1325(a). The decision overrules several lower court decisions which had limited or denied protection to claims which included non-purchase money components. Matter of Dale, No. 08-20583 (5th Cir. 9/8/09). The opinion can be found here.

In the Dale case, the debtor traded in a vehicle with negative equity, which amount was rolled into the purchase of a new vehicle. The amount financed also included a gap insurance premium, taxes and fees and an extended warranty. The debtors filed bankruptcy less than one year later. The bankruptcy court ruled that the portions of the debt for negative equity and other items not related to the physical vehicle were not purchase money debts and could be modified in a chapter 13 plan. The district court reversed.

Under the hanging paragraph, the debtor may not apply the valuation provisions of section 506 to limit the secured portion of a claim to the collateral's value "if the creditor has a purchase money security interest securing the debt that is the subject of the claim" and the collateral was a motor vehicle purchased within 910 days of the petition. Because the term "purchase money security interest" is not defined by Title 11, the Fifth Circuit looked to the use of the term under the Uniform Commercial Code. It explained:

The parties agree that the relevant state law is that of Texas. In Texas, a “purchase-money security interest” in goods is defined as a security interest in goods that are “purchase-money collateral,” and “purchase-money collateral” is in turn defined as goods that secure a “purchase-money obligation.” TEX.BUS. & COM. CODE § 9.103. Texas defines “purchase-money obligation” as “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.” Id. The definition of “purchase-money obligation” thus contains two prongs: (i) the price of the collateral, and (ii) value given to enable the debtor to acquire rights in or use of the collateral.

Opinion at 7.

Official Comment number 3 to Sec. 9.103 explains that the "price" of the collateral and "value given to enable" includes items such as "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." Thus, because the concept of value given to enable the debtor to acquire rights in the collateral is broader than just the purchase price of the vehicle under the UCC, the same analysis applies under the hanging paragraph.

Once the Circuit reached this conclusion, the rest was easy. The debtor could not have acquired rights in the collateral without incurring the entire debt. While the debtor could have purchased a vehicle without an extended warranty, the debtor could not have purchased a vehicle with an extended warranty without paying for the warranty. Similarly, the debtor could have purchased a new vehicle without trading in his old vehicle. However, under Texas law, a dealer cannot accept a vehicle in trade without paying off the existing lien. Thus, if the debtor wishes to trade in an old vehicle with negative equity, paying off that negative equity is part of the amount which must be paid to acquire rights in the vehicle.

In making its ruling, the Fifth Circuit agreed with the Fourth, Tenth and Eleventh Circuits as well as the highest court in New York. In re Price, 562 618 (4th Cir. 2009); In re Ford, 2009 WL 2358365 (10th Cir. 8/3/09); In re Graupner, 537 F.3d 1295 (11th Cir. 2008); In re Peaslee, 13 N.Y.3d 75 (2009)(the New York court was answering a certified question from the Second Circuit). While the result is counter-intuitive, it follows a counter-intuitive state law definition so that the definition is consistent between state and federal courts.