Congress added a provision to BAPCPA that appeared to be designed to protect auto lenders who financed cars for debtors within 910 days of the bankruptcy filing. This provision sought to prevent the cramdown of these so-called “910-day loans” in chapter 13 cases and was included in a section of the legislation entitled “Giving Secured Creditors Fair Treatment in Chapter B.” H.R. Rep. No. 109-31 at 72 (2005). Unfortunately, this provision was unnumbered and simply added at the end of §1325(a). Now known as the “hanging paragraph,” the apparent misplacement of this provision, together with its confusing language, has created extensive litigation on a number of issues.

To qualify for the statutory protection from cramdown in chapter 13, a 9l0-day loan must, among other things, constitute a purchase money security interest (PMSI). Some debtors have argued that lenders do not hold the requisite PMSI when the loan also finances debts unrelated to the “price” of the financed car, such as (1) a roll-over of negative equity owed on a trade-in car, (2) pre-payment of “gap” insurance covering the difference between the new car’s value and the total amount financed and/or (3) prepaid extended warranty contract premiums. Several courts have adopted this argument and found that 910 day loans that finance these additional items are no longer PMSI and thus not protected from cram-down by the “hanging paragraph.” This article will explore the different positions taken by Florida bankruptcy courts on the issue.

The term “purchase money security interest” is not defined in the Bankruptcy Code. Courts have looked to the definition of PMSI in state law and more specifically, the Uniform Commercial Code. Bankruptcy courts that have looked at Florida law on this issue have come to different conclusions. In In re Blakeslee, 377 B.R. 724 (Bankr. M.D. Fla. 2007), a car loan was incurred within 910 days of filing. The loan included financing of negative equity in the debtor’s trade-in vehicle. Judge Funk of Jacksonville, Fla., found that the “hanging paragraph” was inapplicable and the debtor could cramdown the secured claim. Judge Funk adopted the reasoning of a New York bankruptcy court in In re Peaslee, 358 B.R. 545, 551 (Bankr. W.D. N.Y. 2006), which held that the inclusion of negative equity in a loan means the loan is no longer a PMSI. In Peaslee, the bankruptcy court looked to New York law and found that a PMSI exists where the collateral secures an obligation “incurred as all or part of the price of the collateral or for 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.” Judge Funk agreed and found the term “price of the collateral” to equal the amount the collateral cost to buy—his price does not include the payoff of negative equity. Judge Funk noted that “negative equity is not used to enable a debtor to acquire rights in the collateral.” Instead, financing negative equity is merely an “accommodation” to facilitate the sale. In other words, there are two separate transactions and the payoff of the old loan is not a prerequisite to the new loan. [ED. NOTE: - as set out below, the bankruptcy court’s holding in Peaslee has been reversed].

Once Judge Funk in Blakeslee determined the obligation to be partially a PMSI and partially a non-PMSI (based on the inclusion of negative equity), the court considered the next step—how to apply the hanging paragraph to a claim that is only partially secured by a PMSI. The court found under well established commercial law, that it had discretion to determine the extent of the PMSI by applying either the “dual status rule” or the “transformation rule.” The dual status rule provides that the secured lender has a purchase money security interest to the extent that the amount financed relates to the purchase price for the collateral. In re Price, 363 B.R. 734, 745 (Bankr. E.D. N.C. 2007). The transformation rule, however, “transforms” the entire secured obligation to non-PMSI (i.e. the non-purchase money component transforms the entire claim into a non-purchase money security interest). Id.

In Blakeslee, Judge Funk found that when a debtor finances negative equity in a 910-day loan, the entire security interest is transformed into a non-PMSI loan. The court reasoned:

      While the court agrees that it does have the discretion as to whether to apply the dual status or the transformation rule to a partial purchase money security interest, the court finds that with respect to negative equity, the transformation rule is the appropriate rule to be applied. As the court in Price pointed out, notwithstanding the fact that a sales contract may clearly state the amount of the purported purchase price of a vehicle, a vehicle’s true purchase price and the amount of negative equity is difficult to compute and is in fact a “mystery,” with the actual purchase price being affected by an unreasonably low allowance on a traded in vehicle. Price, 363 B.R. at 745. A creditor’s burden of establishing the difference between the purchase price and advances to pay the debt on the traded in vehicle is “a virtually impossible task.” Id. Moreover, a court is burdened with the task of the allocation of prebankruptcy payments to the purchase money and non¬purchase money portions of the secured debt. Id. The court declines the task of “unwind[ing] the manipulations” which would be foisted upon it were it to apply the dual status rule to the financing of negative equity in retail installment contracts. See Peaslee, 358 B.R. at 560. Accordingly, the court will apply the transformation rule to such situations. [footnote omitted] [The creditor] is not secured by a purchase money security interest in any amount. Consequently, the prohibition against strip down in §1325(a) does not apply and debtor may therefore bifurcate [The creditor’s claim] into secured and unsecured components pursuant to 11 V.S.C. §506(a)(1).

On the same day he issued Blakeslee, Judge Funk issued a decision on a similar issue in In re Honcoop, 377 B.R. 719 (Bankr. M.D. Fla. 2007). In Honcoop, the debtor financed the purchase of a vehicle for $12,000 less than 910 days prior to filing bankruptcy. The debtor also financed an additional $500 for “gap” insurance. The debtor later filed chapter 13 and filed a motion to value the creditor’s secured claim at $4,570. The creditor opposed the valuation motion, arguing that its claim could not be modified based upon the protections of the hanging paragraph.

In Honcoop, Judge Funk applied the same analysis from Blakeslee and adopted the bankruptcy court’s analysis in Peaslee. Judge Funk found that “gap” insurance was not part of the “price of the collateral.” In Honcoop, however, Judge Funk applied the “dual status” rule and not the “transformation rule” because the court found that the contract clearly allocated a specific amount paid for the “gap” insurance. The court was able to calculate the creditor’s PMSI by simply subtracting the cost of the “gap” insurance from the contract amount. Ironically, while the debtor prevailed in Honcoop, the debtor gained very little in the end. The PMSI portion of the secured claim turned out to be $11,500, which was protected by the hanging paragraph and had to be fully paid (with interest) in the plan.

In January 2008, Judge May in Tampa faced the same issues as in Blakeslee and Honcoop, but came to the opposite conclusion. In In re Schwalm,—B.R. uu, 2008 WL 162933 (Bankr. M.D. Fla. January 16, 2008), Judge May rejected the analysis used by Judge Funk in Blakeslee and Honcoop. In particular, Judge May was persuaded by the recent District Court opinion in In re Peaslee, 373 B.R. 252 (W.D. N.Y. 2007), where the district court reversed the bankruptcy court decision relied upon by Judge Funk (i.e. the inclusion of negative equity in the loan took the vehicle out of the 91O-day protections of the hanging paragraph). [Ed. Note: The Peaslee case currently is on appeal to the 2nd Circuit Court of Appeals.] Judge May cited the following from the district court opinion in Peaslee:

     It is not apparent why a refinancing of rolled-in negative equity on a trade-in as part of a motor vehicle sale could not constitute an ‘expense incurred in connection with acquiring rights in’ the new vehicle. If the buyer and seller agree to include the payoff of the outstanding balance on the trade-in as an integral part of their transaction. . . it is in fact difficult to see how that could not be viewed as such an expense.

In Schwalm, Judge May pointed out that items such as negative equity and “gap” insurance are specifically authorized to be included in motor vehicle financing. not only under state law, but under the Federal Truth in Lending Law (15 D.S.C. §1601, et seq.) and Regulation Z (12 C.F.R. §226.l8) (these specific items can be included in the “amount financed” in a motor vehicle retail installment contract). Taking a straight-forward approach to the issue, Judge May found that the debtors negotiated a package financing in compliance with state law:

      [In 2005] it was already common industry practice, sanctioned by state motor vehicle finance law and the Federal Truth in Lending Law, for automobile dealers to offer buyers packaged financing, which includes the payoff of debt on the trade-¬in vehicle, GAP insurance to protect repayment of that amount and the cost of a service contract. These obligations, by the parties’ negotiation and sanctioned by Florida finance laws (as in other states), have the requisite ‘close nexus’ to the acquisition of the collateral and the secured obligation as explained by Comment 3 to §679-1031 [the Florida DCC].

Judge May found further support for his decision in the legislative history of BAPCPA. Many courts have opined that there is scant, if any, legislative history regarding the 2005 BAPCPA amendments (e.g. there is no Conference Report accompanying the legislation). These courts, however, tend to overlook the apparent intent behind the change in the law to give additional protections to auto lenders who made loans to debtors within 910 days of the bankruptcy filing. As an example of this apparent intent, Judge May pointed to the title of the provision containing the hanging paragraph—Giving Secured Creditors Fair Treatment in Chapter 13” and concluded:

      [T]he ‘hanging paragraph’ was adopted to give favored treatment to a limited class of potentially under-secured creditors - those holding a purchase money security interest in a motor vehicle acquired for personal use within the 910 days preceding the bankruptcy petition date. 11 U.S.C. §1325(a). The debtors’ argument carries with it the implicit conclusion that Congress intended the ‘hanging paragraph’ to be inoperative as to a substantial number of lawful auto finance transactions that were industry practice when BAPCPA was enacted. Such an interpretation is not compelled by the text of the ‘hanging paragraph,’ or by its legislative history.

The negative equity issue decided in Blakeslee and Schwalm is currently on appeal before the 1st Circuit in a Georgia case, Graupner v. Nuvell Credit Corp., 2007 WL 1858291 (M.D. Ga. 2007). In Graupner, the creditor argued that under state law, the “price of the collateral” included the negative equity that was included in the total amount financed. The bankruptcy court agreed. The district court affirmed, holding that the price of the collateral included the negative equity:

      The trade-in of the vehicle was an integral part of the sales transaction. The value of that trade-in along with its accompanying debt affected the ultimate price that was paid for the new pick-up truck. The negative equity is inextricably intertwined with the sales transaction and the financing of the purchase. This close nexus between the negative equity and this package transaction supports the conclusion that the negative equity must be considered as part of the price of the collateral. [footnote omitted] Accordingly, the court finds that the creditor has a purchase money security interest for the full amount of its debt. Thus, §506 shall not apply to modify the amount of the secured obligation.

Like Schwalm, the district court in Graupner supported its conclusion by referring to the official comments of the drafters of the UCC, which indicate that the price of collateral includes negative equity. See UCC §9-103 cmt. 3 (price of collateral includes “obligations for expenses incurred in connection with acquiring rights in the collatera1”). The district court in Graupner also referred to other statutory authority defining “sales price” in consumer transactions, such as the Federal Truth in Lending Act, 15 U.S.c. §1601, et seq., as implemented by Regulation Z, 12 CFR Pt. 226 (negative equity treated as part of total sales price) and the Georgia Motor Vehicle Sales Finance Act (“cash sales price” includes negative equity).

As these cases show, courts across the country will continue to wrestle with the PMSI issue related to the hanging paragraph until the Circuit Courts of Appeal or the Supreme Court, hopefully, decide the issue.

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The typical consumer bankruptcy attorney is knowledgeable about bankruptcy law and property rights in general. Today, more than ever, mortgage foreclosure is the event which precipitates bankruptcy filings. Most of the mortgages that are now being foreclosed upon are subprime mortgages originated within the past three years. Many of these subprime mortgage transactions were refinancing transactions. The overwhelming majority of bankruptcy attorneys are unaware of the fact that refinancing transactions within three years prior to the bankruptcy case may be subject to substantial claims or defenses under the federal Truth in Lending Act (TILA) and Regulation Z. Trustees, as well as debtors, have the right to pursue TILA and TILA related claims. In re Smith, 640 F.2d 888, 890 (7th Cir. 1981) quite explicitly holds that the chapter 7 trustee has the sole standing to pursue a TILA claim for a debtor in chapter 7. To the same effect, see In re Polis, 217 F.3d 899 (7th Cir. 2000). The existence of a TILA claim or a pendent state law claim arising from the fraudulent or improper origination of a consumer mortgage, may be the difference between a debtor losing his house or keeping it pursuant to a chapter 13 plan, e.g In re Ramirez, 329 B.R. 727 (D. Kan. 2005).

Both TILA and related Regulation Z require disclosure of material terms of a consumer credit transaction in a highly specific manner. Claims can arise as a result of the lender’s failure to make proper disclosures, including failure to give the consumer a notice of right to rescind and from the lender’s failure to comply with a properly tendered rescission notice. In either circumstance, the consumer debtor may have an extended right to rescind, potentially up to three years from the date of the initiation of the consumer credit transaction.

In a successful TILA rescission claim, the consumer is entitled to a refund of all payments made under the mortgage as well as all finance charges paid incident to the closing. The mortgage lien is null and void. In cases of a lender’s failure to give proper TILA notices, which has a one year statute of limitations, the consumer is entitled to statutory damages of $2,000 and attorney fees. In cases of a lender’s failure to comply with a consumer’s valid notice of rescission, which has a three-year statute of limitations, a consumer is also entitled to statutory damages of $2,000 and attorney fees.

The right of the consumer to rescind is subject to the consumer's tender of the net of the original loan and damages to which the consumer is entitled. This amount is called the "TILA tender." In general, however, the TILA tender will result in all payments, whether principal, interest, late charges or original finance charges, becoming a reduction in principal.

The right to pursue the TILA claim is not limited to claims against the original lender, who may well also be in bankruptcy, such as Delta Funding or New Century Mortgage. Rather, the right to TILA damages extends to assignees. The debtor or trustee must provide notice of rescission to the servicer or the current holder of the mortgage. If the holder or servicer fails to act within 20 days of the date that the notice of rescission was sent, then the mortgage transaction is rescinded and becomes void, conditioned upon tender by the consumer of what she received at the closing.

After rescission, the bankruptcy court has jurisdiction to hear the ensuing adversary proceeding to determine damages against the lender, attorneys' fees, the TILA tender amount and the method by which the borrower must make tender. This is probably a noncore matter, related to a case pending under Title 11. The TILA tender can be conditioned and varied by the court. Some bankruptcy courts have held that TILA tender in a bankruptcy case is limited to the grant of an unsecured claim to the mortgagee. Whitley v. Rhodes (Case No. 93-19652-JNF, Adv. P. No. 94-1008 (Bankr. D. Mass Jan. 24, 1995). Other courts have required that the debtor refinance the property or sell the property. At minimum, the debtor can create substantial equity which otherwise was not available.

Consumer bankruptcy attorneys and creditors should also consider that mortgage rescue transactions, characterized by sales and leasebacks with options to buy, often can be recharacterized as equitable mortgages for purposes of TILA. Because these transactions are often initiated through brokers or other intermediaries, these transactions are subject to the Home Owners Equity Protection Act (HOEPA) provisions of the Truth in Lending Act. Absent proper disclosures, there is often a high likelihood that such transactions may be avoided for the benefit of the estate and even for the debtor. Moore v. Cycon Enterprises Inc., (Case No. 1:04-CV-800), 2006 US Dist. LEXIS 57452 (WD Mi. 2006).

An exhaustive discussion of TILA and HOEPA is well beyond the scope of this note. There is a steep learning curve for mortgage foreclosure defenses and claims under TILA. However, consideration of such claims can be highly rewarding to debtors and trustees administering their estates.

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Section 522(o) of the Bankruptcy Code seems to have the potential to significantly restrict pre-bankruptcy exemption planning for prospective debtors who choose state exemptions (in states that opted out of federal exemptions, bankruptcy debtors are stuck with §522(o and p)). Prior to the passage of BAPCPA, there was no magic language in §522 to indicate what a trustee had to prove if she sought to show that a transfer of nonexempt property into exempt property was improper. Section 522 merely provided that property that fits the definition of exempt property held by a debtor at the time she files bankruptcy can be claimed as exempt.

Pre-BAPCPA, when a debtor transferred non-exempt funds into her homestead, a trustee seeking to object to the claim of exemption had to borrow language from §727, which denies a discharge to a debtor who commits any act that “hinders, defrauds or delays” a creditor. After BAPCPA, a trustee seeking to disallow a homestead exemption can now bring an action directly under §522(o). The addition of the “hinder, delay or defraud” language to §522(o) is curious, though, if a trustee always had the ability to object to a claimed homestead exemption based on the borrowed language of §727. So, just what was Congress’ purpose in putting the same standard into §522(o)?

Since the passage of BAPCPA, there have been several cases claiming divination of what Congress really intended when it added language to §522(o) mirroring the language in §727. Many courts have decided that it was part of the overall scheme of Congress to “toughen up” rules on exemption planning, e.g., In re Addison, 368 B.R. 791 (B.A.P. 8th Cir. 2007); In re Lacounte, 342 B.R. 809 (Bankr. D. Mont. 2005); In re Maronde, 332 B.R. 593 (Bankr. D. Minn. 2005). On the other hand, at least one court has opined that the new language changes nothing in interpreting homestead exemption planning. In re Agnew, 355 B.R. 276 (Bankr. D. Kansas 2006).

A central principle of statutory construction is that language should be read plainly where it can be and that use of legislative history is a last resort. “In interpreting statutes, only after application of the principles of statutory construction, including the canons of construction and after a conclusion that the statute is ambiguous may the court turn to the legislative history.” Carrieri, v Jobs.com Inc., 393 F.3d 508, 518-19 (5th Cir. 2004). Based on the “plain language” canon of statutory construction, using the same words should result in the same cases being decided in the same way. In the matter of: Peachtree Lane Assocs., Ltd., 150 F.3d 788, 796 (7th Cir. 1998). If, in fact, Congress intended to toughen up the standards for pre-bankruptcy homestead exemption planning, it certainly cannot be inferred by looking at the language of new §522(o), which used the same language already in §§548 and 727. As the 5th Circuit has recently said concerning the meaning of 11 U.S.C. §522(p), “[I]f Congress enacted into law something different from what it intended, then it should amend the statute to conform to its intent.” In re Rogers, 513 F.3d 212, 226 (5th Cir. 2008) (quoting the Supreme Court in Lamie v. U.S. Trustee, 540 U.S. 526, 542 (2004)).

Courts who insist that §522(o) has changed the rules concerning homestead exemption planning are going beyond the plain language of the statute and seem to be relying on legislative intent. These judges either do not cite their sources or, perhaps, are simply guessing at what Congress intended. Therefore, it is helpful to look at what legislative history exists regarding §522(o) to determine if Congressional intent is being interpreted accurately. “A statute must be interpreted in a way that is not inconsistent with the purposes that the legislators had in mind at the time of the enactment of the statute.” Helvering v. New York Trust Co., 292 U.S. 455, 465 (1934); In re Beal, 347 B.R. 87, 92-93 (Bankr. E.D. Wis. 2006).

On June 10, 1998, the Subcommittee on Commercial and Administrative Law of the House Judiciary Committee met concerning proposed amendments to H.R. 3150-Proceedings of the House Subcommittee on Commercial and Administrative Law, 144 Cong. Rec. H4404-H4407 (daily ed. June 10, 1998). The transcript of that meeting shows that §522(o) was introduced as an amendment to the bill that would become BAPCPA. The amendment sought to strike a proposed homestead cap of $100,000 in exchange for the addition of a limit on the homestead exemption for debtors who transferred property into their homestead in an attempt to “hinder, delay or defraud” their creditors.

The new language that would become part of §522(o) was passed by the House on a vote of 222 to 204 (Id. at H4438). A review of the debate on the amendment shows a lively exchange between those House members who wanted to protect the right of a state to determine their own bankruptcy exemptions and those who wanted to have a national federal maximum exemption on homestead rights.

I want to explain this amendment. It strikes the $100,000 homestead exemption cap that is in the bill and reverts back to current law in that respect. But it does a little more than that. In addition it denies the right of homestead exemption to somebody who within a year of filing bankruptcy takes assets, cash or whatever and places that into a home for the purposes of defrauding creditors to avoid paying the creditors. I think that is a very important provision that will get around the problems we are seeing people complain about on homestead exemption law abuse, but at the same time it will not deny the States the right to do what they have done since 1792 and that is to decide what property is exempt. I think that is a very important decision to be left to the States to decide. If we put this $100,000 cap in, we are going to dictate to the States; some States have no cap currently, some States have 100,000, some like Massachusetts have 100,000 until you are 62 and then they have 200,000.

Id. at H 4404-H4405 (remarks of Rep. McCollum).

We hear two arguments against [the national $100,000 maximum cap on homestead exemptions for individuals filing bankruptcy]. One is $100,000 is too low. This is $100,000 equity, and there are only 15 percent of the people in this country that have $100,000 equity in their home. The other is that it violates the Constitution or state rights. This is Federal Bankruptcy Courts, not state sourts, Federal Bankruptcy Courts.

Id. at H4405 (remarks of Rep. Barrett).

Because the “states rights” arguments won out over the “national standard” arguments when the §522(o) amendment passed in the House of Representatives, it is arguable that its passage evinced Congressional intent to not overrule existing case law concerning homestead exemption planning. That is, until §522(o) was passed, when a debtor chose state exemptions, courts turned to state law in deciding whether a debtor “hindered, delayed or defrauded” creditors. In light of the House of Representative’s stated rationale for passing §522(o) (to protect the right of states to interpret their own exemption laws with regard to homesteads), it seems incorrect to suppose that §522(o) installed a uniform and harsher “federal standard” for homestead exemption planning. Therefore, whatever “hinder, delay or defraud” was interpreted to mean under prior precedents regarding exemption planning under §727 should still be good law. To assume that the addition of §522(o) should be used by the courts to strip away the precedent of using state law to determine the amount of permissible pre-bankruptcy planning is to interpret the law in a manner inconsistent with both the plain meaning of the statute and the purpose of the drafters in passing the statute.

To paraphrase Forest Gump: statutory construction is as statutory construction does; courts are free to read the available legislative history of §522(o) and come to a different conclusion. However, by looking at the plain language of the statute and the available legislative history regarding §522(o), courts do not need to guess at what Congress meant and can rule on the basis of what the law says and what Congress intended when it wrote the law.

(Norris v. Thomas, 216 S.W.3d 851 (Tex. 2007))

Once upon a time, it was all smooth sailing for Tom. Life was going so swimmingly that he had managed to acquire a 68-foot yacht, complete with four bedrooms, three bathrooms (or “heads” as nautical types would say), a galley and upper and lower salons. From stem to stern, Tom’s yacht was worth several hundred thousand dollars. Tom and his wife sold their prior home on the range, moved into the yacht, and ranged from New Orleans to Florida and points beyond.

Unfortunately, Tom’s spending exceeded his means and, when the creditors closed in, he put the yacht in dry-dock and filed for personal bankruptcy. Since the Bankruptcy Code provides that a bankrupt debtor may keep his homestead, Tom claimed his yacht could not be got. But the folks he owed money to felt that Tom should not be able to simply sail away and leave them high and dry.

It fell to the court to decide whether Tom’s yacht was a protected homestead or something else. Everyone agreed that it was his home—but was it his homestead? Homestead laws don’t define what a homestead is. While the court agreed with Tom that the homestead laws should be construed generously, it noted that courts cannot stretch those laws “beyond their moorings.”

The court concluded that a man’s home may be his castle, but a castle tends to be firmly planted on the ground. It’s not here one day and gone tomorrow. A homestead is steady, still, stationary. Even though Tom’s yacht may be in dry-dock today, it might be roaming the seven seas tomorrow, which homesteads just don’t do. So, alas, poor Captain Tom had to walk the plank.

            Moral: When times are tough

             And seas are rough,

             And you’re upset

             By too much debt,

             If all you’ve got

             Is just your yacht,

             That’s good news for

             A creditor.

Prof. Bob Rains is the author of True Tales of Trying Times: Legal Fables for Today, a collection of 52 illustrated “legal fables” based on actual cases. True Tales is available for purchase at http://www.willowcrossingpress.com.

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