(Mis)use of State Law in Bankruptcy: The Hanging Paragraph Story

Abstract

This article addresses the use of state law in bankruptcy in the context of the controversial “hanging paragraph” of the Bankruptcy Code, which was added to the Code by the 2005 amendments. The hanging paragraph appears to grant undersecured car lenders full payment in Chapter 13 bankruptcy cases, treatment that gives such lenders better treatment than other secured lenders. The provision is particularly controversial when applied to negative equity financing. Negative equity financing is provided by lenders when a car buyer offers a trade-in vehicle that is worth less than the outstanding loan that it secures. When a lender makes a negative equity loan, it is undersecured on the day the loan is made.Whether a negative equity loan is entitled to full payment under the hanging paragraph turns on the definition of “purchase money security interest,” a term that is used but not defined in the Bankruptcy Code. The majority of all courts that have addressed the issue, as well as all nine of the Circuit Courts of Appeal that have done so, considered the term to be defined by state law, relying on a 1979 Supreme Court case, Butner v. United States. In this Article, I explain why state law should not define the term purchase money security interest for hanging paragraph purposes.To do so, I propose a framework for analysis that is based on the difference between bankruptcy entry rights and bankruptcy exit rights to show that an analysis that relies only on Butner to determine the appropriate use of state law in bankruptcy is incomplete. This entry/exit framework requires a detailed examination of the package of rights inherent in any property interest in order to determine whether that right is one that bankruptcy policy should respect. I then explain that because a purchase money security interest in a consumer good (such as a car subject to the hanging paragraph) refers only to a bankruptcy exit right, it should be defined according to federal law, following another 1979 Supreme Court case, United States v. Kimbell Foods. I conclude by proposing a bankruptcy policy-based definition of purchase money security interest for hanging paragraph purposes.