But Can She Keep the Car? Some Thoughts on Collateral Retention in Consumer Chapter 7 Cases
Culhane, Marianne B., White, Michaela M., Fordham Journal of Corporate & Financial Law
On November 15, 2001, at the Eugene P. and Delia S. Murphy Conference held at Fordham University School of Law, we addressed the topic of reaffirmation. Reaffirmation means making a new contract to pay and retain personal liability on a debt that would otherwise be discharged in Chapter 7.(2) While unsecured debts may be reaffirmed, debtors more often reaffirm to persuade a secured creditor to let them keep collateral. We will look at reaffirmation in that aspect, as one of several Chapter 7 collateral retention tools.
Many consumer debtors come into Chapter 7 with a heavy load of secured debt on their cars and household goods.3 Those who own homes carry big mortgages as well. These secured claims, plus exemptions, often leave no value for unsecured creditors, causing the trustee to abandon the collateral. After the discharge removes the debtors' personal liability, the liens remain attached to the collateral,4 and when the stay ends, the secured creditors may repossess.5
Repossession is not always what a secured creditor wants, however. Often, the creditor hopes the debtor will keep the collateral, and continue paying for it.6 After all, if the creditor retakes and sells a car or refrigerator, the creditor will recover only a low liquidation value. When the debtor keeps the asset, however, the creditor may collect much more from the debtor than repossession would yield. Consumer creditors are frequently undersecured. A few years ago, for example, an auto finance executive told the Reporter for the National Bankruptcy Review Commission that new car loans were undersecured by an average of $4,000.(7) Such shortfalls are a powerful incentive to seek retention payments rather than settle for repossession and liquidation value. Not surprisingly, many creditors routinely pursue retention arrangements.
The debtor's wish may coincide with the creditor's hope.8 Often, the debtor is the person with the highest and best use for consumer collateral.9 Allowing the debtor to retain collateral prevents lost value, and the secured creditor is better off if the debtor pays more for retention than liquidation value.
Professor William Whitford developed the concept of varying values of the same collateral to debtors and creditors more than twenty years ago. Assume a Chapter 7 debtor owns a car, several years old, but in decent condition, subject to a $10,000 lien. Assume further that repossession would net the creditor only $6,000. The debtor needs a car to get to work, is familiar with this car's quirks, and knows that if it were lost, she would have to replace it at retail price, with all the hassle and time off work that used-car shopping entails. Thus, she values the car at much more than $6000. She may fear that no one would give her credit to buy another car soon after bankruptcy. These fears may cause the debtor to overvalue retention, leading her to agree to pay too much, that is, more than replacement cost or more than she can afford.
Professor Barry Adler and his co-authors recently explored the same hypothesis, using slightly different terminology. They agree that typical consumer collateral has two values, value to the debtor (AD) and liquidation value to the market (AM). Whenever AD>AM, both the debtor and society realize a surplus (AD - AM) if the debtor retains the asset. The surplus is lost entirely if the creditor repossesses.10
Certainly, retention may be in the debtor's best interest, but only under three conditions: 1) she needs the asset for her fresh-start life; 2) retention will cost no more than she would have to pay to replace the asset, and 3) she can afford the cost to retain. If the debtor does not need the collateral or binds herself to pay too much, retention will frustrate, rather than further, Chapter 7's central goal: the fresh start. The debtor and her family may suffer prolonged financial hardship, and the economy may lose the fresh start's productivity enhancement. …