CHAPTER 4, A. Cross-Collateralization and a Debtor's Options Under § 1325(a)(5)

• Jurisdiction: United States

A. Cross-Collateralization and a Debtor's Options Under § 1325(a)(5)

ABI Journal

January 2019

Joseph D. Austin

Kemp Smith LLP

El Paso, Texas

Nearly every bankruptcy case filed under chapter 7 or 13 will include a vehicle (or two), either in a debtor's chapter 7 statement of intentions or under a debtor's chapter 13 plan. Credit unions are a common source of financing for auto loans: They are member-based and can offer greater flexibility on loan terms.

Credit unions typically include cross-collateralization provisions in loans made to their members, and many consumers will not even realize that their loan and security agreements include cross-collateralization provisions. These provisions are sometimes referred to as dragnet, future-advance or all-indebtedness provisions. Whatever the preference in your region for terminology, a cross-collateralization provision may turn a debtor's dream purchase into a nightmare.

Simply put, cross-collateralization provisions allow consumers to use collateral from one loan to secure another debt. These provisions allow the use of a financed vehicle to secure other debt such as a credit card loan, or even another car loan. While the latter option seems duplicative and unnecessary, a creditor will be better off if it can apply equity from one vehicle loan toward a secured loan, and the better a creditor's position will be during the life of a loan and in a potential bankruptcy. The result could turn an unsecured credit card claim where a creditor often receives pennies on the dollar into a partially secured debt.

Depending on which side of the transaction you are on, cross-collateralization is often looked at as either creative financing for unqualified and risky borrowers, or an oppressive financing tactic to secure non-purchase-money obligations of the unsuspecting debtor.

To a consumer, cross-collateralization provisions are likely found as boilerplate wording at the end of a loan or security agreement and are difficult for the consumer to understand. To a creditor, the provisions might prove critical, and if a creditor does not have them in existing agreements, the creditor should consider adding them.¹ Convincingly, states across the nation are overwhelmingly enforcing cross-collateralization provisions as valid.²

Cross-Collateralization Provisions

Cross-Collateralization Effect
Secured Claims	Collateral Securing Each Secured Claim
Car Loan	Car Truck
Truck Loan	Truck Car

Let's consider the exhibit at right to demonstrate the effect that cross-collateralization provisions have on a debtor in a chapter 13 bankruptcy. A member of a credit union finances two vehicles using both loan and security agreements that both include cross-collateralization provisions. The member obtains a car in 2013 and a truck in 2014. Due to the cross-collateralization provisions, the car loan is secured by the car and truck, and the truck loan is secured by the truck and car. Therefore, the member's debts and collateral securing each loan are shown in the exhibit.

After a short time, this member is unable to pay his debts and soon thereafter files for bankruptcy. Chapter 7 and 13 provide consumer debtors with numerous options to retain their vehicles.³

In a chapter 7 bankruptcy, most of a debtor's debts are discharged in exchange for the debtor relinquishing his/her nonexempt property. For a debtor in chapter 7 to keep an asset securing a debt that would normally be discharged, the debtor must reaffirm the debt.⁴

On the other hand, in chapter 13, a debtor could elect to keep his/her vehicle and pay the secured debt through the chapter 13 plan. As long as the debtor is current on his/her bankruptcy plan payments and keeps the car insured, the debtor will likely be able to keep his/her car under bankruptcy law.

However, when a debtor has two vehicles financed from a creditor and the contracts include cross-collateralization provisions as the exhibit demonstrates, the debtor's options are not as clear as they might appear under § 1325(a)(5), which provides:

(5) with respect to each allowed secured claim provided for by the plan -

(A) the holder of such claim has accepted the plan;
(B) [the cramdown option];⁵ or
(C) the debtor surrenders the property securing such claim to such holder....⁶

At times, a creditor will agree to the debtor's treatment, but if a creditor does not accept the debtor's plan, the debtor has two remaining options under § 1325(a)(5): the cramdown option or a surrender of the collateral...