What Is the 91/3 Rule for Car Loans in Bankruptcy?
Learn how the timing of a recent car purchase can alter its legal standing in bankruptcy, potentially converting the loan from secured to unsecured.
When a person files for bankruptcy, a trustee is appointed to review their financial history, and car loans taken out shortly before the filing often draw close attention. This scrutiny is based on principles in the U.S. Bankruptcy Code designed to ensure fairness among all creditors. When a debtor finances a vehicle immediately before seeking bankruptcy protection, the trustee will examine the transaction to ensure it does not improperly favor one creditor over others.
The Trustee’s Scrutiny of Recent Car Loans
A Chapter 7 bankruptcy trustee’s duty is to gather a debtor’s non-exempt assets and liquidate them for a fair distribution to unsecured creditors, like credit card companies. Bankruptcy law prevents a debtor from paying certain creditors right before filing, an action known as a preferential transfer. A preferential transfer occurs when a payment made within 90 days of the bankruptcy filing allows that creditor to receive more than they would have in the liquidation process.
Granting a security interest in a new car is a form of payment. By taking on a new car loan, the debtor elevates the new lender’s status above that of existing unsecured creditors, giving them a claim to a specific asset—the car. If a car loan is deemed a preferential transfer, the trustee can take action to reverse the transaction’s effect, ensuring the value of that asset is made available to all creditors, not just the new lender.
The 90-Day Preference Period for Car Loans
The trustee’s power to review these transactions is centered on the 90-day preference period defined in the Bankruptcy Code. This look-back period allows the trustee to review, and potentially undo, certain transactions made in the three months before the bankruptcy petition is filed. The review targets loans known as Purchase-Money Security Interests (PMSIs).
A PMSI is a loan where the funds are provided to purchase the specific collateral that secures the loan, such as a car loan where the vehicle itself is the collateral. When a debtor obtains a PMSI on a vehicle within the 90-day preference window, it falls directly under the trustee’s scrutiny.
If the trustee concludes the transaction is a preferential transfer, they can ask the bankruptcy court to “avoid the lien.” If the court grants the trustee’s request, it legally strips the lender’s security interest from the vehicle, and the car is no longer collateral for that specific debt.
Consequences for the Debtor and the Lender
For the debtor, the car loses its status as a secured asset. The trustee is then empowered to take possession of the vehicle and sell it, with the proceeds added to the bankruptcy estate for distribution among general unsecured creditors. The original car loan debt does not disappear but changes from a secured to an unsecured debt. Now in the same category as credit card bills, it is likely to be completely discharged at the conclusion of the Chapter 7 case along with other qualifying debts.
For the lender, losing the lien means forfeiting the right to repossess the car. Their claim is demoted from a secured to a general unsecured creditor. As a result, the lender must share any available funds from the bankruptcy estate with all other unsecured creditors, diminishing the likelihood of recovering the loaned money.