" Negative Equity – A Positive Problem? "
By Thomas B. Hudson and Patricia Covington*
Upside down? Negative Equity? Whatever you call it, it describes a customer who owes more on his trade-in than it is worth.
Dealers seem to be seeing more and more of this situation. Long term financing amortizes the customer's obligation more slowly than short term financing, and many customers either can't afford or elect not to make a large downpayment. Sometimes the problem can be traced to a previous car purchase that included the financing of negative equity. Regardless of the source of the problem, a dealer who wants to make a sale has to figure out some way to accommodate the payoff of the trade-in.
Traditionally, dealers in many states would simply inflate the price of the car to be purchased enough to permit an allowance for the trade-in that would cover the amount owed. Voila! No negative equity. If this is the way your dealership handles negative equity, you need to stop the practice. Read on.
Several years ago, the Federal Reserve Board addressed the proper disclosure of negative equity. First, Revised Reg. M included a disclosure line for leases that showed the "prior credit or lease balance."
Then the FRB staff tinkered with the Official Staff Commentary to the Reg. Z definition of "downpayment" to address the negative equity issue. The Commentary provided two rules – one prohibited creditors from showing a negative number in the downpayment disclosure box, and the other dealt with how creditors should handle disclosures when the customer's downpayment consists of an upside-down vehicle and cash.
The prohibition on showing a negative number in the downpayment box came from the Reg. Z definition of "downpayment" – "… an amount, including the value of any property used as a trade-in, paid to a seller to reduce the cash price of goods or services purchased in a credit sale transaction." That's perfectly logical – a negative number doesn't reduce the cash price, it increases it. So you can't have a negative downpayment.
The Feds' rule works like this when the consumer has no cash. Assume a consumer owes $10,000 on an existing automobile loan and the value of the consumer's trade-in automobile is only $8,000, leaving a $2,000 deficit. The creditor should show a downpayment of $0, not [negative] <$2,000.>
The rule on how to treat the customer who is upside down and also has cash for a downpayment (we know – these creatures are as rare as unicorns, but evidently the Feds think there are enough of them to justify a rule) are permissive. The Fed offers the following guidance:
If the consumer makes a cash payment, creditors may, at their option, disclose the entire cash payment as the downpayment, or apply the cash payment first to any excess lien amount and disclose any remaining cash as the downpayment. In the above example:
If the downpayment disclosed is equal to the cash payment, the $2,000 deficit must be reflected as an additional amount financed under Sec. 226.18(b)(2), Regulation Z.
If the consumer provides $1,500 in cash (which does not extinguish the $2,000 deficit), the creditor may disclose a downpayment of $1,500 or $0.
If the consumer provides $3,000 in cash, the creditor may disclose a downpayment of $3,000 or of $1,000.
The concept that the Commentary is dealing with in these illustrations is "netting." Creditors may elect to "net" the customer's cash against the negative equity. Alternatively, they may show the cash as a downpayment and then show the amount of negative equity in the amount financed.
So that's the federal disclosure rule. Pretty simple, right? So what's all the fuss about negative equity?
The problem is that the federal treatment of negative equity is only a part of the regulatory scheme dealing with the topic – the federal disclosure part. The states also get into the act.
In "My Fair Lady," Professor Henry Higgins says at one point, "The French don't care what they do, as long as they pronounce it correctly." The Feds are interested in disclosure, and not in the substance of transactions. So the Feds don't care what creditors do, as long as they disclose it properly. As an example, federal law does not limit the amount of late charges a creditor can impose in a credit sale, but federal law does require that the charges be disclosed in a certain way.
It is state law that governs the substance of a motor vehicle retail installment sales transaction, and state laws dealing with negative equity can be dangerous. And plaintiffs' lawyers are using state law theories to attack negative equity deals. Here are some of the problems the consumer advocates have identified:
Does the Consumer Know What the Dealer Is Doing ? Consumer advocates take the view that dealers who "hide the ball" and finance negative equity by increasing the cash price are giving themselves increased opportunities for price deception, sometimes leading to cash price inflations that exceed the amount of the negative equity.
Lemon Law and Other Buy-Backs. Sometimes a dealer is required by a state lemon law to repurchase a car from a buyer. A court or arbitrator could also force a repurchase. A dealer who has buried negative equity in the cash price may find that his obligation to repurchase will be at the inflated price.
Licensing. Consumer advocates note that dealers who advance funds to pay a consumer's negative equity are, in effect, making loans, and that in some states, loan laws would appear to require a license for this activity. After the revisions to the Commentary, many states passed laws to expressly permit dealers to engage in these transactions without obtaining a lender's license, but the question is still an open one in some states.
Retail Installment Sales Act Violations. Most states have a retail installment sales act ("RISA") that governs the credit sale of vehicles. These laws usually define key terms, such as "cash price." In some states, the definition expressly permits negative equity as an element of the cash price, but in others, the definition is murky or worse. Including negative equity in the cash price in the face of a definition that doesn't expressly accommodate it can lead to a charge that the dealer has violated the RISA and/or the state's unfair and deceptive acts and practices ("UDAP") law. Another problem – a state law that would permit burying negative equity in the cash price might still run afoul of the federal disclosure rules, which appear to require the disclosure of negative equity as a line item in the federal Itemization of Amount Financed.
Advertising. Some states' dealer laws and regulations require a dealer to sell a car at the car's advertised price. Juicing the advertised price to include negative equity could violate these laws or regulations, or could be alleged to be a UDAP violation.
Sales Tax Violations. If the vehicle cash price is inflated to cover negative equity and if sales tax is imposed on the inflated cash price, the buyer will be charged a higher sales tax figure. Consumer advocates argue that the extra taxes are damages to the buyer.
GAP Problems. GAP coverage is a popular dealer "soft add." Problems can arise when the GAP policy limits the payout to a percentage of the vehicle's value (say 110%). If there is enough negative equity in the deal, the entire GAP may not be covered, and the dealer's representations in selling GAP could be alleged to be deceptive.
We are sure that there are other issues and problems with negative equity deals that we haven't been smart enough to identify. The problems are limited only by the imaginations of consumer advocates and plaintiffs' attorneys. What's a poor dealer to do? Have your lawyer review federal and state law and make sure that you really understand the rules that apply to your deals. And use an arbitration agreement that prohibits class relief in order to make sure that any problems that develop will be limited to "oneseys and twoseys." A negative equity class action could ruin your whole day.
In response to an article in last month's issue about a negative equity case in Texas, we got the following email:
"We love Spot Delivery and recommend it to everyone in the industry who will listen. Oftentimes, your articles end with tidbits of wisdom to be learned from the cases, but one article in your June 2005 edition left me hanging. The page 1 article entitled Dealer's Treatment of Negative Equity Potentially Violates Texas Finance Code didn't give any advice on the common practice of over allowances on trade-ins. I also searched the archives with no luck. Can you enlighten us?"
This month's negative equity article is a direct response to our reader's email. Although we always try to give practical advice when we write about legal issues, the negative equity case last month dealt with a single narrow Texas law issue and just wasn't a good springboard for a general discussion of the topic. We trust that this month's article fits the bill.
* Patricia Covington is a partner in the Maryland office of Hudson Cook, LLP . Until recently, Patricia was Deputy General Counsel at CARMAX Superstores, Inc. Patricia can be reached at 410-865-5409 or by email at pcovington@hudco.com .
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For more information about Thomas Hudson and Spot Delivery® go to www.spotdelivery.com or contact: tbhudson@hudco.com
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