The Unintended Consequences of Good Intentions

The chapter 11 bankruptcy cases of Chrysler and General Motors received a great deal of press coverage in 2009. (For an excellent and concise summary of these chapter 11 cases, see here.) Although both cases were extremely quick, they were very painful for many people. For example, Chrysler and General Motors collectively terminated their relationships with almost 2,000 franchisees (i.e., local auto dealers), leaving these dealerships with little ability to continue their business operations. For many franchisees, their dealerships were their livelihoods.

Now you may ask, “How can this happen?” You may even agree with some of the dealers and observers that it is “un-American.” As counterintuitive as it may seem, however, this type of contract termination is very common and completely permissible under U.S. bankruptcy laws. When a company files for chapter 11 protection, it receives the right to evaluate its executory contracts (including franchise agreements) and decide whether to keep the contract, assign it to another party or reject it. The non-debtor party to the contract can object to, and the Bankruptcy Court must approve, the debtor’s decision. The non-debtor party also can assert a bankruptcy damages claim if the contract is rejected.

The treatment of franchise agreements and the rights of franchisees are common issues in franchisor chapter 11 cases. Nevertheless, the Chrysler and General Motors cases are different because, among other things, state legislatures and Congress have intervened on behalf of franchisees. At least four states have enacted or are contemplating legislation trying to preserve some of the rights of franchisees under state law, and Congress recently passed legislation (see here section 747) giving franchisees the right to seek binding arbitration as to whether or not their franchise agreements should be terminated. This legislation follows several decisions by the Bankruptcy Court not only approving the rejection of these agreements but, in the Chrysler case, also enjoining the franchisees from pursuing their state law rights.

Now, I have no doubt that legislators are trying to respond to the public outrage over the treatment of the Chrysler and General Motors dealers. This response is understandable from a purely human, as well as political perspective. But is it good policy? Other than the fact that the U.S. government owns part of these companies, is there anything that distinguishes the economic harm suffered by the dealers from that suffered by every other claimant in these and other chapter 11 cases? The federal legislation basically gives this one class of claimants in these two particular chapter 11 cases the right to challenge the decisions of the Bankruptcy Court outside of the bankruptcy process and subject to a different standard of review. (In bankruptcy, the debtor’s decision to reject a contract is reviewed under a business judgment standard. Under the federal legislation, the arbitrator is to consider and balance the economic interests of the debtor, the dealer and the public at large.) What about the state legislation purporting to preserve not only the franchisees’ state law rights but also to foreclose the franchisors’ ability to grant new franchises in the jurisdiction; should states be allowed to legislate around the results of a federal bankruptcy case (and what about federal pre-emption issues; see, e.g., last paragraph here)? And will any of this legislation help the majority of dealers; do they have the resources to keep their dealerships open and participate in the arbitration process? If not, is the potential cost to the federal bankruptcy system really worth the benefits? I do not necessarily have the answers, but I think these are important questions to consider.

You may also like...

8 Responses

  1. “Other than the fact that the U.S. government owns part of these companies, is there anything that distinguishes the economic harm suffered by the dealers from that suffered by every other claimant in these and other chapter 11 cases?”

    Well that’s a pretty big difference. Had it gone through a normal bankruptcy process, creditors et al would have had a true day in court and perhaps the taint of politics wouldn’t have so appropriately attached to the results. Instead, this administration was able to ram-rod these bankruptcies through. So, with the ship of executive interference having already sailed then, I hardly find it separately objectionable that the legislature also wants to prove how little it knows about running an auto business.

    Any wounds to the federal bankruptcy system this process inflicts are self-inflicted; they shoulda, coulda told the WH to butt out…but I guess they too were still basking in the glow of change we could believe in.

  2. Michelle Harner says:

    Thank you for the comment. You are right that the government’s intervention raises unique issues in these cases. (For an interesting and broader review of the government’s role in business during the crisis, see a recent paper by J.W. Verret titled, “Treasury, Inc.”, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1461143&rec=1&srcabs=1436660.) And that intervention is a key concern underlying the questions I raise. That being said, I am not sure the government’s presence influenced the company’s decision to close dealerships or the court’s approval of that decision. Corporate debtors typically receive substantial deference with respect to their contract treatment decisions.

  3. Garrett Wollman says:

    *Public* outrage? I’ve heard precious little of that. The only outrage I’ve heard about this has come from the people who benefit from long-term relationships with these dealers: sellers of advertising space/time (newspapers, radio and TV stations), and of influence (politicians).

  4. Michelle Harner says:

    Garrett:

    Thank you for the comment. I think you identify two of the key voices in this debate, but I also think there are others. For example, the dealers themselves have been very vocal. They have used the media and the court itself, filing almost 200 responses to Chrylser’s motion to reject certain dealership agreements. And I think there has been a lot of public support generated for these dealers in their home jurisdictions. If the concern was solely the loss of advertising space, presumably states would not be proposing legislation to block Chrysler and GM from granting new franchises in their jurisdictions. That being said, I suspect that you are right that it has played some role. In any event, my reference to “public outrage” really was focused on the dealers and their supporters who have circulated petitions and otherwise been very active in this process.

    Best regards, Michelle.

  5. Confused 2(now 3)L says:

    I think its important to realize that in many states dealer franchisee agreements already exist in a highly regulated and primarily dealer favorable environment in almost all states. Manufacturers are prohibited from selling directly to market, dealers are granted exclusive territories, once granted manufactures were prevented or severely limited from terminating and restructuring agreements. The degree of the closings are largely attributable to the fact that manufacturers were incapable from pruning their dealer networks over the last few decades.

    The reasoning behind the favorable treatment of dealers is the outsize role car dealerships have generally played in local life and especially in local politics. As a class, dealers have always been generous contributors to candidates for state government and the House. This explains why all the complaints so far have originated in the House, and from both sides of the aisle, while very few senators have weighed in on the issue.

  6. Michelle Harner says:

    Thank you for the comment and insights. I particularly like your points regarding state law protections for dealers and the difficulties of pruning dealership agreements. I seem to recall that GM paid a large sum of money to buy out its Oldsmobile dealership agreements in the early 2000s.

  7. I agree the government presence was probably not wholly dispositive as to dealer de-selection but this administration’s presence surely added an appearance of impropriety.

    As an exercise, mentally rank union workers, union retirees, non-union retirees, bondholders and auto dealers in order of who did best under the bankruptcy; now rank by where you think they fit in the Obama coalition. Any changes? If you didn’t trust the government going into the process, nothing about it gives you any reason to rethink your suspicions.

  8. Michelle Harner says:

    I understand your point. Interestingly, in cases not involving the government, we are seeing similar influence exercised by senior lenders and what I like to call activist distressed debt investors. These parties of course lack regulatory control over the debtors, but they are finding ways to dictate the outcome of chapter 11 cases. I am going to discuss the issue of increasing creditor control in a future post. Thanks again for the comment.