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.