NOTE: The following article is from the collection of articles in our Automobile Dealership Buy/Sell Newsletters. The newsletter deals with the complex area of buying and selling automobile dealerships. Some of the material may not be up to date because of changes in the law from the date shown at the end of the article. This article is not to be taken as legal, accounting, tax, or other advice. You should consult your own professionals for such advice and for any updating of the information provided.
Imagine the following scenario. A dealer is in serious financial trouble. He has just gone out of trust with his flooring lender, and is having difficulty paying rent, making payroll, and meeting other substantial obligations in a timely manner, such as sales tax and EDD contributions. Although the dealer has tried to work things out with the flooring lender, he has decided his best course of action is to sell his dealership as a going concern in order to realize as much of his dealership's asset value, including goodwill, as possible. He has found what he believes to be a willing and able buyer and has begun negotiations for the sale of the dealership as a going concern. The problem, however, is that the flooring lender, for whatever reason, does not believe the selling dealer and his prospective buyer have the ability to close an escrow within a reasonably short period of time, or at all. Fearful of incurring what it believes to be additional losses on account of a continuing out of trust situation, the flooring lender has decided to "staunch the flow of blood" by foreclosing its security interest in the remaining inventory of motor vehicles and parts. Such action will necessarily force closure of the dealership and effectively kill any prospect the selling dealer had of selling at going concern value. What, if anything, can the selling dealer and his prospective buyer do to keep their buy/sell prospects on track?
In this troubled situation, the filing of a bankruptcy proceeding by the selling dealer may be the answer. Although this may not be a perfect solution to the selling dealer's problems (a greater degree of patience and cooperation by the flooring lender would certainly be preferable). the filing of a bankruptcy proceeding may be the only way the selling dealer and his prospective buyer can move the buy-sell process to completion while keeping creditors at bay. However, because of various features of bankruptcy law necessarily brought into play, bankruptcy can change the normal course of the buy-sell process, giving rise to certain distinct advantages and disadvantages. Both the selling dealer and the buyer should be aware of these when the critical decision is made whether to file a bankruptcy proceeding or not.
I. PRELIMINARY CONSIDERATIONS
Immediate Benefit. The immediate benefit to the selling dealer and perhaps the chief reason for filing bankruptcy to begin with--is the "automatic stay" which goes into effect upon tile filing of the bankruptcy proceeding. The automatic stay is a statutory restraining order which bars creditors from filing or continuing lawsuits, repossessing collateral, making demands for payment of debts or return of collateral, or taking any other steps to interfere with the dealership's business. If a creditor desires to take any such action, it would be required to first file the appropriate action in the bankruptcy court, obtain a court hearing, and give notice to the dealership and all other interested parties. Since this process takes time, the automatic stay necessarily gives the selling dealer breathing space to move the buy-sell process forward without creditor interference.
Initial Choice: Chapter 7 v. Chapter 11. The first choice the selling dealer must make is whether his dealership corporation should file a Chapter 7 proceeding or a Chapter 11 proceeding. Since Chapter 7 is designed for liquidation and Chapter 11 for reorganization, Chapter 11 would be the obvious choice. However, there is another reason to select Chapter 11. If a Chapter 7 liquidation is filed, a trustee will be automatically appointed to take possession of and handle the sale of the assets. In a Chapter 11, absent some fraud or malfeasance on the part of the dealer, a trustee would not normally be appointed. The selling dealer would be entitled to remain in possession of, operate, and sell the dealership assets without a bankruptcy trustee. A debtor in-that situation is referred to as a "debtor-in-possession." A dealer would be far better off operating and selling his dealership's assets as a debtor-in-possession under Chapter 11 than having a bankruptcy trustee do it for him in Chapter 7.
Cost Consideration. The decision to file a Chapter 11 proceeding adds a significant cost element to the equation: bankruptcy attorneys' fees. The selling dealer generally will not be able to use his personal attorney or corporate attorney, but rather will have to have his Chapter 11 case filed and handled entirely by a bankruptcy specialist-most likely one who is experienced in handling Chapter 11 reorganizations in general and reorganizations for motor vehicle dealerships in particular. Such bankruptcy specialists usually demand an up-front retainer of $75,000 or more. By the time the Chapter 11 case is over, the total attorney's fees for the selling dealer's bankruptcy attorney could substantially exceed even that figure.
Continued Operation of Dealership. As mentioned above, one of the principal advantages of utilizing Chapter 11 is the right of the selling dealer, as debtor-in-possession, to continue to operate the dealership in the normal course of business without a bankruptcy trustee. Another distinct advantage under bankruptcy law is that the dealer, as debtor-in-possession, is entitled to sell or lease inventory and other-wise use dealership property in the ordinary course of business without notice to or approval of creditors, or even approval of the bankruptcy court. In other words, once the Chapter 11 is filed, the dealership may continue to operate in the ordinary course of business without any unusual restraints imposed by bankruptcy law. The only important exception to this right of continued operation-and it is indeed a significant exception-is that the dealership may not spend or otherwise use proceeds of sales of inventory (referred to under bankruptcy law as "cash collateral") without either the flooring lender's approval or bankruptcy court approval. Since this cash collateral is the lifeblood of the dealership, it is critical that the dealership obtain one of these approvals at the very outset of the Chapter 11 case. As one of his first duties, the selling dealer's Chapter 11 attorney should immediately attempt to negotiate a cash collateral agreement with the flooring lender-although under bankruptcy law this will usually require the dealership to give the flooring lender consideration in return, such as additional security (if any is available) or some other acceptable assurance that the dealership will not go further out of trust while it is in Chapter 11. This additional form of consideration is referred to under bankruptcy law as "adequate protection." If the flooring lender will not agree to the dealership's use of cash collateral, then the Chapter 11 attorney should immediately file a motion to obtain bankruptcy court approval. Again, however, the dealership will have to offer some form of adequate protection to the flooring lender to obtain bankruptcy court approval. Once approval is obtained, whether from the flooring lender or the bankruptcy court, the dealership can continue operating in the normal course of business as a debtor-in possession. This is especially important if the selling dealer is to keep its buy-sell process on track at going concern value, and to avoid a conversion of the case to a Chapter 7 liquidation.
II. MOVING THE BUY-SELL THROUGH THE BANKRUPTCY PROCESS
Now that the initial issues and considerations have been taken care of, the selling dealer must continue to move the buy-sell process forward through the bankruptcy court. The first and best step he and his prospective buyer can take in that direction is to complete negotiations and enter into a written buy-sell agreement as soon as possible. Once the written agreement has been executed, bankruptcy court approval of the sale must be obtained. The process for obtaining bankruptcy court approval raises a number of issues not always associated with the normal buy-sell process. Motion and Court Hearing Required. A sale of all or substantially all of the dealership's assets requires bankruptcy court approval at a bankruptcy court hearing. For this purpose, the dealership's Chapter 11 attorney will normally, in lieu of a full-blown plan of reorganization, prepare a motion for approval of the buy-sell, attach a copy of the buy-sell agreement itself, file it with the bankruptcy court, and give notice to interested parties, such as the dealership's creditors, of the buy-sell agreement and the date of the court hearing. Creditors or other interested parties would then be free to appear at the court hearing if they had any objection to the buy-sell. Generally speaking, if the dealership meets certain limited requirements, including those outlined below, the bankruptcy court should approve the buy-sell even over the objections of an interested party.
(i) Defaults Under Franchise Agreement Must Be Cured Since a franchise agreement is considered to be an executory contract under bankruptcy law, bankruptcy law requires the dealership to cure any defaults under the franchise agreement as a condition to court approval of the buy-sell. This usually means that the dealership will be required to pay all past due amounts owing to the franchisor under the franchise agreement, such as charges due on the parts account, for signage, or otherwise.
(II) Approval of Flooring Lender. Since the assets being sold in the buy-sell will usually include those in which the flooring lender typically has a security interest, such as fixed assets and goodwill, bankruptcy law requires the dealership to obtain the consent of the flooring lender (subject to exceptions beyond the scope of this article). Realistically, the flooring lender should be reasonable and flexible in this regard, even if the proceeds of sale are less than the total amount of the flooring lender's secured debt, since the flooring lender will realize that the buy-sell will yield substantially more than would a liquidation sale.
(III) Overbidding. A feature unique to the bankruptcy process is overbidding. At the bankruptcy court hearing regarding approval of the buy-sell, the bankruptcy court will allow other prospective buyers to overbid the amount of the purchase price contained in the original buy-sell. This sometimes leads to a public auction of the dealership assets, creating the potential for driving the sale price up. However, it should be pointed out that not just anyone can waltz into court to overbid. Oftentimes the bankruptcy court will establish overbid procedures prior to the court hearing. Such procedures could include the requirement that an initial deposit be made with the court by prospective overbidders, supported by a letter of credit; the submission of financial statements by prospective overbidders prior to the court hearing; and proof of availability of floorplan financing. Moreover, the bankruptcy court will often require that the bidding process be done in minimal increments, usually of six figures. All of this is done to ensure the bona fides of any prospective overbidder . If the overbidder ends up being the high bidder at the court hearing, he then can become the buyer under the buy-sell agreement, subject, of course, to franchisor approval. If this happens, the original buyer will have been smart to have previously negotiated for a "break-up" fee from the seller, for reimbursement of the original buyer's costs and expenses. To the extent the potential for overbidding in bankruptcy puts a "chill" on the original buyer, the break-up fee can help ease his concerns.
(iv) Approval of Motion. Assuming that defaults have been cured and the flooring lender approval has been obtained, and subject to any overbidding, the bankruptcy court will normally approve the buy-sell and will not interfere with the business judgment of the dealer and his buyer in that regard. Franchisor Approval On the issue of franchisor approval, bankruptcy law explicitly defers to applicable, non-bankruptcy law. Applying California law, this means that, as in a non-bankruptcy setting, the franchisor cannot unreasonably withhold its consent to the buyer. However, there is a major difference if the buy-sell is being conducted through bankruptcy. If a franchisor is inclined to disapprove a particular buyer, the dealership can force the franchisor into bankruptcy court on this issue for a quick resolution. The dealership can bring the franchisor's disapproval to the bankruptcy court's attention and seek a ruling as to whether the franchisor acted reasonably under California law. This can happen at the same hearing as the buy-sell motion, or at a separate hearing held not long after. In either event, the parties can receive an expeditious resolution of the issue in the bankruptcy court, contrasted with what would be much more protracted litigation before the new Motor Vehicle Board outside of bankruptcy.
In an asset purchase, the general rule is that the buyer acquires only the seller's assets but none of the seller's liabilities. Over the years, the law has created exceptions to this general rule. For example, a seller's liability for defective products or for Title VII employment and civil rights discrimination can be imposed upon an asset purchaser. More pertinent to the automobile dealership buy-sell, an asset purchaser may be held liable for the seller's unpaid sales tax and EDD contributions if he has not withheld a sufficient amount from the purchase price to cover the seller's obligations. Bankruptcy law can significantly limit this successor liability. Some cases have held that, whereas an asset purchaser would otherwise be liable for the seller's product liability or discrimination torts, the purchaser would not be subject to such liability if it acquired the assets through a sale in bankruptcy. With respect to sales tax, California regulations specifically state that successor liability for sales taxes will not apply if the asset sale was conducted through a bankruptcy proceeding. The potential for restrictions on successor liability is a distinct advantage for the buyer when the buy-sell is conducted through the bankruptcy court.
Conducting a buy-sell through the bankruptcy court has distinct advantages and disadvantages. The advantages include:
- The automatic stay gives the selling dealer breathing space.
- Pending completion of the buy-sell process, the selling dealer can continue to operate the dealership in Chapter 11 without formal approval from the court or a trustee.
- The overbid process holds the potential for driving the sale price up for the selling dealer.
- Franchisor disapproval can be resolved quickly in the bankruptcy court.
- Potential successor liability of the buyer is limited.
The disadvantages of pursuing a buy-sell through the bankruptcy court include:
- The added expense of substantial bankruptcy attorney's fees.
- Bankruptcy court approval is required at various steps along the way
- The involvement of the court combined with additional procedural requirements make the process
more time consuming.
- Defaults under the franchise agreement are required to be cured.
- The overbid process might chill initial buyers who do not want to invest time and money as a mere"stalking-horse" for the ultimate high-bidding buyer.
These are some of the major issues which come into play when a decision is made to conduct a buy/sell through the bankruptcy court. Other issues may also be involved, depending upon the circumstances of the particular situation. Regardless of the circumstances, a selling dealer and his prospective buyer should always consult with an experienced bankruptcy attorney before making a decision of this magnitude.