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.
The new California Automotive Franchise legislation that takes effect on Jan. 1, 1999 will have considerable impact on dealership buy-sell transactions in the state. AB 2707 modernizes the Automotive Franchise Act (the “Act”) in California which was first enacted in 1973.
The original legislation recognized the disparity in bargaining power between California new car dealers and vehicle manufacturers, and added many dealer/consumer protections. The Act accomplished this by:
- requiring manufacturers, distributors, and their representatives to be licensed by the DMV;
- establishing a list of unlawful and prohibited manufacturer acts to prevent coercive manufacturer conduct; and
- creating dealer protest rights to be adjudicated before the New Motor Vehicle Board (“Board”).
Although some of the provisions of the Act had been updated during the past 25 years, the Act itself had not undergone a major revision until the enactment of AB 2707. AB 2707 was the product of extensive discussions and negotiations conducted in both houses of the legislature, and generated overwhelming bi-partisan support: Assembly Transportation Committee 13-1; Assembly Floor 68-2; Senate Judiciary 7-0; Senate Floor 32-2; and Assembly Concurrent 72-1.
This article focuses on the various provisions of the new Act affecting the process of buying and selling automobile dealerships.
Updating the Definition of “Franchise”
Virtually all automotive franchise agreements grant the dealer/franchisee a non-exclusive right to purchase from the franchisor new motor vehicles for resale or lease, and specify conditions under which the franchisee is authorized to perform service and warranty repairs on those vehicles.
The Vehicle Code has long regulated the performance of warranty repairs and service by new motor vehicle dealers, manufacturers, and distributors, and has granted dealers a variety of warranty protest rights. However, a reference to warranty repairs and service was not specifically included in the definition of a “franchise.” Moreover, when the definition of “franchise” was added to the Vehicle Code in 1974, leasing new motor vehicles by franchisees was not commonplace. Last year, leasing accounted for approximately 35% of all California retail new vehicle transactions, and for some vehicle line-makes, such as Mercedes Benz and BMW, leasing penetration hit 80%.
AB 2707 updates the Vehicle Code definitions of “franchise” and “franchisee” to clarify that automotive franchise agreements cover not only the right to sell new motor vehicles manufactured by the vehicle’s manufacturer or distributor, but also the right to lease such vehicles and perform authorized warranty repairs and service.
Satellite Warranty Facilities
Under the existing provisions of Vehicle Code Section 3062, a new car dealer is permitted to challenge before the New Motor Vehicle Board a manufacturer’s decision to add a new “dealership” of the same line-make within the 10-mile relevant market area surrounding his or her dealership. However, when Vehicle Code Section 3062 was crafted back in 1973, the term “dealership” was not defined. A definition was not necessary because virtually all new car dealerships include sales and service facilities at a common location.
Manufacturers and dealers have recently begun to experiment with “satellite warranty facilities” – stand-alone dealer-owned facilities where authorized warranty repairs can be performed but no selling or leasing takes place. Some manufacturers have taken the position that the term “dealership” only includes facilities where vehicle sales occur, and that when a manufacturer authorizes the establishment of a new stand-alone warranty repair facility, franchisees of the same line-make who are located within the relevant market area of the proposed new facility do not have the right to challenge the manufacturer’s proposed action.
AB 2707 addresses these problems by: (1) defining the term “dealership” as any facility where a dealer is authorized by its franchisor to offer for sale or lease, display for sale or lease, or sell or lease vehicles; (2) defining the term “satellite warranty facility” as a facility operated by a franchisee where authorized warranty repairs and service are performed but no displaying, selling or leasing of new vehicles takes place; and, (3) specifying that a dealer may challenge the establishment of a satellite warranty facility of the same line-make if it is to be located withintwo milesof his or her dealership.
It is important to note that AB 2707 doesnotprohibit the establishment of a satellite warranty facility within 2 miles of an existing dealership of the same line-make. Rather, AB 2707 simply permits a dealer who has heavily invested in a full service dealership that is currently providing healthy competition and convenient warranty service to challenge the need for a surplus warranty facility to be located within 2 miles of his or her dealership before a state board that was created to hear just such matters.
When challenging the manufacturer’s proposed action, the challenging dealer would have the burden of proof to demonstrate that “good cause” does not exist for the establishment of an additional warranty facility. In such a proceeding, the Board would be required to consider the criteria set forth in Vehicle Code § 3063.
Under existing law, a dealer may not sell, assign, or transfer an existing franchise without the consent of the franchisor, but the franchisor may not unreasonably withhold consent. However, existing law does not establish a procedure for the processing of a dealer request to transfer a franchise or specify a time period during which a franchisor must respond.
AB 2707 corrects these deficiencies by: (1) requiring the transferring dealer to give written notice of the proposed transfer to the franchisor together with a copy of all of the agreements related to the proposed transfer and a completed application by the proposed transferee to become the successor franchisee; (2) requiring the franchisor to make a determination whether to approve or disapprove the proposed transfer within 60 days of the dealer notifying the franchisor of the proposed transaction (the time period can be extended by mutual agreement) and supplying the franchisor with a completed transfer application; and, (3) if the proposed transfer is disapproved, requiring the franchisor to include in the notice of disapproval a statement setting forth the reasons for the disapproval.
Finally, AB 2707 clarifies that in any action under the Vehicle Code in which a manufacturer’s or distributor’s withholding of consent is an issue, whether the withholding of consent was “reasonable” is a question of fact requiring consideration of “all the existing circumstances”.
Right of First Refusal
Under existing law it is unlawful for a manufacturer or distributor “To prevent or require, or attempt to prevent or require, by contract or otherwise, any dealer, or any officer, partner, or stockholder of any dealership, the sale or transfer of any part of the interest of any of them to any other person or persons.” Some manufacturers insert rights of first refusal provisions in their franchise agreements which can prevent a dealer from selling his or her dealership to a buyer of choice.
AB 2707 permits the exercise of a right of first refusal option provided the franchisor meets the following reasonable requirements:
(1) The right of first refusal is contained in the franchise agreement.
(2) The franchisor gives written notice of its exercise of the right of first refusal within 45 days of receiving a completed dealer request for approval of the proposed sale, transfer, or assignment.
(3) The proposed sale, transfer, or assignment must relate to not less than all or substantially all of the assets of the franchised business, or to a controlling interest in the franchised business.
(4) The proposed transferee is not a family member of an owner of the franchised business, nor a managerial employee of the franchisee owning 15% or more of the franchised business, nor a corporation, partnership or other legal entity owned by the existing owners of the franchised business. However, a manufacturer may still disapprove the proposed transfer if the family member or managerial employee does not meet the franchisor’s reasonable requirements to qualify as one of its dealers.
(5) The consideration paid by the franchisor to the franchisee must equal or exceed all consideration which he or she would have received under the terms of, or in connection with, the proposed sale, assignment, or transfer, and the franchisor must comply with all the terms and conditions of the agreement to sell, transfer, or assign the franchised business.
(6) The franchisor shall reimburse the proposed transferee for any reasonable expenses paid or incurred by the proposed transferee in evaluating, investigating, and negotiating the proposed transfer.
PROVISIONS NOT DISCUSSED IN THIS ARTICLE
There are other amendments to the Act not discussed in this article consisting of notice requirements manufacturers are obligated to give in terminating, relocating, establishing, or modifying a franchise; abolition of the model change carryover allowance rule; technical provisions dealing with New Motor Vehicle board decisions; and prohibitions against factory discrimination in favor of partially or wholly owned factory stores.
QUESTION AND ANSWER DISCUSSION OF AB 2707
The following is an interview conducted by Dealer Buy-Sell editor Penny L. Reeves with her partner, Joseph E. Berberich and former partner Bert Rasmussen regarding about the impact of the new California Franchise Legislation on dealership buy-sell transactions.
Reeves: Is there anything in the new definition of a franchise which may impact the buy-sell process?
Berberich: The new definition does make it clear that a franchise includes not only the right to sell new vehicles, but to also lease new vehicles, and to perform authorized warranty repairs and service. Although this does not appear to directly impact the buy-sell process as we know it, it is an important clarification of what a franchise is.
Rasmussen: Another interesting aspect of the new law is the discussion in the franchise definition and in other areas of the legislation relating to protest rights regarding the establishment of satellite service facilities by franchisors of the same line-make in a dealer’s relevant market area. If the satellite service center is within two miles of a dealer’s place of business, the dealer has a right to protest to the New Motor Vehicle Board.
Berberich: An important part of the statute dealing with satellite warranty facilities is that section of the new law that defines a satellite warranty facility as a place where authorized warranty repairs and service are performed, but which contains a specific provision that there shall be no display, selling or leasing of new vehicles at that facility. Some dealers may be tempted to think that they can display or sell new vehicles at those facilities, but the law does specifically prohibit that. However, I would imagine we are going to see used vehicles being sold from satellite service facilities.
Reeves: I see the new law has several technical terms regarding notice of protest rights. What impact will this have on buy-sell agreement drafting issues?
Rasmussen: Generally, we find that the seller will be asked to make a warranty in the buy-sell that he has not received any notice or other communication from the factory indicating the factory is about to take some action that could be subject to protest such as a termination of the franchise, establishment of a nearby franchise location, or a modification of the franchise agreement. With the detailed notice requirements contained in this new law, it should be extremely clear to a dealer if he or she has received such notice.
Berberich: That’s right because as anyone who reads the statute will find out, the notice of a franchise termination, or a notice that an additional motor vehicle dealership is going to be established in your relevant market area, or that your franchise is being modified, has to be very conspicuous on the letter or notice that a dealer receives from the factory.
Reeves: This law talks a lot about rights of first refusal and procedures to be followed when a dealer decides to sell an interest in the franchise business. Could you please give our readers a brief description of what a right of first refusal is?
Rasmussen: A right of first refusal generally is a right to acquire property from the seller simply by matching the terms that a prospective buyer is ready to pay. Usually submitting a buy-sell agreement to the factory for approval triggers the right of first refusal. Once triggered, the factory needs to decide whether to exercise the right by some preset deadline usually contained in the franchise agreement.
Berberich: Yes, and it’s true that most franchise agreements, but not all, do have rights of first refusal in one form or another.
Reeves: Are all of the rights of first refusal found in franchise agreements the same?
Rasmussen: No, as with any other contractual term, rights of first refusal are subject to great variation from one franchise agreement to another. For those that do include them, some purport to apply not only to dealership personal property assets, but real property as well, and sometimes even if the real property is owned by another dealer principal rather than the dealer entity itself. Others are drafted more like options where, for example, the factory has the right to acquire the dealership by paying in cash the value of the consideration to be received by the seller. Such an option in theory would permit the factory to bypass a condition in a buy-sell that the buyer employ the seller as a consultant. The factory would just pay a lump sum equal to the value of the consultant’s compensation. There are many other variations as well. Timing differences, differences in the notice that must be given to the factory in order to start the clock ticking on their opportunity to exercise the right of first refusal, and so on.
Reeves: What would you say to someone who maintains that rights of first refusal harm buyers not sellers?
Rasmussen: Well, the answer would be that by having invested time and money in putting a buy-sell together, only to be left out in the cold upon exercise of the factory’s right of first refusal, buyers do appear to be the primary casualties, but sellers can also be damaged. Rights of first refusal can chill the interest level of prospective buyers, succession plans can be derailed, careful planning over the exact makeup and timing of purchase price payments can be upset, and a poorly drafted agreement might leave the seller open to a breach of contract claim by the jilted buyer, if for example, there was no contingency set forth in the agreement that relieves the seller of the duty to sell if the factory exercises the right of first refusal.
Berberich: However, it has been my experience that a factory exercising a right of first refusal is a fairly rare thing to see in the world of buying and selling automobile dealerships. However, the fact that a right of first refusal does exist in a franchise agreement always clouds the process and so the new statute will bring some order or standardization to the process of an exercise of a right of first refusal.
Reeves: What would you consider to be the single most important benefit of this new statute in bringing some order to the world of rights of first refusal?
Berberich: Well there is one provision of the statute that makes a factory’s exercise of the right of first refusal dependent upon the factory complying with “All of the terms and conditions of the agreement or agreements to sell, transfer or assign the franchise business.” This is a very important provision because dealers can now expect that if a factory is going to exercise a right of first refusal, any conditions to the sale agreed to by the buyer must also be met by the factory. Bert, you might want to give some examples of how that might work in the real world.
Rasmussen: Some examples of conditions that the factories might wish to avoid, but would now be obligated to satisfy, would be employment of the selling dealer principal in the new dealer operations, or as a consultant over some period of years, and perhaps employment of some trusted and loyal employee such as the business manager for some period of time after the sale closes. Other instances could include the payment of the purchase price in the form of some unique property that is only available from the seller. In that instance there would be a question as to whether or not the factory would be in a position to meet that condition.
Berberich: I believe one of the most important results of this new provision in the law is that when a dealer wants to sell or lease the real property on which the dealership does business and that becomes one of the conditions of the sale, then for a factory to exercise the right of first refusal it would have to agree to those same terms. In other words, if the dealer and the prospective buyer have arrived at the amount of the purchase price for the sale of the real estate, that is what the factory would be bound by. Or, if they have arrived on the terms of a lease, the factory would be bound by that also. There might even be situations where the sale of the dealership might be conditioned upon the buyers buying another dealership owned by that same dealer. If that were the case, for a factory to exercise the right of first refusal under this law, the factory would also have to buy that other dealership.
Reeves: Are there any exceptions to the factory’s exercise of a right of first refusal?
Rasmussen: Yes. I believe this was one of the key standardization aspects of the statute. Many rights of first refusal had by their own terms excluded their applicability to transfers to for example, persons named on the successor addendum to the franchise agreement. Some allowed family members to be excluded under certain circumstances. The new law sets up a very comprehensive list of situations where the right of first refusal would not be subject to exercise by the factory. These include the sale or transfer to a member of the dealer’s family (the term family being defined in the statute quite precisely), transfers to managerial employees of the dealership who own a 15% or more interest in the dealership entity, and transfers that do not involve the transfer of all or substantially all of the dealership assets or a controlling interest in the dealership business. So, for example, if a dealer elected to sell 25% of the store to a third party, a right of first refusal, however drafted, would not, under the terms of this statute, apply. Likewise, if the dealer elected to sell an important asset of the franchise business such as the dealership owned real property, the sale of the property would most likely not be considered substantially all of the dealer assets and so that transfer could take place regardless of the terms of the right of first refusal in the franchise agreement.
Reeves: What happens to the poor buyer who has spent a lot of money with lawyers, accountants, environmental consultants, and the like, and then the factory does exercise its right of first refusal?
Rasmussen: Well, in that case, the law recognizes that the buyer should not simply be left hanging, having been in essence a stalking horse for the factory’s ultimate decision to go ahead and purchase the dealership. Therefore, the factory is required to reimburse the jilted buyer with reasonable expenses incurred for attorney fees, environmental review and other reasonable expenses.
Reeves: How long does the factory have to exercise its right of first refusal?
Rasmussen: They have 45 days from the date the dealer submits the information that the statute now identifies for seeking factory approval to a proposed buy-sell.
Reeves: I know that the new statute provides a lot of detail about the process of factory approval when a dealer wants to sell the dealership. What are some of the important issues covered in this area?
Berberich: One thing that shows up in the new statute is the California legislature’s reaffirmation of a dealer’s right to sell, assign or transfer the dealer’s franchise. Sale, assignment or transfer of the franchise is something quite different from a dealer’s termination of a franchise and the issuance of a new franchise to the new dealer. That is commonly the way it has been done.
Rasmussen: Right. The factories ask the seller to terminate his or her existing franchise agreement and propose a new franchise agreement to the buyer. And while this practice might be acceptable to all parties in many cases, other situations find the factory seeking to impose restrictions or new requirements on the buyer that the seller had never been required to live with under the existing franchise.
Reeves: Are you implying that a factory cannot impose new requirements on the buyer that the seller was not required to comply with?
Rasmussen: Yes, the statute frames the issue in terms of not allowing the franchisor to condition its consent on any modification of the franchise or the waiver or release of any claims or defenses of the dealer. So while the exact contours of this provision are yet to be explored, it can reasonably be assumed that a factory cannot use the opportunity of a buy-sell to extract additional requirements from the new dealer or seek to have the selling dealer waive or release any legal rights that he or she might have against the franchisor.
Reeves: Does this mean that if a dealer had an existing two year franchise with six months to go on the franchise, the buyer would be receiving that franchise with only six months left to go on it?
Rasmussen: Well, as we have pointed out on other occasions, the duration of a franchise is somewhat of a tricky issue in California given our New Motor Vehicle Board’s jurisdiction over attempts to terminate or fail to renew a franchise, but I believe the argument could be made that the franchise that is to be transferred with the factory’s reasonable consent would be with the remaining term and other pertinent rights under the existing franchise.
Reeves: Don’t you think as a practical matter that dealers and factories will still continue to operate the way they have in the past, namely, the selling dealer terminates the franchise and the buyer receives a new franchise?
Berberich: Yes. Practically speaking, there are several things that need to be changed in the agreement in any event such as the statement of ownership, dealer-operator designation, name of dealer and other matters. So a new franchise agreement most likely would be executed with the old contract being deemed terminated. However, if the rights and duties of the buyer were being substantially modified by the factory, the buyer should be able to rely on the law as modified by these new statutory terms to argue that his or her franchise agreement should be substantially identical to the one the seller had operated under.
Reeves: The new statute requires that factories either approve or disapprove of a buyer within 60 days after the new buyer’s application has been submitted to the factory. Is this a sufficient amount of time to accomplish a franchise transfer?
Rasmussen: Well, the specific issue that is subject to the 60 day timing rule is the approval of the prospective transferee, and although the buy-sell may actually close on a date beyond the 60 day period, many cases would find the information in order for the factory to grant their consent to the transfer in advance of the closing. For those situations where the franchisor needs more time to review and investigate the qualifications of the prospective transferee, the statute provides for flexibility in the form of extensions by mutual written agreement as well as triggering the commencement of these deadlines only after appropriate information has been provided.
Berberich: You have to remember that that 60 days does not start running until the buyer has submitted all of the information required by the factory. My experience has been that sometimes it can be 30 to 60 days before a buyer has given the factory everything that the factory requires for approval. Another interesting aspect of this new statute is that it really now falls on the seller to deliver the buyer’s application and information to the factory. This puts the seller in much more direct control of the entire process. In times past, sometimes a seller wouldn’t quite know what was going on between the buyer and the factory, but the new statute clearly indicates now that all of the buyer’s information is to be submitted through the seller – so the seller is going to have a lot more information about the current status of the approval process than most sellers had in the past.
Rasmussen: That’s right, and the statute also says that if the factory deems the application incomplete or in need of further information, the factory will notify the seller of whatever information is needed to make the application complete. Of course, the statute also says that such information requests should also be copied to the proposed transferee.
Reeves: What criteria can the factory use in approving or disapproving of a prospective buyer?
Berberich: The new statute deals with that issue, but it does not lay out a laundry list of criteria to be used. Instead, it provides that whether or not the factory’s consent or refusal to grant consent is reasonable depends on an inquiry into all of the existing circumstances and will be treated as a question of fact rather than a question of law. That means that it is left to an ordinary common sense approach taking into consideration all relevant circumstances to determine whether or not the refusal to grant consent is unreasonable, and it does not depend on some legalistic formulation of reasonableness of consent.
Reeves: Is that a change in existing law?
Rasmussen: It certainly clarifies existing law and changes the rule from that enunciated in some reported court decisions, primarily from bankruptcy courts. Under those decisions, it had been ruled that factories could withhold their consent and be deemed to have acted reasonably where one, and only one, justifiable business criteria existed to reject the application. In other words, the factory could establish its own list of qualifications that prospective transferees would have to meet, and if it could be shown that just one item on that list was both a reasonable business criteria and that the prospective transferee fell short of the mark on that criteria, the entire application for transfer could be denied.
Reeves: Does this mean, for example, that a factory might not be able to disapprove of a buyer on the sole grounds that the buyer’s consumer satisfaction performance in running another dealership was not as high as the factory would like to see it?
Rasmussen: Yes. If there was merely a failure by the buyer to demonstrate a stellar CSI and this was the factory’s sole basis for a turn down, most likely there would be other circumstances that would overcome this one deficiency such that overall it would be unreasonable for the factory to withhold its consent on the basis of a modest CSI rating.
Reeves: What if a dealer wants to sell to a publicly owned company, does this statute allow the factory to disapprove of a sale to a publicly owned company?
Berberich: I think this statute must be considered to have remained silent on the issue of public ownership in favor of an approach which again focuses attention on all of the facts and circumstances existing at the time of the proposed transfer. So for example, if a dealer of a line-make which currently has a substantial amount of public ownership were to be turned down on the basis of a new policy by the factory to limit public ownership, that turn down might be considered unreasonable. A factory, however, could turn down a publicly owned buyer if the factory could show that there were reasonable grounds for the turndown under all of the facts and circumstances.
Reeves: You have talked a lot about the reasonableness of franchise turndowns being determined as a question of fact under all of the circumstances. Where would a dealer go to have an adjudication of reasonableness in such a situation?
Rasmussen: For many years, the prevailing thought had been that the New Motor Vehicle Board would be not only available to resolve such disputes, but would be the exclusive forum for hearing such disputes. Recent case law and another statutory change have backed away from the notion that the New Motor Vehicle Board would be the exclusive forum to resolve factory-dealer disputes. Now, in light of these court cases and legislation, it is quite clear that a dealer faced with a factory turndown which the dealer considers to be unreasonable could go directly to court over the issue. Whether the dealer could elect instead to go to the New Motor Vehicle Board and file a petition is somewhat of an open question. Although the Board would most likely accept such a petition for filing at this point, the nature of the relief that could be afforded to the petitioning dealer is limited.
Berberich: In these types of situations there is usually a need for some rather quick action because the prospective buyer typically does not want to be tied up for two years in court litigation. The advantage of taking these types of disputes to the New Motor Vehicle Board is that they are resolved quite quickly and that very early in the proceedings a settlement conference is held by the Board with the parties.
Rasmussen: That is right. My experience is that many matters brought before the Board are resolved at the mandatory settlement conference.
Reeves: You said that the new statute does not specifically address the issue of public ownership. Does it make any changes in the area of factory ownership of motor vehicle dealerships?
Berberich: Yes, the new statute contains a very important provision which basically says that factories are prevented from unfairly discriminating in favor of any dealership which they own or control in whole or in part. The effect of this is that factories will not be allowed to give factory owned stores special allocations of vehicles which are the most favored product, factories will not be allowed to provide factory stores with more favorable financing than is given to other dealers, and factories will not be able to discriminate in any way in favor of such dealers.
Rasmussen: I agree that this is a very important provision in this age of increased factory owned or controlled stores, especially when you consider that the general law which would prohibit discrimination generally among dealers is quite limited in its scope and enforcement.
Note: As you can see from the foregoing discussion, AB 2707 is a complex piece of legislation. We will keep our readers advised of new developments arising out of this legislation in upcoming newsletters.