Free Enterprise - The FindLaw Small Business Law Blog

Chrysler Plans to Cut 789 Dealerships; When Franchisors Declare Bankruptcy

Chrysler plans to eliminate 789 of the dealers in its network. This represents 25% of its dealers, many of whom still had life left on their Dealership Agreements. As a warning to any franchisee whose franchisor might declare bankruptcy, the bankruptcy process may allow a franchisor to reject the franchise agreements it wants to shed.

In normal circumstances, a franchisor (even if it's one of the Big 3 automakers) may not simply reject franchise agreements it has in place. This can quickly change, however, if the franchisor declares bankruptcy. Chrysler filed for bankruptcy on April 30. Its plan for reorganization involves a marriage to Italian automaker Fiat and shrinking its dealership network. Thouh it hasn't declared bankruptcy, according to the Washington Post, GM will allow around 1100 dealer agreements lapse next year.

As the Post quoted from Chrysler's filing today with the bankruptcy court, "[i]mmediate rejection of these agreements is necessary and appropriate to begin the work necessary to complete the transition to the smaller, more effective, and more profitable dealer network . . . and minimize disruption upon the closing of the Fiat" sale.

So, what happens to franchisees when the franchisor declares bankruptcy?

Franchise agreements are treated by the bankruptcy code as "executory contracts." When a debtor (here Chrysler) declares bankruptcy, they have the option of either "assuming," "assuming and assigning" or "rejecting" executory contracts.

"Assumption" means accepting the obligation of the agreement (and also curing any breaches). "Assuming and assigning" means selling the franchise agreement to a third party. "Rejection," typically the worst case scenario for a franchisee, means that the franchisee will no longer be obligated to perform its side of the bargain.

Selection of any of these options must be approved by the bankruptcy court. The other side on such contracts (here, the dealerships) can petition the court to object. However, courts typically use a "business judgment" test to determine whether the debtor may take the course of action chosen. If the court finds the debtor to have made an informed judgment that contract rejection would benefit the bankruptcy estate, it will likely let the franchisor reject.

This leaves franchisees out in the cold. The franchisor is no longer required to perform under the agreement (often meaning no supply of products or ingredients). Rejection of the franchise agreement is considered a breach of the contract, for which the franchisee can sue. However, damage claims for rejection of franchise agreements are treated as unsecured pre-bankruptcy petition claims.

This puts franchisees with rejected franchise agreements in the back of the line with everyone else having claims against the franchisor, typically collecting only pennies on the dollar.