Facility improvements deal killers?

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Dealership facility upgrades are a constant point of contention between factories and dealers. Factories can impose a wide range of facility demands, ranging from light brand image or signage updating, to complete facility refurbishment, rebuild, or even relocation. Dealers view many such requests as onerous and/or unlikely to provide any boost to sales.

Working around dealer protection laws by way of incentives

Dealer protection laws (also called “franchise laws”) have been enacted to rein-in factory overreach when it comes to dealership facilities. For example, California Vehicle Code section 11713.13 provides protections to dealers when contemplating facility upgrades. It prohibits factories from requiring a dealer to establish, maintain, or remodel facilities or display space if such imposition would be unreasonable in light of all existing circumstances, including economic conditions. The law also deems a required facility alteration unreasonable if the facility has been modified within the last 10 years at a cost of more than two-hundred fifty thousand dollars ($250,000), and the modification was required, or made for the purposes of complying with a franchisor’s brand image program and was approved by the factory—with certain exceptions. In any case, the burden of proof is on the factory to establish that the modification or expansion was reasonable.

Factories have attempted to maneuver around these laws. One of the most significant loopholes employed by the factories is to claim that these laws apply only to facility improvements that are “required” by the factory under the dealer agreement. If, rather than pursuing the desired remodeling under the dealer agreement, the factory provides an “incentive,” the factory argues that the facilities statutes become inapplicable. Under this view, facility improvements are merely a condition to the receipt of such incentives. Consequently, many factories have modified their incentive programs—including what most dealers would consider the most important, the margin program. Today, it is common that margin payments released to the dealers will be unavailable to dealers who have not complied with factory requests to make certain improvements or to those who have agreed to perform a facility improvement in some separate agreement and have failed to meet that obligation. Although participation in these incentive programs is technically voluntary, most dealers find they cannot effectively compete against dealers who receive the incentives because the margin programs often constitute the only source of profit on a vehicle sale.

How a buyer can protect itself in a buy-sell

In the buy-sell context, things get even more complicated, and factories will often condition approval of the buy-sell on the buyer agreeing to facility requirements. While the law clearly dictates that factories may not “unreasonably withhold consent”, the buyer does not have standing to pursue a factory for unreasonably withholding consent because only the entity holding the dealer agreement – the seller - does. This situation means that factories often are bold enough to suggest that consent to the buy-sell will be conditioned on buyer’s agreement to facility improvements. The dealer can counter that the factory is required to pass along to the buyer whatever rights the seller currently has under its dealer agreement. This argument has convinced some OEMs to revert to limiting their threats to incentive funds being unavailable.

What can the buyer do to protect itself? Buyer’s best source of protection would be a well drafted condition precedent concerning factory approval in the buy-sell agreement. A condition precedent is a condition that is put into the agreement that ensures that a party’s obligation, in this context the buyer’s obligation to close the transaction on penalty of loss of the deposit (or worse) is only required if the stated event (the “condition”) occurs first, effectively giving the buyer a “walk right” if the condition does not occur.

While a condition precedent for factory approval is universally found in all buy-sell agreements, as the above discussion shows, that “approval” may come with onerous conditions. There are several types of conditions precedent that a buyer can negotiate in the buy-sell agreement. The first variation could be called “mere approval.” Here, the condition precedent merely requires that the factory “approve” or “consent” However, such language says nothing about demands the factory might make of the buyer. As such, if the factory issued a letter indicating “approval granted, please sign the new dealer agreement,” and the dealer agreement contained an onerous facility requirement—the seller may claim that the buyer did in fact receive approval and is obligated to close the transaction. A second variation that is quite common specifies “approval by the factory on terms satisfactory to Buyer in Buyer’s sole discretion.” While this provides the most protection to the buyer, this leaves an opportunity for the buyer to walk away from the deal for any or even no reason. Furthermore, this language gives the buyer considerable leverage to renegotiate the deal at the last hour before closing. As such, the seller will likely not allow such language to be used in the buy-sell agreement as the seller wants to avoid giving the buyer such an absolute walk right. A third variation contemplates “approval by factory on terms reasonably satisfactory to Buyer.” While this condition is more balanced than the second, it is not without problems. “Reasonably satisfactory” does not provide clear guidance. Consequently, there can be a lot of confrontation between the buyer and seller on what reasonable means, should the factory seek to impose heavy-handed facilities requirements. For example, even if the factory demand is onerous, it can still pass the muster of being reasonable if the factory had been transparent and vocal about this requirement with the seller. The last variation is “approval by the factory on terms reasonably satisfactory to Buyer, but without a requirement of facility renovations to be done by Buyer that would cost in excess of $____”. To account for demands being made as a condition to participation in incentive programs, but not entering into a dealer agreement with the buyer, the condition could also include language specifying that there be no such factory requirement either as a condition of the dealer sales and service agreement or any generally available incentive or margin program.”

Considerations the seller should keep in mind

From the perspective of the seller, there are three choices: (1) the seller can ignore the problem and let the buyer deal with the issue, (2) the seller can go through the actual process of getting an accounting of the entire cost of the project and approval of the proposed plan by the factory, or (3) make the necessary improvements on their own. The seller should avoid the first option because uncertainty of the amount of the expense will likely result in the purchase price suffering a potentially significant and unacceptable haircut. Uncertainty in a buy-sell should be avoided by both sides where possible. The second option is a better option than the first, if feasible, because it removes uncertainty, resulting in both sides feeling more confident about the purchase price and closing. Furthermore, having an accounting of all the improvements may help experts determine the capitalization rate and thus lessen the haircut on the deal. Under option three, if the seller conducts the facility upgrades itself, the seller will not have the fear of cold water dampening the deal. The seller will also be in a better position to negotiate a favorable purchase price upfront, than in option two, above, and will be able to offset the cost of the renovations. However, certain renovations are bound to take a long time. Therefore, if time is of the essence for the seller, the seller might be better off with the second option and have the buyer make the necessary improvements.

With so many facility requirements being forced on dealers, dealership agreements can be viewed as conditional because factories want to commit dealers to facility upgrades before giving approval. Therefore, the buyer should be cautious when negotiating the buy-sell agreement so as not to be stuck with undue demands from the factory. As discussed, it would be wise for the buyer to place a conditions precedent that allows the buyer to walk if the renovations exceed a certain price point or if they are conditioned on incentive programs. Seller should carefully ponder its own circumstances so that it can maximize its realization on the sale as well. Ultimately, it is imperative that both sides to the buy-sell consider the facility demands being imposed by the factory to avoid spending valuable time and resources only to have the deal killed.