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Gone In 60 Seconds – When Dealerships Go Bad, What’s Their Lender To Do?
Monday, August 24, 2009

Thousands of car dealerships across the country have closed their doors in the past year as the recession deepens and the very survival of the nation’s automobile industry is in doubt. General Motor’s high-profile bankruptcy will result in the eventual closing of 2,300 dealerships. Chrysler, too, will close nearly 800 dealerships in the wake of its bankruptcy. According to The Wall Street Journal, as of July 1st, 2,483,627 cars had been sold in the United States so far this year, a 35.4 percent decrease from last year at this time. Additionally, sales of lightduty trucks and SUVs have decreased 34.8 percent and 45 percent respectively. While this economic crisis constitutes an enormous challenge for all participants in the automobile industry, from the steel companies that provide the raw material to the dealerships that sell the finished products, this crises also raises a myriad of challenges for the banks and other financial institutions that finance individual dealerships.

As the economy struggles and car sales decrease precipitously as a result, these lenders have reason to worry about dealerships selling inventory and pocketing the proceeds, an increasing problem known in the trade as “sales out of trust” or “SOT.” A sale out of trust occurs when a dealer sells a vehicle that is financed through a floor plan arrangement, and then fails to repay the associated inventory advance on that vehicle within the time constraints of the contract. This article addresses this growing problem and offers lenders practical solutions for how to mitigate the losses that arise when dealerships default on their financial obligations. While this article focuses on motor vehicle dealerships particularly, it applies to all companies that use floor planning as their inventory financing tool, such as furniture or electronics retailers.

In a typical floor plan arrangement the lender enters into a revolving credit agreement with the respective dealer. The lender finances the purchase of cars from the manufacturer in which each loan advance is made against a specific piece of collateral. As each item of inventory is sold by the dealer, the loan advance is repaid to the lender with interest and the dealer keeps the remaining proceeds as its profit. Simply, in a floor plan financing arrangement, the dealer borrows against retail inventory and then the dealer repays the debt as each item of inventory is sold and borrows against the line of credit to purchase additional inventory. Thus, the inventory serves as collateral for the loan.

While floor planning carries many of the same risks as other forms of inventory financing, the exposure to loss is greater because the lender does not exercise full control over the collateral. Consequently, lenders must be proactive in policing their collateral – making certain that the dealership has not or will not default on its loans. Though such due diligence might seem a burden for a lender with many borrowers, the potential costs of not policing the collateral are much higher. The lender must regularly check the dealership’s financial records to confirm solvency and proper record keeping to help guard against the diversion of retail sales proceeds.

If the dealer is experiencing financial difficulties, the lender should monitor the dealership even more closely to ensure that it does not default on its payments during hard economic times. The lender must also check the dealership’s inventory on a regular basis, by making inspections of the dealership and its inventory. The lender must look for warning signs such as any dramatic spikes and dips in the inventory. If in the course of an inspection the lender discovers such irregular activity, then this may be a warning sign. The lender must make certain that the amount of the outstanding floor plan corresponds to the inventory on hand. Discrepancies should generate alarm bells for the lender and could mean one of several unpleasant scenarios.

The most favorable scenario is that the discrepancy between the amount of inventory and received payments is due to a minor and temporary fault, such as the disorganized administration of the dealership or some type of accounting error. Though serious, the lender can usually take steps with the dealer’s cooperation to remedy the situation so that it does not recur. Another scenario is that the dealer is late in payment. Though dealers that sell large quantities of inventory are given a limited time to repay the lender, there can be numerous reasons for a delay. However, lenders should not accept such delay. Any suspicion that the dealer is using the “float” by delaying payment represents a significant problem that must be quickly and firmly addressed and stopped. Evidence that an SOT has occurred or that one may occur in the near future must be treated with the urgency it deserves. Lenders must take immediate and aggressive actions to safeguard their interests if such a scenario arises.

If a lender has any reason to suspect that an SOT situation has occurred, immediate action should be taken to physically inspect the inventory to make sure that it matches the lender’s books and records or that any discrepancy is not the result of a dealer defalcation. If the inspection confirms the existence of an SOT (as opposed to merely a delay in payment or sloppy bookkeeping), then the lender should consider taking the following actions:

1. seize and safeguard all remaining inventory, including all titles. The lender should also station a representative at the dealership to monitor all vehicle sales activities and financial operations. The representative should retain all titles and release them only upon payment to the lender for that item of inventory sold;
2. declare a default in the underlying loan agreement and guaranty and terminate the agreement accordingly. If the dealer refuses to allow the inventory repossession or the SOT is severe enough, litigation should be commenced against the dealers and all guarantors;
3. seize any other collateral that secures the loan (although other lenders may have rights to the collateral that may interfere with this); and

4. seek the appointment of a receiver or fiscal agent in state or federal court. The receiver or fiscal agent should be charged with taking control of the dealership and its finances under court supervision and determining (after consulting with the lender) whether to continue the business or shut it down and liquidate its assets.

When a sale out of trust occurs, it is almost always indicative of massive financial difficulties. When a business is unable to pay its creditors, the business may file or be placed in bankruptcy under either Chapter 7 or Chapter 11 of the United States Bankruptcy Code. Under Chapter 7, the business ceases active operations and a trustee liquidates all of its assets, distributing the proceeds to its creditors. Any type of bankruptcy filing imposes an automatic stay that stops almost all creditor action. In order to repossess its collateral or obtain payment from the debtor, the lender must file a motion for stay relief. As a secured creditor, the lender can usually obtain whatever is left of its collateral by moving for stay relief, particularly if the dealer is unable to make payments to the lender known as adequate protection payments and to safeguard the collateral. In order to minimize its losses, the lender must move quickly to obtain stay relief. Inaction or a delay can be costly for a lender in this situation. Rather, the lender must be proactive in the bankruptcy process in order to secure relief and thus minimize its losses.   

Although the dealership could file or be placed in Chapter 11, an SOT dealership bears a striking resemblance to the “roach motel,” in that it can check into a Chapter 11, but it almost never checks out, at least as an ongoing business. Having “stolen” from its floor plan lenders and perhaps others as well and being in material violation of its franchise agreement, the best the SOT dealer can usually hope for in a Chapter 11 is to avoid a trustee and be permitted to liquidate its assets quickly and on its own. However, most Chapter 11s for SOT dealers are either converted to Chapter 7 or a trustee is appointed in the Chapter 11.

Often, the guarantors of the dealership debt will file for bankruptcy in an attempt to obtain a discharge of their guarantee to the lender. However, this is not a slam dunk by any means, and if the guarantors participated in the SOT, numerous cases hold that their debt will not be discharged.

The bottom line in all of this is the need for intensive and extensive floor plan lender vigilance. A passive response to even a small monetary breach is unwise, for dealers who default on their loans may be unable or unwilling to cure the default on their own. Lenders must carefully “police” their collateral, and if an SOT situation appears likely or has already developed, lenders must be proactive to safeguard their collateral and work out arrangements with the dealer to remedy any SOT or to prevent one from happening. Repossession of the collateral and litigation on the floor plan obligations and guarantees is the next step. Finally, if bankruptcy intervenes, creditors should take immediate steps to protect and reclaim their collateral. Though a complete recovery of all debt is unlikely, quick and early intervention will at least help mitigate the loss.

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