United States: "Free At Last!" - Consent To Transfer Franchises Under New Jersey Law

The franchise world is littered with examples of "hard luck" franchisees. The circumstances of one such person provided the basis for a New Jersey Superior Court, Appellate Division opinion that imparts valuable lessons for franchising parties in many jurisdictions. The case, VW Credit, Inc. v. Coast Automotive Group, Ltd, et al. (N.J. Super. Ct. App. Div., Jan. 2002) examined whether specific performance may compel the transfer of a franchise where the franchisor has unreasonably withheld its consent.

Our unfortunate franchisee tried to build a successful Volkswagen and Audi auto dealership but things went badly, in rapid succession. The new models just weren't moving off the lot. Then a fire wiped out most of the dealership's facilities and a large chunk of the inventory. He defaulted on his credit line and the financing company's lawsuit forced him to file for bankruptcy protection. Suddenly, a white knight appeared.

A group offered to lend money to the franchisee to enable him to repay his creditors, salvage the franchise and avoid liquidation. Unfortunately, that deal turned sour and the lender ended up suing the franchisee. Next, his two franchisors, Volkswagen and Audi, stepped in and filed claims to terminate their franchises. The franchisee finally decided to throw in the towel. He reached an agreement with the lender and entered into a consent order. It provided that an assignee of the lender would acquire the dealerships along with the real property owned by the franchisee's affiliated company. Unfortunately, this arrangement didn't sit well with the franchisors. When the applications to transfer the dealership franchises were presented to them, they refused to accept the applications on various grounds, alleging that there were "deficiencies" in the answers and citing "character concerns" with respect to a member of the proposed transferee (allegations of organized crime connections were referred to by the franchisors).

The NJ Franchise Practices Act. The New Jersey Franchise Practices Act (the "Act") has been in effect since 1971. It established comprehensive rules and restrictions that govern much of the interplay between franchisors and franchisees. Over time, the New Jersey legislature recognized that a particular class of franchise relationships - the motor vehicle dealership industry - deserved special attention. In 1989, the state's legislators saw fit to add a substantial number of sections to the Act, including one that eloquently expressed the plight of the auto dealership franchisee. Section 56:10-7.2 states, in part, that "inequality of bargaining power continues to exist between motor vehicle franchisors and . . . franchisees." Car dealers, it points out, were subject to "compulsion and duress" in their negotiations over franchise agreements, which often contained terms and conditions "detrimental to the interests of the motor vehicle franchisee." The "public interest" demanded that these franchisees be provided with a level playing field (or perhaps a field designed to the franchisees' advantage). The remedy that emerged was the codification of specific contract terms and other rights designed to equalize the bargaining position between auto franchisors and their dealer franchisees.

Notice and Rejection. It was in this pro-franchisee environment that the New Jersey Appellate Division considered the case before it. When the consent order between our ill-fated franchisee and its lender was entered, the parties notified Volkswagen and Audi of their intention to transfer the franchise to the lender's affiliate. The notice process is mandated under Section 56:10-6 of the Act. This section does not simply let a franchisee provide a cursory notice and promptly carry out the proposed transfer. An extensive, informational written notice is required, setting forth not only the prospective franchisee's name and address, but providing a statement of the transferee's financial qualifications and a description of its business experience during the previous five years. The franchisor is allowed 60 days after receipt of the notice to either approve of the sale in writing or send a written response to the franchisee indicating that it finds the transferee to be unacceptable. The rejection letter must set forth "material reasons relating to the character, financial ability or business experience of the proposed transferee." If the franchiser chooses not to respond by the end of its 60 day review period, it is deemed to be a grant of approval.

In this case, Volkswagen and Audi reacted to the franchisee's notice of its intention to sell the franchise by requesting an order to show cause for a preliminary injunction to enjoin the sale. The lower court denied the franchisors' application for an injunction and, on appeal, they were denied again. About a month and a half later, on May 1, 2000, the prospective transferee, a limited liability company whose members ran other dealerships, submitted an application for the transfer of the dealership franchise to Volkswagen and Audi, respectively. Just before the end of the 60 day notice review period, on June 29, 2000, the franchisors disapproved the applications in writing. They based their rejection on their claims that the applications were deficient and their concerns regarding the character of the applicant's majority member.

Franchisors - Inform Your Applicants! The franchisee and the prospective transferee filed for an order to show cause to compel the transfer. The lower court was cooperative and directed the parties to continue the application process so that Volkswagen and Audi could advise the potential transferee regarding the application process. The judge also found that the rejection letters were void and ineffective because the franchisors did not advise the applicant-transferee of the conditions for approval of their franchises. In the view of the judge, if a franchisor could reject a deficient application that was submitted in good faith without fully disclosing its criteria for an acceptable application, then "the Franchise Practices Act would have virtually no teeth, because then every franchisor could circumvent the law by either creating a contentious environment or by failing to supply adequate information . . . " The transferee prepared a second pair of applications, which were turned down again by the franchisors on basically the same grounds as before. In a plenary hearing, the trial court found that Volkswagen and Audi unreasonably withheld their approval. Their letters of rejection were declared ineffective and a written order directed that the applications be deemed approved. Under the language in Section 56:10-6 of the Act, the transferee could now enter into the franchise agreement under the same terms and conditions that existed for the predecessor franchisee.

Volkswagen and Audi filed an appeal. In addition to claims of lack of standing on the transferee's part and an improper preliminary injunction, both of which were disallowed by the Appellate Division, the franchisors maintained that the lower court erred in determining that their consent was unreasonably withheld. Even if it was, they argued that the only remedy that the court could impose was to award damages for a violation of the Act exclusively to the franchisee, not the potential transferee. The franchisors considered the trial court's action, deeming the franchise agreements to be in effect for the transferee, to be an unconstitutional taking.

Criteria for Rejection. In order to determine whether a franchise application is deficient, a franchisor must examine the extent to which the prospective franchisee fails to meet three criteria: financial qualifications, business experience and character. The Appellate Court's opinion points out that Section 56:10-6 of the Act has been interpreted to impose a "requirement of reasonableness" on a franchisor's decision to reject a transfer. Applying an objective test, the franchisor must support its denial with "substantial evidence showing that the proposed franchisee is materially deficient."

The trial court determined that the transferee met all three prerequisites for approval. Reviewing the facts established at the lower level, the Appellate Division found that the trial judge's findings were supported by "adequate, substantial and credible evidence." Those findings held that the two franchisors did not meet their burden of proof in order to demonstrate lack of qualification and unreasonably withheld their consent to the proposed transfer.

Specific Performance or Money Damages? The Appellate Division next considered the nature of the relief granted. Volkswagen and Audi asserted that they had the right to reject a proposed transferee and, once they did, regardless of the reasonableness of their disapproval, the remedy of specific performance is not permitted. Analyzing Section 56:10-6, the Appellate Division noted that this section not only restricts a franchisee's ability to assign a franchise without its franchisor's consent, but also restrict a franchisor's ability to reject a proposed franchisee. The franchisor must base its rejection on a "bona fide business decision." The Appellate Division came to the obvious conclusion that if there is an acceptable transferee and the franchisor unreasonably withholds its consent, the franchise is automatically transferred by operation of law - in this case, through the mechanism of specific performance. Essentially, when a franchisee has an acceptable substitute in the wings, it should not be forced to choose between losing its investment and remaining in a relationship with the franchisor. The only condition is that the proposed transferee must provide written assurance to the franchisor that it will comply with the existing franchise agreement.

The argument by Volkswagen and Audi that specific performance cannot be relied upon once their disapproval is registered was rejected outright. The opinion stated that "it would be nonsensical

. . . to allow for specific performance if the franchisor did nothing, but if the franchisor timely rejected the proposed transfer in bad faith, the franchisee is limited to damages." Section 56:10-6 "contemplates the continuation of the franchise . . . thus specific performance is required to accomplish that expectation." Further, the Appellate Division confirmed that the franchisors could not rely on the damages clause under Section 56:10-10 of the Act, in lieu of the transfer and continuation of the franchise agreement. As a basic rule of interpretation, the more specific provision (56:10-6) has priority over the more general provision (56:10-10).

The final point raised by the franchisors was that the trial court's decision was an unconstitutional taking of private property. The Appellate Division, citing a New Jersey Supreme Court decision, said that issues of lack of due process for a franchisor are valid where the franchisor had bona fide reasons and refused, in good faith, to approve a transfer or renewal. Here, since Volkswagen and Audi unreasonably withheld their consent, their property rights were properly subject to the exercise of the government's police power.

This decision reflects a position shared by the courts of many other states on the appropriateness of the remedy of specific performance to force the transfer of a franchise upon an unwilling and unreasonable franchisor. Franchisors are well-advised to rely on clear facts and fair arguments if they seek to oppose the transfer of a franchise. If their reasons for opposing the application of an objectionable transferee are not well-documented and rational, they will very likely fail to prevent the transfer of the franchise.