Bankruptcy Code Preempts State Law Requiring New Chrysler to Offer Right of First Refusal to Rejected Dealerships

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Contributed by Edward Wu

The District Court for the Southern District of New York recently held  In re Old Carco LLC (f/k/a Chrysler LLC) that “New Chrysler,” the purchaser of substantially all the assets of the chapter 11 debtor Chrysler LLC (now known as Old Carco), was not required to comply with state laws affording car dealerships certain rights of first refusal.  Such state laws, which otherwise would protect the rights of the car dealerships if the debtors rejected its dealership franchise agreements under section 365 of the Bankruptcy Code, are preempted by the Bankruptcy Code.

During Chrysler’s chapter 11 cases, the debtors sold substantially all of their assets under section 363 of the Bankruptcy Code to New Chrysler, a newly created entity partially owned by Fiat, the autoworkers’ union retirement health care trust, and the United States and Canadian governments.  In connection with the transfer of assets, the debtors assumed and assigned to New Chrysler a multitude of franchise agreements with automobile dealerships across the country, which permitted such dealerships to continue selling vehicles manufactured by New Chrysler.  Not all dealerships’ franchise agreements, however, were assumed and assigned.  Because New Chrysler sought to streamline the Chrysler dealership network, the debtors simply rejected many franchise agreements.

Subsequently, Colorado and Kentucky amended their state dealership laws to require automobile manufacturers to offer a right of first refusal to rejected dealerships prior to offering new franchise agreements to prospective dealerships in the same geographic vicinity occupied by the rejected dealerships.  New Chrysler, among others, filed a declaratory judgment action against government officials of Colorado and Kentucky, asserting that the amended state dealership laws are contrary to the order approving the rejection of the franchise agreements and should be preempted by the Bankruptcy Code.

The District Court first dismissed the declaratory judgment action as to Colorado, who argued that the action was not ripe because Colorado did not believe New Chrysler was bound by its amended dealership laws.

As to Kentucky, whose officials did not dispute that New Chrysler was subject to the state’s amended dealership laws, the District Court ruled that the dealership laws were preempted.  The District Court began its analysis by quoting the Supremacy Clause in the U.S. Constitution, which provides that federal law “shall be the supreme Law of the Land . . . any Thing in the Constitutions or Laws of any State to the contrary notwithstanding.”  The Court further noted that the authority of Congress and the federal courts to pass and enforce federal bankruptcy laws has not only been long recognized, but that federal courts have guarded against encroachment by the states into the bankruptcy realm.

To show the breadth of preemption in the bankruptcy context, the District Court cited to a Second Circuit decision that held that state law claims directed toward violations of the automatic stay were preempted because the Bankruptcy Code already provides for penalties and protections for such violations.  The District Court also cited to one of its previous decisions, which barred as preempted a breach of fiduciary duty claim asserted against a third party for inducing a debtor to file for bankruptcy because the Bankruptcy Code already includes remedies to protect against the misuse of the bankruptcy process.  Citing a Ninth Circuit decision, the District Court noted that even minor incursions by state laws on federal bankruptcy law are tantamount to interfering with the whole reticulated bankruptcy process itself.

Kentucky’s amended dealership laws, the District Court found, constitute a collateral attack against the conduct of bankruptcy proceedings and the judicial orders issued pursuant to the Bankruptcy Code.  The Court explained that the ability of a debtor to reject an executory contract under section 365 of the Bankruptcy Code is vital in bankruptcy cases and allows debtors to maximize value to creditors, consistent with the goals of bankruptcy law.  It noted that the order approving the rejection of the franchise agreements was issued by the Bankruptcy Court because the debtors demonstrated that, under their business judgment, a smaller, more centralized network of dealerships would result in an optimal configuration for a national market.  The Bankruptcy Court previously had found that rejection rather than assumption and assignment of the franchise agreements was necessary and appropriate to consummate the sale with New Chrysler.  Not only did the order approving the rejection of the franchise agreements provide that the rejected dealerships would have “no further rights (direct, indirect, contractual or otherwise) to act as an Authorized Dealer . . .,” but the order also provided that so-called state law “blocking statutes” that frustrate the benefit of the rejection process were preempted.

Interestingly, Kentucky argued that the preemption doctrine only applies to regulations and statutes and not to judicial rulings, such as the rejection order.  The District Court’s response was that the Bankruptcy Code is not “self-executing,” and that section 105(a) of the Bankruptcy Code allows bankruptcy judges to “issue any order, process or judgment that is necessary or appropriate to carry out the provisions of this title.”

Under the preemption doctrine, state law will be preempted by federal law where (i) Congress expressly preempts state law, (ii) Congress legislates so comprehensively within a particularly field such that there is no room for state law, or (iii) state law conflicts with federal law such that it is impossible for a party to comply with both or the local law is an obstacle to the achievement of federal objectives.  Concluding that the last scenario was applicable in the instant case, the District Court held that Kentucky’s amended dealership laws conflicted with the rejection order issued in accordance with the Bankruptcy Code.  The District Court found that, by requiring the offer of a right of first refusal to rejected dealers, the Kentucky statute purported to revive rights to continue as dealers that were extinguished by the rejection order.  As such, the Court ruled that Kentucky’s dealership laws are preempted as they apply to New Chrysler.