Out-of-trust cases raise concerns of 'bloodbath' for retailers

When Reagor Dykes Auto Group collapsed in a messy bankruptcy case in August, fellow Texas dealer Rick Ford had seen the trouble brewing.

Before it was accused of massive floorplan fraud, Reagor Dykes paid Ford's RFJ Auto Partners for three dealer trade vehicles with bad checks. If Ford Motor Credit Co. hadn't "stepped in and made us whole," Rick Ford said, RFJ could have been out tens of thousands of dollars.

The Reagor Dykes case is just the tip of the iceberg. Ford said he has been warned to be careful about doing business with certain troubled retailers and also approached by dealers offering to sell stores for "fire sale" prices.

Ford said he last saw this level of financial distress in 2008 and 2009. During the Great Recession, credit suddenly dried up and U.S. new light-vehicle sales dropped 35 percent in that two-year period.

"But it's different this time," Ford said.

Today's economy is healthy with auto sales at historically robust levels though expected to drop below 17 million vehicles this year for the first time since 2014.

Given the strong vehicle sales, buy-sell adviser Mark Johnson said he's surprised by the number of dealers having cash flow problems and being accused by their lenders of selling vehicles without repaying floorplan loans in a timely manner, also known as selling vehicles out of trust.

"If that's any indication of the sort of debt dealers have gotten into, thinking this is the way that things are going to be forever, the downturn is going to be a bloodbath," said Johnson, president of dealership buy-sell firm MD Johnson Inc. in Enumclaw, Wash.

Johnson and other industry advisers say they are seeing out-of-trust situations happen more frequently in the past 18 months — and maybe more than people realize. The uptick has financial institutions and automakers keeping a closer eye on dealerships.

Even other dealers, such as Rick Ford, are more watchful about how they interact with nearby stores. Because for many stores, when they go out of trust, they also go out of business.

While an exact count of dealerships alleged by their lenders to have sold vehicles out of trust isn't known, Automotive News has reviewed more than 10 cases during the past year.

Industry experts, including lawyers, accountants, buy-sell advisers, receivers and even dealers, acknowledge the problem is getting worse.

Outside of the cases that have gone public, they say, many other dealers are trying to solve their cash woes with improved internal oversights or by turning to lenders to try to work out the situation.

In some cases, lenders will work with borrowers for a time to get the dealership back into compliance, experts say. Captive lenders and their automaker parent companies don't want the dealerships representing their brands to suddenly close, or "go dark" in industry parlance. That can severely damage brand image with consumers in those communities.

But if borrowers continue to miss payments or sell vehicles out of trust, lender contracts generally allow them to accelerate repayment and require debtors to pay all that's owed within a few days.

And automakers can move to terminate dealers whose stores have sold out of trust, as that's a violation of the dealer agreement. In some cases, automakers try to arrange buyers for a distressed store.

It may be that the dealership group grew too fast or borrowed too much, even in a strong economy. Dealers face shrinking vehicle margins, higher labor costs, rising interest rates and increased floorplan expenses. All of that, coupled with the slight dip in new-vehicle sales in the last year, is pushing a number of dealerships into financial peril.

Operating dealerships requires more working capital than it used to, said Erin Kerrigan, managing director of Kerrigan Advisors in Irvine, Calif., a sell-side dealership brokerage. If dealerships grew aggressively and spent a lot, they might not have enough cushion to absorb the higher interest rates and slowing auto sales.

"It's like a game of musical chairs," Kerrigan said. "If the music stops, you don't have enough working capital."

And dealership debt levels are increasing. For every dollar of equity, the average dealer had $1.44 in debt as of the first quarter of 2019, not including floorplan and mortgage debt, according to Kerrigan Advisors' Blue Sky Report, citing data from the National Automobile Dealers Association. That's up 30 percent from $1.11 in the first quarter of 2015.

With that rising debt comes a spike in the sales of distressed dealerships. Kerrigan wrote in the report that she has seen a "notable increase in out-of-trust and bankrupt dealerships for sale."

U.S. light-vehicle sales rose 0.6 percent in 2018 to 17.33 million, according to the Automotive News Data Center, but the last rolling 12 months have seen sales drop by 1 percent. Most forecasters predict vehicle sales will fall for all of 2019. Many, including NADA, expect sales of 16.8 million. Through the first five months of 2019, U.S. light-vehicle sales slipped 2.4 percent.

Beyond 2019, sales are expected to continue to tumble; some analysts talk of a possible recession.

U.S. dealerships on average reported an operating loss last year for the first time in at least a decade, according to NADA. Floorplan, or the loans dealerships take out to stock inventory, became an expense for the average dealership last year after the Federal Reserve hiked interest rates, NADA reported.

That swing followed several years where floorplan actually contributed income to the dealership because of rock-bottom interest rates and floorplan credits that automakers pay dealerships for putting new vehicles into their inventories. Dealerships on average paid $55,164 — or $61 per vehicle — in floorplan interest last year vs. a gain of $17,083 — or $19 per vehicle — in 2017, NADA said.

Dealerships' increased reliance on automaker incentives and stair-step programs is another factor in some of the financial woes dealers face.

"The incentive monies are for many the only way to make a profit. So if the dealer doesn't meet all the requirements to receive incentive money, that may well push a dealer into being out of trust," said Los Angeles dealership lawyer Christian Scali, who reports seeing more dealerships go out of trust in the past year in California and New York.

Scali has represented Momentum Auto Group, a California retailer that closed seven stores in 2018 after lenders sued the company for selling vehicles out of trust. Scali did not speak on behalf of Momentum for this story.

When out-of-trust problems reach the point that lenders file public lawsuits, they also often seek court orders to seize remaining vehicles on dealership lots. That cripples a store's ability to stay in operation, and many dealership groups in out-of-trust situations collapse, causing embarrassment and shame for their dealers. And with personal guarantees common for many loans, plus cross collateralization across multiple stores, the lawsuits are downright devastating.

Dealership groups that default on floorplan loans may have grown too quickly or had poor cash management strategies, experts say. In some cases, dealers may let a few vehicle sales go out of trust, thinking they can make it up the following week. But the situation often spirals.

"Those things can snowball very, very quickly and then they get out of hand," said Stephen Dietrich, a partner at Holland & Knight law firm in Denver. "Then it doesn't matter how good-intentioned you are or how nice your lender is. If it gets to a big-enough problem, you just can't solve it."

In some cases, courts appoint receivers to oversee stores and assets for lenders, and dealerships may be sold to recoup funds for those lenders. For the dealerships that are able to stay open, a lender's representative typically handles vehicle titles and all keys for test drives.

Some of the dealership groups alleged recently to have sold vehicles out of trust were led by dealers with prominent roles in the industry. A sampling: Brad Fenton, former chairman of Nissan's dealer advisory board; Andrew Gabler, former president of the National Independent Automobile Dealers Association, which represents the used-vehicle industry; and Rahim Hassanally, a former American International Automobile Dealers Association board member and named one of Automotive News' 40 Under 40, who ran Momentum. They also have included former NFL players, veteran dealer principals and some first-time dealers.

Momentum ranked No. 124 on Automotive News' 2017 list of the top 150 dealerships in the U.S.; Reagor Dykes ranked No. 131 that year.

The lawsuits reviewed by Automotive News involve captive finance companies such as Nissan Motor Acceptance Corp., Ford Credit, Hyundai Capital America, Volkswagen Credit and Toyota Motor Credit Corp., plus regional lenders and community banks.

Alan Haig, president of Haig Partners, a buy-sell firm in Fort Lauderdale, Fla., said out-of-trust situations appear to happen more at groups with stores concentrated in weaker brands. A Porsche dealership would be unlikely to go out of trust, Haig said.

In some cases, financial problems are so pressing that dealers turn to bankruptcy court for protection.

One such case is Long Island City Volkswagen. After being sued by VW Credit over allegations of selling vehicles out of trust, the dealership filed for bankruptcy in March. Now the store is set to be auctioned off in August.

Lenders either declined to comment to Automotive News about out-of-trust situations or indicated it wasn't posing a major risk to their portfolios.

A Ford Motor Credit spokeswoman said the number of its dealers in out-of-trust positions remains "very low."

Doug Timmerman, president of auto finance at Ally Financial Inc., told Automotive News, "Any time that the industry shifts a little bit, you're going to have dealers that are challenged. We are very consistent in the market. We take a very consultative approach with our commercial customers. When dealers struggle, we're proactive; we work with them and help guide them through difficult times."

Several of the cases reviewed by Automotive News involve dealerships with floorplan financing and other loans through Nissan Motor Acceptance. The captive told Automotive News that each independent Nissan dealer is responsible for funding its own operations.

Dietrich said some dealers appear to have lost the discipline they developed to survive the recession 10 years ago. It means a small financial hiccup can cause big problems. Some dealers facing money troubles are newer dealers who didn't have a recession experience to learn from, he said.

While dealers sometimes know they are going out of trust, it can also happen under the radar, Dietrich said. Scali said he is aware of one dealer who went out of trust because his business manager quit and the replacement, unfamiliar with the industry, thought it was OK to prepay trades and let the flooring loan float for a few days.

In January, Dietrich told Automotive News he was seeing more clients encounter stresses with lenders in the previous year to 18 months. In late May, he said he has continued to get a few more inquiries from lenders questioning out-of-trust situations or those dangerously close to it. But he said he has also seen a bit of improvement, as dealers have taken steps to aid operations, such as laying off staff and trimming costs.

Also in January, two of Dietrich's "well-run" dealership clients were in talks with lenders about breaching loan agreement covenants, and several others were examining loan documents, concerned they might be in breach. A year earlier, he had no clients having those conversations. Ultimately, Dietrich's two clients did not go out of trust, he said.

"They're continuing to work with their lenders to get a plan in place, and the lenders have been patient and supportive partners working with them," he said. "But those clients have also been very engaged. They've taken the phone calls. They've sat down with the lenders to figure out what's going on. They've worked with the lenders and shown them their budgets."

And the clients who were concerned about possible problems have worked to tighten operations by making staffing changes, implementing tighter controls of inventories and renegotiating vendor contracts, Dietrich said.

In January, representatives from accounting firm Crowe told Automotive News that none of its dealer clients were in out-of-trust situations but it had been doing work related to out-of-trust dealerships for captive lenders.

Crowe partner Jodi Kippe said the dealership network overall is in good financial health, but there are dealers that need to be more aware and mindful of cash flow and cash management. Some dealers made store acquisitions in the past five to seven years that were "very leveraged," Crowe partner Edmund Reinhard said.

"The ability for them to make their monthly payments is based upon certain income levels. So that shifted," he said.

"People do difficult things sometimes to try to save their businesses, but it all comes back to people overpaying probably for some of these stores or leveraging them too much on the front end or getting into facility [upgrades]."

After the run-in with Reagor Dykes and another dealership group that wrote a bad check for a dealer trade, Rick Ford ultimately changed RFJ's policy. The days of a handshake deal are gone, and now his group requires a check in hand, or the manufacturer's certificate of origin if it's taking in the trade.

RFJ, with 23 dealerships and ranking 36th on Automotive News' 2018 list of the top 150 dealerships in the U.S., also implemented a new parts policy this year. If a dealership is believed to be having financial issues, it is put on a cash-only basis to receive parts, Ford said.

While more out-of-trust dealerships can be a negative for other dealers, they also present opportunities to acquire.

Ford said he's fielded about five calls this year from brokers indicating their dealer clients were in financial trouble and needed to sell their stores.

Ford said he received a call from Brad Fenton of Fenton Motor Group before news broke that many of Fenton's stores allegedly had sold vehicles out of trust. Fenton asked Ford to buy the stores left in his portfolio. Ford passed on the deal.

Going forward, experts said, dealers should be concerned and thinking about how to avoid out-of-trust situations, especially if sales continue to drop.
If a dealer starts having any financial challenges or gets lender calls, don't ignore them, Dietrich stressed.

Johnson sums it up simply: "Dealers have to manage cash flow. Dealers that don't manage their cash flow end up out of trust."

Amy Wilson, Hannah Lutz and Jackie Charniga contributed to this report.