Franchisees Unite to Purchase Franchisor

It was chaos. Diners were asked to finish in the middle of their meals so that the restaurants could be secured. Food supplies were either secured or looted. News of the widespread closures in the United States was reported by the Associated Press, and customers incorrectly assumed the franchised locations were closed as well. Without employees, The Ground Round, Inc. (“GRI”) could not respond to rumors regarding the reasons for closure, whether the closures were permanent and whether customer gift certificates would be honored.

The franchisees were dependent upon GRI for procurement of food and supplies. With that corporate buying activity suspended, the franchisees were forced to fend for themselves. Some franchisees were subtenants of GRI and had paid rent to GRI, but GRI's landlords had not been paid. Similarly, advertising fees, development fees, initial franchise fees, and other payments to GRI had been diverted from their intended purposes, leaving franchisees with nothing but contract and tort claims against a company without any employees. Unprecedented legal and business issues confronted the franchisees, along with a need for immediate action.

Assessing the Situation

The franchisees already had an active franchise advisory council, which discussed issues of mutual interest with GRI as issues arose, but no active litigation or contentious issues existed when the closure occurred. Some of the franchisees were sophisticated multi-unit, multi-brand developers. Some were new to the business; and others had not yet opened even their first franchise.

Franchisees began by consulting their lawyers to determine who to sue. The seven leaders of the Council selected a law firm to commence a RICO lawsuit, but first entertained a telephone conference with lawyers from Nixon Peabody, who suggested an alternative to litigation by forcing a bankruptcy.

A week had passed since the closure, and former officers of GRI would not answer questions about whether the franchisees would ever again receive their contractually mandated support. Nixon lawyers delivered a letter on Friday, Feb. 20 on behalf of the Council demanding immediate compliance with the franchise agreements, but even more importantly, full disclosure of financial information. The letters were hand-delivered to each of the members of the Board of Directors of GRI, explaining that they were all fiduciaries because GRI was in the “zone of insolvency” and that the duty was owed to all creditors, including the franchisees. GRI, its parent, and its six affiliates filed emergency petitions for protection under Chapter 11 of the Bankruptcy Code 4 hours later.

Seizing the Moment

The franchisees chose to “setoff” royalties before the bankruptcy was filed. Without royalties, GRI was forced to conduct an expedited sale of assets. Recognizing the vulnerability of GRI, the franchisees asserted their power.

The franchisees formed a buying cooperative to recover the buying power lost when GRI closed its restaurants. The cooperative required an investment by each franchisee, and each franchisee would own a share of the cooperative ' one share per restaurant. This cooperative became the vehicle for acquiring the franchise assets in the bankruptcy.

The franchisees then invited all potential bidders for the franchise assets to meet with them in an airport hotel to determine whether they had compatible cultures. The franchisees had already declared themselves as possible bidders for the assets, and a danger of collusion existed in such a meeting; nevertheless, counsel for GRI and the creditors committee were invited to the 2-day meeting. The Bankruptcy Court refused to issue an injunction to prevent the meeting. Meetings with six possible bidders and/or strategic partners occurred over 2 days. The franchisee leadership concluded at the end of the meetings that the franchisees were the natural buyers of the assets and should position themselves as probable purchasers.

Using Leverage

Each of the franchisees was injured in some way by the closures, and some much more than others. The franchisees asserted breaches of more than $40 million in the Bankruptcy Court. Bankruptcy law requires cure of these breaches as a prerequisite to the franchise agreements being acquired, but many uncertainties existed in this situation, including: the true amount of the breaches; who would be responsible to cure the breaches; and even whether the assets could be sold at a high enough price to compensate for the breaches. The law was also uncertain whether nonmonetary breaches, such as failure to properly use advertising funds, ever required cure during the bankruptcy and whether these breaches could be asserted as defenses to royalty collection after the bankruptcy. These uncertainties injected some speculation into the process, but creating a quagmire is useless unless used strategically. The Cooperative served as a vehicle for strategically coordinating and harnessing the claims.

Familiar faces appeared at the auction tables for the franchise assets. The franchisee Cooperative sat at one table, and a restaurant specialty real estate investment trust (“REIT”), with whom the franchisees previously met, sat at the other. The REIT bid a reasonable cash price that the franchisees could not match, $6.5 million. But the franchisees bid what they considered to be a higher and better offer. The Cooperative had obtained powers of attorney to control all of the $40 million of franchise claims. The franchisees then offered $1 million, plus satisfaction of $40 million worth of claims. The franchisees' offer was rejected in favor of $6.5 million cash, and the litigation began.

The Wisdom of Litigation

The bankruptcy process provides abbreviated litigation methods to allow estimates of the franchisee cure claims. Unless the franchisee claims could be compromised to an amount less than $6.5 million, such a bid by the REIT would offer no benefit and could even cost the creditors money. GRI reserved the right to set the auction aside within 60 days if the auction would not provide a net benefit. Relentless discovery was exchanged for the next 3 weeks, along with settlement discussions. The litigation generated information and wisdom on both sides.

The franchisees knew that an arm's-length buyer valued the assets at $6.5 million. They also knew that the price reflected a discount based on transition costs for a new owner and uncertainty regarding future royalty revenues. The franchisees knew better than anyone their probable royalty stream, and they could save on transition costs, as well as due diligence. They estimated the value of the assets at $10-12 million, without regard to their claims. The discovery highlighted the weaknesses in some claims, which helped them decide to offer more cash. The franchisees decided they would go as high as $4.5 million in cash as an alternative to the REIT's auction bid.

Through discovery, GRI concluded that while the claims were not worth $40 million, the collective claims could be conservatively valued at $3.5 million; however, the cost of litigating the claims could approach $1 million. GRI communicated that a $5 million cash payment with release of all claims would be more acceptable than a $6.5 million offer. Settlement seemed only $500,000 apart, but both sides were stubborn. The creditors' committee appointed in the bankruptcy tried to bridge the gap by brokering the available insurance.

During the discovery, it became apparent that $30 million of insurance could be available to satisfy certain franchisee claims. If the franchisees would pay the deductible, the franchisees could have access to the insurance as additional recovery. The parties then calculated the cost of the deductible, the probable coverage of the insurance, and agreed to a price of $4.85 million.

Franchisee Governance

The franchisees needed to vote to authorize the purchase price of $4.85 million and the finance of the purchase price. The Cooperative already had the mechanism for corporate democracy in place for approving the purchase price and financing. The vote provided the purchase price and financing terms, but also identified the acute need for complex corporate governance.

The new structure required the franchisees to decide among themselves who might need royalty relief, who could expand, how to raise or change operating standards, how to and against whom to enforce the franchise agreement, and who should be terminated or not renewed. The Cooperative evolved into the Ground Round Independent Owners Cooperative LLC (“IOC”) with rather unique provisions in its bylaws.

The IOC recognized the need for royalty relief and reduced the royalty rate by half. The IOC under its charter can agree by vote to increase its own royalties rate; accordingly, each franchise agreement has a variable royalty rate agreed upon by the franchisees. The IOC remains an entity in which each operating restaurant operator owns one unit of ownership for each restaurant operated; in other words, each restaurant casts one vote. The bylaws of the IOC prevent the voting of shares by franchisees without a restaurant in order to prevent existing franchisees being subject to the whims of former franchisees and eliminate speculative trading of units. The IOC does not pay dividends, but is structured to allow capital appreciation to be realized if the franchise system is ever sold. Although the IOC is not for sale, its value was enhanced when the franchise assets were purchased out of bankruptcy. The bylaws of the IOC are the constitution for the Ground Round franchisees. They contain checks and balances so that no faction of franchisees can dominate the others and are intended to maximize the resale value of each restaurant in the Ground Round system. The profits stay at the unit level rather than at the franchisor level, unless the IOC votes otherwise.

Realizing the Dream

On July 28, 2004, the members of the IOC came to the settlement table with $4.85 million and releases for $40 million, and they walked out with a turnkey franchise system, custom designed for themselves by themselves. They have already opened their first franchise in California and expect another six to open in 2004. Each franchisee has 1-year development rights, which is intended to encourage internal growth. The IOC is not yet ready to sell new franchises, but is preparing to do so.

The franchisees are realizing the dream of governing themselves. When they undertook this task, their goal was uncertain, their finances were thin, and their tactics unproven. They are now better positioned to compete against their competitors with the knowledge that they themselves are solely responsible for their success. Their competition is fierce, better financed, and larger, but they have beaten the odds before. Only time will tell whether the owners of the Ground Round IOC will be as good a franchisor as they have been as franchisees.

Sixty franchisees forced The Ground Round restaurant chain to file bankruptcy on Feb. 19, 2004. The same franchisees, 4 months later, became their own franchisor. They bought the franchise assets out of bankruptcy, including all the franchise agreements, the development agreements, 42 trademarks, and 38 prime leases which they assigned to the subtenants. The franchisees formed a for-profit cooperative, reduced their own franchise royalties, and obtained traditional bank financing. They achieved their goal by maintaining a united front, developing a unique governance structure, and maintaining a vision for operating profitably unlike anyone else in the casual-dining restaurant sector.

The Surprise Closure

Valentine's Day 2004 promised to be an extraordinary business day for restaurant owners. The first Valentine's Day to fall on a Saturday in several years, everyone stocked their freezers on the Friday before in anticipation. Seventy company-owned Ground Round restaurants and 58 franchised locations operated normally until the Friday the 13th announcement was made. The financiers of the Ground Round would not fund Friday's payroll, and all company-operated restaurants would immediately close. All of the 6500 corporate employees and officers were laid off by the Board of Directors.

It was chaos. Diners were asked to finish in the middle of their meals so that the restaurants could be secured. Food supplies were either secured or looted. News of the widespread closures in the United States was reported by the Associated Press, and customers incorrectly assumed the franchised locations were closed as well. Without employees, The Ground Round, Inc. (“GRI”) could not respond to rumors regarding the reasons for closure, whether the closures were permanent and whether customer gift certificates would be honored.

The franchisees were dependent upon GRI for procurement of food and supplies. With that corporate buying activity suspended, the franchisees were forced to fend for themselves. Some franchisees were subtenants of GRI and had paid rent to GRI, but GRI's landlords had not been paid. Similarly, advertising fees, development fees, initial franchise fees, and other payments to GRI had been diverted from their intended purposes, leaving franchisees with nothing but contract and tort claims against a company without any employees. Unprecedented legal and business issues confronted the franchisees, along with a need for immediate action.

Assessing the Situation

The franchisees already had an active franchise advisory council, which discussed issues of mutual interest with GRI as issues arose, but no active litigation or contentious issues existed when the closure occurred. Some of the franchisees were sophisticated multi-unit, multi-brand developers. Some were new to the business; and others had not yet opened even their first franchise.

Franchisees began by consulting their lawyers to determine who to sue. The seven leaders of the Council selected a law firm to commence a RICO lawsuit, but first entertained a telephone conference with lawyers from Nixon Peabody, who suggested an alternative to litigation by forcing a bankruptcy.

A week had passed since the closure, and former officers of GRI would not answer questions about whether the franchisees would ever again receive their contractually mandated support. Nixon lawyers delivered a letter on Friday, Feb. 20 on behalf of the Council demanding immediate compliance with the franchise agreements, but even more importantly, full disclosure of financial information. The letters were hand-delivered to each of the members of the Board of Directors of GRI, explaining that they were all fiduciaries because GRI was in the “zone of insolvency” and that the duty was owed to all creditors, including the franchisees. GRI, its parent, and its six affiliates filed emergency petitions for protection under Chapter 11 of the Bankruptcy Code 4 hours later.

Seizing the Moment

The franchisees chose to “setoff” royalties before the bankruptcy was filed. Without royalties, GRI was forced to conduct an expedited sale of assets. Recognizing the vulnerability of GRI, the franchisees asserted their power.

The franchisees formed a buying cooperative to recover the buying power lost when GRI closed its restaurants. The cooperative required an investment by each franchisee, and each franchisee would own a share of the cooperative ' one share per restaurant. This cooperative became the vehicle for acquiring the franchise assets in the bankruptcy.

The franchisees then invited all potential bidders for the franchise assets to meet with them in an airport hotel to determine whether they had compatible cultures. The franchisees had already declared themselves as possible bidders for the assets, and a danger of collusion existed in such a meeting; nevertheless, counsel for GRI and the creditors committee were invited to the 2-day meeting. The Bankruptcy Court refused to issue an injunction to prevent the meeting. Meetings with six possible bidders and/or strategic partners occurred over 2 days. The franchisee leadership concluded at the end of the meetings that the franchisees were the natural buyers of the assets and should position themselves as probable purchasers.

Using Leverage

Each of the franchisees was injured in some way by the closures, and some much more than others. The franchisees asserted breaches of more than $40 million in the Bankruptcy Court. Bankruptcy law requires cure of these breaches as a prerequisite to the franchise agreements being acquired, but many uncertainties existed in this situation, including: the true amount of the breaches; who would be responsible to cure the breaches; and even whether the assets could be sold at a high enough price to compensate for the breaches. The law was also uncertain whether nonmonetary breaches, such as failure to properly use advertising funds, ever required cure during the bankruptcy and whether these breaches could be asserted as defenses to royalty collection after the bankruptcy. These uncertainties injected some speculation into the process, but creating a quagmire is useless unless used strategically. The Cooperative served as a vehicle for strategically coordinating and harnessing the claims.

Familiar faces appeared at the auction tables for the franchise assets. The franchisee Cooperative sat at one table, and a restaurant specialty real estate investment trust (“REIT”), with whom the franchisees previously met, sat at the other. The REIT bid a reasonable cash price that the franchisees could not match, $6.5 million. But the franchisees bid what they considered to be a higher and better offer. The Cooperative had obtained powers of attorney to control all of the $40 million of franchise claims. The franchisees then offered $1 million, plus satisfaction of $40 million worth of claims. The franchisees' offer was rejected in favor of $6.5 million cash, and the litigation began.

The Wisdom of Litigation

The bankruptcy process provides abbreviated litigation methods to allow estimates of the franchisee cure claims. Unless the franchisee claims could be compromised to an amount less than $6.5 million, such a bid by the REIT would offer no benefit and could even cost the creditors money. GRI reserved the right to set the auction aside within 60 days if the auction would not provide a net benefit. Relentless discovery was exchanged for the next 3 weeks, along with settlement discussions. The litigation generated information and wisdom on both sides.

The franchisees knew that an arm's-length buyer valued the assets at $6.5 million. They also knew that the price reflected a discount based on transition costs for a new owner and uncertainty regarding future royalty revenues. The franchisees knew better than anyone their probable royalty stream, and they could save on transition costs, as well as due diligence. They estimated the value of the assets at $10-12 million, without regard to their claims. The discovery highlighted the weaknesses in some claims, which helped them decide to offer more cash. The franchisees decided they would go as high as $4.5 million in cash as an alternative to the REIT's auction bid.

Through discovery, GRI concluded that while the claims were not worth $40 million, the collective claims could be conservatively valued at $3.5 million; however, the cost of litigating the claims could approach $1 million. GRI communicated that a $5 million cash payment with release of all claims would be more acceptable than a $6.5 million offer. Settlement seemed only $500,000 apart, but both sides were stubborn. The creditors' committee appointed in the bankruptcy tried to bridge the gap by brokering the available insurance.

During the discovery, it became apparent that $30 million of insurance could be available to satisfy certain franchisee claims. If the franchisees would pay the deductible, the franchisees could have access to the insurance as additional recovery. The parties then calculated the cost of the deductible, the probable coverage of the insurance, and agreed to a price of $4.85 million.

Franchisee Governance

The franchisees needed to vote to authorize the purchase price of $4.85 million and the finance of the purchase price. The Cooperative already had the mechanism for corporate democracy in place for approving the purchase price and financing. The vote provided the purchase price and financing terms, but also identified the acute need for complex corporate governance.

The new structure required the franchisees to decide among themselves who might need royalty relief, who could expand, how to raise or change operating standards, how to and against whom to enforce the franchise agreement, and who should be terminated or not renewed. The Cooperative evolved into the Ground Round Independent Owners Cooperative LLC (“IOC”) with rather unique provisions in its bylaws.

The IOC recognized the need for royalty relief and reduced the royalty rate by half. The IOC under its charter can agree by vote to increase its own royalties rate; accordingly, each franchise agreement has a variable royalty rate agreed upon by the franchisees. The IOC remains an entity in which each operating restaurant operator owns one unit of ownership for each restaurant operated; in other words, each restaurant casts one vote. The bylaws of the IOC prevent the voting of shares by franchisees without a restaurant in order to prevent existing franchisees being subject to the whims of former franchisees and eliminate speculative trading of units. The IOC does not pay dividends, but is structured to allow capital appreciation to be realized if the franchise system is ever sold. Although the IOC is not for sale, its value was enhanced when the franchise assets were purchased out of bankruptcy. The bylaws of the IOC are the constitution for the Ground Round franchisees. They contain checks and balances so that no faction of franchisees can dominate the others and are intended to maximize the resale value of each restaurant in the Ground Round system. The profits stay at the unit level rather than at the franchisor level, unless the IOC votes otherwise.

Realizing the Dream

On July 28, 2004, the members of the IOC came to the settlement table with $4.85 million and releases for $40 million, and they walked out with a turnkey franchise system, custom designed for themselves by themselves. They have already opened their first franchise in California and expect another six to open in 2004. Each franchisee has 1-year development rights, which is intended to encourage internal growth. The IOC is not yet ready to sell new franchises, but is preparing to do so.

The franchisees are realizing the dream of governing themselves. When they undertook this task, their goal was uncertain, their finances were thin, and their tactics unproven. They are now better positioned to compete against their competitors with the knowledge that they themselves are solely responsible for their success. Their competition is fierce, better financed, and larger, but they have beaten the odds before. Only time will tell whether the owners of the Ground Round IOC will be as good a franchisor as they have been as franchisees.