Restaurant Industry Chapter 11 Bankruptcies

In February, Unique Ventures Group, LLC, which owns 28 Perkins restaurants that it bought for $38 million, filed for Chapter 11 in Pittsburgh. Amid disputes among ownership factions, the bankruptcy court recently directed the appointment of a Chapter 11 trustee.

In January, Capital Pizza Huts, Inc., the owner of 56 Pizza Hut stores located across six states with over 1,400 employees and $20 million in debt, filed for bankruptcy in Kansas, citing declining gross sales and increasing food costs.

In October 2016, Garden Fresh Corp., which operates the Sweet Tomatoes and Souplantation restaurant chains, filed for Chapter 11 in Delaware. The group included 125 restaurants, had 5,500 employees, and owed approximately $200 million to its creditors.

In September 2016, Cosi, Inc., which operated 72 company-owned “fast casual” restaurants, plus another 35 franchised locations, and employed over 1,500 people, filed for Chapter 11 in Boston. The company, whose stock was then publicly traded, owed $8 million to noteholders and an additional $15 million to other trade creditors.

In August 2016, Roadhouse Holding Inc., the parent company of Logan's Roadhouse, a Nashville-based chain of steakhouses with approximately 200 locations, 13,000 employees, and $400 million in debt, filed in Delaware; it confirmed its Chapter 11 plan and emerged from bankruptcy in December.

Also in August 2016, Last Call Guarantor LLC, which owned the Fox & Hound, Bailey's Sports Grill, and Champps Kitchen restaurant chains, filed for Chapter 11 protection in Delaware — the second filing for the group since 2013. The company operated 79 restaurants in 25 states, and had 4,700 employees.

The restaurant business has always been challenging, and failure is common. Most restaurants operate on very thin margins: after food costs, labor costs, lease and other occupancy costs, marketing and other expenses, a 5% profit margin is common. Any change in revenues or expenses can work a substantial disruption in the business and precipitate a potential filing.

Clearly, some businesses in the industry perform better than others. Cosi, which never had a profitable year since going public in 2002, accumulated $300 million in losses before filing. But several restaurant chains are experiencing softening revenues over the past year. And a parallel pattern of recent bankruptcies in the retail sector may signal a broader decline in discretionary spending, suggesting that tougher times are ahead for the restaurant industry.

Why the Bankruptcies?

The squeeze may be coming from the expense side as well as the revenue side. Food costs can increase as diners demand better quality ingredients, but customers don't necessarily want to pay more for them. Labor expenses may also be on the rise, between pushes to increase the minimum wage in some states and additional health care costs being borne by employers. The recent political environment on immigration policy may also have an impact, as many restaurants have traditionally relied extensively on undocumented immigrants, as do many farmers who grow the crops that supply those restaurants.

The pressures may be greatest on those restaurants situated in the middle of the market: “casual dining,” as distinguished from “fast food” or “fast casual” on one end, and fine dining on the other. These types of venues, which offer table service at a moderate price point, bear all the costs of operating a full-service restaurant — higher lease expenses because they require more space, higher labor costs for hosts and servers and bussers and dishwashers, plus their larger operations often require more management support — but they are limited in how much they can charge their customers.

Many of these ventures are financed through private equity firms, which can create greater pressure to generate higher returns on those investments than with traditional bank financing. If internal, same-store sales will not generate sufficient growth, businesses often look to expansion as a substitute. But an overaggressive expansion plan that isn't supported by underlying profitability is often a formula for business failure. And, unlike traditional bank lenders, private equity firms typically have no hesitation about taking back the business and operating it if the loan goes into default.

What Can Be Accomplished in a Restaurant Chapter 11?

Lease Issues

A common factor among many restaurant Chapter 11s is a poorly executed expansion plan. Often, one of the first steps in rehabilitating a restaurant business is paring back — getting rid of unprofitable locations and refocusing on profitable aspects of the core business. Rejection of unprofitable leases under 11 U.S.C § 365(a) provides a mechanism for doing so, while also providing the benefit of capping lease rejection pursuant to 11 U.S.C. § 502(g). Moreover, since lease rejection claims will be classified with other general unsecured claims for distribution purposes, the value of such claims may be fairly minimal. As a result, even the anticipation of a likely Chapter 11 filing may be sufficient motivation for a landlord to negotiate a consensual lease termination on favorable terms in advance of an actual filing, and potential debtors often should pursue such negotiations before filing.

On the other hand, sometimes a restaurant business may file Chapter 11 in order to keep its lease. That seems to be the case with Le Cirque, whose first-day filings indicate that the bankruptcy was triggered by a notice of default on the $95,000/month lease for its Upper East Side space. Although 11 U.S.C. § 365(d)(3) requires the debtor-in-possession to timely perform all post-petition obligations under a lease until assumption or rejection, a debtor may seek to extend its time for performance for up to 60 days; though if Le Cirque fails to address its cash shortfall issues, such an effort may not be successful.

In a sale scenario, Chapter 11 also facilitates the process of assuming and assigning retained leases to a purchaser pursuant to 11 U.S.C. § 365(b) and (f), while simultaneously providing one forum for addressing and resolving issues relating to cure obligations in connection with the assigned leases.

Franchise Issues

The recent spate of restaurant Chapter 11s has primarily involved company-owned chains. But the industry also includes a number of franchise operations, which raise their own set of issues in Chapter 11.

Where the debtor is the franchisee, one of the key issues is the assignability of the franchise agreement. In particular, the provisions of 11 U.S.C. § 365(c)(1), which provide that an executory contract may not be assumed or assigned if applicable law excuses a non-debtor party to the contract from accepting performance from or rendering performance to an entity other than the debtor, can restrict the debtor-franchisee's ability to assign the franchise agreement to a third party.

When a franchise agreement confers the right to use a trademark, as is usually the case, the franchisor may have the right under the Lanham Act to refuse to accept or render performance to a third-party assignee, and courts have held that this right remains enforceable in the bankruptcy assignment context pursuant to § 365(c)(1). See, e.g., In re Wellington Vision, Inc., 364 B.R. 129 (S.D. Fla. 2007). Indeed, assumption of such agreements can be prohibited even in the absence of assignment to a third party. See In re Trump Entertainment Resorts, Inc., 526 B.R. 116 (Bankr. D. Del. 2015); In re Kazi Foods of Michigan, Inc., 473 B.R. 887 (Bankr. E.D. Mich. 2011). As a result, a franchisor may retain a significant degree of control in a franchisee bankruptcy.

If the debtor is the franchisor, the potential rejection of the franchise agreement can create another set of issues. Under 11 U.S.C. § 365(n), the licensee of a right to intellectual property under an agreement rejected by a debtor-licensor has the option to either: 1) treat the contract as terminated by the rejection, if the rejection amounts to such a breach as would permit termination under applicable law or another agreement of the licensee; or, 2) retain its rights under the licensing agreement and any supplementary agreements to the intellectual property, for the duration of the agreement and any applicable extensions as of right.

In other words, the debtor franchisor cannot terminate the non-debtor franchisee's right to continued use of the intellectual property for the duration of the agreement, if the franchisee so elects, rather than treated the agreement as terminated. See Sunbeam Products, Inc. v. Chicago American Mfg., LLC, 686 F.3d 372 (7th Cir. 2012).

Sale Process and Balance Sheet Restructuring

Often, restaurant businesses will file Chapter 11 to facilitate a sale of the business as a going concern. Sections 363 and 364 of the Bankruptcy Code provide the means to obtain additional debtor-in-possession financing to continue operations until a sale process can be conducted and closed, while also providing the means to sell assets free and clear of the claims of creditors, and assuming and assigning leases and executory contracts to the purchasers.

But the market for these restaurant assets does not exactly appear robust. In the Garden Fresh case, an auction sale was canceled after no qualified bids were submitted, resulting in the approval of the sale of the debtor's assets to the “stalking horse” bidder in January 2017 — effectively, a credit bid by the debtor's pre-petition secured lenders. Cosi likewise canceled an auction sale when no competing bids were submitted above a stalking horse bid from the pre-petition and debtor-in-possession lenders.

Cosi's revised Chapter 11 plan, rather than proceeding with an actual sale, now provides for what amounts to a “virtual sale” which represents an approximation of the value associated with the stalking horse purchase offer. Under the Plan Settlement proposed by the Cosi plan, $5 million of the lenders' debt is converted into equity in the reorganized debtors; after general unsecured creditors other than the lenders receive $1.5 million, the noteholders and general unsecured creditors share in additional funds available for distribution. The plan is projected to yield a 10%-20% distribution to general unsecured creditors.

In other cases, restaurant businesses may emerge from bankruptcy by restructuring debt rather than pursuing a sale process. In Logan's Roadhouse, for instance, the holders of $400 million of long-term secured debt agreed to convert most that debt into equity, reducing the company's long-term debt to $100 million, and creating a $1 million fund to pay the company's unsecured trade creditors. Though that $1 million was only projected to provide about a 3% recovery, it was still likely a better result than liquidation, which would have yielded nothing for trade creditors, while putting several thousand employees out of work.

Conclusion

As bankruptcy practitioners know, Chapter 11 does not magically fix underlying business issues. Restaurant chains that have made multiple trips through Chapter 11 — like the Fox & Hound group, and Sbarro before it — will attest to this fact. Chapter 11 provides a fresh start, but it's still up to the company to create a recipe for future success.

****
David Rosendorf is a partner in the Miami-based law firm of Kozyak Tropin & Throckmorton, LLP, and focuses his practice on business bankruptcy and other commercial litigation. He has over 20 years' experience representing debtors, creditors, asset purchasers and other parties in Chapter 11 bankruptcy proceedings, including clients in the restaurant and hospitality industries. He may be reached at [email protected].

The past year has brought a wave of restaurant businesses filing for reorganization in Chapter 11. With inherently low profit margins, increased competition, limited pricing flexibility and a propensity for expansion without the support of underlying business fundamentals, the industry is particularly susceptible to business failure. The recent filings range from luxurious high-end restaurants to casual budget eateries, and often involve hundreds of locations, thousands of employees, and hundreds of millions of dollars of debt. This article discusses the causes of the recent trend, and some of the issues that arise when restaurants avail themselves of the Chapter 11 process.

A Wave of Restaurant Chapter 11s

In March, NYLC, LLC, the owner of Le Cirque, a legendary Manhattan restaurant open since 1974, filed for Chapter 11, blaming temporary cash flow issues. Its first-day filings reflect a projected 15% income shortfall compared with anticipated expenses of more than $460,000 during its first 30 days of operation in Chapter 11.

In February, Unique Ventures Group, LLC, which owns 28 Perkins restaurants that it bought for $38 million, filed for Chapter 11 in Pittsburgh. Amid disputes among ownership factions, the bankruptcy court recently directed the appointment of a Chapter 11 trustee.

In January, Capital Pizza Huts, Inc., the owner of 56 Pizza Hut stores located across six states with over 1,400 employees and $20 million in debt, filed for bankruptcy in Kansas, citing declining gross sales and increasing food costs.

In October 2016, Garden Fresh Corp., which operates the Sweet Tomatoes and Souplantation restaurant chains, filed for Chapter 11 in Delaware. The group included 125 restaurants, had 5,500 employees, and owed approximately $200 million to its creditors.

In September 2016, Cosi, Inc., which operated 72 company-owned “fast casual” restaurants, plus another 35 franchised locations, and employed over 1,500 people, filed for Chapter 11 in Boston. The company, whose stock was then publicly traded, owed $8 million to noteholders and an additional $15 million to other trade creditors.

In August 2016, Roadhouse Holding Inc., the parent company of Logan's Roadhouse, a Nashville-based chain of steakhouses with approximately 200 locations, 13,000 employees, and $400 million in debt, filed in Delaware; it confirmed its Chapter 11 plan and emerged from bankruptcy in December.

Also in August 2016, Last Call Guarantor LLC, which owned the Fox & Hound, Bailey's Sports Grill, and Champps Kitchen restaurant chains, filed for Chapter 11 protection in Delaware — the second filing for the group since 2013. The company operated 79 restaurants in 25 states, and had 4,700 employees.

The restaurant business has always been challenging, and failure is common. Most restaurants operate on very thin margins: after food costs, labor costs, lease and other occupancy costs, marketing and other expenses, a 5% profit margin is common. Any change in revenues or expenses can work a substantial disruption in the business and precipitate a potential filing.

Clearly, some businesses in the industry perform better than others. Cosi, which never had a profitable year since going public in 2002, accumulated $300 million in losses before filing. But several restaurant chains are experiencing softening revenues over the past year. And a parallel pattern of recent bankruptcies in the retail sector may signal a broader decline in discretionary spending, suggesting that tougher times are ahead for the restaurant industry.

Why the Bankruptcies?

The squeeze may be coming from the expense side as well as the revenue side. Food costs can increase as diners demand better quality ingredients, but customers don't necessarily want to pay more for them. Labor expenses may also be on the rise, between pushes to increase the minimum wage in some states and additional health care costs being borne by employers. The recent political environment on immigration policy may also have an impact, as many restaurants have traditionally relied extensively on undocumented immigrants, as do many farmers who grow the crops that supply those restaurants.

The pressures may be greatest on those restaurants situated in the middle of the market: “casual dining,” as distinguished from “fast food” or “fast casual” on one end, and fine dining on the other. These types of venues, which offer table service at a moderate price point, bear all the costs of operating a full-service restaurant — higher lease expenses because they require more space, higher labor costs for hosts and servers and bussers and dishwashers, plus their larger operations often require more management support — but they are limited in how much they can charge their customers.

Many of these ventures are financed through private equity firms, which can create greater pressure to generate higher returns on those investments than with traditional bank financing. If internal, same-store sales will not generate sufficient growth, businesses often look to expansion as a substitute. But an overaggressive expansion plan that isn't supported by underlying profitability is often a formula for business failure. And, unlike traditional bank lenders, private equity firms typically have no hesitation about taking back the business and operating it if the loan goes into default.

What Can Be Accomplished in a Restaurant Chapter 11?

Lease Issues

A common factor among many restaurant Chapter 11s is a poorly executed expansion plan. Often, one of the first steps in rehabilitating a restaurant business is paring back — getting rid of unprofitable locations and refocusing on profitable aspects of the core business. Rejection of unprofitable leases under 11 U.S.C § 365(a) provides a mechanism for doing so, while also providing the benefit of capping lease rejection pursuant to 11 U.S.C. § 502(g). Moreover, since lease rejection claims will be classified with other general unsecured claims for distribution purposes, the value of such claims may be fairly minimal. As a result, even the anticipation of a likely Chapter 11 filing may be sufficient motivation for a landlord to negotiate a consensual lease termination on favorable terms in advance of an actual filing, and potential debtors often should pursue such negotiations before filing.

On the other hand, sometimes a restaurant business may file Chapter 11 in order to keep its lease. That seems to be the case with Le Cirque, whose first-day filings indicate that the bankruptcy was triggered by a notice of default on the $95,000/month lease for its Upper East Side space. Although 11 U.S.C. § 365(d)(3) requires the debtor-in-possession to timely perform all post-petition obligations under a lease until assumption or rejection, a debtor may seek to extend its time for performance for up to 60 days; though if Le Cirque fails to address its cash shortfall issues, such an effort may not be successful.

In a sale scenario, Chapter 11 also facilitates the process of assuming and assigning retained leases to a purchaser pursuant to 11 U.S.C. § 365(b) and (f), while simultaneously providing one forum for addressing and resolving issues relating to cure obligations in connection with the assigned leases.

Franchise Issues

The recent spate of restaurant Chapter 11s has primarily involved company-owned chains. But the industry also includes a number of franchise operations, which raise their own set of issues in Chapter 11.

Where the debtor is the franchisee, one of the key issues is the assignability of the franchise agreement. In particular, the provisions of 11 U.S.C. § 365(c)(1), which provide that an executory contract may not be assumed or assigned if applicable law excuses a non-debtor party to the contract from accepting performance from or rendering performance to an entity other than the debtor, can restrict the debtor-franchisee's ability to assign the franchise agreement to a third party.

When a franchise agreement confers the right to use a trademark, as is usually the case, the franchisor may have the right under the Lanham Act to refuse to accept or render performance to a third-party assignee, and courts have held that this right remains enforceable in the bankruptcy assignment context pursuant to § 365(c)(1). See, e.g., In re Wellington Vision, Inc., 364 B.R. 129 (S.D. Fla. 2007). Indeed, assumption of such agreements can be prohibited even in the absence of assignment to a third party. See In re Trump Entertainment Resorts, Inc., 526 B.R. 116 (Bankr. D. Del. 2015); In re Kazi Foods of Michigan, Inc., 473 B.R. 887 (Bankr. E.D. Mich. 2011). As a result, a franchisor may retain a significant degree of control in a franchisee bankruptcy.

If the debtor is the franchisor, the potential rejection of the franchise agreement can create another set of issues. Under 11 U.S.C. § 365(n), the licensee of a right to intellectual property under an agreement rejected by a debtor-licensor has the option to either: 1) treat the contract as terminated by the rejection, if the rejection amounts to such a breach as would permit termination under applicable law or another agreement of the licensee; or, 2) retain its rights under the licensing agreement and any supplementary agreements to the intellectual property, for the duration of the agreement and any applicable extensions as of right.

In other words, the debtor franchisor cannot terminate the non-debtor franchisee's right to continued use of the intellectual property for the duration of the agreement, if the franchisee so elects, rather than treated the agreement as terminated. See Sunbeam Products, Inc. v. Chicago American Mfg., LLC , 686 F.3d 372 (7th Cir. 2012).

Sale Process and Balance Sheet Restructuring

Often, restaurant businesses will file Chapter 11 to facilitate a sale of the business as a going concern. Sections 363 and 364 of the Bankruptcy Code provide the means to obtain additional debtor-in-possession financing to continue operations until a sale process can be conducted and closed, while also providing the means to sell assets free and clear of the claims of creditors, and assuming and assigning leases and executory contracts to the purchasers.

But the market for these restaurant assets does not exactly appear robust. In the Garden Fresh case, an auction sale was canceled after no qualified bids were submitted, resulting in the approval of the sale of the debtor's assets to the “stalking horse” bidder in January 2017 — effectively, a credit bid by the debtor's pre-petition secured lenders. Cosi likewise canceled an auction sale when no competing bids were submitted above a stalking horse bid from the pre-petition and debtor-in-possession lenders.

Cosi's revised Chapter 11 plan, rather than proceeding with an actual sale, now provides for what amounts to a “virtual sale” which represents an approximation of the value associated with the stalking horse purchase offer. Under the Plan Settlement proposed by the Cosi plan, $5 million of the lenders' debt is converted into equity in the reorganized debtors; after general unsecured creditors other than the lenders receive $1.5 million, the noteholders and general unsecured creditors share in additional funds available for distribution. The plan is projected to yield a 10%-20% distribution to general unsecured creditors.

In other cases, restaurant businesses may emerge from bankruptcy by restructuring debt rather than pursuing a sale process. In Logan's Roadhouse, for instance, the holders of $400 million of long-term secured debt agreed to convert most that debt into equity, reducing the company's long-term debt to $100 million, and creating a $1 million fund to pay the company's unsecured trade creditors. Though that $1 million was only projected to provide about a 3% recovery, it was still likely a better result than liquidation, which would have yielded nothing for trade creditors, while putting several thousand employees out of work.

Conclusion

As bankruptcy practitioners know, Chapter 11 does not magically fix underlying business issues. Restaurant chains that have made multiple trips through Chapter 11 — like the Fox & Hound group, and Sbarro before it — will attest to this fact. Chapter 11 provides a fresh start, but it's still up to the company to create a recipe for future success.

****
David Rosendorf is a partner in the Miami-based law firm of Kozyak Tropin & Throckmorton, LLP, and focuses his practice on business bankruptcy and other commercial litigation. He has over 20 years' experience representing debtors, creditors, asset purchasers and other parties in Chapter 11 bankruptcy proceedings, including clients in the restaurant and hospitality industries. He may be reached at [email protected].