Restaurant IndustryChapter 11 Bankruptcies

By David L. Rosendorf

The past year has brought a waveof restaurant businesses filing forreorganization in Chapter 11. With inherently low profit margins, increased competition, limited pricingflexibility and a propensity for expansion without the support of underlying business fundamentals, theindustry is particularly susceptibleto business failure. The recent filings range from luxurious high endrestaurants to casual budget eateries, and often involve hundreds oflocations, thousands of employees, and hundreds of millions of dollars of debt. This article discussesthe causes of the recent trend, andsome of the issues that arise whenrestaurants avail themselves of theChapter 11 process.

A WaveofRestaurant Chapter 11s

• In March, NYLC, LLC, the owner of Le Cirque, a legendaryManhattan restaurant opensince 1974, filed for Chapter11, blaming temporary cash flow issues. Its first-day filings reflect a projected 15%income shortfall comparedwith anticipated expenses ofmore than $460,000 during itsfirst 30 days of operation inChapter 11.
• In February, Unique VenturesGroup, LLC, which owns 28 Perkins restaurants that itbought for $38 million, filedfor Chapter 11 in Pittsburgh. Amid disputes among ownership factions, the bankruptcycourt recently directed theappointment of a Chapter 11trustee.
• In January, Capital Pizza Huts,Inc., the owner of 56 Pizza Hutstores located across six stateswith over 1,400 employeesand $20 million in debt, filed for bankruptcy in Kansas, citing declining gross sales andincreasing food costs.
• In October 2016, GardenFresh Corp., which operates the Sweet Tomatoes and Sou-plantation 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 another35 franchised locations, andemployed over 1,500 people,filed for Chapter 11 in Boston.The company, whose stockwas 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, 13,000employees, and $400 millionin debt, filed in Delaware; it confirmed its Chapter 11 plan and emerged from bankruptcy in December.

• Also in August 2016, Last CallGuarantor LLC, which ownedthe Fox & Hound, Bailey’sSports Grill, and ChamppsKitchen restaurant chains, filed for Chapter 11 protection in Delaware the second filing for the group since2013. The company operated79 restaurants in 25 states,and had 4,700 employees.

The restaurant business has always been challenging, and failureis common. Most restaurants operate on very thin margins: after foodcosts, labor costs, lease and otheroccupancy costs, marketing andother expenses, a 5% profit marginis common. Any change in revenuesor expenses can work a substantialdisruption in the business and precipitate a potential filing.

Clearly, some businesses in theindustry perform better than others. Cosi, which never had a profitableyear since going public in 2002, accumulated $300 million in lossesbefore filing. But several restaurantchains are experiencing softening revenues over the past year. And aparallel pattern of recent bankruptcies in the retail sector may signala broader decline in discretionaryspending, suggesting that toughertimes are ahead for the restaurantindustry.

WhyTheBankruptcies?

The squeeze may be coming fromthe expense side as well as the revenue side. Food costs can increaseas diners demand better quality ingredients, but customers don’t necessarily want to pay more for them.Labor expenses may also be on therise, between pushes to increase theminimum wage in some states andadditional health care costs beingborne by employers. The recent political environment on immigrationpolicy may also have an impact,  asmany restaurants have traditionallyrelied extensively on undocumented immigrants, as do many farmers who grow the crops that supply those restaurants.

The pressures may be greateston those restaurants situated in themiddle of the market: “casual dining,” as distinguished from “fastfood” or “fast casual” on one end,and fine dining on the other. Thesetypes of venues, which offer tableservice at a moderate price point,bear all the costs of operating afull-service restaurant — higherlease expenses because they requiremore space, higher labor costs forhosts and servers and bussers anddishwashers, plus their larger operations often require more management support — but they are limited in how much they can chargetheir customers.

Many of these ventures are financed through private equity firms,which can create greater pressureto generate higher returns on thoseinvestments than with traditionalbank financing. If internal, same-store sales will not generate sufficient growth, businesses often lookto expansion as a substitute. But anoveraggressive expansion plan thatisn’t supported by underlying profitability is often a formula for business failure. And, unlike traditionalbank lenders, private equity firmstypically have no hesitation abouttaking back the business and operating it if the loan goes into default.

What CanBeAccomplished InARestaurant Chapter 11?

Lease Issues

A common factor among manyrestaurant 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 unprofitablelocations and refocusing on profitable aspects of the core business.Rejection of unprofitable leasesunder 11 U.S.C § 365(a) provides amechanism for doing so, while also

providing the benefit of cappinglease rejection pursuant to 11 U.S.C.§ 502(g). Moreover, since lease rejection claims will be classified withother general unsecured claims fordistribution purposes, the value ofsuch claims may be fairly minimal.As a result, even the anticipationof a likely Chapter 11 filing maybe sufficient motivation for a landlord to negotiate a consensual leasetermination on favorable terms inadvance of an actual filing, and potential debtors often should pursuesuch negotiations before filing.

On the other hand, sometimes arestaurant business may file Chapter11 in order to keep its lease. Thatseems to be the case with Le Cirque,whose first-day filings indicate thatthe bankruptcy was triggered by anotice of default on the $95,000/month lease for its Upper East Sidespace. Although 11 U.S.C. § 365(d) (3) requires the debtor-in-possession to timely perform all post-petition obligations under a lease untilassumption or rejection, a debtormay seek to extend its time for performance for up to 60 days; thoughif Le Cirque fails to address its cashshortfall issues, such an effort maynot be successful.

In a sale scenario, Chapter 11 alsofacilitates the process of assumingand assigning retained leases toa 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 connectionwith the assigned leases.

 Franchise Issues

The recent spate of restaurantChapter 11s has primarily involvedcompany-owned chains. But theindustry also includes a number offranchise operations, which raisetheir 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 provisionsof 11 U.S.C. § 365(c)(1), which provide that an executory contract maynot be assumed or assigned if applicable law excuses a non-debtorparty to the contract from accepting performance from or renderingperformance to an entity other thanthe debtor, can restrict the debtor-franchisee’s ability to assign thefranchise 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 theLanham Act to refuse to accept orrender performance to a third-partyassignee, and courts have held thatthis right remains enforceable inthe bankruptcy assignment contextpursuant to § 365(c)(1). See, e.g., Inre Wellington Vision, Inc., 364 B.R.129 (S.D. Fla. 2007). Indeed, assumption of such agreements canbe prohibited even in the absenceof assignment to a third party. SeeIn 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 mayretain a significant degree of controlin a franchisee bankruptcy.

debt is converted into equity in the reorganized debtors; after general unsecured creditors other than the lenders receive $1.5 milli

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 prepetition 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’ on, the noteholders and general unsecuredcreditors share in additional funds available for distribution. The plan is projected to yield a 10%-20% distribution to general unsecuredcreditors.

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 KozyakTropin& 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 dlr@kttlaw.com

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