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A Special Report on Business Restructuring and Bankruptcy: Restructuring concepts for troubled restaurant franchisees

It should come as little surprise that rising food and commodity costs, unstable energy prices and high unemployment are key ingredients to the current stagnant economy affecting the fast food and casual dining industry in the United States. While 2010 showed signs of growth, some fast food and casual dining franchises struggled. Given the relatively low menu prices and ubiquitous attraction for the average American consumer, one would assume that restaurant franchisee’s fortunes do not falter when the economy lags. In a low margin business, maintaining high customer volumes is critical to success. Unfortunately, that success is not the reality for every restaurant franchisee.

As in any garden-variety restructuring, the fate or fortunes of a troubled business are dictated by, among other things, access to capital, existing contractual arrangements, the strength of its management team, and an overall demand for its products or services. A distressed restaurant franchisee situation includes many of these same issues; however, in most cases, the franchisor wields atypically strong leverage in the process. This article outlines five concepts to which a franchisee’s manager or advisor should pay particular attention when faced with a distressed restaurant franchise. While these topics may be self-explanatory, they are sometimes overlooked.

Understand the franchisee’s financing documents

Having a thorough understanding of the intricacies of a lender’s or secured party’s loan documents, lien positions and priority of competing secured claims is necessary for mapping a strategy for a troubled franchisee. In an out-of-court restructuring, it is critical to know whether defaults under such financing agreements can be cured or are cross-defaulted to other obligations, including the franchise agreements. In certain instances, financing documents are cross-defaulted with both the franchise agreements and, if the franchisor is also the landlord, to the underlying real property leases. All of these agreements need to be read in concert with the financing documents to help determine the manner and method of the restructuring. For example, one may face a situation where the secured lender is neither the franchisee’s depository institution nor the holder of an account control agreement with the franchisee. In most situations, the lender may not have the right to sweep bank accounts or, if a restaurant franchisee files bankruptcy, the secured lender may have only limited rights in the franchisee’s postpetition use of cash.

In the bankruptcy context, a franchisee may also be able to challenge a secured lender’s interest in cash based on a line of bankruptcy case law that holds that cash generated from the postpetition operation of the restaurant does not constitute use of the lender’s cash collateral. Bankruptcy courts have noted that the restaurant industry, in general, is a service-oriented industry. In comparison with food wholesalers and retailers who sell food products in their natural or packaged state, restaurants expend a great deal of time and energy preparing individual food orders by transforming these natural or packaged foods into menu items. Therefore, some bankruptcy courts have found that revenues generated by a restaurant do not constitute proceeds from the sale of inventory (which is typically covered by a UCC-1 filing per the secured lender’s loan documents). Other courts have reached a similar conclusion: holding that only a portion of the cash received by a restaurant from its patrons constituted proceeds from the sale of inventory, but the bulk of the proceeds represented payment for services. This line of case law, if followed, is damaging for those lenders whose lien positions are not well-protected. In light of the foregoing, a franchisee may have an opportunity either pre-filing or early in a bankruptcy case to mitigate cash collateral issues, especially if the lender wishes to avoid the risk of further written precedent following the case law referenced herein. This scenario may be the rare instance where a franchisee has the leverage whereby it can operate with minimal restrictions in a cash collateral order. Another practical impact of a lender’s lack of control over cash may lead the major case parties to agree to reserve all the perfection issues and legal briefing on the nature of the restaurant services to permit the prospect of global resolution without a judicial finding on the issue.

Recognize that the franchise agreements are the cornerstone of the business

Unlike other creditors of a restaurant franchise, the franchisor has far more invested in the franchisee than simply money. A franchisor is also deeply concerned with protecting the goodwill, reputation and intellectual property associated with the business. All of a franchisor’s rights are explicitly spelled out in the franchise agreement, which includes capital expenditure requirements, non-compete and other restrictive covenants for the franchisee. These powers sometimes create an uneasy tension between the franchisor and the franchisee’s lender. Once those parties recognize distress, they will establish positions to maximize their respective benefits, which may be mutually exclusive. For example, a franchisor will want to leverage the restructuring or bankruptcy to ensure maximum payment of royalty and advertising fees, and the continued operation of the restaurant. On the other hand, the franchisee’s lender may conclude that a forced or orderly liquidation is the best way for such lender to maximize the value of its collateral (especially in cases where the franchisee owns the real estate subject to the lender’s mortgage). The franchise agreements may further complicate matters due to de-identification obligations and method of closing such locations. As this struggle unfolds, the franchisee must serve as a mediator while continuing to push a viable exit strategy.

If a bankruptcy is filed, an additional challenge for a restaurant franchisee is that a franchise agreement provides a franchisor with veto power over the assignment of franchise rights. One area of law that causes confusion is the assumption and assignment of franchise agreements. Assignments of franchise rights (whether to a third party or assumed as part of a plan of reorganization) may not be approved by a bankruptcy court where applicable non-bankruptcy law allows the franchisor to withhold its consent. Courts, however, are split on the issue of whether a franchisee can assume a franchise agreement without the franchisor’s consent. Courts of Appeals in the Third, Fourth and Ninth Circuits interpret the assignment language in 365(c)(1) of the Bankruptcy Code as asking whether a franchisee could hypothetically assign its franchise even if the debtor is only proposing to assume the contract. The “hypothetical” test gives franchisors a veto over the assumption (and subsequent assignment) of a franchise agreement in bankruptcy. On the other hand, courts in the First, Eighth and Ninth Circuits follow the “actual” test and permit a franchisee to assume a franchise agreement if the franchisee does not actually intend to assign it. While the franchisor has the ultimate veto power over an assignment to a third party in all circumstances, one must consider which of the above tests apply in considering venue options for a particular case, especially if the existing management is seeking to reorganize (rather than sell the franchise) and will simply assume the existing franchise agreements.

Identify and address critical vendors

Typically, the franchise agreement provides that the franchisor shall approve all major vendors, including food and other products used throughout the franchisor’s system. Suppliers must meet certain required service, product and/or equipment specifications, maintain certain standards and satisfy other approval criteria on an ongoing basis. In addition, vendors of perishable products may have certain statutory liens in the event of non-payment. Not surprisingly, this leaves a franchisee with limited options when dealing with these vendors both in and out of a bankruptcy proceeding. Indeed, a restaurant franchisee’s ability to operate the business is entirely dependent upon the continued supply from these primary vendors (often referred to as “critical vendors” in bankruptcy parlance). The ongoing support from the franchisee’s “critical vendors” is vital to maintaining the going concern value of the business especially during the planning process or the precarious early stages of a bankruptcy case. Liquidity issues are often pervasive in a troubled franchise restructuring and an interruption in the supply of goods and services by the “critical vendors” could shutter the business if not adequately addressed. While courts require a higher standard for granting relief to pay pre-bankruptcy creditors, negotiations should commence and resources should be allocated for those “critical vendors” in the 13-week cash flow projections. In certain instances, the franchisee may be able to leverage the franchisor’s clout with a particular “critical vendor” to relieve some of the franchisee’s acute cash obligations. If this occurs, however, a franchisee may face future challenges to cash flow in the form of more arduous bank terms or price increases at a later date. However, in the context of a bankruptcy proceeding, if a franchisee has written supply contracts with a “critical vendor,” the franchisee may have the ability to force such vendor to perform on a go-forward basis according to the terms of such contract.

Communicate with the landlords

In those instances where a franchisee operates multiple restaurants, the restaurants are often leased and not owned. In this current real estate environment, many of the lease terms are above-market. Working with the landlord out-of-court on rent concessions may free up needed cash to assist in solving a short-term liquidity crisis. If, however, there are too many troubled leases or that short-term concessions are not sufficient to address the liquidity shortfall, dealing with the leases through bankruptcy is an option. The Bankruptcy Code provides a debtor with 210 days (at most) to address lease issues in bankruptcy before landlord consent is required. In addition, a restaurant franchisee can reject leases at under-performing locations it intends to close. Nevertheless, a franchisee will need to maintain the goodwill of its landlord base and keep landlords informed as the restructuring unfolds.

Look beyond the immediate crisis

Many managers and advisors fall into the trap of treating the symptoms of the immediate distress as opposed to providing a comprehensive solution. While liquidity issues and defaults need to be addressed quickly, parties must look for long-term answers to a restaurant franchisee’s problems. Examples of potential long-term solutions are:

  • Budgeting for rising commodity or food prices
  • Addressing employee turnover
  • Amending leases
  • Negotiating with the franchisor over an extension of capital expenditure obligations
  • A reduction of future advertising and royalty fees

Understanding the interplay among the franchisee, lender, franchisor, vendors, and landlords is critical to the long-term success in a franchisee restructuring.

For more information, please contact:

Michael J. Kaczka
216.430.2028
mkaczka@mcdonaldhopkins.com

Scott N. Opincar
216.348.5753
sopincar@mcdonaldhopkins.com

Business Restructuring and Bankruptcy

The twists and turns of business restructuring are complex and demanding. Our attorneys approach every case with creativity and insight to ensure the solutions are cost-effective and practical. At every turn, you can be confident that our attorneys will guide you through the process, always providing practical and informed advice. We are positioned to respond to the special demands of a variety of matters in a wide range of industries, including health care, automotive, retail/distribution, franchise distribution and technology, real estate/construction, telecommunications, and mining/exploration.

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© 2011 McDonald Hopkins LLC All Rights Reserved. This Alert is designed to provide current information for our clients, friends and their advisors regarding important legal developments. The foregoing discussion is general information rather than specific legal advice. Because it is necessary to apply legal principles to specific facts, always consult your legal advisor before using this discussion as a basis for a specific action.