United States: As Restaurants Falter, Planning For Restructuring, Bankruptcy Is Crucial

It's the perfect storm: a confluence of events has converged upon the restaurant industry, driving those operating in this sector to brace for the inevitable shakeout. Because many of the restaurants at risk are chains, their potential for insolvency raises a number high-stakes issues. By employing advance planning, restaurant owners, operators, lenders, vendors, trade creditors and other interested parties can stem their losses and improve their positions.

On a daily basis, the devastation wrought upon the American consumer by rising commodity prices and the subprime mortgage debacle is becoming more apparent. Even before the subprime mortgage crisis and gas prices were making headlines, the cost of grain and other food products was rising at an alarming rate. Needless to say, for a restaurant owner, rising food costs have a direct impact on profits. The cost of gas also has a significant impact on the profitability of restaurants, as restaurant suppliers seek to pass along their increased distribution costs—and consumers have less disposable income.

The profitability of restaurants also has been adversely impacted over the Past several years by laws requiring employers to pay increased minimum wages, which has hurt the profitability of restaurants. Faced with a rising cost structure and a troubled economy, restaurants have suffered reduced headcounts and have been unable to pass along their skyrocketing costs.

There is no apparent business remedy for the squall confronting the industry— but some trimming of the sails is unavoidable, and indeed has begun to happen. Restaurant chains are being forced to evaluate all of their operational and legal alternatives, and amid these economic issues, some chains have been driven to the brink of insolvency. Others have been forced to file chapter 11 bankruptcy cases.

Many of the issues that arise in chapter 11 cases involving restaurant chains are similar to those that arise in other retail bankruptcy cases, such as those relating to nonresidential real estate leases and vendors. This article will address some of the issues that are of critical importance to a troubled restaurant chain.

Lease Assumption or Rejection

Generally, restaurant chains lease all or substantially all of their locations from third-party lessors. Under the October 2005 amendments to the Bankruptcy Code, lessees of nonresidential real estate only have 120 days after the commencement of the bankruptcy case to make a determination concerning the assumption or rejection of nonresidential real estate leases.¹ That period may be extended by a bankruptcy judge upon a showing of "cause," but only for a period not to exceed 90 additional days.²

Accordingly, a restaurant chain will have at least 120 days, but no more than 210 days, to determine whether to assume or reject its restaurant leases.

These statutory provisions do not afford restaurant chains with much time to determine whether to assume or reject leases during the bankruptcy case. To make matters worse for the restaurant owner, the filing of a chapter 11 case almost always results in some level of distraction and disruption to the debtorin- possession. Accordingly, every effort should be undertaken to evaluate nonresidential leases prior to the commencement of a bankruptcy case.

To facilitate that end, where time allows prior to the filing, the restaurant operator should endeavor to undertake a full-blown analysis of its leases. For borderline locations, the restaurant owner may not want to close the restaurant prior to the filing, but instead seek concessions from landlords. Landlords generally are more receptive to negotiating lease modifications after a bankruptcy filing because landlords then face the real possibility of rejection of leases, empty leaseholds, and minimal returns on account of any lease rejection damages claims. After a bankruptcy filing, the debtor and their professionals should seek to negotiate lease modifications with landlords concerning unprofitable or underperforming restaurant locations.

Closure Prior to Case Commencement

During the pendency of a chapter 11 case, the debtor-in-possession is required to timely perform all obligations under a nonresidential real estate lease.³ If, however, prior to the commencement of the case, the restaurant chain (i) closes a restaurant, (ii) surrenders the leasehold property to the landlord (thereby terminating the restaurant operators' possessory interest in the real estate), and (iii) files a motion on the first day of the case to reject the lease, then several bankruptcy courts have held that there are no obligations that must be timely performed under the lease.⁴

Once again, advance planning is critical. To proceed with such a strategy, the restaurant chain must conduct an analysis of its locations and leases prior to commencement of the bankruptcy case.

The obligation to timely perform obligations under nonresidential real estate leases is also of particular importance at the start of a case because several bankruptcy courts have held that obligations need only be timely performed if they become due during the pendency of a chapter 11 case.⁵ For example, if rent under a lease becomes due on the first day of a month and a chapter 11 case is filed on the second day of the month, then the payment of the rent for the calendar month of filing need not be timely paid.⁶ With regard to that month's stub rent, the debtor-in-possession can wait until the time of assumption of the lease and address the rent for that month at that time.⁷

In contrast, if rent under a lease becomes due on the fifth day of a month and a chapter 11 case is filed on the second day of the month, than the payment of the rent for the calendar month of filing must be timely performed.⁸

If the lease later is rejected, then the landlord will have the burden of coming forward to request payment of an administrative expense claim for the unpaid stub month of rent.⁹ This burden also exists in the context of lease rejection, where the landlord needs to demonstrate that during the post-bankruptcy time period where rent was not paid, the leasehold was an actual and necessary cost of the administration of the bankruptcy case.¹⁰

While a pro-rated portion of the stated rent amount in the lease is presumptively the amount of the administrative claim, the claim amount may be limited to the actual value of the leasehold to the bankruptcy estate during the applicable time period.¹¹

Labor and Plant Closing Laws

When closing restaurant locations or otherwise laying off employees, it is always important to review laws that impose liability or severance obligations on account of mass layoffs. Reviewing these laws is particularly important in light of an amendment to the Bankruptcy Code that became effective in October 2005 that provides that back pay attributable to the post-bankruptcy filing period may be a first priority administrative expense claim, even if the conduct giving rise to the claim occurred prior to the commencement of the bankruptcy cases.¹²

Accordingly, under certain circumstances, a pre-bankruptcy layoff may give rise to an administrative expense claim in the bankruptcy case.¹³

Vendors and Suppliers

Continuing the supply of goods and services is critical for any retail business— and restaurants are no different. You cannot sell omelets without eggs. Accordingly, to maximize the likelihood of a successful outcome, restaurants that are experiencing financial difficulties must effectively manage their relationships with vendors and suppliers.

It is critical to understand the legal rights and remedies of suppliers. Under the Perishable Agricultural Commodities Act, 7 U.S.C.A. § 499(a), et seq. ("PACA"), suppliers of perishable agricultural commodities generally are held to have extraordinary rights. A statutory constructive trust under PACA (the "PACA Trust") is imposed on a buyer's entire inventory of "perishable agricultural commodities," and all products, receivables or proceeds related to the sale thereof (the "PACA Trust Assets").¹⁴

As a result of the PACA Trust, PACA "effectively vitiates a lender's security interest in trust assets held by produce purchasers vis-à-vis unpaid produce suppliers."¹⁵ Upon the imposition of a PACA Trust, courts construing PACA consistently have held that PACA Trust Assets are not "property of the estate" pursuant to section 541 of the Bankruptcy Code.¹⁶ The legal ramifications of these legal realities are significant; because the restaurant does not own the product, its lender's floating lien on inventory does not attach to these products.¹⁷

In addition, the return of these products to the supplier upon the commencement of a bankruptcy case generally would cause significant disruption to the restaurant business. To avoid disruption and to address these rights upon a bankruptcy filing, chapter 11 debtors routinely seek first day authority to pay in the ordinary course of business suppliers for products covered by PACA.

Accordingly, stakeholders should consider the magnitude of these claims in a variety of contexts, including the calculation of borrowing bases and the provision of adequate protection to the lender's interest.

Section 503(b)(9) Claims

Another concern for stakeholders is the right of suppliers of goods under section 503(b)(9) of the Bankruptcy Code to make an administrative claim for the value of goods sold to the debtor in the ordinary course of business and received by the debtor within 20 days before the commencement of the bankruptcy case.¹⁸ Generally, amounts allowable under this statutory provision do not need to be paid in a chapter 11 case prior to confirmation of a plan.¹⁹

In an effort to receive a return on their payment of these claims, many chapter 11 debtors condition their prompt payment on suppliers' continuing provision of goods to the debtor in the ordinary course of business under ordinary credit terms.

Reclamation Rights

Certain creditors have limited rights to reclaim goods delivered prior to the bankruptcy.²⁰ Although the rights of reclaiming creditors generally have been limited by statute and recent cases, it is critical to understand these rights.²¹ Otherwise, the debtor will be unable to effectively work with the underlying vendors.

Critical Vendors

In some cases, to stabilize operations upon the filing of a chapter 11 case, the payment of claims of certain critical vendors may be appropriate. Obtaining authority to pay the pre-bankruptcy claims of critical vendors is difficult in certain venues.²² This practice is nonetheless accepted in the bankruptcy courts for the District of Delaware.²³

From the perspective of the chapter 11 debtor and its lender, the objective generally is to minimize the amount of critical vendor payments. There are, however, situations in which critical vendor payment is absolutely necessary to promote a smooth transition in chapter 11 and to maximize value. The ability of a vendor to retain post-filing critical vendor payments generally is tied to an agreement by the supplier to continue to provide goods on ordinary credit terms to the chapter 11 debtor.

Accordingly, the use of a critical vendor motion and the corresponding critical vendor payments is often well worth the expenditure because of the stability associated with continuing to do business with critical suppliers, and credit terms the debtor receives after the filing.

Rough Waters Ahead

Though many restaurant chains are facing choppy waters, each situation varies. The key to navigating the financial uncertainties is understanding the sector well enough to plan for complications before they arise.

Editor's note: Reed Smith has significant experience advising restaurant owners, operators, lenders, vendors, trade creditors and other interested parties through the legal issues that arise when restaurants face financial difficulties and insolvency.

Footnotes:

1. See 11 U.S.C. § 365(d)(4)(A)(i); In re Tubular Techs., LLC, 362 B.R. 243, 245 (Bankr. D.S.C. 2006)

2. See 11 U.S.C. § 365(d)(4)(B)(i); Tubular Techs., 362 B.R. at 245.

3. See 11 U.S.C. § 365(d)(3) ("The trustee shall timely perform all the obligations of the debtor... arising from and after the order for relief...until such lease is assume or rejected").

4. See 11 U.S.C. § 365(d)(3).; In re Montgomery Ward Holding Corp., 268 F.3d 205, 211 (3rd Cir. 2001) (interpreting an obligation to pay as arising only when the debtor is legally bound to pay it).

5. See Montgomery Ward, 268 F.3d at 211.

6. See Montgomery Ward (cited above); but see In the Matter of Handy Andy Home Improvement Centers, Inc., 144 F.3d 1125, 1128 (7th Cir. 1998) (applying a proration approach).

7. In re HQ Global Holdings, Inc., 282 B.R. 169, 175 (Bankr. D. Del. 2002).

8. See Montgomery Ward, 268 F.3d at 211.

9. In re Chi-Chi's, Inc., 305 B.R. 396, 402 (Bankr. D. Del. 2004) ("the Landlord's appropriate remedy is to file an administrative claim.")

10. In re C & L Country Market of New Market, Inc., 52 B.R. 61 (Bankr. E.D. Penn. 1985) ("Since the debtor did not assume the lease with the Landlord within the meaning of 11 U.S.C. § 365 of the Code, the amount of the administrative claim is limited to the 'actual, necessary costs and expenses of preserving the estate...'") (citations omitted).

11. In re William H. Herr, Inc., 61 B.R. 252, 254 (Bankr. E.D. Pa. 1986) (contract rate is only the presumptively "fair and reasonable charge for the use of the premises") (citations omitted).

12. See 11 U.S.C. § 503(b)(1)(A)(ii).

13. See 11 U.S.C. § 503(b)(1)(A)(ii); but see In re First Magnus Financial Corp., 2008 WL 2491636, *5 (Bankr. D. Ariz. 2008).

14. See 7 U.S.C. § 499e(c)(2); 7 C.F.R. § 46.46(b); Idahoan Fresh v. Advantage Produce, Inc., 157 F.3d 197, 199 (3d Cir. 1998) ("[A] buyer's produce, products derived from that produce, and the proceeds gained therefrom are held in a non-segregated, floating trust for the benefit of unpaid suppliers who have met the applicable statutory requirements."); Botman Intern., B.V. v. International Produce Imports, Inc., 205 Fed. Appx. 937, 940 n.1 (3d Cir. 2006).

15. Consumers Produce Co. v. Volante Wholesale Produce, Inc., 16 F.3d 1374, 1379 (3d Cir. 1994); see also Middle Mt. Land & Produce, Inc. v. Sound Commodities, Inc., 307 F.3d 1220, 1224 (9th Cir. 2002) ("[T]he enactment of the PACA amendment elevated the claims of unpaid perishable agricultural commodities suppliers over all other creditors of the bankrupt estate with regard to funds in the PACA trust"); Tom Lange Co. v. Kornblum & Co. (In re Kornblum & Co.), 81 F.3d 280, 284 (2d Cir. 1996); L. Natural Foods Corp., 199 B.R. at 884.

16. See In re Long John Silver's Restaurants, Inc., 230 B.R. 29, 32 (Bankr. D. Del. 1999); Morris Okun, Inc. v. Harry Zimmerman, Inc., 814 F. Supp. 346, 348 (S.D.N.Y. 1993).

17. See, e.g., Country Harvest Buffet Restaurants, Inc., 245 B.R. 650, 653 (9th Cir. 2000).

18. 11 U.S.C. § 503(b)(9).

19. See In re Global Home Products, LLC, 2006 WL 3791955, *5 (Bankr. D. Del. 2006)

20. 11 U.S.C. § 546(c)(1) ("the rights and powers of the trustee...are subject to the right of a seller of goods that has sold goods to the debtor, in the ordinary course of such seller's business, to reclaim such goods if the debtor has received such goods while insolvent, within 45 days before the date of the commencement of a case...").

21. Compare In re Advanced Mktg. Servs., Inc., 360 B.R. 421 (Bankr. D. Del. 2007) (application for temporary restraining order concerning goods subject to reclamation denied), with Phar-Mor, Inc. v. McKesson Corp., 2008 WL 2756588 (6th Cir. 2007).

22. See In the Matter of Kmart Corp., 359 F.3d 866 (7th Cir. 2004) (finding that to pay "critical vendors" need evidentiary showing that (i) recipients would not have done post-petition business with debtor absent payment and (ii) payment would improve prospects for other noncritical vendor creditors).

23. See In re Zenith Indust. Corp., 319 B.R. 810, 817 (Bankr. D. Del. 2005) ("Approval of a critical vendor motion is discretionary based upon the facts and circumstances presented.") (citing In re Just for Feet, Inc., 242 B.R. 821, 824-26 (D. Del. 1999)).

This article is presented for informational purposes only and is not intended to constitute legal advice.