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Former Quiznos Investors Continue Battle against Schaden Group

DENVER – After a Colorado federal judge threw out a lawsuit against the former owner and executives of the now-bankrupt Quiznos sandwich chain, the private equity investors are challenging the decision in the Tenth Circuit, U.S. Court of Appeals.

Headed by Avenue Capital and Fortress Investment Group, the hedge funds will again assert that former owner and chief executive Richard "Rick" Schaden and his management team fraudulently induced them into the 2012 Quiznos restructuring deal with bogus financial data that artificially inflated the true value of the sandwich chain, which prompted them to provide an infusion of capital for an ownership stake. After reaching a deal with the Quiznos executives, Avenue Capital and Fortress agreed in January 1, 2012 to fund Quiznos' restructuring in exchange for 70 percent ownership interest in the company.

What does this mean for franchisees and Quiznos corporate? Restaurant analyst John Gordon explained, "This ongoing legal action means that the Quiznos Chapter-11 bankruptcy case continues into a third year. Quiznos cash is very low, and Fortress and Avenue Capital's only realistic chance to recover their lost investments is to score a legal judgment against the Schaden Group, on appeal. Observers say this has little effect on existing Quiznos franchisees or the remaining Quiznos corporate office since there is so little cash or earnings potential left, and because all of the other investors other than Fortress and Avenue have given up."

The federal court decision states that Schaden's restructuring scheme was supposed to keep Quiznos out of bankruptcy court, but that did not happen. On March 14, 2014 Quiznos filed for Chapter 11. As a result, Avenue Capital and Fortress lost all of their equity in the deal, costing them hundreds of millions of dollars. The investors proclaim in legal documents that they never would have entered into the restructuring plan had they known the true financial condition of the Quiznos chain.

Colorado District Judge Philip A. Brimmer dismissed the case in its entirety on September 17, 2015, as the Quiznos bankruptcy proceedings continued to wind down, well after its June 30, 2014 effective date.

In his decision, Judge Brimmer explained how Avenue Capital and Fortress, the largest lien holders in the restructuring transaction, brought claims against Schaden and his top echelon for violating statutes of the Securities Exchange Commission, as well as for common law aiding and abetting fraud. But in his analysis he explained that the restructuring plan didn't constitute an "investment contract" under SEC rules, because the investors did obtained a majority ownership interest in Quiznos as part of the transaction. The judge said that allowed the investors to step in and change the course of the company's direction if they chose to.

The court decision states, "Nothing in the complaint or the QCE Parent LLC agreement suggests that plaintiffs are unsophisticated, or dependent on a particular member or manager for expertise in the restaurant franchise industry, or that plaintiffs must rely on others to ensure the success of the company."

Regarding the investors' securities fraud allegation, Judge Brimmer stated that in their motion to dismiss the former executives challenged the third element, "a connection between the misrepresentation or omission and the purchase or sale of a security," of the five requirements that must be met to plead a claim under the SEC statute. They argued that the transaction did not involve the purchase or sale of securities as that term is defined under the S.E.C. Act.

The judge explained that after the Schaden management team realized the major decline of the franchise chain, losing thousands of restaurants, they determined they needed to amend its credit facilities, restructure their debt, or secure additional capital. The Schaden's board, which included Rick Schaden and his brother Fredrick, chose a transaction plan, which was presented to Avenue Capital and Fortress to receive accrued, unpaid interest and a pro rata share of $75 million of the aggregate principal amount in the detailed plan.

Avenue Capital, Fortress Investment and their affiliate firms filed a notice of appeal on October 16, 2015. A letter to the Tenth Circuit, U.S. Court of Appeals, certifying the record is complete, was filed last week. Avenue Capital is represented by Stephen M. Baldini and Jeffery Dailey of Akin Gump Strauss Hauer & Feld, and Fortress by Allen Lanstra of Skadden Arps Slate Meagher & Flom.

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