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Avenue Capital Again Defeated by Quiznos’ Ric Schaden Executive Team

Multi-billionaire Marc Lasry, CEO/chairman of privately-held Avenue Capital Group, with other hedge fund firms, lost another court battle in the ongoing lawsuit asserting that Richard "Ric" Schaden and his former Quiznos executive team had engaged in a "conspiracy to defraud" when investors took over the troubled sandwich chain in 2012.

Following the September 21, 2016 hearing, the Tenth Circuit Court of Appeals in Denver issued its decision on December 13, 2016, affirming Colorado district court's decision to dismiss the securities fraud case. The complex litigation developed when the investment firms agreed to a transaction to restructure Quiznos' debt after the sandwich chain's financial condition plummeted. Tenth Circuit stated that Avenue Capital Group and Fortress Investment claimed in their lawsuit that Quiznos managers and officers had fraudulently misrepresented Quiznos' financial condition, invoking Sect. 10(b) of the Securities Exchange Act of 1934 and Securities and Exchange Commission Rule 10b-5.

The district court had dismissed the cause of action for securities fraud based on failure to state a valid claim. Avenue Capital and Fortress had argued that the transaction involved investment contracts, triggering the Securities Exchange Act and SEC Rule. It rejected the equity firms' argument, reasoning in part that the transaction had given them control over Quiznos. And, ultimately, the district court dismissed the securities-fraud causes of action, concluding that Avenue and Fortress had failed to identify facts showing that their newly acquired interests in Quiznos constituted investment contracts.

"Avenue and Fortress failed to adequately allege facts showing that their collective interests constituted investment contracts and forfeited the remaining appeal points. Thus, we affirm," the Circuit judges stated.

The two top equity firms, Avenue Capital and Fortress Investments, explained in the federal lawsuit that Quiznos' top echelon put together the conspiracy in 2011, in an effort to induce the investment firms to purchase equity in the franchise company, inject liquidity into it by Avenue Capital, and restructure debt that Quiznos owed to the investors. The complaint alleges that at that time Quiznos was experiencing economic turmoil, having seen its adjusted earnings before interest, taxes, depreciation and amortization (EBITDA") drop nearly 50 percent over four years. As background, in 2006, under Schaden's leadership, the company's management team saddled Quiznos with massive amounts of debt, making its financial footing unstable. When finally realizing the chain's precarious position meant that a substantial restructuring was needed, either through an out-of-court plan or an in-court bankruptcy reorganization filing, Schaden and his key executives engaged the hedge fund firms.

In their argument against the district court's decision, Avenue and Fortress challenged its conclusion on three grounds: "The transaction involved investment contracts; stock, and instruments commonly known as securities." The Tenth Circuit disagreed. "The transaction did not involve investment contracts, and Avenue and Fortress failed to properly preserve their current arguments characterizing the interests as stock or instruments commonly known as securities."

The circuit court emphasized that documents showed Quiznos had borrowed heavily before its business sharply declined. It stated that from 2007 to 2011, Quiznos lost roughly 3,000 franchise restaurants and profitability plunged. It said, "With this plunge, Quiznos could no longer satisfy its loan covenants. As a result, Avenue, Fortress, and others could foreclose on collateral, call in debt, or accelerate payments. To avoid a calamity, Quiznos restructured its debt."

On another point arguing against the investment firms' challenges, the circuit judges also explained how with the restructuring of the debt, Avenue and Fortress gained control over Quiznos. The transaction made Avenue and Fortress members of a manager-managed limited liability company that operated Quiznos. They said Avenue acquired about 70 percent of the LLC's shares, and Fortress acquired about 10 percent. "In exchange, Avenue pumped $150 million into Quiznos and Avenue and Fortress reduced Quiznos' debt," the judges stated. And the firms collectively obtained the power to amend the LLC agreement "however they wished." The agreement also empowered Avenue to appoint seven managers to the board, and Fortress to appoint one.

The Tenth Circuit also explained how Avenue and Fortress collectively controlled the profitability of their investments in Quiznos, meaning the interests cannot constitute investment contracts. The firms had argued that they did not intend to exercise control because they continued to expect the board and the officers to operate Quiznos. The Circuit Court stated that the interests could constitute "investment contracts" only if Quiznos' managers and officers were irreplaceable, or insulated from Avenue and Fortress' ultimate control. They stated, "There is no suggestion that Quiznos' managers or officers were irreplaceable or otherwise beyond Avenue and Fortress' ultimate control."

Lastly, the Tenth Circuit rejected the investment firms' argument characterizing their "interests" as "stock" or "instruments commonly known as securities. It explained that in district court Schaden and the Quiznos management team contended that the interests conveyed to Avenue and Fortress did not constitute stock under the Securities Exchange Act. The two firms did not respond to that argument, and the Tenth Circuit declined to consider "the newly presented arguments characterizing the interests as stock or as instruments commonly known as securities."

In reading the Tenth Circuit opinion, restaurant expert analyst John A. Gordon said both the district court judge and the appeals court judges discounted or didn't understand the nature of required business due diligence in making their decisions. "Avenue Capital and Fortress Investments were absolutely reliant on information that the then-Quiznos CEO and management team should have provided with good faith in mind. This was not information in audited financial statements but operating statistics such as unit counts, franchisee financial condition, marketing and supply chain metrics. That data is not in audited financial statements. Avenue and Fortress did not get the information that mattered," Gordon professed.  

The financial consultant stated that on the other hand, once Avenue and Fortress assumed majority ownership, they should have brought in a new executive team, a chief executive officer and a chief financial officer at a minimum. He said it is surprising that was not done.

"Considering both the post 2006 bond investors, Avenue and Fortress, and the Chapter 11 write downs, about $800 million in debt write offs and cash injections was lost. Considering the app, 4500 U.S. franchise units that failed, another $1.8 billion in estimated franchisee investment, injected equity and operating loss experienced before closure, assuming $400K per unit, was a loss. The total Quiznos loss to post 2006 investors and franchisees seems to be over $2.5 billion," Gordon explained.

"Finally," the analyst continued, "smart Wall Street MBAs and mom and pop franchisees with varying degrees of experience and resources were all sucked into the Quiznos vortex. The belief that there must have been value or an opportunity to make money was not well founded."   

In an effort to obtain insights on the judges' ruling from the attorneys representing both sides, Blue MauMau contacted the parties by email. Rex S. Heinke of Akin Gump Strauss Hauer & Feld in Los Angeles, who argued before the Tenth Circuit in representing Avenue Capital, and Nathaniel P. Garrett of Jones Day in San Francisco, who argued for the Quiznos executive team did not respond. Avenue Capital did respond stating they declined to make comment.

The officers and management executives are Richard "Rick" Schaden, his father Richard F. Schaden, and brother Frederick H. Schaden. Others named in the lawsuit are Greg MacDonald, Dennis Smythe, Andrew R. Lee, Patrick E. Meyers, Tom Ryan, now CEO of Smashburger, and long-time Ric Schaden attorney John M. Moore.


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