In the Hole, Canadian Business magazine

[Gibbons] This was not a down-and-dirty CCAA for a quick flip.

Canadian Business magazine
April 1, 2002

In the hole
A restructuring plan at Country Style doughnuts has some feeling fried
Kevin Libin and David Menzies

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Franchisee Chris VanderKrys and wife Carol: "Hortons came and kicked the shit out of us."

After 13 years frying up fish and chips, Steven and George Finos were looking forward to doughnuts and coffee. They were particularly thrilled to be launching a new business with the help of one of Canada’s foremost national doughnut chains. With 277 stores nationwide and a 38-year history behind it, Country Style looked to the hardworking Greek father and son like a reliable, growing company. So last spring, after patiently saving up the $20,000 franchise fee for a Kingston, Ont. outlet, the Finoses confidently handed over a cheque to parent company Country Style Food Services Inc. of Richmond Hill, Ont. “We worked hard, we were washing dishes for so many years to try to pick up some money to create a new business,” says Steve, the elder Finos. With their deposit out of the way, the aspiring franchisees were eager to get started. But Country Style suddenly began acting less than enthusiastic. Months went by, and head office just kept stalling, the Finoses say. “We had everything ready, the land, the owner agreed to build the property,” says Steve. But it wasn’t until December that the Finoses knew that things had gone horribly wrong.

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Country Style CEO Patrick Gibbons is trying to put his company's troubles behind him.

That was when Girts Steinhards, then Country Style’s director of franchising, called up the Finoses to tell them the parent company was insolvent and would be filing for protection under the Companies’
Creditor Arrangement Act (CCAA). He reassured them they shouldn’t worry since their money was being safely held in a segregated trust—just as it should have been. Steinhards was mistaken. Now, less than a year later, the only thing the Finoses know for sure is that they’ll never have that Country Style outlet they were dreaming about. And they’ll never see their money again. “These people, they tricked us,” Steve Finos alleges. “It’s not like I have any big business; I have a little takeout place here and I make a little living here. It’s going to take me a couple of years to make up that money.”

The Finoses aren’t the only people left devastated by the abrupt decision of one of the country’s largest and oldest doughnut chains to file for creditor protection. Landlords, suppliers and franchisees across Canada, as well as many longtime employees of Country Style’s six different companies—Country Style Food Services Inc., Country Style Food Services Holdings Inc., Country Style Realty Ltd., Melody Farms Specialty Foods and Equipment Ltd., Buns Master Bakery Systems Inc. and Buns Master Bakery Realty Inc.—are also reeling from the unexpected insolvency. Like the Finoses, many creditors believed their money was safely held in specific trusts, secure from the risk of bankruptcy. No one entertained even the remotest possibility that something like this could ever happen to Country Style. “Insolvency was never an issue because the 11 years I spent there, it was a very profitable company,” says Steinhards. “Never for a second did I think there was any risk to the deposit moneys.”

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Most creditors are only now finding out how wrong he was—the hard way. On a chilly morning in early March, in a cramped little courtroom in downtown Toronto, a dozen lawyers and a handful of spectators watched in silence as a judge approved a restructuring plan for Country Style that left most of its creditors with only a few pennies on the dollar. It wasn’t how most expected the hearing to go. In fact, at one point it looked like things were going to get pretty ugly. On the heels of Country Style’s CCAA filing, one unsecured creditor in particular—Taragon Mercantile Inc., a Toronto-based company which had put down a US$85,000 deposit for a master franchise for Cuba—began aggressively opposing the restructuring plan. Taragon alleged that the filing for bankruptcy protection was unnecessary and that Country Style was misrepresenting itself to get out of some lousy leases—and taking innocent creditors down with it. It also raised a stink about the role of accounting firm Deloitte & Touche LLP, which not only acted in the dual role of Country Style auditor and consultant before the company was insolvent, but also became its court-appointed monitor after its CCAA filing—meaning the firm was responsible for looking after the best interests of creditors.

In an unexpected twist, however, just hours before Taragon was set to oppose Country Style’s restructuring plan before a judge, the two parties suddenly worked out their differences in a last-minute, undisclosed, out-of-court settlement—and the proposal sailed through without a hitch. But with all the allegations raised by Taragon neatly swept out of the way, serious questions remain for hundreds of other creditors and disgruntled franchisees: What forces conspired to bring Country Style down? And was the extreme move by a company as Canadian as, well, doughnuts themselves, ever really necessary?

It’s a day after the restructuring hearing, and in Country Style’s suburban Toronto headquarters, Patrick Gibbons, the company’s president and CEO, is looking to put the tragic chapter in the chain’s long history behind him. His office is a veritable shrine to Canadiana: mixed in with promotional posters exalting the glory of the doughnut sit hockey souvenirs, including photos of the exec posing with Toronto Maple Leaf stars. “It’s a 38-year history, but recently it’s not been a very happy one,” acknowledges Gibbons, who, with his square jaw, neatly trimmed moustache and authoritative manner, might even pass for a cop.

The Country Style boss has been in the hot seat only a few months; he was lured away from a job as chief marketing officer for Burger King Canada by the challenge of turning around the teetering doughnut chain.
“It was clear that the company was in financial difficulty,” he says. “I was well aware that the company was already in default with some of its covenants with the Bank of Nova Scotia. But based on everything I had seen in the stores and so on, I felt very comfortable that I could have a significant impact on this company and turn it around.”

After Gibbons' first upbeat day on the job on Sept. 10, things seemed to go from bad to worse. Within a couple of months, he says, Country Style was running out of cash-and was in serious danger of becoming insolvent. After the company announced that it would file for CCAA protection on Dec. 13, Gibbons set about closing 102 underperforming stores. A total of 52, he says, had already been abandoned by their owners, leaving head office to pay the rent. (Most Country Style store leases are owned by a company subsidiary, Country Style Realty, which then sublets to franchisees.) The rest, Gibbons maintains, were in violation of their franchisee agreements, usually because they weren't up to acceptable standards or because they owed the company money. "We were not insisting on maintaining our standards and, as a franchisor, that's a fundamental flaw," Gibbons notes. "We were simply enforcing our franchise agreement. Why weren't we enforcing that before? I have no idea."

Gibbons says he gave the underperforming franchisees a chance to make a go of things as independents; about 20 of them took him up on his offer. Many who didn't were given only a few hours' notice to pack up and get off the premises, before company officials, with Deloitte & Touche monitors in tow, padlocked the doors and set about stripping all traces of the Country Style name from the buildings.

With all that unpleasant business behind him and a restructuring plan now firmly underway, Gibbons is looking straight ahead, jazzed about a freshly baked ad campaign. The biggest in Country Style's history, it includes a major prize giveaway to compete with Tim Hortons wildly successful Roll Up The Rim to Win sweepstakes. It is aimed at winning back some loyalty from Canadian coffee drinkers-and renewed interest from potential franchisees. "This is a chain that has been deemed by the general public to have been a run-down, non-focused chain," says Gibbons, who sees the new campaign as a first step to a brighter future. "I think it is now going to be perceived as a significant opportunity. People will very much want to jump on the bandwagon. This was not a down-and-dirty CCAA for a quick flip."

Competing head to head with Tim Hortons is never something Country Style had much luck with before. Not so long ago, the company-founded in Toronto in 1963 by Alan Lowe a year before the first Tim Hortons-owned the Canadian doughnut market hands down. But after Lowe's death in the early '80s, the chain began to lose its edge. After remaining a few years in the Lowe family, Country Style was flipped from one owner to another. It was first bought by Maple Leaf Foods Inc., which was acquired by UK-based Hillsdown Holdings, before again being sold to McCain Capital Corp. and the Ontario Teachers' Pension Plan Board in 1995. After aborting a plan to take the company public in 1998 due to "unfavorable market conditions," Maple Leaf unloaded a $45-million majority stake the following year to current owner CAI Partners & Co. II LP, a Wall Street equity investment fund, which had plans to flip the chain yet again down the road. "We usually look to exit from our investments in a three- to five-year time frame," says Manfred Yu, a CAI partner. "That exit can come in the form of an initial public offering, a merger with an industry participant-we don't want to limit our options."

But while Country Style's ownership may have been continuously changing, its stores and its strategies were firmly stuck in a rut, according to Gibbons. "It seemed the company lost its way, lost its focus and was not able to rally to the challenges of the marketplace," he says, referring to the growing competition from Tim Hortons. "It is a foreign concept to me to let people come into your backyard and eat your lunch."

Many Country Style outlets had grown dated and ugly-and all were hit hard by the company's switch to non-smoking in 2001. No matter what it did, Country Style always seemed a few paces behind Tim Hortons when it came to innovations like introducing sandwiches and drive-through windows. While
Maple Leaf busily expanded the chain internationally-opening stores in Thailand, Indonesia the Philippines and Brazil-it was neglecting its home turf. "You can have the great brand strength of 38 years and have the best coffee," says Gibbons. "But at the end of the day if a competitor with an efficient drive-through comes into your backyard, it is very hard to defend against."

Gibbons admits Country Style's troubles also had a lot to do with the way its revolving-door ownership began to treat the once venerable chain-growing ever eager to squeeze money from franchisees instead of helping them build successful Country Style stores. As the guy who dealt directly with franchisees, Girts Steinhards remembers the change in management philosophy vividly. "It was described as a cash cow," he says. "They were more interested in just taking money out of the company. They weren't interested in reinvesting in the company's future."

Today, former franchisee Chris VanderKruys can't speak about Country Style without breaking down and crying. For years, his Angus, Ont., store was a jewel in the Country Style crown, and consistently ranked in the top fifth percentile of performance. Now, 11 years after he first went into business with the chain, VanderKruys has nothing left to show for his hard work. "The first four and half years were really good," he recalls. "Then Hortons came in and kicked the shit out of us."

Even as sales were diving, VanderKruys says his costs began to skyrocket. "When Maple Leaf owned us, we were making money, but they weren't investing back in," he says. "All they wanted to do was make money with us to buy pigs." VanderKruys alleges that Country Style also began "gouging" franchisees. "They swore that we were being charged only 5% to 10% over cost on supplies," he explains, "but on some stuff it was 25%." Still, he adds, his good relationship with the company, a one-time winner of the Canadian Franchisee Association's Hall of Fame award, gave him faith things would eventually turn around.

Former Country Style president Garry Macdonald even convinced VanderKruys to set up a second store down the road in Meaford, Ont., in 1995. But like a lot of franchisees, he believes the sales projections given to him by the company were completely out of whack. "We did $20,000 the first month, but we needed to do $40,000 to break even," he says. After borrowing $178,000 to buy his second store, VanderKruys was stunned to see yet another Tim Hortons suddenly pop up across the street-and his business began hemorrhaging cash. "I bought a dead horse," he says, choking back tears. "It was like being raped." When Maple Leaf finally sold Country Style to CAI, the new owner sent VanderKruys a letter giving him 10 days to settle outstanding bills of $122,000. He laid off his 18 workers-and walked away from Country Style for good.

Others say they know how he feels. Kevin Press opened a Country Style franchise in Fernie, BC, last year with an initial investment of $160,000. The store struggled from day one. "I asked everyone at Country Style, 'Is everything achievable-the food costs, the labor models?'" recalls Press. "They said, "Yeah, yeah, yeah.' I did background checks, but they were with corporate stores and they were very reluctant to give out information." Press suspects he'll be forced to shut his store any day now. "Right now they have put me close to bankruptcy," he says. He's suing Country Style for misrepresentation and is seeking $1.82 million in damages.

With so many franchisees abandoning outlets across the country, Country Style Realty soon found itself on the hook for dozens of useless leases. But with the property business effectively functioning as a separate company, some creditors and franchisees say they can't understand why Gibbons declared the entire operation insolvent. Just days before reaching a settlement with Country Style, Taragon president David Harding told Canadian Business he was convinced that of the six different companies in the Country Style portfolio, only the realty divisions for its doughnut chain and its Buns Master bakeries were in trouble. The rest, he claimed, were in decent shape. "Most of the leases are in realty, so we asked the question: Did Country Style Food Services guarantee the leases?" said Harding. "And we were told, 'No they did not.'" Harding also noted that Gibbons himself testified to the financial health of Buns Master in the CCAA hearings-and said he had no plans to alter the company after the restructuring was over.
"So I asked him, 'If it is showing a profit to the company and you don't plan on changing anything, why is it in CCAA?' You know what his answer was? Silence."

Gibbons maintains that despite what Harding thinks, the six companies are really just different parts of the same whole-though he does confirm he won't be closing any of the company's 61 Buns Master stores. "All of the companies are dependent on one another," he says. "Some people believed certain entities could go into CCAA without the others and that is just absolutely not possible as all of the companies are co-dependent. We don't do separate bottom-line P and Ls [profit and loss statements]. That's just ignorance on behalf of those people. We went into CCAA because we ran out of money."

Country Style's former controller, however, has said the decision to combine the businesses was a relatively recent one. In an affidavit sworn in February and registered with the Ontario Superior Court of Justice in the Taragon case, Gordon Tom, who handled the books for the chain until he was let go in December, alleges that the company made the decision only a year earlier to start paying all those leases from its main treasury. "At the time of seeking court protection on Dec. 13, 2001, Buns Master Bakery
Systems Inc. was profitable," he swears. "It certainly was not insolvent. Country Style Food Services Inc. was profitable until approximately 12 months ago. The difference for this company between continuing profits, and not continuing profits was the decision to pay rent support. In other words, to pay the leases owing by Country Style Realty Ltd. But for its being saddled with this burden, Country Style Food Services Inc. would have continued to operate profitably."

To Taragon CEO Harding, things started looking pretty strange when the company's former controller said the doughnut and bakery chains were deliberately burdening themselves with onerous debts by mixing themselves up with less solvent companies in the Country Style family. Even stranger, said Harding, was that financial statements released to his lawyer by Country Style indicated that cash flow projections detailed by the company in its CCAA filing were way off base. "They are solvent," alleged Taragon's lawyer, Arnold Schwisberg, who was also contacted before the settlement. "They've made $1.2 million since declaring insolvency-six times what they predicted [for the months of December and January]."

CAI Partners' Yu insists Taragon got it all wrong. December's $1.2 million cash flow, he explains, was a temporary blip resulting from the CCAA filing. "The court gave Country Style a stay on all of its liabilities, but we were continuing to collect our receivables, and that created a positive cash flow situation." says Yu. "To be truly fair here, the $1.2 million we collected basically came out of the hides of those unsecured claims out there."

Still, Harding was confident enough with Country Style's health that, before the Taragon settlement, he even offered an alternative to CCAA by bringing together a group of investors who were willing to assume the debts owing to the Bank of Nova Scotia, the company's primary creditor. Gibbons turned them down.

Part of the problem, Harding believed, was that Deloitte & Touche had been retained by the company to act as both its auditor and consultant prior to the CCAA filing. That same sort of controversial role was played by Arthur Andersen in the Enron Corp. debacle. Since then, Deloitte & Touche has announced it will spin off its consulting arm into a separate entity. In the meantime, however, the firm continues to act as Country Style's monitor under the CCAA arrangements-despite comments made in February by Deloitte & Touche senior vice-president for Canada, Wes Treleaven, that the combined roles can potentially lead to a conflict of interest.

It certainly looked that way to Harding. He wondered how a firm that relies on auditing and consulting for a good portion of its revenue could then turn around and represent the best interest of creditors against one of its clients. "How do you serve two masters like that?" he asked. "Auditor-consultant is bad enough. But auditor-consultant-monitor?"

Yu defends Deloitte & Touche's multiple roles. "If we were to bring someone else in who was independent, you'd have to get them up to speed on what the problem was," he explains. "So having Deloitte in there as monitors to properly communicate the status of the company more quickly to get a solution to the problem, I don't necessarily see a conflict there. The alternative was the company go into receivership and you don't have a company anymore." Besides, notes Yu, the situation isn't really all that unique. He's right. "It should be very unusual-but it isn't," says Toronto forensic accountant Al Rosen.

Much of what a distressed company like Country Style brings into court is put together by its monitor. But when the monitor also happens to be the company's former auditor, Rosen argues, there might be temptation to be less than dutiful. Judges, he adds, can't be expected to "be experts on everything on earth." They rely on insolvent companies and their creditors to vigorously defend their interests. "They are assuming each side is equally informed and will beat the other guys up," says Rosen. "It's a matter of the other side bitching."

That's something Taragon was doing quite a lot of-and doing it so well that some national media started paying attention. But with the last-minute settlement in place, everyone now seems content-and Gibbons says he has no intention of rehashing Taragon's allegations. "I have no interest in talking about stuff that has been dealt with, resolved, and is no longer of significance," says the Country Style CEO. Besides, he points out that with Taragon on board, nearly 93% of Country Style's creditors approved the CCAA restructuring plan. However, under CCAA, votes are counted not only by the number of creditors but also by the amount of money each one is owed. Of course, the lion's share of voting was held by the Bank of Nova Scotia, Country Style's only secured creditor, which was owed more than $11 million, 60% of the company's $18.5 million total debt. There was $4.5 million more owing to a diverse collection of about 450 other creditors. Landlords counted for less than 5% of voting debt, or $900,000-and franchisees, some of whom saw their stores taken away from them, less than 2%, with only $300,000 in outstanding claims.

Unfortunately for the little guy, it's a fact of CCAA life that some votes count more than others. But in a sworn affidavit also filed with the Ontario Superior Court of Justice in the Taragon case, Catherine Mauro, Country Style's former director of marketing and product development, makes a surprising claim: that Country Style was able to win votes from particular unsecured creditors by quietly paying them off. She alleges that she personally spoke to suppliers who were persuaded to vote in favor of the plan that way. Mauro further swears that she confirmed with current Country Style head office employees that Gibbons made it clear to them that: "[I]f a creditor would agree to vote in favor of the Applicant's Plan of
Arrangement, that a 'cheque would be released' or otherwise that financial dispensation would be made. This was said and planned in the presence of Deloitte & Touche Inc."

According to Mauro's affidavit, she also spoke with a long-standing acquaintance at Nestlé Canada, a company with more than $1 million owed to it. "[I]t was clear to me that Nestlé's received a contract renewal for the exclusive supply of coffee and soup products," she swore, "provided that Nestlé's returned the proxy to vote in favor of the Plan." She further alleges that an acquaintance in Country Style's equipment division told her that Gibbons had "instructed selected head office staff to say to current suppliers unless they were to return the proxies in favor of the Plan of Arrangement, that they would no longer be contracted to supply goods or services."

Yu thinks it's all just another misunderstanding. He notes that Country Style has never accepted the affidavit allegations from the Taragon case-and, besides, with the matter settled, they are now moot. "I think you have a case of 'He said, she said,'" says Yu. "To my knowledge, there were no such arrangements." The Finoses, though, are sticking to their story: they say they were told to vote in favor of the plan and Country Style would see to it that they were compensated for their lost $20,000 deposit. Fed up, they voted no anyway.

In the end, enough creditors did give their approval to the Country Style rearrangement for it to receive court approval on March 7. The final settlement will probably see unsecured creditors receive about 14¢ on the dollar. And with 102 leases cleanly broken and the Taragon settlement now out of the way, it's back to the doughnut and coffee business for Patrick Gibbons, CAI Partners and the rest of the Country Style team. Many of the faces at head office have changed, though. Longtime employees like Mauro, who worked loyally for Country Style for 16 years before being let go in February, got lumped in with the unsecured creditors-and will see only a fraction of a typical severance package. Steinhards had been with the company over a decade before being cut loose in January, and there were plenty of others who had devotedly stood by the Canadian doughnut icon and its franchisees-even through its endless parade of owners-that also got the axe. "The company's been around for almost 39 years, and there's been an unusually large number of long-term employees at the company, people that cared about it," says one ex-employee, who requested anonymity. "I think anyone who made more than $40,000 to $50,000 a year and had more than five years' seniority-gone. With one exception: the legal counsel. I'm sure they needed him."

Gibbons says it was all for the good of the company. "I felt there was a need to bring in a new skill set," he says of the layoffs. And he insists that his new group of employees has got what it takes to bring some of the lustre back to the Country Style name-including rebuilding strained relationships with remaining franchisees. "We have changed a number of policies here so that franchisees are given more opportunity to succeed and profit," Gibbons maintains. "My franchisees are my partners." He's also confident he can revitalize the once-neglected doughnut chain with some great new ideas, including remodeled stores and killer brand marketing. Kicking off the new era, is the current "Turn up a Winner" promotion, which will give away $25 million worth of trips, cars and other prizes. The best part, says Gibbons, is that everyone wins something.

Steve Finos is pretty sure he won't be playing-though he suspects his five-figure franchise deposit may have helped foot the bill for some of the prizes. "These people wanted to take the money from us," he grumbles. "Now they have this contest-you win $10,000, you win a car, you win this. After they save all this money." Maybe not everyone ends up a winner after all.

Deloitte


Risks: Was new franchisor money really old $ siphoned offer before false insolvency was declared?, Uncharacteristically shy with media requests, Infamous trademark system, Federal insolvency laws used to shirk legal claims, Misrepresentations, Fraud, Conflict of interest, Companies' Creditors Arrangement Act, CCAA, Canadian Franchise Association, CFA, Independence, Intentional franchisor insolvency, Termination of franchisee, mass, Private Members’ Bill, Rent increase, Gouging on supplies, Must buy only through franchisor (tied buying), Doughnut, Lease controlled by franchisor, Industry in disrepute, Public perception of sleaze and greed, Trustee/consultant does mass terminations under insolvency to flip to new owner, Franchisees are pawns in insolvency flip, Opposition to fake franchisor insolvency and ownership flip, Conflict of interest, No real penalties for abuse of federal insolvency laws, Insolvency strips employees' severance payments, Enron-like scandals, National press coverage, Insolvent trading, Canada, 20020401 In the

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