The award of a state contract announced with great fanfare more than three years ago now is being blamed as leading to the downfall of W.S. Lee & Sons Inc.

Gov. Ed Rendell announced in October 2004 that the company had been awarded a five-year, $250 million contract by the State Department of General Services to serve as sole food distributor for all state-run facilities such as hospitals and prisons.

The contract, which went into effect in March 2005, was part of the Commonwealth’s Strategic Sourcing Initiative, created with the goal of saving taxpayers money by consolidating the purchasing power of state agencies.

With that contract, W.S. Lee reopened the former Fleming Cos. warehouse at 3010 Seventh Ave. to house a new division: Lee Systems Solutions LLC.

As it turned out, the contract played a major role in the company’s financial crisis.

The company, founded in 1872 by Warren S. Lee at Seventh Avenue and 13th Street in Altoona, recently went through Chapter 11 bankruptcy and emerged as Lee Food Service Inc. The process started in March 2006.

The new and former chief executive officers see the contract as an issue.

‘‘We had an 800-pound gorilla — the state contract,’’ said Robert S. Donaldson, who today serves as the company’s CEO.

‘‘The contract was priced at a number where everything would have had to click right to make money. It was priced on the promise of about $50 million on annualized sales.’’

One of the problems, said Robert E. Lee, who was CEO at the time, was that the various state institutions had problems adapting to the new single-source system.

‘‘They were used to buying from their suppliers and a multitude of sources. It was challenging for them to order in a new way. It should have been simple for them, but it wasn’t,’’ Lee said.

While the company put in the financial commitment to meet the needs for the state, the state didn’t come through with its purchasing commitment.

‘‘I will go to my grave saying if the contract would have been implemented correctly, it would have been great for W.S. Lee and the commonwealth,’’ Lee said.

Marty Marasco, president and chief executive officer of Altoona-Blair County Development Corporation, agreed that the contract never materialized the way it was hoped.

‘‘They began to lose money when they took on that activity. It never rolled out the way they anticipated,’’ he said.

Contract issues

In the meantime, the commonwealth had put W.S. Lee on notice that the company wasn’t meeting expectations. Curtis Topper, General Services deputy secretary for procurement, said requirements in the contract were not being met.

‘‘There were a number of performance problems. We tried to correct them up until the time that they filed for bankruptcy,’’ Topper said. ‘‘They couldn’t meet the requirements dealing with inventories and deliveries within certain periods of time.’’

Donaldson, who had been brought aboard by W.S. Lee officials in December 2005 to serve as company president, was to coordinate and facilitate the day-to-day activities of the business.

He had 25 years in leadership in the food service distribution industry, including a stint as executive vice president and chief operating officer of ProSource Distribution Services, a $4 billion nationwide distributor to chain restaurants with headquarters in Miami.

He said vendors began asking for cash on delivery as cash flow problems in the fall of 2005 began to surface.

Employees, meanwhile, said they were not aware of the depth of the situation.

‘‘We heard numerous rumors and stories. When Robert Donaldson came aboard, he started to communicate with us and let us know what was going on,’’ said Sam Musselman, director of warehousing, who was hired Sept. 18, 2005. ‘‘It was shocking.’’

Randy Himes, who took over as director of transportation in September 2005, said he also learned about the problems.

‘‘It was pretty bad when I arrived as far as payment with the vendors. I knew they needed some help. I knew they were overspent in transportation,’’ Himes said.

Donaldson said he learned of the severity of the problems the day before he started on the job when he received a call from Donita Koval, president and chief executive officer of Omega Bank.

‘‘I learned the difficulties were deeper than I diagnosed previously,’’ Donaldson said. ‘‘By the end of December, I realized the numbers were really catastrophic. The place was in chaos.’’

*Finding a solution*

Koval said when Lee’s financial picture began to change, it happened at a fast pace.

She likened the situation to a train moving forward.

‘‘How could you stop it with as few casualties as possible without causing the train to wreck?’’ she asked.

Some steps were taken to try to improve the situation — including reducing the distribution radius from 300 miles to 150 miles to their ‘‘multiunit groups,’’ which are second- and third-level chain businesses such as growing food chains like Jimmy John’s Gourmet Sandwiches. Prices were increased to schools to which W.S. Lee delivered products, Donaldson said.

In January 2006, Omega Bank, which had loaned the company $20 million, hired a consultant to do an audit and make recommendations to Lee’s board of directors.

‘‘The bank suggested complete sale of the company, to liquidating the company, to filing for Chapter 11. There was a full range of recommendations. No one understood the depth of the problems,’’ Donaldson said. ‘‘We had to peel off layers of the onion to figure out what was going on here.’’

By the first week of March, Donaldson said it became clear that filing for Chapter 11 bankruptcy, which would give the company protection from its creditors while taking steps to become profitable, was the only option.

Omega Bank agreed to finance the company through the bankruptcy process if the Lee family members agreed to name Donaldson as chief executive officer and give him authority to file for bankruptcy.

‘‘We didn’t really have options considering the financial condition of the company,’’ Donaldson said. ‘‘We were very close to going out of business. If we didn’t file when we did, we were days from going out of business.’’

Lee said the agreement also called for him to be the majority stockholder after the company emerged from bankruptcy — but that never happened.

‘‘They never sent me the papers to sign,’’ Lee said. ‘‘The only reason I agreed to give authority to Donaldson was that I would remain majority stockholder.’’

Donaldson has a different view on Lee’s claims.

‘‘I am confident an objective review of the documentation would show a different conclusion,’’ Donaldson said. ‘‘I don’t know how to respond. It is categorically false.’’

*Filing for bankruptcy*

W.S. Lee filed for bankruptcy March 14, 2006.

Declaring bankruptcy was very difficult, Lee said.

‘‘You can’t know the pain and heartache that goes through a decision like that, after you have put so much hard work and sweat into a business — not just me, but the family and the employees, for all those years,’’ Lee said.

The company, which had about 380 employees the previous summer, reduced its work force to 150 and brought in a new management team. That team included Hugh P. Reilly as senior vice president and chief financial officer and Mark A. Koschny as senior vice president of sales, purchasing and marketing.

In April 2006, the company reached an agreement with the state Department of General Services to end the state contract.

‘‘We negotiated a parting of the ways so they wouldn’t come after us and seek damages. They agreed to pay us the money they owed us and assisted in placing some of the inventory we had brought in for them,’’ Donaldson said.

The state paid W.S. Lee more than $1 million and helped send the products to other distributors, Donaldson said.

The next major step was to meet the Aug. 31, 2006, deadline to put together a plan of reorganization that would gain the approval of U.S. Bankruptcy Judge Bernard Markovitz.

In September, Markovitz gave the company an extension until Nov. 7. The company also asked Markovitz to force Lee family members to return more than $1 million to the company or justify use of the money.

The company’s management, headed by Donaldson, filed a complaint that said W.S. Lee officers Robert E. Lee and Walter J. “Jamie” Lee III had used company funds for personal expenses as well as funds from another firm — a partnership called R&J Development Limited — they manage.

In October 2006, the company reached a settlement with Omega Bank and a committee of unsecured creditors — such as suppliers — to pay Omega $2.3 million and $1.1 million to unsecured creditors.

The plan of reorganization was filed Nov. 7 and included changing the corporate name to Lee Food Service Inc.

The filing provided details of how the company — aided by $2 million in new investments, which included $875,000 each from Stephen Sheetz, chairman of the board of Sheetz Inc., and Donald Devorris, chairman of the board of The Blair Cos. — would restructure.

According to the reorganization plan, no members of the Lee family remained, and the board of directors would be comprised of Devorris, Sheetz and Donaldson.

‘‘Our primary purpose was to save the jobs at Lee Foods. That was our driving force and decision-making process,’’ Devorris said. ‘‘We think it is a fine company, and over the next two or three years, [it] will get back its financial strength.’’

Devorris admitted there was risk involved in investing in the company.

‘‘Any time you take a company out of Chapter 11, there is risk involved by the nature of the beast. You are rolling the dice on whether you will be able to resurrect a company that is damaged financially,’’ Devorris said. ‘‘We are concerned, but we are optimistic the management team will be able to turn the company around.’’

Robert E. Lee and his brother Walter J. ‘‘Jamie’’ Lee III, who had served as company vice president, objected to the reorganization plan.

Robert called the plan ‘‘an attempt to orchestrate a hostile takeover’’ of the company.

‘‘Their plan of reorganization became the dagger through the heart. We didn’t know Don and Steve had been brought in as investors. We had never heard about it. The family believed it was not in the best interest without family involvement,’’ Lee said. ‘‘I felt betrayed by Mr. Donaldson and the parties involved with the agreement. He walks away with the company that our family started, and we are out of the company.’’

Lee said he met with other potential investors that would have included the Lee family. That investment group included Harry Benjamin, chief executive officer of Altoona Beasley Manufacturing Inc.

‘‘We were looking at it. It was a serious group that included a Fortune 500 company,’’ Benjamin said. ‘‘In the end, we didn’t think the information we were provided was sufficient to go forward.’’

*Moving forward*

Omega Bank, as the company’s largest secured creditor, had to approve the reorganization plan. Koval said the bank didn’t believe the Lee family members had the necessary skills to lead the company through the process.

‘‘We were looking at the skill sets needed to manage the company through the bankruptcy. We were looking for a different type of skill sets to accomplish this,’’ she said.

In March 2007, more than 94 percent of W.S. Lee’s creditors voted in favor of the reorganization plan.

In April, Markovitz delayed approval of the plan because of a single objection filed by Robert E. Lee.

Later that month, Lee dropped his objection, and the company agreed to drop the request to force family members to return the more than $1 million and to stop attempts to repossess from Lee four company cars that included a 1996 Mercedes and 1990 Corvette.

The Lees and the company came to an agreement, under which Robert and Jamie would be paid not to work for a competitor or talk to customers or employees about the company for six months.

Robert opted out Nov. 1, meaning he was free to work or talk, while Jamie renewed his agreement for six more months.

‘‘They paid me to keep my mouth shut. They wanted me to go away,’’ Robert E. Lee said.

On April 30, 2007, Markovitz signed a court order confirming the reorganization plan, and Lee Food Service Inc. was launched May 11.

While Donaldson said Omega Bank was a good partner and stuck by the company throughout the bankruptcy process, some people credit him for saving the company.

‘‘He absolutely saved the company,’’ Musselman said.

He and Himes said if Donaldson had not come in, 130 people would be working somewhere else or looking for work elsewhere.

Devorris, however, said it took more than just Donaldson.

‘‘The management team in general and the key employees deserve credit. It is more than just him,’’ Devorris said.

Needless to say, Robert E. Lee isn’t one of Donaldson’s fans.

‘‘He is the villain, and the employees out there know it. He got rid of a lot of employees,’’ Lee said. “His credibility has greatly suffered.’’

He also said he isn’t happy the new company includes the Lee name.

‘‘Why do they want the family name on the building but don’t want the family as part of the business?’’ Lee asked. ‘‘The Lee family is not involved, Lee people are not involved. I don’t think it is right that the Lee name should be involved.’’

*Looking ahead*

Donaldson said the future of Lee Food Service is bright.

The company was required to present a five-year plan when it emerged from Chapter 11.

Lee Food Service began a partnership with Hoss’s Steak & Sea House Inc. Dec. 31, under which Lee assumed responsibility for Hoss’s purchasing, warehousing and distribution for the Duncansville-based restaurant chain.

‘‘By bringing on Hoss’s and some other things, we have been able to move about one year ahead of our five-year plan,’’ Donaldson said.

The company also recently hired six sales representatives to increase distribution to the restaurant and eateries market in the Pittsburgh area.

‘‘We have a lot of irons in the fire. We are in a very good spot right now,’’ Donaldson said.

The Hoss’s partnership is huge for the company, Koval said.

‘‘The comeback has started to re-energize the company. Customers are getting excited, and they are picking up more customers,’’ Koval said. ‘‘The cog wheel starts slow and picks up the pace. They have momentum that is important, and we are pleased with that.’’

Lee is not sure about his future plans, but he knows what he would not do.

‘‘I am looking at some new opportunities and looking forward to the challenges ahead,’’ Lee said. ‘‘If I had to do it over, I would never have gotten involved with government agencies. Bureaucrats make a lot of promises, but ultimately, it is the people involved in the business that face the task of achievement.’’

Mirror Staff Writer Walt Frank is at 946-7467.