The Subway system under fire

Mr. Downer is still in business. He broke a window to get in, tore down the paper and sent the security guard home. He paid the $4,800 four days later, then was hit with Subway’s $4,600 legal bill to cover the cost of chasing him down. Following his lawyer’s advice that it’s cheaper to pay the bill than drag the case through the courts, Mr. Downer is paying it off in monthly installments…Welcome to the hardball world of franchise disputes.

The Globe and Mail
November 28, 1995

The Subway system under fire
John Southerst

Chris Downer has spent more than $100,000 getting his Subway sandwich shop franchise up and running last year. But when he arrived at his Etobicoke, Ont. store one day this March, he found the windows papered over, the locks changed and a security guard posted inside.

The 27-year-old single father says that in January and February he missed about $4,800 in royalty payments to franchisor Subway Franchise Systems of Canada, Ltd., based in Milford, Conn., and it repossessed his store.

He’s angry that Subway didn’t give him more time to pay, considering the amount he’d invested in his suburban Toronto store. But the franchisor’s Toronto development agent, Tom O’Neill, says Mr. Downer had not been co-operative when asked about the overdue payments.

Mr. Downer is still in business. He broke a window to get in, tore down the paper and sent the security guard home. He paid the $4,800 four days later, then was hit with Subway’s $4,600 legal bill to cover the cost of chasing him down. Following his lawyer’s advice that it’s cheaper to pay the bill than drag the case through the courts, Mr. Downer is paying it off in monthly installments.

Welcome to the hardball world of franchise disputes. Subway’s tactics certainly discourage delinquent payments, but some franchise lawyers and Subway franchisees wonder whether Mr. Downer’s experiences – and others like them – suggest the company is focusing too much on growth without enough support for the people running the stores.

In fact, Subway is a lightning rod for what’s right and wrong with franchising. It has opened new stores at a rate of 1,000 a year since 1987. Now there are more than 11,000 of them – 1,000 in Canada – making Subway North America’s second-largest fast-food chain, next to McDonald’s Corp.

Franchisees pay a fee of just $10,000 (before building costs, inventory, equipment and other expenses) to climb aboard, a pittance in the world of fast-food eateries. Mary Brown’s Fried Chicken, for example, charges a franchise fee of $20,000 and Harvey’s Restaurants $27,500.

But there’s another side to this growth. Subway’s uniform franchise offering circular, a U.S. disclosure document, says the chain aims to open one store for every 30,000 people. Already, store density has risen to the point where about a third serve markets of 20,000. With the opening of the 1,000th store in Canada, the one-in-30,000 average has been achieved nation-wide.

Fred DeLuca, Subway’s chairman, CEO and founder, says the 1-to-30,000 ratio is just an initial target. “What we will do is continue to grow until there is a leveling of sales,” he says.

Some critics say Subway’s all-out charge to expand is putting franchisees at risk. “On what basis do they say the market can sustain this many franchises?’ says John Sotos, a Toronto franchise lawyer. “It would be wiser to stop, see whether support exists and then move forward.”

It’s difficult to determine how many unprofitable stores exist in any franchise chain, because franchisees usually sell them, prop them up with personal funds or walk away from them. The chains often resell abandoned locations and count them among their operating franchises.

Subway’s Mr. DeLuca says just 71 stores were closed worldwide in 1994. In cases where franchises were abandoned or seized for non-payment of rent or royalties, “if we thought these were really good locations, we’d try to reopen them,” he says.

Subway’s system is also attracting critical attention because of the number of complaints from franchisees. Although only two lawsuits have been filed against Subway in Canada, the chain’s U.S. offering circular, dated Sept. 15, 1995, lists 54 pending litigation actions, many involving multiple claimants, in which Subway is involved. It also lists another 58 that have been settled, dismissed or disposed of.

Conflict is inevitable in the franchise business, Mr. DeLuca says. It is not easy to settle disputes with franchisees, even those who run inferior operations. “You don’t just walk in and say, ‘Okay, you’re fired.’ There’s a whole legal procedure you have to follow.”

But some franchisees who want to dispute Subway’s treatment of them say they can’t afford to challenge Subway in the courts. Ned Levitt, a Toronto franchise lawyer, says the chain’s low initial fee leaves the door open to undercapitalized, inexperienced franchisees who empty their bank books to get in. “Franchisees without a lot of capital have nothing to fight with,” he says.

A number of franchisees, like Mr. Downer, say the chain has tried to take possession of franchises for not paying relatively small amounts of royalties. In Canada and the United States, Subway has been accused of opening new stores too close to old ones.

Other franchisees allege that the chain distributes coupons and flyers for new stores in the vicinity of existing stores, tries to repossess stores for minor violations of quality control standards such as weeds or potholes in the parking lot, and fails to train and support franchisees.

At the root of many complaints is a quirk in the way Subway sells and maintains its system. The franchisor recruits independent contractors, called development agents, who buy the right to handle franchise sales, site selection, training and operational assistance for each region.

Agents receive compensation in proportion to income generated from their territories. For instance, they get half of the franchise fee and one-third of royalties. But what raises eyebrows is the fact they are entitled to one-third of profits – or must absorb one-third of losses – on the operation and sale of franchises that have been repossessed. Agents also earn bonuses or pay penalties depending on whether they meet or fall below development schedule for new stores in their regions.

Because of the agents’ compensation and bonus arrangement, disgruntled franchisees say there is a financial incentive to open stores indiscriminately and to repossess and resell weak franchises rather than support them.

“You don’t even have to be very cynical” to draw that conclusion, Mr. Sotos says. “Provisions such as these are not franchisee-friendly.”

But Mr. DeLuca, Subway’s chairman, says the agents cannot focus on simply selling stores, because they also have to meet average sales volume targets. There’s no money to be made reselling a shop because the store sits idle in the interim and rent arrears build up, he says.

“The way to make money isn’t through turnover of shops. It’s taking those operators who are in business and allowing them to go forward and open additional stores.”

Mr. DeLuca also denies that Subway opens new stores without regard of existing locations. Like many other franchisors, Subway conducts market studies on behalf of franchisees who object to new proposed store sites. If the impact on present stores is judged to be severe, the site is turned down. Mr. DeLuca says about one third of new locations challenged by existing franchisees are ultimately turned down after a market study.

He also says Subway develops marketing programs, financed by the company and development agent, for struggling franchisees.

But Mr. Sotos, who also runs the Ontario Franchisee Coalition, an alliance of 4,000 franchisees from 10 chains, says the dealer/agent arrangement is unfair because the franchisor gives up substantial control over the way franchisees are selected. “When the franchisor introduces a third party, it necessarily gives control over what is told to franchisees, how it trains them and to what to do.”

If the use of development agents were to spread widely as a common practice, Mr. Sotos fears it would sour the franchising market. “A good way to expand is one store at a time. You nurture them and develop a personal relationship between the company and the franchisee.”

Subway’s Mr. DeLuca (?) that franchise chains n(?) ways to deal with problem franchisees. “Some people enter the business and they really can’t do. We encourage them to sell their stores to somebody else. One of the things about Subway is that there is a tremendous resale market.”

In the past, Mr. DeLuca’s enthusiasm in getting underperforming to sell has landed him in hot water. Earlier this year, the U.S. Small Business Administration stopped guaranteeing loans to Subway franchisees because Subway revised its new franchise agreement to repurchase franchises “at (?) The SBA said the clause effectively removed the rights associated with business ownership.

De. DeLuca says he has had the clause removed.

Nonetheless, he still says “Somebody might meet the thresholds for compliance – the business, they wear a uniform(?) they’re not doing bad(?)you can terminate them. option in my opinion is to(?) please sell your store.’”

Ultimately, franchisees (?) one of a franchisor’s mo(?)duties. Poor judgment results in wasted time, a damaged reputation and extensive legal bills.

Mr. O’Neill, the Toronto development agent, says errors place a burden on him as an agent for the franchisor. “When people do what they say they’ll do, the buck stops here.”

Franchise buyers also have the duty to investigate their future business partners, and Subway’s franchisees admit their enthusiasm blinded them to the realities.

“I didn’t know as much as I should have about Subway,” says Mr. Downer, the Etobicoke franchisee. “I really didn’t do my research.”

With their life savings on the line, that’s an error franchisees can’t afford to make.

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Risks: Development agents, Self-help: take your own store back, de-brand and run to fund a fight, Raining litigation, No franchisor support, Justice only for the rich, Encroachment (too many outlets in area), Necessary illusions, Expands too quickly, Sales cannibalization, Canada, 19951128 The Subway

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