Sub Mission: The Controversy Behind the Subway Sandwich Chain

The Subman waves a jaunty hello to the eager business students and professors who scurry into the University of New Haven's Dodds Hall on a rainy weekday morning.A goofy man-sized submarine sandwich with floppy red tomatoes for ears, slices of lettuce and cheese poking out from the sides of a full-body whole wheat roll, and the brown and yellow logo of its creator -- the Subway restaurant chain -- in the center of his chest, the Subman cheerily performs his warm-up acts: shaking hands, meeting and greeting, posing for the occasional photo op.The main act this morning is franchise tycoon, Subway founder and local business hero Fred DeLuca, who's making a special visit to UNH to share his now-legendary rags-to-riches story, begun in Bridgeport and in Milford, with the next generation of local boys and girls hoping to make good. DeLuca's phenomenal success in expanding Subway from its first tiny Bridgeport store to a 12,500-store worldwide franchise empire -- second only to McDonald's in sheer number of stores -- is at center stage. But it's actually the Subman who makes a more fitting icon for the Subway chain: Peering out through an eye-level window of netting in the cheery costume is the distinctly miserable face of the man trapped inside.The miserable faces behind the Subway success story belong to franchisees -- the small business "owners" who pay the company start-up fees, royalties and equipment expenses for the rights to run a Subway shop. Over the past decade, franchisees have accused the company of everything from acute insensitivity to running roughshod over individual franchisees' business interests. The complaints have surfaced in the courts, within the company, in the press, and in front of the Federal Trade Commission, the Small Business Administration and the U.S. Congress. Several months ago, 32 Subway franchisees filed suit against Fred DeLuca, his partner Peter Buck and a network of suppliers, alleging that they conspired to cheat franchisees out of their profits by inflating prices and restricting trade. The franchisees are seeking $100 million in damages.Subway says that the complaints are isolated cases, often brought by lousy businesspeople looking for someone to blame for their own failures. Spokespeople explain that the lawsuits are inevitable in a business as big as Subway's.Franchisee advocates and lawyers, though, say that Subway is one of the best examples of almost everything that's worst about the franchise industry, from unfair policies designed to benefit the company at the expense of the franchisee, to strong-arm tactics such as contract clauses that make it nearly impossible for franchisees to go after Subway's owners in court.The result, says Susan Kezios, executive director of the American Franchisee Association, is that franchisees enter the industry dreaming of owning their own businesses -- and discover that "I bought myself a low-paying job I get to work at six or maybe seven days a week."Such practices by the franchise industry -- which now makes up 40 percent of retail sales in the country -- call into question the viability of small businesses being created in the newly downsized, increasingly entrepreneurial economy of the '90s, says Dean Sagar, a minority staff economist for the U.S. House committee on small business, which held hearings on franchising in 1991. "We tried to go after franchising from the standpoint of the economic consequences: [Are] these really small businesses or just adjuncts of big corporations that were getting around the law?"Subway, he says, is a case study in all that's wrong with franchising. "They are the key example in almost everything we investigated." Dave Balch and Patrick McCartney operate Subways on opposite U.S. coasts: Balch in the Westville section of New Haven, McCartney in Portland, Oregon. Their experiences as Subway franchisees have been as divergent as their store sites.Balch bought his Whalley Avenue store about five years ago, after decades of work in various food industry jobs and almost three years of research into franchises. He and his wife, Jo Ann, decided on Subway because of its moderate start-up costs, its reputation as a fast-growing powerhouse and its local roots. It seemed a safe bet for a first store and offered promise for more stores to come."It's been great for my wife and I," Balch beams from behind the tall wooden counter of his Westville store. "We actually think it's the best around."Balch works behind the counter -- wearing a purple polo Subway shirt, a black Subway baseball cap and bearing a ready customer service smile ("Cookies or chips today, sir?") -- upwards of 40 hours per week. He spends another 10-20, he says, ordering the bread, meat and vegetables for delivery, making new hires, or filling out paperwork to send back to "corporate."Just last year, the Balches took some of the proceeds from their Westville store, which sells a steady 2-3,000 subs per week, and sunk them into building a new Subway from scratch, this one at the intersection of routes 17 and 22 in Northford. The Northford store has all the modern adornments, Balch explains during a mid-afternoon lull at the Whalley Avenue shop: a curved glass counter, roomier booths. It's so state-of-the-art, Subway even used it as a model store for a recent advertising photo shoot. "Corporate really gives you a lot of support, in all aspects of the business," says Balch. Altogether, he concludes, he turns a tidy profit.For the first few years he worked with Subway, Patrick McCartney turned a profit too. He joined on in 1985, just as Subway was beginning to hit the West Coast, buying one, then two and finally four Subway franchises. "It was an upstart company, very, very exciting," says McCartney. "I've seen the chain grow from less than 300 to where it is now."But as the chain has grown, McCartney's sales have fallen drastically, especially in the "extreme expansion of the last three or four years." Now, sales at his three remaining stores are "down double-digits going on the second year in a row."McCartney's sure he knows why he's been losing money -- and it's not because he suddenly became a bad businessman or didn't wash his windows often enough. Subway, he says, is putting him out of business.Three or four years ago, he began to notice Subways cropping up all over town: in convenience stores, in gas stations and even just a mile down the road from his own store. For Subway's owners, that meant more royalties: Fifty stores are almost guaranteed to bring in higher total sales than just five or 10.For McCartney and the other franchisees, though, that meant increased competition. The customers who used to come into his store might stop off at the store down the road instead of driving the extra mile. Or they might grab a sub while pumping gas at the station instead of making an extra trip.In addition, Subway's push for more of the market has meant more advertising hype in the form of "meal deals" and specials. Designed to get new customers into the stores, the special prices often become a cut into the store owner's profits: Food costs for the owners stay the same. With new customers coming into the store, overall sales might increase, but the amount of money that the store owner makes off of each sandwich becomes so slim as to be almost non-existent.What's more, even if sales dollars dip, corporate Subway can absorb the slight loss in revenue in return for the added boost in customer base. The individual franchisees, says McCartney, can't afford it.For McCartney, the $.96-cent meatball sandwich deal that Subway offered a few months back was like a death blow. He ended up eating extra costs on every sandwich he sold -- but he had to keep the program going. "When [customers] see a commercial, they think it's systemwide. When they do come into a store and they're not charging the same price as the corporate-promoted campaign, they cry deception."If he doesn't give the customers the deal they're looking for, says McCartney, the customers don't come back.Fred DeLuca opened his first sub shop at the age of 17. For the first few months, sales were great. Then summer ended, and they dropped off. And kept dropping. Rather than give the subs up for good, though, DeLuca and his business partner, Peter Buck, decided to open a second shop. That way, they reasoned, people would see them expanding and think that they were making money. And they'd want to come to the store.It didn't work with the second store. But by the time the third store opened, DeLuca and Buck found themselves at the head of a booming sandwich business. They made the partnership permanent and dubbed themselves Doctor's Associates, Inc., after DeLuca's former medical school aspirations.DeLuca relayed that story to the students at UNH as an illustration of the power of unconventional thinking. But many franchisees hear it and glean a different lesson: In the face of failure, Subway plows ahead, offering the appearance of success rather than the real thing. How many store owners find Dave Balch's success and how many end up just scraping by like Patrick McCartney depends on who you ask. Subway proudly claims a 1 percent failure rate. That's the number of stores that permanently shut down.But the company doesn't keep track of the number of owners a particular store has over the course of a lifetime. According to franchisees, five or six owners could shell out the $10,000 franchise fee, spend thousands more to open for business and then shut down because they couldn't make it. But if Subway could find another buyer, that store would still be considered a success."One percent, 1 percent," mutters Mike Johnson, a franchisee in North Carolina who's had three separate stores close. "What do they determine is failure? Does that mean that 1 percent of the franchisees shoot themselves in the head?"Leslee Scott, president of International Association of Independent Subway Franchisees (IAISF), places the number at more like 10 percent, if you define it in terms of the number of franchisees who fail financially. "I guarantee you there's more than 1 percent." In 1992, DeLuca told the Wall Street Journal that about 50 percent of Subway owners make a profit, 25 percent break even and another quarter eventually sell at a loss. Company records, the Journal reported, showed that "within three years, about 40% of the 2,300 Subway shops listed as open or preparing to open at the end of 1987 either changed hands, relocated, closed down or never opened." Subway's record of growth indicates that more buyers are always available. "The goal has always been to match or exceed the number of units McDonald's has," says Subway spokesperson Michelle Klotzer. Mike Johnson, for one, thinks they'll make it. "Fred DeLuca has the ability to sell an air conditioner to a dog in a snowstorm."Subway's allure for prospective franchisees is also one of its pitfalls. While its simple operations -- no frying, no grilling, no need for more than a few employees -- give it one of the cheapest start-up costs in the business, that simplicity also assures limited volume and a low profit margin. In addition, Subway charges one of the highest royalties in the business.A new Subway franchisee lays down $10,000 for the franchise fee -- the rights to use Subway's name -- and up to $200,000 for equipment, rent, signs and insurance, depending on the size and location of the store. In most cases, the franchisee picks the site of the store, then asks the company's development agents -- who are responsible for recruiting new store owners -- to sign off on it.Then it's off for a two-week get-to-know-the-business session at Subway's Milford training center, a week or so with an in-store adviser, maybe a visit from the Subman -- and the Subway franchisee is on his or her own. From the first day of business, Subway franchisees must pay an 8 percent weekly royalty on after-tax sales and an additional 2.5 percent advertising charge back to Franchise World Headquarters, the Milford company responsible for the nuts and bolts of Subway operations. The advertising money goes into an independent trust fund used for local and national ad campaigns. Franchise World Headquarters passes the royalties along to Doctor's Associates, Inc., the franchise company owned by DeLuca and his partner, Peter Buck. In 1995, those royalties brought Doctor's Associates $229 million. DeLuca himself made $60 million in 1994. Subway doesn't offer numbers on what sort of profit its individual store owners can make. According to Dean Sagar of the U.S. House Small Business Committee, most owners aren't making much. "Operators say to themselves, 'Either I spend my life trying to eke out $30,000 a year or open five, six stores making $10,000 each,'" Sagar explained in an interview for the Broward, Fla., Daily Business Review. "A few get big, a lot of them fail."And it's not until they fail that many franchisees realize that they've signed what, by many estimates, is one of the most draconian franchise contracts in the entire industry. "I've read about 200 franchise agreements, and this is the worst," one Florida franchise lawyer told the Broward Review. "In 1994, the U.S. Small Business Administration stopped lending to Subway franchisees until the company fixed a contract clause that allowed it to seize any store at any time "without cause." Subway finally removed that clause and restored its relationship with the SBA.According to Patrick McCartney, that's typical of Subway's insistence on maintaining absolute control over its franchisees. And the company will keep doing it, he says, until someone pushes it to do the right thing. When McCartney broached his own complaints with Subway, the company told him that if he didn't like the system, he should get out, he says. "I bought a low-paying job from them, and this is what I get," McCartney comments incredulously. Instead of ducking out and losing his investment, McCartney decided to find other franchisees who thought they were being screwed by Subway -- and figure out what, if anything, they could do about it.So he joined the International Association of Independent Subway Franchisees -- and became president. According to Leslee Scott, a franchisee advocate who now runs the IAISF, franchisees like McCartney want to see the Subway contract revised. Most of all, they're worried about:¥ ENCROACHMENT.Once a franchisee opens a store, there's nothing in the contract to prevent Subway from opening another store in direct competition with the first -- and cutting into the first store's sales for an overall gain in the company's profits. Some franchisees say there's a fundamental conflict of interest between the franchiser and the franchisee.While recognizing that encroachment is a real issue in franchising, Doctor's Associates, Inc. national litigation counsel Jack Dunham, a partner at the New Haven law firm of Wiggin & Dana, says that franchisees are blowing it out of proportion. "It's a really simplistic and really inaccurate view of things. Common sense tells you that if you have a large number of successful happy franchisees paying continuing royalties over time," everyone's better off.¥ ARBITRATION CLAUSE.Anyone who opens a Subway signs a standard contract that includes a mandatory arbitration clause. Under the clause, the franchisee agrees to bring any legal disputes with the company to a hearing by the American Arbitration Association. According to the contract, the arbitration must take place in Connecticut.The company says the clause is a matter of uniformity; Subway can't have its lawyers running all over the world just to settle disputes. In addition, says Dunham, "arbitration is quicker, less expensive and tends to produce more rational results."The franchisees, however, say it's a way for the company to make sure that few franchisees bring complaints in the first place. "It's a discouragement and discrimination tactic," says the American Franchisee Association's Susan Kezios. "You're not going to find an attorney in Connecticut and fly your lawyer into Connecticut. You'll say, 'Screw it. I lost 50 grand and I'll get a job and pay it off.'"¥ SUB-LEASING.Subway franchisees never sign a lease. Instead, they sign a sub-lease with a leasing company created by Subway. The leasing company has no money; all it does is sign leases and collect rent, which it then passes on to the landlord.Officially, the leasing company is separate from Subway's wealthy owner, Doctor's Associates. But franchisees say that it's one of DAI's most cunning tools to keep store owners under control.The required lease says that any breach of the franchise agreement with Doctor's Associates is grounds for eviction. For a franchisee, that means that any dispute with DAI -- even as minor as a late payment or a dirty store -- could mean losing their entire investment.What's more, if a franchisee is evicted and wants to take the leasing company to court, the leasing company doesn't have any money--so who's the franchisee going to sue?"You'll find examples of [franchisers] who use some of these things [in contracts]," says economist Sagar. "There may be others who use the sub-leases, the mandatory arbitration, the shell corporations. But nobody else uses all of these devices. What alarms us is that [Subway] is an example of every problem we've looked at."Franchisee Mike Johnson says he opened a Subway in a corporate-approved site so lousy that the store barely lasted eight months. "It was so bad that when the produce company called and said, 'Where are you located?' we said, 'We're out here at the intersection.' They said, 'We're out here -- but we can't find you,'" says Johnson. He sold the store for a $30,000 loss.After ditching that first store and opening at a new and better site, Johnson found himself swamped with unexpected debt from his payments to Subway. Then he discovered that the Subway exec at the Milford headquarters who had been advising him was embezzling money and charging him significantly more than what he actually owed to Subway. Subway repaid him the stolen money, says Johnson, but refused to help with the credit problems and personal debt he had run up as a result of the embezzlement. In the midst of a divorce, he sucked it up, moved back into his parents' home, and accepted a buy-out deal on his stores.Now, Johnson says, he's still paying for Subway's mistakes. He's scheduled to lose the Subway store he still owns within a few months. According to Johnson, at the time of the embezzlement, he had been so distraught that he agreed to get rid of his Subway stores for pennies on the dollar.Johnson decided to sue DAI. He says he signed the agreement because of the stress and debt he was under at the time he signed the agreement. He likens it to a sexual assault case in which the woman consents -- but only because the man has a gun to her head. Subway points to the contract that Johnson signed -- agreeing to sell his stores and get out of the company. Johnson and Subway are now awaiting a federal court decision -- the third in Johnson's case--that will determine whether or not Johnson can take Subway to court, or whether the two parties must arbitrate.DAI lead counsel Dunham says Mike Johnson's case is "unfortunate." But, he says, Subway repaid the money it owed to Johnson -- and Johnson needs to forget about the incident and move on rather than spending his time trying to get the case moved out of arbitration. "I think that's sad, particularly for someone who is upset and wants to have his day."Johnson is incredulous when he hears comments like that. "If you buy a house, and somebody tells you that it's OK, and then you find out later that it's eaten up with termites, do you just eat that or do you hold someone accountable for that?"Accountability is tricky turf in franchising. In any industry, some businesses will fail. In addition to the arbitration clause that restricts the franchisees' right to take a case into a local courts, often the law just isn't on the franchisee's side. "A franchise is a creature of contract," explains Dunham. "What rights they have are principally defined by the contract. Whether there is encroachment that is actionable and gives rise to legal actions" all depends on what the contract says.Despite the franchiser safeguards in the contract, some Subway franchisees have had their days in court. Many arrived there under the wing of St. Louis attorney David Duree, a partner in the Reinert & Duree law firm, who has sued Subway upwards of three dozen times over the past 10 years and achieved the unofficial title of Company Enemy Number One.His dealings with Subway have led him to some rather un-generous conclusions: "Subway operates through a system of fear and intimidation, both with their franchisees and with anyone who dares to oppose them," says Duree.Dunham's assessment of Duree is equally kind. "What we have here is one extraordinarily overzealous and unethical lawyer who has managed, not withstanding all of his effort over the last few years, to get a very small number of people out of an enormous universe to hire him to bring these claims," Dunham told U.S. Business Litigation magazine this year.The courts have vindicated neither side absolutely. Duree has won several high-profile awards against Doctor's Associates, starting with $1 million in punitive damages that was upheld in Illinois state court five years ago.He also won a $10 million award from DAI in 1995, which is currently up for appeal in the federal courts. In that case, a Chicago landlord sued DAI for violating a lease agreement restricting the number of stores Subway could place near the landlord's building. According to Duree, the lease said zero stores; Subway put in six. (It wasn't a classic encroachment case; the beef was between the landlord and the leasing company, not between franchisee and franchiser.) By demonstrating that the shell leasing company -- which had no money -- was in fact an "alter ego" of DAI--which has a lot of money -- Duree was able to sue DAI for damages. This year, though, DAI and Dunham won a case against Duree himself. A federal court found that Duree had manufactured evidence in the form of a false tax return as part of his trial strategy in a fraud case brought by two Subway franchisees. The Kansas state court which heard the case fined Duree $408,445.25 for DAI's legal fees in fighting the fraud suit and barred him from practicing law in Kansas. While this is the largest award against Duree, he's been sanctioned seven separate times in a variety of state courts. "It is an extraordinary event in any lawyer's life to be sanctioned even once," says Dunham. "To be sanctioned seven times is unheard of."Duree says Subway is simply out to get him. "This is a campaign against me because I've represented some franchisees who've had some success and Subway has concluded that the best way to respond to that is to personally attack me. It's consistent with their entire method of dealing with the people they do business with. If you don't do it their way, they're going to come down hard on you in whatever way they can."The biggest current battle shaping up between Duree and DAI is a $100 million class action lawsuit being brought by 32 Subway franchisees against Fred DeLuca, his partners and about a dozen Subway food suppliers. The lawsuit alleges that DeLuca and his partner, Peter Buck, use the advertising trust fund -- to which each franchisee contributes 2.5 percent of after-tax sales -- to profit themselves rather than the franchisees. In addition, the lawsuit accuses the suppliers of conspiring with DeLuca, Buck and the other defendants to inflate the prices franchisees pay for food and equipment.The lawsuit is based on the same complaints as Patrick McCartney's: The advertising may benefit the chain as a whole, but the individual franchisees lose out. That means that DeLuca and Buck profit unfairly off of the franchisees' contributions. According to the lawsuit, the advertising money is also used for such expenses as computers and staff at Subway's Milford offices, Franchise World Headquarters, and to pay attorneys who perform the evictions for Subway's leasing companies. "It's a rip-off of the advertising trust that would otherwise be payable by Mr. DeLuca and Mr. Buck and their various companies," says Duree.Dunham declined to discuss the details of the case, except to say that the defendants have filed in federal court to uphold the arbitration clause and break the class action status, forcing each of the franchisees to individually enter into arbitration in Connecticut. Dunham did say that Duree "is wrong on all of the factual allegations and he is wrong on all of the legal conclusions he draws from his incorrect factual allegations. When all is said and done, we expect that arbitration is going to be done by individual franchisees."A few months ago, franchisee Mike Johnson gave a speech at a local high school. A student who works part-time in Johnson's Subway shop thought he might have some business advice to offer to her class.Johnson says it was a low-key event: no Subman, no balloons, not even a crowd that seemed particularly interested in what he had to impart. Several students lay with their head on the desks, taking casual naps, or staring disinterestedly into space.They perked up, though, he says when he started talking about encroachment. "If you had your own business, would you do that?" Johnson asked the class.One kid, who had been face-down for the entire talk, raised his head, Johnson says, and looked at him disdainfully. "The kid was like, 'No, that would be stupid. You'd be competing against yourself.'"I was like, 'Wow, how old are you? Fifteen -- and you've figured it out.'"Johnson says that if he were in front of a crowd of enthusiastic young business students -- like the ones to whom Fred DeLuca spoke at the University of New Haven -- he'd offer them the same advice he gave to the class of North Carolina high schoolers."I don't want to kick the philosophy of the Easter Bunny or whatever, but you just can't go on the information that they give you," says Johnson. "You've got to understand the difference between the myth and the realities of franchising."He returns to a phrase that his father used to repeat to him -- and that he wishes he had remembered."If something seems too good to be true," Johnson reflects ruefully, "then it probably is."

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