FORTUNE MAGAZINE – MARCH 16^TH 1998

Why Subway Is 'The Biggest Problem In Franchising' That's the assessment of a congressional staffer who studied
By Richard Behar

Talk about an entrepreneur's dream. Frederick DeLuca was 17 when he borrowed $1,000 from a family friend to open a submarine-sandwich shop in Bridgeport, Conn. It didn't do too well, so he opened a second one--'to create the image of success,' he recalls with a smile. Apparently it worked: By the fifth store he had a clear winner, and after nine years he started selling franchises. Today DeLuca's chain, Subway, sells sandwiches from 13,136 franchised stores in 64 countries, a number of outlets second only to McDonald's. More than 10,000 of them have opened in the U.S. in the past decade, a burst of development unmatched in franchising. Systemwide sales exceed $3 billion a year. And Fred DeLuca, now 50, is a billionaire.

It's an inspiring story. But look more closely and you'll see that Subway wasn't built in quite the same way as the other franchise empires--McDonald's, Kentucky Fried Chicken, Burger King, and the rest. DeLuca has used methods all his own, creating a corporate reflection of his own complicated personality. The result has been not just enormous wealth but also a set of problems unmatched in the business, including unhappy franchisees, disputes with landlords, and run-ins with regulators. Every big franchise operation has such problems, of course, but what sets Subway apart is scope: It faces so much more trouble than its competitors on all these fronts that it's simply in a league of its own.

Now conflict and rebellion greet DeLuca from every side:

--Legal disputes disclosed in an annual report required by the Federal Trade Commission total 160--more than the combined total listed by Subway's seven largest competitors (McDonald's, Burger King, KFC, Pizza Hut, Wendy's, Taco Bell, and Hardee's). The number has nearly doubled in four years and doesn't include 50 cases in Milford, Conn., the company's hometown, against various dummy entities DeLuca has used to conduct business.

--A growing number of Subway's development agents--the 220 salespeople who peddle these stores to first-time entrepreneurs--say Subway has broken contracts with them. Angry agents last summer organized a union to gain power against DeLuca. Earlier they had tried to get rid of him by offering around $1.5 billion to buy Subway in an LBO; he turned it down but acceded to their demand that he hire outside consultants to analyze company operations.

--Many Subway franchisees insist bitterly that the company has defrauded and damaged them, sometimes by opening too many franchises in their neighborhoods. Against DeLuca's wishes, they have started a food-buying co-op to lower their costs, and now they also are fighting mad and want to organize. Average revenues per store are down some 8% from their 1994 high of $280,000.

--Judges and juries in several cases have found that the company has conned or misled landlords by using shell companies.

The U.S. House of Representatives' small-business committee studied the franchise industry for six years, and staff economist Dean Sagar concludes: 'Subway is the biggest problem in franchising and emerges as one of the key examples of every abuse you can think of.' Says Cliff Marshall, a franchise consultant for more than 30 years: 'If anyone in my family ever asked whether they should buy a Subway, I would say absolutely not, no way.'

It's hard to say exactly how many Subway owners are angry or in trouble. Certainly hundreds are prosperous, particularly if they have excellent locations and more than four stores. But owning one store usually means 'you bought yourself a middle-paying job,' says Steve Sager, a recently departed Subway agent from New Jersey. Consultant Marshall estimates that 25% of franchisees are unhappy and suffering, while about 40% are 'just getting by and making a few dollars,' and 30% to 35% are happy and doing fine--though many of the happiest owners are also agents, who can control the number of competing Subways in their vicinity. Sager estimates that half the franchisees in the Northeast are suffering. FORTUNE tried hard to find happy franchisees, but even those who were doing well complained about the company's practices. Franchise experts agree that anger and unhappiness are far more prevalent among DeLuca's franchisees than those of any other major chain.

In a series of interviews with FORTUNE, DeLuca insists his system works. 'I really feel terrific that so many people have done so well,' he says, after touring several stores in Southern California. 'But there are risks. People can lose money. It bothers me that people lose money, but I don't lose sleep over it. This is America.'

When Sagar of the House small-business committee says Subway commits 'every abuse you can think of,' the company's extraordinary franchise agreement is a logical place to look first. Florida attorney Keith Kanouse, who was asked to chair a national commission in 1995 that developed fair franchising standards, says, 'I've seen over 300 franchise agreements, and Subway's is the worst. Fred DeLuca happens to be a friend of mine, and I've told him this to his face.'

How bad is it? Some of Subway's franchise terms are illegal in certain states. The agreement requires arbitration of all disputes in Connecticut--it doesn't matter if your store is in Canada or Costa Rica--and caps awards at $80,000. (Subway has found a way to skip arbitration by signing leases with landlords and then subletting stores to franchisees; as de facto landlord, Subway can quickly evict owners in a dispute.) An Illinois court has called the eviction/ arbitration provision 'unconscionable' because it 'lacks mutuality.' In Michigan, officials discovered in 1989 that Subway was not registered to do business there. When it did register, it listed only two of nine contract clauses that are unenforceable in that state. DeLuca calls it a 'minor technicality' for which he paid an $8,000 fine. 'We considered it to be very serious,' counters Robert Ward, an assistant attorney general. 'We had a restraining order for seven weeks when they couldn't do business. Their general counsel was unwilling to reach any accommodation. I think you'll find that's their attitude with everything they do.' The U.S. Small Business Administration stopped lending to Subway owners until DeLuca removed a contract clause that gave him the power to seize and purchase any franchise without cause.

Then there's the royalty: Franchisees must pay the company 8% of gross sales, the highest royalty in the food franchise industry. They also pay a 3.5% advertising fee (recently hiked from 2.5%). By contrast, the healthiest franchisors usually keep both figures around 4% or 5%; the total is lower, and far more of the money builds business through advertising, while less goes to the franchisor. At Subway, DeLuca and Peter Buck--the friend who loaned DeLuca $1,000 three decades ago and owns the company with him fifty-fifty--now split about $160 million a year.

Most restaurant chains provide protected areas for their franchisees. Not DeLuca, whose franchise agreements state that he may compete with his owners and 'adversely affect' their sales. But DeLuca is convinced that clustering Subways together usually creates more awareness and raises everyone's revenues. As proof, he faxes over a graph created by his 24-year-old son, who has a bachelor's degree in economics. The graph purports to show that for each additional store (per million population), average store revenues in the region rise $20 to $60 per week. FORTUNE showed the analysis to economist Ralph Bradburd, a franchising expert at Williams College in Massachusetts. 'In my view this tells us absolutely nothing,' says Bradburd. 'It's missing too many variables. If this [theory] is true, then why not have 15 Subways on the same block? Wouldn't they all be doing splendidly? The answer is, obviously not.' Yet company incentives spur dramatic growth. Agents must meet new-store quotas or they can lose their territories. In most cases they must match the largest number of units held by the area's top rival, typically McDonald's.

Under pressure from franchisees, DeLuca instituted a 'site review' program two years ago. He says a three-member panel at Subway will now halt the opening of any store deemed likely to hurt the sales of a neighboring store by more than 10%. Many franchisees are skeptical about how seriously he'll take the reviews. But before the program, the company showed no interest at all in stopping the encroachment of new stores on old. 'We did nothing,' admits Subway executive Tina Perazzini. 'We put them up any f--ing place we could.'

Why have thousands of franchisees signed an agreement as onerous as Subway's? Can't they read? In many cases, maybe they can't. 'I think a lot of these people are incapable of reading these documents,' says Subway executive Alexander Dembski, who designs the two-week training sessions at headquarters for new franchisees. Dembski estimates that 30% to 50% of franchisees are immigrants. Fifteen years ago he proposed proficiency tests in math and English to screen these applicants, but his idea was rejected. DeLuca finally agreed last March, only to discover that 35% of the trainees were failing the new tests.

Even those who can read adequately are unlikely to be sophisticated in business matters. As the company stresses in its marketing, a Subway store costs much less to open than do other franchises; while a typical Taco Bell demands a $1 million investment and a $600,000 net worth (exclusive of residential property), a typical Subway purchaser must come up with just $100,000, and no minimum net worth is required. Fewer than 10% of Subway franchisees bother to read the contracts or FTC reports, according to a recent company survey. 'One-third of the students have no illusions,' Dembski says. 'The rest have huge gaps in knowledge, don't do their homework, or don't know what questions to ask. It's mindboggling.'

Dembski estimates that one-third of new franchisees are 'clueless' that they have to pay Subway any royalties at all. 'They come to class and say, 'Why didn't you tell us?' They claim the seller [of the store] never told them.' Many purchasers of existing stores have never even seen the books. Why doesn't Subway require sellers to provide more data to purchasers? 'We've thought about that a lot in my department,' says Dembski.

Another executive, sales director Don Fertman, coaches agents on getting prospective franchisees to buy. 'Get them to make a decision on the spot,' he urged agents at the company's convention last summer. 'Talk to them like they're already owners.... Trap them.... Get them to say yeses.... Work the angles!'

DeLuca's lifestyle reflects his background as a factory worker's son who spent part of his childhood in a housing project in the Bronx. For 25 years he signed virtually every company check--until 1990, when his controller convinced him his time was too valuable. A year later, when Connecticut instituted a personal income tax, DeLuca moved his home and company (at least on paper) to tax-free Florida, where he drives a seven-year-old Lincoln and owns a modest two-bedroom condo. 'Most people are amazed that I fly coach,' he says. 'Sometimes I find it astounding. I just have a hard time spending the money.'

It's hard not to like DeLuca, at least at first. His IQ is so high that he's a member of Mensa. He is handsome, gentle, and casual, and he drips honey when he wants to charm. During a recent dinner at Subway's 'franchise school' in Connecticut, female graduates were swooning over his green eyes. Back in his school days DeLuca majored in psychology, and he still enjoys applying it. All new employees and franchisees fill out a 172-question 'predictive index.' DeLuca says he keeps these personality profiles in a file cabinet, where an ombudsman can retrieve them during disputes in order to understand 'where people are coming from.'

DeLuca's own index might show a disinclination to deal with confrontation. Agents say that when they told him they wanted to meet privately at the start of Subway's annual convention last summer, DeLuca felt betrayed and insisted they do it in a separate hotel. He also disconnected the agents from Subway's voice-mail system so that they could no longer communicate as a group (he eventually reconnected them). By all accounts, DeLuca's failure to deal with conflict is what leads to so much litigation. 'Fred feels that if he gives in on one thing, everything else is gonna come in the same way,' says Ralph Slivka, who left in 1995 after six years as Subway's controller and tax manager. 'So he fights everything, and he loses a lot of them. It's a business approach.'

Case in point: John 'Mike' Weible, who received 20 sales awards from Subway after buying and improving a low-volume store in Los Angeles. Despite his success, Weible started fighting with his sales agent, who refused to let him buy a second unit. As a result, Weible withheld $25,000 in royalties and started organizing franchisees. Subway retaliated with an audit of his books, which showed that Weible had been underreporting sales and owed about $4,700. Weible demanded an independent audit by an outside accounting firm, which concluded that Subway actually owed him nearly $200. Even so, a week later the company evicted Weible, sold his store for more than $70,000, and pocketed the proceeds.

Weible sued Subway for fraud and breach of contract. Subway spent $330,000 in legal costs trying to collect the withheld royalties that Weible no longer owed (since Subway had kept the proceeds from the store sale). A panel of arbitrators ruled in Weible's favor and awarded him $220,000 in 1993, which he says barely covered his own costs. 'I don't really know the story with him,' says DeLuca about Weible. 'I don't recall any face-to-face meetings.' But in sworn testimony obtained by FORTUNE, DeLuca described 'many meetings' with Weible stretching over five hours at a Hawaii convention where they tried to settle.

DeLuca says the annual failure rate for the chain is just 2%, but that doesn't include the failure of an owner if another franchisee buys his store. A more telling figure is the so-called transfer rate, which includes resales, abandonments, and terminations. That rate runs roughly 10%, says DeLuca, although a Chicago agent says that his turnover rate is closer to 20%. Subway's FTC reports indicate that the store-abandonment rate has tripled since 1993. For troubled franchisees, bailing out is a tough decision because their life savings may be tied up in the business. 'Truthfully, I don't know how some of these people continue to do it without saying, 'Okay, I've had enough,' ' says ex-agent Sager. 'It becomes like the battered-wife syndrome, where tomorrow will be a better day. And people refuse to leave and accept the failure.'

Franchisees may also fear trying to change the system. Consider Carolyn and Jim Greco, who put in 70-hour weeks operating two Subways in Rhode Island. After about ten years in the business they're taking home some $45,000 a year. 'With my store doing $5,000 per week [gross sales in 1997], I'm an average Subway owner,' says Carolyn. 'My development agent said that if everyone ran their store the way I do, this area would be growing a lot faster. But I'm working seven days a week as a sandwich maker to make ends meet. There are all these costs they never tell you about when you start the business.'

Greco says sales dropped five years ago after Subway opened another outlet nearby--a common complaint from franchisees. At the time, the Grecos joined five other frustrated franchisees on a pilgrimage to Subway headquarters. 'We demanded to see Fred DeLuca,' recalls Carolyn, who claims he refused to receive the group. 'That was a bad thing to do. All the franchisees that were involved in that [trip] had a very hard time with their development agents after that. I'm still afraid to talk to you.' DeLuca says he doesn't recall the situation.

For years DeLuca allowed the company's food vendors to overcharge franchisees and then return money to them for local advertising. Franchisees, fearing a ripoff, formed a purchasing co-op last year that is already saving some $55 million annually. 'DeLuca wanted to kill us,' says Illinois franchisee Jim Troiani, who helped launch the co-op. Now Troiani talks about revolution. 'The only way we'll get Fred to the table talking sense is to just stop the royalty payments and put them in escrow,' he says. Troiani estimates that owners of perhaps 700 stores are willing to participate, though that could take some doing, since Subway draws the royalties directly from their bank accounts.

Subway's franchisees began organizing eight years ago, but DeLuca stopped the move by forming a toothless advisory board. Now the board is talking about breaking away and going independent. DeLuca didn't schedule any sessions over Subway's last five-day convention to field questions from his franchisees. 'He should let us hammer him and express how we feel,' said California's Jeff Drucker, who had a proud owner of four stores sign dangling from his neck. 'He should sell out or hire new management. He doesn't see beyond his royalties.'

DeLuca has unusually contentious relations with landlords as well. In 1995 an Illinois jury awarded landlord Nicholas Jannotta $10 million in punitive damages after concluding that Subway had defrauded him. Jannotta's mother had signed a lease with a dummy shell company that she and her son had been led to believe was the corporate parent. After a franchisee failed and moved out, Nicholas spent a fruitless year trying to collect the rent from Subway, where an executive dared him to 'sue us.' But after Jannotta threatened to seek punitive damages, DeLuca spent $1.3 million to resolve 72 similar claims from landlords. Subway has used more than a dozen shell companies in much the same way.

In the courtroom a former agent testified that he attended role-playing sessions at headquarters where agents were taught to tell landlords that the leasing firms were not shells. On the stand, DeLuca was asked if he had any responsibility to tell landlords what kind of dummy companies they were signing leases with. 'No,' he said flatly. 'It's not a requirement under the law.'

The Jannotta case also shed light on DeLuca's encroachment practices. The lease had a clause, unusual for the company, that prevented any Subways from being placed within approximately two miles of the store. Subway went ahead and put six stores in the zone anyway, helping to cause two different franchisees to fail at the Jannotta location. Under oath, the company's top lawyer, Leonard Axelrod--architect of Subway's contracts, nicknamed Lenny the Ax, who keeps a collection of shark figurines on his desk--said he saw no problem since the Jannotta lease was signed by a different entity from the ones that handled the new stores.

Thanks in part to Axelrod's testimony, an Illinois appeals court concluded last September that there was 'overwhelming' proof that Subway had committed 'far-reaching fraud' in the Jannotta case and that DeLuca 'had a policy of using shell leasing companies' to avoid rental obligations. But because of a technicality involving jury instructions, the court ordered a new trial on the punitive damages. Separately, one of the judges stated that 'the real losers here are the subtenants who opened a Subway business only to be subjected to inevitable failure because of the unwarranted competition--not from other fast-food chains, but from their own.' Two days after the court's decision, DeLuca wired the following E-mail to FORTUNE: 'We got good news on the Jannotta case. Our appeal was successful and the decision was reversed.' Not exactly: The decision stands, but he doesn't have to dig deeply into his pockets yet.

A California judge concluded in 1990 that Axelrod had misled a local landlord and given statements that contradicted Subway's own documents involving a shell entity. Axelrod's testimony was 'absolutely unbelievable,' exclaimed Judge Harkjoon Paik from the bench. 'I just don't understand how an attorney could say things like that.... Everybody was in this kind of vast conspiracy...so long as the corporate entity made the money.' Axelrod says the judge was a 'local yokel' who was 'confused.'

A New York landlord, Frank DeLeonardis, has had a judgment pending against a Subway dummy company since 1993. 'You're not going to find Burger King and McDonald's doing business like this,' gripes DeLeonardis, who is owed about $350,000. For years Subway wouldn't even show up to defend these lawsuits in out-of-state courts, instead defaulting and then waiting for landlords to sue in Connecticut. 'I'm not going to say that ultimately we're very proud of it,' Axelrod once testified about this practice. Slivka, the former Subway controller, says that landlords like DeLeonardis are 'stupid' and don't deserve the money. 'Why should they [Subway] pay?' he wonders. 'Are you talking about a moral or legal standpoint? Lenny the Ax once said to me, 'If you're looking for morality, leave it outside the door.' ' Axelrod responds, 'I never said that to him.'

At a meeting with agents and department heads in Florida last April, DeLuca announced he was tired of all the fighting and litigation and wanted 'everything resolved.' But store revenues are starting to creep back up, so he may lose the incentive to try. Franchisees and agents have a big list of demands: more professional management at headquarters, lower royalties, better contracts, more communication, more ad money, more control over menu additions. 'I think he could be more compassionate towards people,' says longtime agent Earl McDaniel, whose territory comprises 319 stores in the Midwest. 'He has a group of development agents who would do 'most anything for him, including me. I only hope he appreciates that kind of loyalty.'

Looking ahead--and beyond Subway--DeLuca says he wants to launch a micro-lending movement. He hopes to recruit 'missionaries' to open 1,000 chapters across the U.S. that will make tiny loans to 'disadvantaged' people so that they can launch businesses, just as he did with Peter Buck's $1,000. 'In a sense, it's charity,' he says. 'The best thing that will happen is you'll get your money back and you'll feel good.'

DeLuca is also putting his accomplishments on tape. He's starring in educational videos that will be distributed to 500 colleges this summer. 'Once students hear Fred's story, they really get excited,' says Jennifer Kushell, whose Young Entrepreneurs Network is coordinating the project. 'He was reluctant at first. He really had never looked at himself as a role model. I don't think he realizes what effect he can have on a lot of lives.'

[BOX]

THE LEADER IN LAWSUITS

The FTC requires franchisors to provide prospective franchisees with data about relevant litigation. Here are the numbers of pending and concluded cases* for the eight largest fast-food chains over the past decade.

*Includes arbitrations.

Pizza Hut 4 Taco Bell 5 Wendy's 10 Hardee's 25 McDonald's 26 KFC 28 Burger King 29 Subway 160

From the Mar. 16, 1998 Issue