FRANCHISE FUROR

Pittsburgh Post-Gazette (PA)

Author: DEBORAH MENDENHALL, POST-GAZETTE STAFF WRITER

As franchise owner Kenneth Korb received an award from General Nutrition Cos. for a job well done in October of last year, an internal company memo was circulating that said he had to go.

Beginning that month, GNC's routine inspections of Korb's two Cleveland franchise stores took an adversarial turn. His stores were cited for dust on the floors, delinquent invoices and insufficient inventory.

Although some of the violations were later determined to be untrue, the bottom line is, four months later, Kenneth and Rozann Korb, counted among GNC's most successful and oldest franchisees, were out.

"If GNC can do this to me, they can do it to anybody," Korb said. "It ought to send a chill down any franchisee's spine."

From a business standpoint, it's hard to argue with GNC's success. The company rose from an independent start-up founded by David Shakarian in 1935 to a health product powerhouse that was acquired last year by the Dutch nutrition manufacturer, Royal Numico, for $2.5 billion.

Its shareholders have benefited tremendously. Locally, it ranks as one of the region's bigger companies, with 954 employees and a Downtown headquarters in a renovated century-old building on Sixth Avenue.

Along the way, however, GNC also has earned a reputation as a company whose hard-charging executives are used to doing things their way. In 1994, the Federal Trade Commission levied a fine of $2.4 million against GNC -- the largest penalty to that date -- for deceptive claims on more than 40 products. From 1995 through 1998, GNC was hit with six lawsuits that accused several senior executives of sexual harassment and discrimination. Most have been settled; one remains active.

More recently, management has become entangled in litigation with franchisees who contend they are being crushed by the very company they helped build.

It's not unusual for franchisees to feel abused by their parent company. Studies have found that, far from being on a road to riches, franchisees often struggle to make money and are subject to the whims of their chain's owners. Some of the nation's most successful chains, including McDonald's, Burger King and Pizza Hut, operate under a barrage of litigation.

"In most instances, franchising is neither safe nor secure nor is it business ownership," said franchise expert Robert Purvin, who wrote the book. "The Franchise Fraud." "The franchisee is actually an indentured servant."

GNC is among the worst offenders, Purvin said, and some of GNC's own franchisees -- the people who helped make the company a giant in the vitamin and nutritional supplement industry -- agree. In 28 lawsuits -- the majority filed within the last two years -- franchisees from Florida to California have sued, claiming:

* Franchisees can't make a profit because of "predatory pricing." That involves GNC's marking up wholesale prices to its franchisees. GNC then sells the same products to the public at lower prices. In effect, franchisees must sell at uncompetitive prices.

* "Encroachment." Franchise stores are being surrounded by other GNC stores that lure away customers.

* Some GNC sales promotions violate federal laws.

* GNC has terminated franchises and then seized stores on technicalities so that they could be resold or replaced with company stores.

At the heart of the disputes is the belief that GNC promotes franchising as a safe way to business ownership with itself as a partner. The lawsuits contend that shortly after contracts are signed and large fees collected, GNC uses franchisees as another market to be exploited; and that GNC siphons as much money as possible before closing them down and replacing them with company stores or reselling the franchise and starting the process all over again.

"GNC is a system at war with itself, and the reason is greed," said Jeffrey Goldstein, a Washington, D.C., attorney who filed suit on behalf of GNC franchisee Igor Rafalovich.

GNC officials declined requests for interviews for this story.

But in a prepared statement, the company defended its relationship with its franchisees, saying its subsidiary, GNC Franchising, "works to facilitate an open and constructive relationship with all of our franchisees, and we believe we have a better record in franchisee relations than any other franchise of our size and international scope."

GNC also said 51 percent of those who signed agreements to open additional stores over the past year were existing franchisees, and that fewer than 1 percent of franchisees are involved in litigation against the company.

However, three lawsuits are currently seeking class-action status that could affect more than 1,000 franchisees.

In addition, franchise experts say lawsuits tell only part of the story.

Last year, 189 GNC franchises, or 12 percent of the 1,584 stores, left GNC. An additional 84 left in the first six months of this year.

"That is a high percentage," said Ann Dugan, franchise expert and director of the small business development center for the Katz Graduate School of Business at the University of Pittsburgh. She speculated that "predatory pricing" by the company against its franchisees is a major reason for the comparatively high exodus.

Franchise fallacies

Purvin, a franchise attorney who has represented both sides, has watched GNC and its franchisees battle for years. He said most of the company's tactics are not new. Other companies have treated their franchisees similarly in the past and will do the same in the future if the system is not changed, he said.

In his book, Purvin describes an industry rife with abuse, with contracts and laws designed to protect the company, not the franchisee.

He wrote the book, he said, to educate would-be entrepreneurs before they invest life savings in franchises. Too many, Purvin said, reach for the American dream only to end up losing their businesses, homes and life savings and destroying their credit ratings.

The myth that franchising is safe began with a set of faulty statistics that said 95 percent of all franchises remain in business after five years, while 55 percent of all independent start-ups fail, Purvin said.

The first figure came from a 1986 U.S. Department of Commerce pamphlet that relied on a small voluntary survey of franchisers and accepted the industry definition for success as any store still open after five years, he said. A store was considered a success even if the original owner went bankrupt and was replaced by other franchisees or a company store. If a franchise changed hands five times, it was considered five successes, and no failures.

The second misunderstood figure -- 55 percent -- was misquoted from a U.S. House committee hearing on small businesses. The testimony actually said 55 percent of businesses that fail do so within the first five years, Purvin said.

The industry considers both of those statistics to be deceptive and misleading, Pitt's Dugan said.

Yet GNC has been using those old figures on its Web site, where it also assures potential investors it is "committed to providing the assistance you need to tap into your share of this growing market."

"If GNC continues to quote those figures, that makes me think they have a hidden agenda," Dugan said. "Even the International Franchise Association, the franchisors' own trade group, said that is a false study and should not be quoted."

Most people who hear those figures think the government has studied franchising and pronounced it to be safe, which is not true, Purvin said.

The reality, he contends, is that many companies often use franchising as a relatively inexpensive way to build stores and markets as opposed to building them on their own.

Once the market is built and the stores are doing well, companies may turn on their franchisees, citing very technical violations of the contractual agreements between the parent and the franchised operation.

"A company can trump up a charge through performance reviews, terminate the franchise agreement, invoke the noncompete clause, assume the lease and put a franchisee out of business," Purvin said.

The biggest "crime," in his view, is that "most of what companies do is totally legal. That's why they usually prevail in court."

But others allege that GNC's tactics are illegal and are looking to the courts for relief, particularly in light of what it costs to become a franchisee -- roughly $130,000 to $208,000 per store.

Some lawsuits allege that GNC made many misrepresentations and omissions in its Franchise Offering Circular, a disclosure document required by the Federal Trade Commission. In the document, companies must reveal material risks to investors before they sign contracts, said Goldstein, the attorney for GNC franchisee Rafalovich.

GNC's circular shows a profit margin of 55 percent at GNC stores, but fails to disclose a marketing plan of company-store and online discounts that would make that figure impossible for a franchised store to achieve, according to Rafalovich's lawsuit.

The lawsuit alleges that Rafalovich was deceived by GNC and would not have invested $200,000 in a Baltimore franchise if he had known the truth.

Feeling misled

Rafalovich's contract promised a two-mile protected territory against other GNC stores and mail order sales, and he was told that all GNC stores were the same from appearances to prices, the lawsuit said.

However, Rafalovich's store was soon surrounded by 17 GNC company stores and outlets inside Rite Aid drug stores -- some inside his so-called protected territory. GNC online and company store sales also pulled Rafalovich's customers away by offering double discounts, the lawsuit said.

The lawsuit also alleges that while the circular promises franchisees "reasonable" wholesale prices, GNC routinely sells products to the public at lower prices than Rafalovich paid wholesale.

One example cited is GNC's popular diet product Xenadrine, which costs franchisees $18.58 a bottle, wholesale. GNC sells the same product to the public for $12.31 at company-owned stores.

Rafalovich's profits were depleted further when GNC regularly shipped products and displays that he hadn't ordered, charged him for them, then refused to take them back, the lawsuit said. In addition, GNC "consistently failed to apply credits toward invoices."

Because Rafalovich also paid more than 12 percent of gross sales for royalties and advertising, a common practice in the franchising industry, GNC was able to make money on sales at his stores even though he wasn't profiting.

Goldstein said GNC's marketing plan is win-win for the company and lose-lose for franchisees. That's because when a franchisee is able to hold his own against company-owned stores and online sales, GNC wins by increased revenue. And when a franchisee loses so much money he can't remain in business, GNC wins by reselling the franchise or taking over the entire market with its own stores.

"GNC sets up a situation in which the franchisee can't compete, but doesn't tell them," Goldstein said. "Who would invest $200,000 in a franchise knowing all this?"

In a legal response to Rafalovich's lawsuit, GNC said "the agreement is in writing and speaks for itself," and that allegations "inconsistent with the language of the agreement ... are denied."

GNC has filed a countersuit against Rafalovich, asking for royalties, back payments and attorney fees.

In response to inquiries, GNC also said its franchising subsidiary "strives to provide all franchisees with an opportunity to make a good profit on their investment while maximizing their gross profit margin."

GNC said the average store that participated in its financial accounting service "demonstrated more than $64,000 in earnings capability" between Feb. 1999 and Dec. 1999.

Other lawsuits filed by franchisees against GNC raise additional issues.

Richard Kolenda, a former Jacksonville, Fla., franchisee, alleges that GNC has perpetual sales that violate federal law.

Kolenda, a retired Air Force major who conducted corporate fraud investigations for the Pentagon, said he invested his life savings in a Jacksonville franchise in April, 1994.

He grew suspicious of GNC's unending promotions that offered one product at half price when customers bought one at full price, and contacted the Federal Trade Commission. He said he was told that perpetual promotions were against the law.

"I refused to participate in anything illegal, and I let GNC know it," Kolenda said, adding that he reported the practices to the FTC.

Kolenda said GNC told him that refusing to participate in the offer put him in violation of GNC guidelines and threatened to terminate his franchise.

"In these inspections, I kept getting written up that I wasn't following their guidelines," he said. "I kept pointing out to them that to do that, I would be breaking the law."

Kolenda filed a lawsuit in 1997, and is seeking class-action status.

"Right after I filed suit, GNC built stores to the north, to the east and to the southwest of me," he said. "To the west, there was a swamp."

One was between Kolenda's store and nearby Mayport Naval Station, where he had drawn most of his customers. His store began to fail GNC's routine inspections for things that had been acceptable in the past, Kolenda said.

"As far as I'm concerned, that was a way for them to take my business, and that is what they did."

In December, 1999, GNC took Kolenda's store, and reimbursed him at a discounted rate for his inventory and fixtures, subtracting $9,000 in attorney fees.

"I had to resign my commission in the Air Force to go into GNC's franchise system," he said. "I don't know what I will do now."

An FTC spokesman declined to comment on whether a complaint had been filed against GNC. However, he confirmed that perpetual promotions are in violation of FTC laws.

Often, franchisees run out of money and don't make it as far as a courtroom, Purvin said. The company may cut off product shipments, leaving franchisees with no way to make a living or finance a lawsuit.

It doesn't help that most contracts call for disputes to be settled in the company's home state, Purvin said. This requires a franchisee to pay a second attorney and travel expenses. Mediation is usually stipulated in the contract, which further eats up a franchisee's legal defense fund.

"Sometimes a franchisee will prevail if they can get into court, but the system is designed to keep them out," he said. "Most run out of money and fold."

That's what happened to the Korbs.

The Korbs

The couple were among GNC's first franchisees and in the group GNC called "the pioneers," Korb said.

The couple bought five franchises, built a strong customer base and eventually sold three successful stores back to GNC. Their remaining stores were in upscale regional malls anchored by Saks Fifth Avenue, Nordstrom and Kaufmann department stores.

In prime locations, the GNC stores were profitable. In early 1999, Korb discussed selling the stores back to GNC and buying franchises in a state where the market wasn't as saturated.

But a price could not be agreed upon. Negotiations ceased in June 1999, when GNC announced it would not be buying any more franchise stores. The Korbs couldn't sell to a private buyer because, since 1994, GNC had reserved large malls for company stores.

In August 1999, GNC conducted routine inspections at Korb's stores. Inspections were usually conducted twice a year and used to identify areas for improvement.

The inspector noted dust on the floors, insufficient product on the shelf and past-due invoices. Both stores received low scores.

As he had done in the past, Korb tried to correct the problems. He received a $30,000 bank loan and ordered more inventory. He checked his accounts and found nothing was owed to GNC. And he continued a policy to dust the store daily -- dust was a chronic problem because the store was directly beneath an anchor store's heating and cooling system.

In October 1999, Korb received an award for his efforts in local cooperative advertising from Mike Brower, GNC district director of franchise operations. It was one of more than a half-dozen awards he had received from GNC in 10 years.

What Korb didn't know was that Brower was also circulating an internal GNC memo that identified the Korbs as "operators that do not belong in our franchise system," according to evidence discovered through Korb's lawsuit.

Days later, GNC sent the couple a default letter saying an August inspection had shown they were in breach of the franchise agreement. On Dec. 2, GNC conducted another inspection. Improvements were noted in all areas except for inventory, which received a low score.

Inventory was low because of brisk holiday sales and because an order had not arrived from GNC, Korb said.

GNC sent another default letter in December, giving the Korbs 30 days to correct problems.

In the past, problems had been corrected with a telephone call to William Watts, GNC's chief executive officer, Korb said. (Watts has announced he is stepping down next year and will be replaced by Greg Horn, a nine-year GNC veteran and son of former Chairman Jerry Horn.)

But when Korb called Watts this time, he said, no one would accept his calls.

Rozann Korb responded in January with a five-page letter that answered charges point by point and added that inventory was low because GNC had not shipped one order and had no record of a second one she had placed.

GNC answered Feb. 4 with another inspection.

The inspector noted improvements in all areas, except for inventory. An order from GNC had arrived, but had not yet been placed on the shelf. The inspector refused to count it and gave the store a zero for inventory.

On Feb. 22, the Korbs received a letter notifying them that the franchise agreements and the subleases for both stores had been terminated because they failed to display merchandise according to guidelines, had insufficient merchandise and had failed to pay $77,574 in invoices and fees.

The Korbs filed a lawsuit asking for restraining order to prevent GNC from taking the stores.

During discovery, GNC's documents revealed that the Korbs had paid all invoices except for $1,000, which GNC had failed to post as a credit. Bower's internal memo also surfaced, as well as a GNC record that showed the Korbs' stores were among the high-selling stores in northeast Ohio.

"GNC's attorneys admitted our sales and profit margins were good," Korb said. "We scratched our heads and said, `Then why are you terminating us?' They said, `Because you did not adhere to the guidelines.' They took my stores based on low inventory, which was low because they didn't ship our orders."

In the end, the Korbs ran out of money. GNC considered them in violation of the franchise agreement and stopped selling them products. Unable to make a living, they couldn't finance a legal battle and negotiated a settlement.

GNC gave the Korbs 60 days to sell their stores and agreed to accept an outside buyer, and the Korbs agreed to pay GNC's lawyers. In all, legal fees cost the Korbs about $200,000. The couple sold their franchises at a loss.

"This just seemed like a no-win situation," Korb said. "I felt that no matter what I would have done, they would have pressed and pressed and pressed. Maybe to a jury our story would have meant a little more."

It probably would have, agreed Purvin and attorneys who fought GNC on behalf of franchisees and won.

Of the 28 lawsuits, 14 remain active, including three which are seeking class-action status. Nationwide, 1,000 franchisees own 1,720 stores. Other lawsuits have been settled or dropped.

Franchisees have been encouraged by two lawsuits that have recently gone the distance and ended in large awards.

In March, Allegheny County Common Pleas Judge Joseph M. James awarded $507,680 in damages to Boston franchisee Ana Oganesov in a lawsuit that charged GNC with violation of protected territory, unfair competition through company stores, and unfair and deceptive trade practices.

In August, GNC paid $400,000 to franchisee Manjit Sarna, who filed a lawsuit in San Diego, claiming breach of contract, misrepresentation and violation of protected territory. GNC offered to settle as a trial date loomed weeks away, said Sarna's attorney Jon Miller.

GNC maintains it does all it can to resolve disputes.

"By the time an issue gets to the litigation stage, GNC Franchising has explored and exhausted all possible avenues to resolve the issue at a business-to-business level," the company said. "It causes the company great concern when a solution cannot be found at this level and a franchisee decides to enter the legal arena."

Caption:

PHOTO: Linda Spillers/Associated Press: Igor Rafalovich, left, a GNC owner, is suing GNC for damages his franchises incurred. Attorneys Jeffrey Goldstein and James Loots sit at right in Goldstein's office in Washington.