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Franchisees Fire Legal Attack on Quiznos for Ongoing Fraudulent Scheme

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Escalator to “Schaden Ownership Group” Headquarters, Downtown Denver

DENVER – After years of legal battling between Quiznos and its franchisees, most surrendering under flags of settlement, the crippled sub sandwich chain is once again being bombarded with store owner lawsuits.

 The litigation attacks Quiznos for its continuing “fraudulent scheme” in “stealing hundreds of millions of dollars on kickbacks and royalties leaving them in financial ruin.

In representing the franchisees, Jeffrey Cohen, now with Ballard Spahr in Denver near Quiznos headquarters, appears to be going after the economic motive in his approach, according to one insider. In view of the New York litigator’s background in restructuring, bankruptcy and capital recovery, Cohen tracks how the money from royalties and hidden charges was obtained and where it went. The 90-page complaints also reveal that there is common control of all Quiznos entities in the system, which share common officers and directors.

Cohen seems to be taking a different direction than the previous litigation. He has filed the lawsuits in Denver district court, asserting violations of the Colorado Organized Crime Control Act. Those alleged breaches are related to selling franchises and mandating franchisees to buy specific products from Quiznos entities at unreasonable prices, and to the franchisor’s unlawful control over store owners through racketeering activity.

In addition to past litigation claims of fraud, misrepresentation, conspiracy, and others, the new lawsuits asserts violations of the Colorado Consumer Protection Act, promissory fraud, violations of Colorado Civil Theft Act, and transfer of property in violation of Colorado Uniform Fraudulent Transfer Act.

Former owners Richard “Rick” Schaden and father Dick Schaden are named individually as part of the “Schaden Ownership Group,” as are former Quiznos president Steven B Shaffer and legal counsel Patrick E Meyers.  Also included is Rick Schaden Cervantes holding companies.

Franchisees have also accused Avenue Capital Group, the private equity firm that bought Quiznos in late 2011, in a debt-for-equity transition to save the chain from bankruptcy. 

After the lawsuits were filed on January 31, 2013, defendant Meyers attempted, on behave of defendants, to get the lawsuits transferred to federal district court. They said the complaints did not explicitly assert a federal cause of action, and their state-law claims raise substantial federal action. The judges rejected that notion and remanded the lawsuits to state court. 

In addition Chang Cohen, Perkins Coie and Snell & Wilmer representing other defendants, Meyers has now retained for himself Bruce Scott Bennett of Jones Day in Los Angeles, renowned for his expertise in business bankruptcies, restructuring and reorganization.  Attorneys from Hogan Lovells, former Hogan & Hartson, are representing Avenue Capital, and Quiznos lead supplier of products American Food Distributors, and numerous other entities.

The heart of the litigation

At least ten franchisees have now filed lawsuits in Denver district court against the franchisor, claiming 28 counts related to the “fraudulent scheme.”  Franchisee counsel explains the litigation in his complaints this way,

“Quiznos, not content to generate its profits from royalties, devised a way to steal hundreds of millions of dollars from its store owners each year by creating pass-through companies, such as American Food Distributors.” That plan allowed Quiznos to add significant hidden mark-ups to the food, paper, and other supplies that franchise owners were contractually obligated to buy from Quiznos, marketed as the ‘Mandated Essential Goods’.”

They consist of store owners who not only opted out of the 2010 Class Action Settlement Agreement, but also those who accepted the proposal and released the company from further litigation.

That settlement, although valued at $206 million, only required the franchisor pay out $6 million to thousands of franchisees, and another $10.8 million to their attorneys and expert witnesses. In March 2011, Quiznos’ insurance carrier reimbursed Quiznos owners $9,800,000 to cover the settlement and defense costs.

One expert following the litigation, observed that the latest complaints are revolutionary in that they now have the benefit of all litigation prior to 2013. He said they are well-armed with years of pleadings and all the discovery attached. 

Schaden group’s five-step program to defraud

As a preface to the complaints, attorney Cohen states,

“First, and most important, in the early 2000’s Quiznos began to develop what Denver District Court Judge Robert L. McGahey, Jr would later call the “cash generating engine of AFD [American Food Distributors].”

That engine was the first of five components used in Quiznos’ “fraudulent scheme.” As a second step, through American Food Distributors (AFD), Quiznos was able to keep its mark-ups to food, paper and other supplies hidden from franchisees.  By conspiring with the “pass-through” entities that provided the goods to store owners, they omitted the AFD mark-ups from the franchisees’ invoices. In doing so, the distributors “acted as a fence and front man” that kept AFD’s scheme hidden.

By mid-2000s, American Food Distributors was making more than $100 million in profit each year while the majority of franchisees were losing money or barely breaking even. The lawsuits reveal that a Quiznos’ former vice president stated,“with the creation of AFD, Quiznos underwent a ‘regime change’ by morphing from a legitimate franchise operation focused on making profits through royalties to a food distribution operation focused solely on increasing the number of franchisees to whom it could sell overpriced food, equipment, services and supplies.”

Quiznos aggressively signed up new owners despite knowing most existing franchisees were unprofitable and that such expansion would encroach upon existing stores, and harm the franchisee’s bottom line. Under the supervision of Steven B Shaffer, Quiznos grew from approximately 1,000 franchisees in 2000 to more than 5,000 by 2006.

The third component to the alleged scheme states, while the system was rapidly growing, Quiznos artificially increased the amount of the “mandated essential goods,” the products owners were required to buy from AFD by increasing couponing and other discount programs.  As franchisees were contractually required to honor the discounts, AFD’s profits increased, while franchisees’ declined.         

Once store owners were ensnared, Quiznos began its fourth component. It continued its practice of intentionally lying to and misleading the franchisees on the cost of supplies and products, and the kickbacks it was receiving. When owners approached the company about overcharging, the company presented a white paper, which denied the claims. Instead of taking action to reduce prices, the franchisor sent out memos to franchisees proclaiming Quiznos was “working together with franchise owners to grow profitably by leveraging our restaurants’ collective purchasing power.”

Lastly, in the mid-2000s, as profits from the hidden mark-ups reached more than $100 million each year, the Schaden ownership group set in motion a plan to fraudulently transfer hundreds-of-millions of dollars to themselves, leaving Quiznos insolvent and the franchisees on the path to certain failure.

The complaints asserts the Schaden Ownership Group authorized a number of capital transactions in 2005 and 2006, including a leveraged buyout and dividend recapitalization, which ultimately left Quiznos more than $870 million in debt. Shortly thereafter, they transferred nearly all the proceeds of the $870 million debt to themselves as “member distributions” without providing Quiznos any consideration in return.

Those transfers were a part of the scheme to defraud franchisees. The Schaden group knew they would leave Quiznos insolvent and unable to service or repay the $870 million debt without charging franchisees the hidden mark-ups in perpetuity.

The Schaden group also made those transfers to prevent the franchisees from recovering on any judgment rendered against Quiznos as the result of lawsuits similar to this new legal action.

Summarizing the scheme

Attorney Cohen summarizes the fraudulent scheme like this: 

It should come as no surprise that after more than a decade of running its parasitic scheme, Quiznos has sucked most of its franchisees dry and its remaining franchisees are nearly tapped out. In fact, Quiznos’ scheme played out just as would be expected. From 2000 to 2006, Quiznos grew exponentially from nearly 1,000 franchisees to more than 5,000 franchisees. However, in the six years since the Schaden Ownership Group burdened the company with the $870 million debt and absconded with the proceeds, the Quiznos system has rapidly dwindled to approximately 1,500 franchisees at present. The number of franchisees continues to fall due to the ongoing fraudulent practices alleged in this Complaint.

Response from parties

Quiznos released a statement last week saying the lawsuits were completely without merit. “Quiznos management team will not allow these lawsuits to distract us from our mission." That mission being to deliver a premium product and experience to their guests, and “helping franchise owners grow their sales and profits.”

Jeffrey Cohen declined to make comment on the litigation filed last month. Quiznos outside counsels Leonard MacPhee of Perkins Coie and Fredric “Ric” Cohen of Cheng Cohen did not respond to phone calls.


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