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Papa Murphy 's Franchisee Litigation Flares Up; Investigation Begins on IPO

Take 'N Bake
photo/bmm

VANCOUVER, Wash. – A second group of franchisees filed a lawsuit last week against Papa Murphy’s Pizza. They claim the franchisor induced them into purchasing their franchises with fraudulent disclosure documents and misleading financial information.

The first lawsuit was filed in early April, approximately a month prior to Papa Murphy’s IPO (Initial Public Offering), trading under NASDAQ as FRSH. Because of concerns over the chain's low sales volumes of its outlets, its reliance on small mom-and-pop operators and its substantial debt load, investors became leery of the $11 a share offer, news reports state this week. As the market closed Thursday, its stock traded at $9.30 a share.

Prior to publishing, Blue MauMau learned that Papa Murphy’s Holdings Inc. is being investigated over its disclosures to investors. Zamansky LLC, a leading stock law firm that specializes in securities, shareholder fraud and class actions is conducting the investigation.

Core of the litigation

Both franchisee lawsuits were filed in Washington State Court by the Bundy Law Firm in Kirkland, Washington. The core claims are identical in both complaints, and the litigation represents about 96 plaintiff franchisees, operating a total of 85 stores.

For the most part, store owners assert they were unfamiliar with Papa Murphy’s at the time they purchased their franchises and they relied on the company’s claims that it operated a strong franchise system, one that would support its franchisees. Instead, they discovered Papa Murphy’s had presented them with franchise disclosure documents (FDDs) that misrepresented the health of the system and gave them financial information that was misleading. The franchisor also required them to waive their legal rights in violation of state laws. And it routinely overcharged them for local marketing that it mandated of them.

Because Papa Murphy’s encouraged prospective buyers to finance their investment in the franchise with their 401(k)s and other retirement and savings accounts, causing them to incur debt, franchise owners maintain they were not profitable. The latest amended complaint filed June 18 states that as a result of Papa Murphy’s fraudulent conduct, the franchisees have suffered “devastating financial losses and their dreams of owning their own business have become a nightmare.”

The latest lawsuit representing store owners in Alabama, Florida, South Carolina, North Carolina, Tennessee and Texas contends that Papa Murphy’s did not disclose accurate information regarding store sales. Franchisees say they now know that there are major difference in store volumes in their own regions which the Franchise Disclosure Documents do not reveal. Some some stores in Texas, Arkansas and Louisiana are averaging a third of the volumes of those in Washington, Oregon and Idaho.

Papa Murphy’s responds to allegations

Last week, a Papa Murphy’s spokesperson denied the franchisees’ claims, insisting that the lawsuits were “frivolous” and have no basis in law. Papa Murphy’s hopes the court will grant its initial motion to dismiss the lawsuit. In a prepared statement, a company official said "for over 30 years we have been a strong, reputable franchisor with a history of good franchise relations and very little franchise litigation. Assisting Franchise Owners to grow sales and increase profitability is an ongoing priority for us."

Chief Executive Officer Ken Calwell Wednesday refuted the lawsuit allegations in an hour-long interview with Forbes. Referring to the litigating store owners as “disgruntled franchisees,” he said they are simply more inexperienced and operating in newer developing markets, where take-and-bake pizza is less known. He insisted that Papa Murphy’s is seeing new markets outside its core Pacific Northwest territory grow, and the regions are experiencing stronger results.

While CEO Calwell insists that the allegations against his company are frivolous and have no merit, this type of lawsuit against franchisors, in which it is claimed that corporate executives use fraudulent data to induce buyers to invest in a franchise, have become quite common. A number of these lawsuits win or are settled by the franchisor out of court for sizable amounts. Critics of abusive franchising practices say that bogus numbers in franchise disclosure documents and misleading financial performance representations are tempting for franchisors to publish because they can be powerful in attracting sizable investments from prospective franchisees. The problem is that although the Federal Trade Commission permits franchise unit earnings claims in Item 19 of the disclosure document that is handed out to buyers, it has not issued guidelines. And even if there were standards, no one audits the accuracy of the financial figures. That has allowed unscrupulous franchisors to manipulate unit financial data by cherry picking or even fabricating numbers, to make the franchise offering look substantially better than reality.

Mr. Calwell shared several stats to rebuke the lawsuit allegations. He gave one stating that the breakeven on a typical Papa Murphy’s store is estimated to be around $5,300 in average weekly sales, due to the low-cost, no-oven format of the stores.

Franchisee lead counsel Howard Bundy retorted: “It will be interesting to learn which Papa Murphy stores have in the last 10 years broken even at $5,300.” 

John Gordon, restaurant analyst at Pacific Management Consulting Group, who is familiar with Papa Murphy's trends, thinks that $5,300 in weekly sales was way too low for a Papa Murphy’s franchise to survive. "Franchisees need to pay for debt service, both principal and interest, and for future years renovation and other capital expenditures. The term breakeven used here is misleading. Papa Murphy's also seems to be excluding store manager salary in the calculations, as per its SEC documents."

The following phrase is from Papa Murphy’s S-1 SEC document:

As of December 30, 2013, a majority of our franchise owners owned one store, and approximately 75% owned one or two stores. We believe many of these owners operate and manage their stores themselves. For fiscal year 2012, our domestic franchise stores that had been open for at least one full year generated average weekly sales ("AWS") of approximately $11,100 and generated a store-level EBITDA margin in excess of 15% after royalties and advertising but before the impact of manager/owner salary. Additionally, our stores have a low breakeven AWS, which we estimate to be less than half the system average. Our operating model requires a low initial capital expenditure on average of approximately $200,000 per store. In the first full fiscal year after a store has been open, we believe that our franchise owners can earn, on average, a cash-on-cash return of approximately 20% after royalties and advertising but before the impact of manager/owner salary. We believe the combination of our efficient operating model, low initial cash investment and attractive store economics has resulted in our ability to generate consistent new store growth from both new and existing franchise owners, as evidenced by over 570 net new store openings since 2004.

Law Firm attorney Caroline Fichter commented last week to Restaurant Finance Monitor saying, “Not all of our clients are new operators. It’s not a case of a single operator in a single state. There are 85 stores. Some of them go back almost a decade.” Fichter cited the Texas market, which she said is not a new market and yet is doing “very poorly in terms of average weekly sales.”

Executives allegedly knew fraudulent docs were used to sell franchises

Not only is Papa Murphy’s and its various entities named in the litigation, Lee Equity LLC, which owns the majority interest in the company is also listed. The latest complaint states that the equity firm exerts significant control over the franchisor’s operations, including the appointment and approval of executives and board members.

A number of officers of the company who served at relevant times are also individually named. They include John D. Barr, chairman of the board of directors and CEO, and Ken Calwell, current CEO. Others include current or former directors Thomas H. Lee and Yoo Jin Kim in New York, as well as John D. Shafer of Massachusetts. Janet Pirus, former chief financial officer is also named, along with the company’s vice president of operations, and senior VPs of strategy and development and sales.

Victoria Blackwell, Papa Murphy’s senior vice president and general counsel, hired in part for her knowledge and experience in franchise law, was identified as one of the sales and development company officials.

Franchisees claim several executives were directly involved in the franchise sales process including the creation and approval of franchise disclosure documents. Other staff drafted, reviewed or approved of the use of the FDDs, which included the “fraudulent performance representations, misstatements of material fact and unlawful waivers” of the franchisees’ legal remedies. Item 19 of the FDD was not representative of the Papa Murphy’s franchises in their region, and they claim the company mischaracterized store performance in their areas.

Another observation restaurant analyst Gordon noted was that Papa Murphy's franchise development pattern is spread out over the broad U.S., with few units in many states that are far afield from its Pacific Northwest core. It is a known industry best practice that new restaurant development should be in concentric markets to take advantage of customer familiarity. GE Capital, the large franchise industry lender, noted this earlier this month in it own best practices display."


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