Doughnut Franchisees Are Rancor-Filled

Donut maven Arthur S. Pfefferman’s business credo says there are two kinds of dough: “The kind you earn and the kind you bake.”

As founder and president of the Woodland Hills-based Donut Inn franchise, the 49-year-old entrepreneur has excelled at making both. Starting his doughnut career as an apprentice baker in the 1960s, Pfefferman has turned a humble business in the San Fernando Valley into a chain of at least 30 franchises spanning Southern California, Nevada and two foreign countries.

Along the way, he also has established an impressive civic and professional resume that includes being named the 1985 Fernando Award winner as the Valley’s volunteer of the year. Since 1993, Pfefferman has been president of Mayor Richard Riordan’s Cultural Affairs Commission and has taught classes on franchising at Cal State Northridge.

But at the same time, say a dozen of the small-business people who are his investors, Pfefferman has been selling them franchises with sweet promises of success, then systematically harassing them into abandoning their businesses in order to cash in on start-up investments, a process known as churning. One has won a judgment against him in court.

Lawsuits have accused the company of intimidation, breach of contract, fraud and oppressive business practices. Investors allege that Donut Inn made false promises of profits and support, failed to make state-mandated disclosures of past litigation and often harassed franchisees with fines and even surveillance.

Pfefferman repeatedly declined to comment on the turmoil within his company. Reached at home on a recent Friday night, he said, “I’d prefer you do whatever investigation you’re doing without making any comment that might mischaracterize things.”

Tensions between franchiser and franchisee are not uncommon in any industry, but the Donut Inn case is unusual for the amount of litigation involved and the level of the vitriol, legal experts say.

As is the industry norm, the typical Donut Inn franchisee is an immigrant--most commonly from Southeast Asia, India or the Middle East--whose entire family is involved in running the business.

The competition is particularly fierce in Southern California, which is the solid center of the nation’s $4-billion doughnut industry. Southern California has more donut shops per capita than any other region.

These pastries have ranked among the nation’s favorite snacks since the 1950s, when doughnut shops replaced the diner as the breakfast spot of choice. Today, the average American consumes 2.4 pounds of doughnuts a year, from chocolate bigfoots to lemon eclairs.

In 1992, former Garden Grove franchisee Dennis Wilson couldn’t understand why the Donut Inn shop run by his wife and son was such an unexpected headache to operate and why it didn’t do the booming business promised by the Donut Inn salesman.

Until a telephone conversation with Art Pfefferman.

“He said, ‘Maybe you aren’t cut out for this business,’ and all of a sudden a red light went off in my head. This guy wants my store back. What a great deal. He’s got my [investment] money. And if I walk away, he resells it,” Wilson said.

Last year, Wilson won a judgment of more than $450,000 against Donut Inn and Pfefferman after a jury found he had been defrauded.

The suit claimed the company engaged in “a pattern of deliberately inducing a high rate of failure . . . and turnover among Donut Inn franchisees [to] thereby realize exceptional profits from the recurring payments of initial franchise fees . . . and from the frequent resales of stores, fixtures and equipment.”

On the day before going to court to defend one franchisee lawsuit--and with several others pending--Pfefferman filed for Chapter 11 bankruptcy protection in September, claiming that soaring legal costs in disputes with franchisees were driving him out of business.

In court documents, Pfefferman claims he spent $600,000 in attorney fees defending 10 franchise lawsuits. But other court records also show that Pfefferman--whose Cadillac sports the vanity plate “RT4 ART”--is still living well.

In November, documents show, U.S. Bankruptcy Judge Geraldine Mund approved Pfefferman’s request that he and his wife be allowed to draw a combined $160,000 annual salary plus expenses--which include membership dues to the Braemar County Club in Tarzana--while he tries to revive Donut Inn, whose annual sales exceed $2 million.

Though Pfefferman declined to be interviewed, one of his lawyers strongly denied that Donut Inn has tried to make money by rolling over franchises rather than by helping individual franchisees to profitability.

“The hardest part is making the franchise sale,” said attorney Frank Conner. “Once you do, it’s in everyone’s best interest to make it work. To take a store that’s producing royalties and sell it to someone else isn’t too swift. What kind of business would do that?”

Conner denied that Donut Inn is a hostile franchiser.

“Franchisees want their own business, but they also pay for expertise,” he said. “So when the company says they’re not keeping the floors or display cases clean, people get turned off. They take as hostility what’s meant as constructive criticism. They don’t want to blame themselves.”

But many small-time investors--some of whom went bankrupt and even lost their homes--paint a picture of a company that preyed on their ambitions of calling their own shots.

Typically, new Donut Inn investors pay between $20,000 and $85,000 in franchise fees and an additional $80,000 to lease equipment. Franchisees pay monthly royalties and marketing fees, in turn receiving the expertise of an established operation, along with training, advertising and the right to do business using the Donut Inn logo.

In a well-practiced sales pitch at his Woodland Hills offices, franchisees say, a gregarious Pfefferman often introduced prospective investors to the Donut Inn family, including his wife, Sandra, and his father, David--a former Army cook nicknamed “Mr. D” whose countenance graces Donut Inn boxes and cups under the phrase “Wizard of Ahhhs.”

But during meetings, investors allege, Pfefferman often overestimated potential profits and made support promises that ran counter to the franchise contract. He has also failed to mention in public disclosures any lawsuits in which the company was involved, investors claim.

In legal documents, one couple claimed Pfefferman even switched contracts between the time they read and signed the papers.

Pfefferman also told franchisees that Donut Inn’s buying volume with suppliers meant reduced costs, investors allege. But according to lawsuits, the company has failed to disclose sweetheart deals with some suppliers that have actually driven franchisee costs up.

Greg D’Amore, who lost his home after his investment crumbled, voiced a common complaint about Pfefferman.

“Pfefferman told me no stores ever went under,” said D’Amore, whose Laguna Hills franchise lasted 18 months. “He said everyone who ever bought in was still with the company. He told me he’d never been sued. And none of it was true.”

Indeed, it was only after they signed the contract, investors say, that they saw Pfefferman’s friendliness sometimes turn to hostility.

For Armenian immigrants Anton and Shoushig Chakmakian, the skirmishing with Donut Inn was nonstop: demanding letters citing the Chakmakians for violations such as dirty floors, making doughnuts the wrong size, not wearing Donut Inn uniforms and not buying from approved suppliers, the couple said.

And finally came the lawsuits, one of which threatened the loss of their franchise for failure to pay royalties of 43 cents Pfefferman said resulted from unreported sales.

“He treated us like rogues, like thieves,” said Shoushig Chakmakian, who with Anton now runs a tiny independent sandwich shop in Sherman Oaks. “But we were just honest people trying to do business.”

Donut Inn admitted no such wrongdoing in a settlement of a lawsuit filed by the Chakmakians, who said they believe Pfefferman wanted them to walk away from the franchise.

“He always used to ask me: ‘Why are you staying? Why don’t you just get out?’ ” Shoushig Chakmakian said. “Well, I stayed and I fought. But I got fed up. I realized I was dying with this. I let it go.”

Industry experts say franchisers have rights under contract to ensure that their operators meet company standards and that they can cancel a contract if they show just cause.

For example, McDonald’s severed its Paris franchise because the restaurant was continually dirty and Southland Corp. canceled contracts with some 7-Eleven franchisees who had gouged customers during the 1992 Los Angeles riots.

But experts acknowledge that overzealous franchisers can also violate laws in rough-riding investors.

“The best franchises have the most stringent standards, but the question is whether the system is strict to improve the franchise or force franchisees out,” said Robert L. Purvin Jr., president of the American Assn. of Franchisees and Dealers, a pro-franchisee group.

“There comes a level where a person is being abusive as opposed to being reasonable in the way he’s applying his rules,” said Purvin, who is also vice chair of the American Bar Assn.’s Franchise Law Committee and author of the 1994 book “The Franchise Fraud: How to Protect Yourself Before and After You Invest.”

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At least two Donut Inn franchisees contacted the state Department of Corporations, the agency that enforces California’s franchise laws. However, after reviewing the case, state officials declined to investigate the doughnut franchise--calling the company’s adherence to state laws adequate.

Still, investors say many of the Donut Inn claims--both oral and written--are misleading.

Franchisees claim that the company in its franchise circular knowingly overestimates the number of new stores it plans to open--giving the appearance that Donut Inn could double its size in a given year.

The Department of Corporations says that repeatedly making such claims is not illegal and is the usual “puffery” of advertising, but a franchise industry group maintains that a company should not be allowed to make such brazen claims year after year.

“You question things the first time their plans don’t come to fruition, when they start fudging the words around, saying things they don’t mean,” said Bill Cherkasky, former president of the International Franchise Assn. “Because failing to disclose the truth in the circular is not only unethical, it’s illegal. It’s subject to lawsuit and to criminal action.”

Donut Inn franchisees claim Pfefferman takes his enforcement of the contract to extremes.

For example, the company has charged fines of up to $200 apiece--fines Donut Inn described as rent increases--for violating company rules. The infractions range from using improper signs to not having enough doughnuts for sale to using boxes and napkins without the proper logo.

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Purvin and others say such fines are not standard practice for most franchisers.

“The contract says you have to maintain the stores to corporate standards, but the standards change at the whim of Art Pfefferman,” said Eugene Comroe, a Woodland Hills lawyer representing two former franchisees claiming fraud and misrepresentation.

“The best lawyer in the world wouldn’t be able to tell you by reading that contract what really happens once you do business with Donut Inn.”

In eight years of running their Santa Clarita store, Bal Capalad and his wife, Lolita, said they were fined more than $12,000. “We couldn’t always get Donut Inn boxes, so we had to use plain ones, and they fined us every time,” Bal, a 49-year-old Philippine immigrant, said.

“Every time one of his people walked into the store, it was a fine for something,” said Bal, who now runs an independent doughnut store. “When I complained, he audited my books and charged me another $6,000.”

Kampuchea immigrants Hang and Teav Chor still operate the Palmdale Donut Inn that Hang bought in 1987--a success they believe they have achieved despite Donut Inn.

Last year, after a company audit, the Chors were told to pay more than $26,000, which included a fine for buying from unapproved suppliers and marketing and royalty fees on what the company claimed were underreported sales. All that was on top of a charge for the audit.

Now even the stubborn Chors are giving up: Their store is for sale.

“I paid the fines with my life savings,” said Hang, even though he said he disagreed with the company’s claims. “A little fish like me can’t afford to hire a lawyer. . . . So I paid.”

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Indeed, it costs even to leave Donut Inn.

As a condition of many sales, investors allege, Donut Inn has required investors to make unnecessary and costly improvements--such as changing the furniture color--that have run into the tens of thousands of dollars.

“Art wouldn’t let me sell unless I paid for $12,000 in renovations,” Capalad said. “And even though the contract stipulated a $5,000 resale fee, he charged me $6,000. When I asked him about it, he said, ‘You want to sell the store, don’t you?’ ”

Franchisees who find someone to buy their store have run into other problems.

In an interview, former franchisee John Salvino said he tried to sell his interest in Donut Inn but that the company, relying on a right-of-refusal contract clause, discouraged potential buyers, then led them instead to buy other corporate-owned stores.

Some Donut Inn investments have ended in financial disaster.

Spencer and Shirley Maness were $1,000 away from paying off their West Hills home when they bought a franchise in 1990. Today, the former franchisees are $150,000 in debt, and Spencer Maness, a graying retired electrical engineer, works as a security guard to make ends meet.

“This whole thing just about killed my Dad,” said son Greg Maness, who helped operate the store. “Pop’s no spring chicken and he has his pride. He thought he’d be retired today. Art Pfefferman took that away from him.”

For many franchisees, most painful are the allegations that from the beginning, Pfefferman’s scheme was not to help franchises grow, but to sell them as many times as possible.

According to Comroe, Donut Inn’s 30 stores have been resold an average of three to five times since the company began selling franchises in 1979--a turnover of more than 100 buyers. Industry experts said turnover at such a rate is high for a company that size.

The victims, Comroe and others said, include many naive immigrants who would rather walk away from the franchise than file suit. “People are afraid,” one franchisee said. “They know Mr. Pfefferman.”

Lawyer Thomas Yong represented one franchisee, an immigrant from Cambodia whom Pfefferman accused of skimming profits and underreporting sales. “My client always believed he had done nothing wrong,” he said. “He couldn’t understand why he was being dragged into court after all he had sacrificed to go into business. He just wanted to settle. He just wanted out.”

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One irony: Pfefferman was once a franchisee who sued a franchiser--his cousin.

Then the owner of seven California Donut franchises, Pfefferman in 1976 sued the company and its president, Ronald Nissenson, claiming harassment and oral misrepresentations--saying the company threatened investors with eviction if they refused to buy supplies at inflated rates from which the franchiser took a kickback.

He settled his case and transformed his stores into a fledging chain: Donut Inn.

Said Comroe: “Here’s Art Pfefferman in sworn declarations accusing a franchise of doing the same thing he does.”