Professional Beauty Product Diversion

These notable cases show the various legal theories used in this controversial salon-industry topic.
by Jean Warshaw
BSB Columnist and NYC lawyer Jean Warshaw

"Sold Only in Professional Salons." Those are fighting words throughout the beauty industry. They proclaim manufacturers’ and beauty salons’ desires to limit sales of many high-end professional-beauty products to salons. But large drugstore chains and discount retailers often sell products that have packages marked for sale in salons only. And they sell those products in competition with beauty salons despite the manufacturers’ and salons’ wishes.

Diversion happens when professional products that the manufacturers intend for sale only at salons are sold at other types of retail outlets. For example, an exclusive shampoo may be sold by the manufacturer directly to a distributor with a requirement that the distributor must sell the shampoo to salons and not to large drugstore chains. If the shampoo ends up on drugstore shelves, it was diverted. The distributor could have diverted it, the salons could have diverted it, or “collectors” who buy from the salons to sell to mass-market retailers could be the diverters. Diversion is not an issue for mass-market products because those products are designed for sale in discount retailers, drugstores and grocery-store chains.

Professional-product diversion inspires passions on both sides of the issue. Important industry players have differing views on whether salon diversion is a problem or not. Some people make money when products are diverted and other people lose money; so those passions are very understandable. This column is not going to take sides. It will explore some of the legal issues involved and arguments made by both sides. There is a lot of money involved in diversion. One plaintiff estimated in 2010 that the professional beauty-product industry has sales of $5 billion per year, out of which $1 billion is diverted salon-only products. In haircare products alone, industry reports show that $44 million worth of products were diverted in the fourth quarter of 2011.

[Photo: Courtesy of BSB columnist and NYC lawyer Jean Warshaw]

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PROS AND CONS TO INDUSTRY PARTICIPANTS

Even before we get to the legal principles, there are rational business arguments on all sides of this issue. Manufacturers point out that diverted products may be counterfeit, tampered with or handled improperly, resulting in stale, dented and out-of-date products. All of these arguments highlight that companies that deal in diverted products are not complying with the manufacturers’ policies and so manufacturers can’t guarantee that the products are handled in accordance with their recommended best practices. In fact, many manufacturers only guarantee their products if they are purchased from salons.

The distributors and retailers selling diverted products publicize their opinions less often, but they point out that there are few legal restrictions on reselling products to any purchaser willing to buy them. They have defended themselves in lawsuits by pointing out that they don’t know if the companies that purchase products from them simply turn around and resell to supermarkets. Salon owners maintain that the real issue is the exclusive reputation of professional products; not tampering or counterfeiting. They claim that they will lose customers if their clients see “salon only” products in discount retailers because the products lose their attractiveness. They also lose the profits they would have made if the products hadn’t been diverted. The judge in one recent case noted that product sales are an important revenue source for salons and the profit margins on product sales are higher than the margins on haircare services.

Many professional-product manufacturers have taken steps to stop diversion. They often have contracts with distributors that require the distributors to sell only to salons and no other person or business. At least one manufacturer sells its products to salons under contracts that call for penalties of $100 per unit of product diverted by the salon. Another manufacturer’s contract calls for damages of $25,000 for any instance of diversion by a distributor. Still others put tracking codes on each unit so they know who bought each one from the factory. That is followed up by sending test shoppers to chain drugstores and supermarkets to read those tracking codes to try to figure out how those products got on the retailers’ shelves.

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LITIGATED CASES

Not surprisingly, industry participants have sued many times to try to stop diversion. Some have been very successful and some have not. The arguments cover a variety of legal theories, and this column will review several of the notable cases.

In a 1979 case, a manufacturer sued discount retailers because they sold hair dye to consumers even though the hair dye was packaged for salon use and did not have the consumer labeling and allergy warnings required by the U.S. Food and Drug Administration. The court found that the discounters had engaged in unfair competition. The plaintiff did sell products labeled for consumer use, but charged a higher price. The court concluded that the discounters should not buy the cheaper product that didn’t have adequate labeling and sell it to consumers. Consumer labeling has not been a significant issue since this early case was decided, and most cases focus on products already labeled for individual sale.

In a 1994 case, a manufacturer sued a mass-market retailer. The U.S. District Court said that the manufacturer was trying to control distribution after it made its first sale. The manufacturer in that case didn’t have a contract with the retailer, so the court concluded that the retailer didn’t violate the law and couldn’t be found responsible for diversion. The manufacturer did have a contract with two salons that diverted products to the retailer, and those contracts prohibited diversion. The manufacturer argued that under the legal doctrine of tortious interference, the retailer was liable for a breach of the manufacturer’s contracts with the salons, but the court said that the facts didn’t support it.

Under the doctrine of tortious interference, the manufacturer would have had to prove that the retailer knew about the contract that prohibited diversion, intentionally interfered with it, acted intentionally and socially unacceptably, and caused damage. Only then could the retailer be responsible for a breach of contract even though it never agreed to prevent diversion.

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In this case, even though the manufacturer’s salon-only policy was well known, the manufacturer could not prove that the retailer knew about the contents of the agreement between the manufacturer and the salons or acted unacceptably. In fact, the retailers were trying to make sales like any other business, according to the court.

In contrast, an Internet retailer did have to pay damages for tortious interference with contracts in a case that started in Oklahoma in 2001. The retailer knew that distributors had contracts that prohibited sale to any business other than a salon, and so it set out to undermine that system. The court found that it used fake names to buy products, used names that made it sound as if it operated salons, and said it had salons when it didn’t. The case was decided by a jury that awarded the manufacturer $5 million for lost sales and punitive damages because of tortious interference and other claims.

Even the U.S. Supreme Court had a diversion case in 1998. In that case, the Supreme Court found that a beauty-product manufacturer sold products for export to Malta. The products found their way back to the shelves of a discount retailer here in the United States. The manufacturer argued that the products were gray-market goods and could not be reimported into the United States without infringing on the manufacturer’s copyrighted labels. After a lengthy analysis of the Copyright Act, the Supreme Court said that the importation was legal and there was no Copyright Act violation. Since that case was decided, manufacturers have turned to other legal theories in their quest to stop diversion.

In a case that was brought to trial eight years ago, a manufacturer sued a distributor, asking the court to force the distributor to stop diverting a line of professional products. In that case, the judge had harsh words for the manufacturer when it found that the manufacturer tracked its products and could have stopped shipments to the diverter. The court said that the manufacturer “is content to enjoy the profits associated with diverted product, while paying ‘lip service’ to the notion that they are interested in protecting the professional nature of the brand.” The court later noted that the manufacturer made “unprecedented” profits from condoning diversion.

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One recently settled New York federal court case was brought by a consortium of beauty salons. The salons sued several major beauty-product manufacturers, alleging that they were promoting diversion of haircare products and so “salon only” labels were false advertising. According to the complaint, manufacturers reap several benefits from labeling their products for salon sales only. That labeling enhances the image of professional products and allows the manufacturers to rely on salon recommendations instead of investing heavily in advertising. The plaintiffs alleged that the product manufacturers encouraged diversion so they could have a larger market for products while at the same time acquiring exclusive cachet. The salons said diversion harms them by damaging their reputations with customers who find the same products labeled “for sale in salons only” in chain drugstores. Customers blame salons for the false labels according to the plaintiffs. The plaintiffs alleged that the manufacturers knew that the “salon only” labels were false. The salons had the same issue with ads and claims the manufacturers made on their websites. They said the ads, labels and claims on websites are intended to confuse consumers; and said that the websites are false when they say the manufacturers oppose diversion.

The manufacturers asked the court to dismiss the case on several theories, including that the salons weren’t injured because salon-only labels, ads and websites encourage consumers to purchase products at salons and so they actually help the salons make sales. The court refused to dismiss the case on this ground and said that the plaintiffs might have been injured and could argue that consumers’ negative views of salon-only advertising could harm the salons. The manufacturers also argued that consumers don’t take the salon-only labels into account when they make purchases, but the court said that the salon-only claims could make the professional products stand out from mass-market products in consumers’ minds. As a result, the court allowed the case to go forward.

The judge in the case noted recently that the salons didn’t agree on what they wanted out of the litigation. Some wanted manufacturers to keep the salon-only labels on their beauty products and prevent diversion, presumably so they could have the profits from more product sales. Other salons wanted the manufacturers to take off the salon-only labels because of the distrust they engendered with customers. This highlighted that the case was brought to stop false advertising, but some of the salons were more interested in stopping diversion than in stopping the manufacturers from claiming that the products were for sale only in salons.

The salons and manufacturers settled the New York case at the end of March, and so the court did not have a chance to make law on whether salon diversion can be stopped on the theory that salon-only labeling is false advertising if diversion exists.

MOVING FORWARD

Salon diversion is a controversial topic for many industry participants, no matter which side of the issue they are on. The only thing that’s for certain is that there will be more lawsuits in the future. If those lawsuits are anything like the ones so far, they will be creative and important to follow. 

This copyrighted article is intended to help make you aware of some of the issues that you may face, but it is not exhaustive and does not constitute legal advice. You should consult your lawyer for legal advice about the particular circumstances of your beauty business.

Jean Warshaw is a lawyer in private practice in New York City. She provides advice on business and environmental law. She can be reached at 212.722.2240.