Franchisees Win Landmark Internet Arbitration Ruling
Stuart Gittleman
American Lawyer Media

September 12, 2000

In what is believed to be the first ruling on whether a company may use its Web site to compete with its franchisees, an arbitration panel stopped Drug Emporium from selling to its franchisees' customers via the Internet.

The decision was issued by an American Arbitration Association panel.

The panel's ruling affects 29 markets in Arkansas, Kansas, Louisiana and Texas. As part of the agreement between Drug Emporium and its franchises, each franchisee received the exclusive right to conduct business in a designated territory.

In the dispute, the franchisees claimed that the drug chain breached its contractual obligation to honor their territories by using the company Web site to sell directly to customers within the franchisees' territories. The franchisees asked the arbitrators to enjoin the chain from selling to customers within those territories.

In ruling on the request for injunctive relief, the arbitrators phrased the question as, "whether a virtual drug store is a drug store for purposes of a franchise agreement."

They answered in the affirmative.

"It is not for this panel to divine whether a virtual reality is real or whether it is a phantom. We will take [Drug Emporium at its] word. [It] marketed [the site] as 'the full service online drugstore'," the panel wrote. The panel noted that Drug Emporium called the site a "drugstore" in its filings with the Securities and Exchange Commission and advertised the site as "your neighborhood pharmacy for 20 years."

The panel issued a preliminary injunction, concluding that the franchisees established a strong likelihood of prevailing on the merits their contention that the Web site diluted the value of the franchisees' "exclusive" territory.

The panel noted that the site "attempted to build market share by offering special sales at prices that vastly undercut prices available at [franchisees'] stores. The obvious purpose of this practice is to increase ... sales volume.

"The contemplated sale of assets ... and the refusal to include a contractual provision to require the purchase to be subject to this panel's ruling lead to the inference that the intention is to exploit the [chain's trademark] with even greater zeal. Indeed, the $17 million purchase price [of the site] creates a big motive to do so," the panel concluded.

The panel ordered Drug Emporium not to sell to any potential customer physically within the franchisees' territories and to place a notice on the Web site that products cannot be shipped to such customers. The panel further ordered Drug Emporium to direct such customers to the nearest franchised outlet. The panel gave Drug Emporium 12 weeks to put the terms of the order in place and continued the matter to the week of Nov. 13.

When franchisees are given exclusive territories to conduct their store operations, and pay substantial royalties to obtain support from their franchisors, they do not expect to have to compete with their franchisors. This decision enforces the reasonable expectation franchisees -- no competition from their franchisor."

"Internet encroachment is one of the most important issues facing franchisors, franchisees, and their lawyers. This decision underlines the importance of addressing and resolving the legal issues related to Internet marketing under pre-World Wide Web franchise agreements before a marketing program is implemented."

These issues affect many types of retailers. For example, although one can't download a burger and fries, a fast-food chain taking orders over the Internet may be in a position to route the order to a company-owned store instead of to a local franchisee.

Almost all existing franchise agreements, long predated e-commerce. Nonetheless, these agreements will increasingly be examined in an effort to resolve problems online that the contracts were never intended to address.

The challenge to a franchisor and its franchisee alike is to use the Internet to produce more sales, not to raid customers from each other. Meeting this challenge requires new ways of collaborating within the franchise structure.

When asked to name a company in the franchise, dealer or distributor channel that has successfully met this challenge, no one was able to do so. The situation is, another example of technology outpacing the ability of law or businesses practices to address issues that no one ever considered when constructing a contract.