Corporate Legal Times

July, 1998

GRAY GOODS MARKET PROTECTED BY SUPREME COURT DECISION;
Copyrights Do Not Protect Manufacturers

The continuing viability of a multibillion-dollar gray market in unauthorized imports was assured by the U.S. Supreme Court's March 1998 ruling in the case of Quality King Distributors Inc. v. L'anza Research International. In a unanimous decision, the Court decided that a copyright owner loses control over a product once it enters the stream of commerce.

The case drew the interest of some large U.S. retailers. A brief of amici curiae supporting what turned out to be the winning side was joined by Costco Companies Inc., Target stores, Wal-Mart Stores Inc. and the National Association of Chain Drug Stores.

The ruling overturned a 1996 decision by the 9th Circuit. That court had ruled that L'anza, a shampoo manufacturer, had not received full value for its copyright when products it sold at a discount to Quality King for overseas distribution showed up in California drug stores. The label on L'anza's shampoo is copyrighted ["Did Shampoo Manufacturer Get Soaked in Gray Market?" U.S. Business Litigation, November 1997, p. 18].

Domestic Retailers Rely On Gray Goods

The gray market exists because U.S. manufacturers routinely sell consumer goods at deep discounts, through distributors, for foreign markets.

The price differential is often so large that a distributor can re-import the goods at a price that undersells the domestic market. Many products on American retail shelves arrive there via the gray market.

"In a store like Sam's Club or Price Club, for example, all the high-end fragrances are diverted product," says Michael G. Kessler, a New York-based corporate investigator who specializes in intellectual property matters.

"All the Waterford crystal is diverted product. Much of the jewelry is diverted. Those items are meant to be sold in upscale stores, but they wind up in discount clubs through diversion."

The Supreme Court decision was hailed as a victory for consumers, but there is a downside that manufacturers prefer to stress.

In L'anza's argument before the 9th Circuit, it claimed that quality control goes out the window when gray goods come through the door. Kessler says many perishable commodities languish on foreign shelves for an extended period before they are re-imported.

Nevertheless, it would be hard to convince consumers that they are being victimized by the presence of bargain-priced goods in domestic stores. For retailers, the decision puts an end to an uncertain situation that frequently resulted in litigation. Costco, for example, has been sued four times since 1994 on claims that its sale of gray market goods violated U.S. copyright statutes.

Loophole For Manufacturers

"The gray market creates big problems for manufacturers," says Bernard R. Sorkin, senior attorney at Time Warner Inc., New York.

"In our case, a good example would concern the promotion that accompanies release of a new CD. We arrange concert tours and buy advertising to raise public awareness of the artist, and all of it is timed to coincide with the new release. What if a European distributor floods the domestic market with the CD right in the middle of the promotion? It cuts the legs out from under our efforts."

The loss of manufacturers' profit associated with gray-marketing varies, says Sorkin. For his company, the marketing implications are more serious than the economic impact of underpricing.

Sorkin takes pains to point out a serious misconception about the Supreme Court decision.

"It did not abolish protection under U.S. law," he says. "Justice Ginsburg's concurrence is very precise and specific in stating that this ruling does not resolve cases in which allegedly infringing imports were manufactured abroad."

This is an important loophole, in Sorkin's view, and one that needs emphasizing.

"I've seen articles in the foreign press indicating that this ruling wipes out all U.S. protection against parallel imports, and that notion is being used in some countries to support elimination of their own protections against diversion of products back to the U.S."

That not only creates problems for the manufacturer. It creates problems for the foreign country. "Especially if it's a developing country with a low-level economy," says Sorkin. "Normally in that situation we would price our goods for sale there at a level commensurate with the economy. All manufacturers do that. You have to. Otherwise there would be no market for the product. But if all the gray goods protections in country X disappear, it becomes economically impractical for Time Warner to sell its CDs there. So we will just withdraw from that market."

Prevention Is Key For Small Manufacturers

The loophole for goods manufactured abroad only works for companies big enough to set up facilities in foreign countries. "I don't know what smaller manufacturers can do," say Sorkin. "You can write protections into a contract, of course, but that doesn't work very well."

In order to prevail in a breach-of-contract action, a plaintiff has to show the amount of damages suffered, but the losses that result from re-importing goods are hard to quantify. Doing so would require speculation about what would have happened if the gray goods were not available, how many sales might have occurred at a higher price and so on. Also, the distributors who divert product to the gray market are often good customers. Thus, enforcing the contract becomes problematic.

Nevertheless, there are some simple steps small manufacturers can take.

"If you are going to sell your goods in Russia, label them in Russian," suggests Donald E. deKieffer, a partner at deKieffer & Horgan, Washington, D.C. "It costs a few cents more per label, but it's effective. Generally speaking, try to prevent diversion before it gets started. Identify your distributors. Check them out. Often, the people who supply the gray market are crooks, and you're better off not doing business with them."

Diversion of product, Kessler adds, often involves underlying fraud and can be prosecuted. An example would be the fraudulent alteration of a manifest to indicate that products have left the United States when in reality they remain in domestic warehouses until the time is ripe for diversion.

Kessler has developed software that searches the Internet for both counterfeit and diverted products. "Many diverters," he says, "have started using the Web as the venue of choice for gray market goods."