Market Mayhem: Sale of Gray Market Goods Heads to the Supreme Court

The design is deliberately inconspicuous. It's just half a centimeter long, and it is placed on the underside of a watch--thus remaining unseen.

The design's importance, however, may be huge. It is at the heart of a case that could affect billions of dollars in commerce.

At stake is the future of so-called "gray market" goods. These are legitimate branded items, produced and put onto the market with the approval of the appropriate rights owners, and eventually resold outside the rights owners' preferred distribution channels.

For instance, Omega watches are much less costly in Europe than in the U.S., so some of the watches intended for Europe are resold and imported into the U.S., where these unauthorized watches compete with pricier versions available through Omega SA's authorized distribution channels.

As part of its efforts to stop these gray market sales in the U.S., Omega inscribed the tiny, copyrighted globe design on the backs of its watches intended for sale in Europe. When it found that Costco was selling watches with the design in the U.S. without authorization, Omega sued Costco, alleging the warehouse club retailer is committing copyright infringement. Costco Wholesale Corp. v. Omega SA is now before the Supreme Court.

Businesses and consumers have a lot at stake. In the IT sector alone, gray market goods accounted for $58 billion in U.S. sales in 2007, costing the industry $10 billion in profits, according to a 2008 study by KPMG and the Alliance for Gray Market and Counterfeit Abatement.

Because gray market goods are much less expensive than the identical products in other distribution channels, consumers like them. And many businesses fear them: Their bottom lines suffer because gray market goods undercut sales of goods carrying higher prices and higher profit margins.

"The principles behind [Omega] are supremely important," says Eric Goldman, who teaches intellectual property law at Santa Clara University in California. "This cuts across all aspects of the global economy."

Omega's Mess

Omega isn't the only company to wield copyright law against gray market goods. A large--and growing--number of businesses are using this tactic to keep gray market goods from entering the U.S.

It is unclear, however, whether copyright law can be used in this way.

Copyright Act Section 106(3) grants every copyright owner the exclusive right to distribute copies of its work in the U.S. This distribution right is violated, according to Section 602(a), when a copy of the work is imported into the U.S. without the consent of the copyright owner. Thus, Omega's copyright is infringed by Costco's unauthorized importation of watches bearing the copyrighted globe design.

Costco, however, claims it is protected by Copyright Act Section 109(a), which codifies the first sale doctrine. This doctrine provides that upon the first authorized sale of a copy of a copyrighted work, the copyright owner loses all rights to control further distribution of that copy. Thus the purchaser of a copy can resell, lend or otherwise physically transfer the copy.

This doctrine has resulted in the huge--and profitable--markets for used books, music CDs, movie DVDs, computer games and many other items. The doctrine has also allowed Netflix and other DVD rental companies to prosper.

If the doctrine applies to the watches Costco imports, the retailer would not be liable for infringement. However, Omega made and initially sold the watches at issue outside U.S. borders, and experts disagree over whether the U.S. first sale doctrine extends its reach that far.

First Sale

The issue turns on an ambiguous phrase in Section 109(a) of the Copyright Act. The statute states that the first sale doctrine applies only to copies "lawfully made under this title."

Omega argues that because the copies of its globe design were made outside the U.S., these copies were not made under the Copyright Act, and so they are not covered by the first sale doctrine. Costco argues that because the copies were made by the U.S. copyright owner, they were "lawfully made under this title" and should be entitled to the protection of the first sale doctrine.

The provision could be read either way, according to many experts. "The meaning of this phrase is as clear as mud, and there's no legislative history to give us guidance," says Jonathan Hudis, a partner at Oblon, Spivak, McClelland, Maier & Neustadt.

The 9th Circuit, in Omega S.A. v. Costco Wholesale Corp., agreed with Omega's interpretation of the statute. A three judge panel held in September 2008 that applying the first sale doctrine to goods made overseas "would impermissibly apply the Copyright Act extraterritorially."

Most federal district courts that have considered the issue have reached the same result. But some district courts have disagreed, ruling that copies made overseas with the approval of U.S. copyright owners were "lawfully made under this title."

Quality Case Law

In 1998, the Supreme Court held in Quality King Distributors, Inc. v. L'anza Research International, Inc. that copies made in the U.S. and initially sold overseas were "lawfully made under" the Copyright Act. The first sale doctrine thus protected companies that purchased the copies overseas and imported them back into the U.S.

Moreover, Justice John Paul Stevens, writing for eight members of the court, stated in dicta that if a U.S. copyright owner gave exclusive U.S. distribution rights to one company and exclusive British distribution rights to another company, "presumably only those [copies] made by the publisher of the United States edition would be 'lawfully made under this title' within the meaning of ? 109(a). The first sale doctrine would not provide the publisher of the British edition who decided to sell in the American market with a defense."

The 9th Circuit used these comments to buttress its decision in Omega. Many copyright experts, however, assert that Quality King didn't decide this issue. "The Omega case addresses the issue left open by the Supreme Court in Quality King," Goldman says.

Omega is now before the Supreme Court on a certiorari petition. The court has asked the solicitor general to file a brief on the matter, so many expect the court will accept the case. "Asking for the solicitor general opinion is a really good sign," says Ethan Horwitz, a partner at King & Spalding.

It is uncertain, however, how the justices will ultimately interpret Section 109(a). "It's not an easy one for them to decide," Goldman says.

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Steven Seidenberg

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