Combatting Gray Markets: A Copyright-Protected Distribution Right or a Sherman Act Violation?

Posted on Categories Business Regulation, Intellectual Property Law, U.S. Supreme Court

At one time, the prospect of stating legal claims against gray market importers looked bleak.  Product manufacturers tried trademark protection, but trademark law proved disappointingly unsuccessful.  One company has now turned to copyright protection, and this company obtained a Ninth Circuit decision that found a store using a gray market importation scheme unable to raise a defense to copyright infringement.  The company is Omega S.A., a Swiss luxury watch manufacturer known for producing the Seamaster line of watches appearing in many James Bond films, and the case is Omega S.A. v. Costco Wholesale Corp., 541 F.3d 982 (9th Cir. 2008). In spite of Omega’s favorable Ninth Circuit judgment and opinion,  market-wide legal questions about Omega’s distribution practice remain.  Regardless of whether or not a manufacturer could state a claim for copyright infringement against gray marketers, infringement defendants may answer back by counterclaiming an antitrust violation.  And if an antitrust counterclaim can halt copyright enforcement, then Omega’s win at the Ninth Circuit would end up a hollow victory at best or an academic stroll through the Copyright Act at worst.

Here are the facts of Omega v. Costco.  Omega maintains a tight grip on its authorized distribution channels.  Omega attempted to gain control of its watches’ distribution by engraving a design on the back of its watches (pictured below) and registering this design at the U.S. Copyright Office. Omega sold watches with these designs to their authorized distributors.  Somewhere along the distribution line, however, the watches ended up in the hands of distributors outside of Omega’s authorized channels abroad.  As the Ninth Circuit recognized, this is a paradigm gray market importation scheme, in which products meant to be sold in one territory are imported into another, usually for cheaper prices. One of Costco’s suppliers based in New York imported watches from these unauthorized distributors and eventually transferred the watches to Costco, which then sold these watches to its customers in California. One of those purchasing customers turned out to be a plant employed by Omega.

Omega then sued Costco for violating their exclusive right to distribute  its copyrighted works and for importing them without Omega’s authorization.  Costco asserted the first-sale defense, arguing that Omega’s right to control the distribution of its watches under both the distribution and importation statutes ends with its first transfer to its authorized distributors.  Costco v. Omega’s ending at the Supreme Court was a bit anticlimactic, with the U.S. Supreme Court evenly divided 4-4 (Justice Kagan didn’t take part in the non-decision).  This led to a summary affirmance of the Ninth Circuit’s decision below and no rule from the Supreme Court resolving the statutory tension in the Copyright Act.

In the midst of the statutory construction issues dominating the Supreme Court briefs, Costco suggested that Omega’s distribution controls might pose antitrust problems.  This issue popped up very briefly; in one sentence and in one footnote, Costco’s first merits brief surmised that Omega’s distribution controls might qualify as a vertical restraint of trade sanctionable under the antitrust laws.  The issue was mentioned only in passing, but how briefly it appeared should not downplay the importance of the issue.  As noted above, to the extent that gray market importation is still a subject of debate, other litigants may very well challenge practices meant to stamp out gray markets under the antitrust laws.

Following Costco’s argument, Omega’s authorized distributor agreements could be characterized as vertical territorial restraints.  These distributor agreements might also involve vertical pricing fixing or vertical refusals to deal, but for the sake of brevity, this post will consider Omega’s practice as a vertical territorial restraint.  Vertical territorial restraints occur when companies up and down a distribution chain enter into agreements that limit the geographic areas into which they will sell their products.

These restraints used to be treated as per se illegal under the antitrust laws, but they are categorically unlawful no longer.  Taking the per se position on vertical territorial restraints was United States v. Arnold, Schwinn & Co., 388 U.S. 365 (1967).   Justice Fortas, writing for the majority, believed that limiting to whom distributors may transfer a manufacturer’s products is “so obviously destructive of competition that their mere existence is enough.”  Drawing upon other vertical restraint cases, the Supreme Court in Schwinn expressed concern that allowing manufacturers to dictate how their products move down the distribution chain “would violate the ancient rule against restraints on alienation and open the door to exclusivity of outlets and limitation of territory further than prudence permits.”  The Supreme Court in Schwinn skirted a number of lingering questions.  One question was explicitly left off the table: how the principle of protecting the free alienation of property would apply to patents.  Other matters left out were robust analyses of the economic efficiencies hampered or harnessed by vertical territorial restraints.  A majority of the Supreme Court concluded as much ten years after Schwinn in Continental T.V., Inc. v. GTE Sylvania, Inc., 433 U.S. 36, 54 (1977).  GTE Sylvania overruled Schwinn, noting how untethered the nature of a manufacture-to-distributor transaction is to the economic efficiencies and effects on different markets. The GTE Sylvania Court also flagged and examined the economic literature regarding how vertical restraints reduce intrabrand competition among retailers but allows manufacturers to enjoy new efficiencies in their interbrand competition with other manufacturers.  In other words, while there is a possibility that harm to intrabrand competition might be serious enough to warrant antitrust scrutiny, not all vertical territorial restraints are per se illegal.

The Supreme Court’s decision in GTE Sylvania to step away from per se illegality is not limited to vertical territorial restraints.  In like sense, the U.S. Supreme Court once treated resale price maintenance — whereby a manufacturer commands that distributors not set retail prices at, above, or below set figures — as per se illegal.  Albrecht v. Herald Co., 390 U.S. 145 (1968) (maximum resale price maintenance); Dr. Miles Medical Co. v. John D. Park & Sons Co., 220 U.S. 373 (1911) (minimum resale price maintenance).  Both of these cases have since been overruled.  State Oil v. Khan, 522 U.S. 3 (1997); Leegin Creative Leather Products, Inc. v. PSKS, Inc., 127 S. Ct. 2705 (2007).  As GTE Sylvania, Khan, and Leegin indicate, there are pro-competitive reasons for manufacturers to agree with distributors to limit the scope of distribution, whether through prices or geographic regions. And these reasons carry enough weight that the Supreme Court believes it imprudent to penalize every single one of these agreements.  Moreover, these cases signal that hostility toward vertical restraints as potential antitrust problems is subsiding.  In fact, the IP and Antitrust treatise authors argue that “the rule of reason for purely vertical nonprice restraints has resulted in something approaching automatic legality for such arrangements.”  Herbert Hovenkamp et al., IP and Antitrust, § 24.3b1.

The antitrust analysis does not end with the Supreme Court’s treatment of vertical restraints in themselves. Adding another wrinkle is that the territorial restraint here was enforced using a copyrighted design, calling forth the ongoing confusion around how intellectual property and antitrust law should coexist.  For decades, courts and academics have been confounded by the tense intersection between intellectual property and antitrust law.  In fact, they cannot even agree on how to name it: In a lecture before the Antitrust Committee of the New York City Bar Association, Professor Mark Lemley listed several of these names: the relationship, conflict, tension, interaction, interface, or collision between intellectual property and antitrust policy.

That the antitrust laws and intellectual property rights are hopelessly mired in irreconcilable doctrinal conflict is far from being a necessary or inevitable conclusion.  Hovenkamp et al., supra, § 1.3.  In fact, Ward Bowman, Jr. argued that both intellectual property and antitrust promote wealth maximization and prevent restrictions on output.  Ward Bowman, Jr., Patent and Antitrust Law: A Legal and Economic Appraisal (1973), reprinted in part in Hovenkamp et al., supra, § 1.3; Mark A. Lemley, Milton Handler Lecture: The Intersection Between Antitrust and Intellectual Property Part 1-3.  They both have their own roles in accomplishing these ends: antitrust law protects the overall free market environment while intellectual property rights create incentives to innovate.  Hovenkamp et al., supra, § 1.3; Lemley, supra.  Without intellectual property, the argument goes, the market will stagnate.  Hovenkamp et al., supra, § 1.3; Lawrence A. Sullivan & Warren S. Grimes, The Law of Antitrust: An Integrated Handbook § 15.1 (2d ed. 2000); Lemley, supra.

That being said, intellectual property’s economic justifications do not give intellectual property owners carte blanche to enforce their intellectual property rights abusively nor in bad faith.  To be sure, some courts treat certain intellectual property enforcement practices, such as tying agreements and possibly others, as pernicious enough to the competitive process that they should not be tolerated under the antitrust laws, even if the intellectual property laws alone would allow them.  Image Technical Servs. v. Eastman Kodak Co., 125 F.3d 1195, 1216, 1218 (9th Cir. 1996); Data General v. Grumman Systems Support, 36 F.3d 1147, 1182 (1st Cir. 1994); but see In Re Independent Service Organization Antitrust Litigation, 203 F.3d 1322, 1327, 1327-28 (Fed. Cir. 2000) (“[A] patent owner may not take the property right granted by a patent and use it to extend his power in the marketplace improperly, i.e. beyond the limits of what Congress intended to give in the patent laws.” (quoting Atari Games Corp. v. Nintendo of America, Inc., ); SCM Corp. v. Xerox Corp., 645 F.2d 1195, 1206 (2d Cir. 1981) (“[C]onduct permissible under the patent laws cannot trigger any liability under the antitrust laws.”).  After all, the point of intellectual property in the United States is the economic quid pro quo of granting a property right in exchange for enriching society with new artistic and utilitarian creations; intellectual property does not, however, exist only to shower creators and innovators with pecuniary benefits or to further the Lockean notion that labor makes property.  Feist Publications v. Rural Telephone Services, 499 U.S. 340, 352-60 (1991); Mazer v. Stein, 347 U.S. 201, 219 (1954).  In the final analysis, innovation and antitrust policy coexist best when they are balanced: bad faith and baldly anticompetitive intellectual property enforcement should be sanctioned, while the antitrust laws simultaneously allow intellectual property owners to reap the fruits of their patents, copyrights, and trademarks, among other rights.  Herbert Hovenkamp, Federal Antitrust Policy § 5.5a (3d ed. 2005).

Applying this complicated and sometimes conflicting set of legal rules, one can plausibly find pro-competitive reasons for allowing Omega to control its distribution channels this tightly.  In terms of interbrand competition — such as may be the case with other luxury watch designers, like Tag Heuer, Breitling, Movado, and Rolex — constraining distribution channels can protect a company’s brand reputation.  In economic terms, limited distribution to authorized sellers prevents free riding by low-end discount stores that can sell goods for cheaper prices while shirking the customer service and presentation of higher end shops.  Cf. Leegin, 127 S. Ct. at 2715.  This is especially true for a luxury designer like Omega.  With the risk of free-riding by discount stores, a niche market for luxurious goods and the luxe shopping experience could become endangered.  Cf. id. at 2715-16.  If Omega’s fine watches can be had at lower prices than Omega would prefer at stores like Costco, then its brand may very well lose some of its exclusivity and cachet, a key asset to Omega’s ability to compete with other luxury designers.

Furthermore, the circuit decisions cited above demonstrate that the courts have been reluctant to extend antitrust liability to intellectual property enforcement when the underlying intellectual property right is legitimately and duly granted. For its part, the Federal Circuit has limited antitrust liability for patent infringement to the serious cases of fraud before the USPTO, objectively baseless sham litigation, and other situations in which a patent is extended beyond its statutorily granted property right, such as tying agreements. In Re Independent Serv. Org. Antitrust Litigation, 203 F.3d 1322, 1326-28 (Fed. Cir. 2000).  The Federal Circuit thus imposed a high burden on patent infringement defendants to show that intellectual property is being used in such an unduly exclusionary fashion as to warrant antitrust liability.  Id. at 1327.  In the copyright arena, the U.S. Supreme Court has demonstrated support for copyright owners realizing the value of their intellectual property.  Broadcast Music, Inc. v. Columbia Broadcasting System, 441 U.S. 1, 19 (1979) (“Although the copyright laws confer no rights on copyright owners to fix prices among themselves or otherwise to violate the antitrust laws, we would not expect that any market arrangements reasonably necessary to effectuate the rights that are granted would be deemed a per se violation of the Sherman Act.”).  In the First and Ninth Circuits, there is still a doctrinal presumption that intellectual property rights are being used legitimately.  Furthermore, there is close to explicit authorization in the Copyright Act for copyright owners to control their protected products’ distribution.  Hovenkamp et al., supra,  § 24.3b1.  Each of these doctrines heavily weigh against the already hard antitrust case to win.

Challenging Omega’s use of its copyrights as an antitrust violation thus would likely prove to be a daunting uphill battle.

3 thoughts on “Combatting Gray Markets: A Copyright-Protected Distribution Right or a Sherman Act Violation?”

  1. This is a fascinating analysis of a very complicated case. As Andrew Spillane points out, the line between the enforcement of copyright entitlements and unlawful restraints of trade has long been extremely fuzzy.

  2. Very interesting!

    Something very similar happens in the video game industry. I specifically remember that Sony, the maker of the Playstation 3, had problems with extra-territorial sales like that. They price their PS3’s differently based on region. (And strictly control that price – every wonder why all video game consoles sell for the exact same price in every store? If a retailer drops or raises the price, the manufacturer will blacklist that store from further shipments. So even if a Wii is selling on ebay for 4-5 times its retail cost, the actual retailers have to keep selling at MSRP.) Enterprising companies were buying them from the cheap regions and shipping them to the expensive regions and undercutting Sony’s prices.

    I can’t recall if anything legally happened with that. I toyed with writing my law review comment on the pricing problem, but I hardly knew anything about antitrust law, and felt overwhelmed by the area.

  3. Very good article. I feel business owners and corporations need to protect the value of their products. I’m sure Omega had MAP pricing or minimum advertised pricing and Costco was price-gouging Omega’s brick and mortar stores.

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