Business and Legal Strategies for Dealing with Grey Market Imports*

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January 1, 2003
By: Lawrence M. Friedman

INTRODUCTION

United States-based manufacturers and exclusive licensees of foreign products often find themselves in the unlikely position of competing against their own goods imported from abroad. These competing products are parallel imports or grey-market goods.

Grey-market goods are products sold in the United States that were lawfully produced but which the manufacturer or authorized reseller did not intend for sale in the U.S. market. Three distinct scenarios are the most common sources of parallel imports. First, a producer may manufacturer goods in the U.S. for export sale only and find that the merchandise has been diverted back to the United States market either before or after exportation. Second, goods made abroad by a foreign licensee may be imported into the United States without the authorization of the U.S. licensor. Finally, goods made abroad either by the manufacturer or a licensee may be imported into the U.S. market to compete with goods offered by the authorized U.S. licensee.

This article reviews the legal framework surrounding the parallel importation phenomenon and seeks solutions by which U.S. producers and licensees may protect their interests against unauthorized importations. All of the merchandise discussed below is genuine in that it was manufactured by a company authorized to do so. This article does not address the importation of counterfeit merchandise or products that infringe a U.S. patent.¹

1. Who Benefits
   Parallel importations occur because of price differences in the global marketplace. A publisher of computer software may, for example, have only a small market share in Mexico. As a business strategy, that publisher may legitimately decide to introduce a new product into the Mexican market at a substantial discount compared to the sales price for the same product in the United States. If the discount is large enough, it becomes possible for U.S. parties to purchase the software in Mexico and import it to the United States for resale at a discount over the same product in authorized channels. In other cases, a manufacturer may limit its retail distribution to upscale markets. This is common practice in the cosmetics trade where some products are only sold through salons or selected stores. Mass retailers who would like to sell the same product can often find it abroad on sale at deeply discounted prices. That fact give the discounter an opportunity to enter the market from which the producer has tried to exclude it.
   
   Proponents of parallel imports argue that the practice gives discount retailers and consumers an alternative source of merchandise and encourages price competition.² Without parallel sourcing, the argument goes, manufacturers would be able to set prices in the U.S. higher than those in other countries. Thus, parallel importers are seen as a consumer-friendly enterprises fighting price discrimination by manufacturers of elitist products.
    
2. Who Is Hurt
   
   Opponents of parallel imports argue that the practice interferes with their contracts with exclusive licensees and that the unauthorized resellers are free-riding on the authorized sellers' marketing expense and savvy. Thus, authorized licensees do not get the full benefit of their license fees and no authorized retailer gets the full benefit of its advertising and marketing expenses.
   
   In addition, authorized resellers or licensees are usually subject to contractual control by the licensor or manufacturer. The licensor may, for example, require authorized outlets to have trained sales personnel or service departments or to maintain an inventory of service parts. Parallel importers lack privity with the licensor or manufacturer and are under no obligation to provide this level of customer service. Consumers, unaware that they are purchasing from an unauthorized seller, may develop a negative opinion of the product. Thus, grey-market products may undercut the goodwill of authorized resellers.
   
   This often occurs when consumers seeks warranty service on a grey-market product. If the factory refuses to service the good, it will probably alienate the consumer. However, the factory has no obligation to service the good and would incur an unplanned expense if it provided the service. Thus, the unwary consumer of grey-market goods usually gets a product without a factory warranty and has not received the full benefit of his or her bargain. Parallel importers, however, argue that the savings in price make up for these deficiencies and that service is usually available when needed but at an additional cost to the consumer.

• TRADEMARK
  
  The obvious starting point for a U.S. manufacturer seeking to exclude grey-market merchandise is trademark law. A party with U.S. trademark rights would expect to be able to prevent another party from importing or selling goods, even genuine goods, under the same trademark without authorization. After all, the trademark is misidentifying the source of the products. Trademark law, however, does not provide that clear of an answer.
  
  The leading case on the application of trademark law to parallel imports is the Supreme Court decision in A. Bourjois & Company, Inc. v. Katzel.³ The facts of that case set out one of the principal examples of how the grey market operates. Plaintiff was the assignee of a trademark in the United States from a French cosmetics company. The French company continued to operate in France where it produced identical goods including those it sold to Plaintiff. Katzel, taking advantage of a favorable exchange rate, imported genuine merchandise from France and began to sell it under the plaintiff's trademark in the United States.
  
  The Supreme Court based its conclusion that the sale of the grey-market merchandise infringed the U.S. trademark on the assignment from the French company. The Court stated that because the French firm could no longer sell its wares in the United States, it could also not authorize another to do so.⁴ From that premise, it concluded that "[o]wnership of the goods does not carry the right to sell them with a specific mark. It does not necessarily carry the right to sell them at all in a given place."⁵
  
  Katzel argued that the use of the trademark of the French manufacturer was factually correct and did not lead to consumer confusion. In response, the Court held that:
  
  It is said that the trade mark here is that of the French house and truly indicates the origin of the goods. But that is not accurate. It is the trade mark of the plaintiff only in the United States and indicates in law, and, it is found, by public understanding, that the goods come from the plaintiff although not made by it. It was sold and could only be sold with the good will of the business that the plaintiff bought.⁶
  
  
  
  From this pro-trademark holder decision, one would expect that trademark law prohibits the sale and importation for sale of genuine goods bearing trademarks owned by a U.S. entity. The Supreme Court, however, soon found an exception from Katzel.
  
  In Prestonettes, Inc. v. Coty,⁷ Prestonettes purchased genuine "Coty" facepowder, repackaged it with its own base, and sold it is containers identifying Coty as the manufacturer of the powder. The containers were otherwise distinguishable from genuine Coty products. The Supreme Court, via Justice Holmes who also wrote Katzel, held that this did not amount to actionable infringement:
  
  The plaintiff could not prevent or complain of [defendant's] stating the nature of the component parts and the source from which they were derived if it did not use the trade mark in doing so. . . . If the compound was worse than the constituent, it might be a misfortune to the plaintiff, but the plaintiff would have no cause of action, as the defendant was exercising the rights of ownership and only telling the truth. . . . A trade mark only gives the right to prohibit the use of it so far as to protect the owner's good will against the sale of another's product as his. United Drug Co. v. Theodore Rectanus Co., 248 U.S. 90, 97, 63 L. Ed. 141, 39 S. Ct. 48. There is nothing to the contrary in Bourjois & Co. v. Katzel, 260 U.S. 689, 67 L. Ed. 464, 43 S. Ct. 244. . . . When the mark is used in a way that does not deceive the public we see no such sanctity in the word as to prevent its being used to tell the truth. It is not taboo. Canal Co. v. Clark, 80 U.S. 311, 13 Wall. 311, 327, 20 L. Ed. 581.⁸
  
  Thus, the rule prior to the Lanham Act appears to have been that a parallel importer could rely on the trademark to identify the source of the product but could not apply the mark in a way that would lead a consumer to believe that the U.S. trademark holder was the seller.
  
  This interpretation of the law represents a change in the philosophy of trademarks. Prior to Katzel, trademarks were considered to have universal scope. Consequently, a party that purchased a trademarked good abroad was free to import that merchandise and sell it in the United States without fear of infringing a U.S.-held trademark.⁹ Eventually, however, the Courts recognized that trademarks relate to the use in business of a mark and are, therefore, inherently territorial. Katzel is an example of this change in approach. Moreover, trademarks enforceable in federal courts derive from statutory law that has no application extraterritorially. Thus, there is no basis on which to presume that a U.S.-origin trademark carries with it the same goodwill when the product is sold by a third party in Mexico, Europe or elsewhere.¹⁰
  
  Currently, section 1124¹¹ of the Act addresses the importation of merchandise bearing trademarks that "copy or simulate" a U.S.-owned mark.¹² The Act, however, does not specify whether a foreign trademark legitimately applied to genuine merchandise "copies or simulates" the identical trademark in use in the United States. As a result, the status of imported products bearing genuine trademarks was left to the Courts. That issue was addressed in Lever Bros. Co. v. United States.¹³
  
  The issue in Lever Bros. was whether the United States Customs Service properly refused to prohibit the unauthorized importation of merchandise from the United Kingdom bearing a U.S. trademark legitimately applied abroad. The merchandise involved was deodorant soap and dishwashing liquid manufactured by Lever's related party in the U.K. A third party purchased a supply of the merchandise and imported it for sale in the U.S. Lever sought the assistance of the Customs Service to bar the importation pursuant to section 1124.¹⁴ Customs refused on the basis of a regulatory exception that will be discussed below in the section relating to the Tariff Act.¹⁵
  
  The first question before the D.C. Circuit in Lever Bros. was whether section 1124 barred the importation of such merchandise. The Court noted a number of cases in which the courts had permitted the importation of grey-market merchandise in the face of a challenge based on the Lanham Act. Many of these decision permitted the entry of the merchandise on the grounds that the merchandise was genuine and, thus, there was no confusion or consumer deception involved.¹⁶ In each of these cases, however, the merchandise was identical to the goods offered for sale in the United States under the trademark.
  
  Lever, however, presented a different scenario in that the merchandise as sold in the U.K. had been modified to the tastes and preferences of British consumers and British conditions.¹⁷ U.S. purchasers of the grey-market soap, the Court reasoned, would not receive the product they expected and may gain a negative opinion of the U.S. trademark holder. In the end, the presence of the grey-market products could result in a loss of goodwill for the trademark holder in the U.S. The Court noted several prior cases in which courts found differences in the imported product to justify excluding merchandise from the U.S. market on the basis of the Lanham Act.¹⁸ Based on these cases, the Lever Bros. Court concluded that material physical differences in a grey-market product mean that the trademark applied to it "copies or simulates" the U.S. trademark. As a result, it ordered the merchandise excluded from the U.S. market under section 1124.¹⁹
  
  The rule to be deduced from Lever Bros. and the cases cited therein is that a U.S. trademark holder may rely on section 1124 of the Lanham Act to exclude parallel importations where the goods offered for sale abroad are materially different from those offered in the United States.²⁰ When that is true, the product reaching consumers through unauthorized channels is not what the U.S. trademark is intended to represent. This will naturally lead to consumer confusion if not deception.
  
  What constitutes a material difference is, therefore, a fundamental question. In Societe Des Produits Nestle, S.A. v. Casa Helvetia, Inc.,²¹ the Court was faced with determining whether unauthorized chocolates were materially different from the authorized product. To that end, the Court found several factors materials including: quality control procedures, product composition, product configuration, packaging, and price.²² In analyzing these differences, the Court stated that:
  
  We conclude that the existence of any difference between the registrant's product and the allegedly infringing grey good that consumers would likely consider to be relevant when purchasing a product creates a presumption of consumer confusion sufficient to support a Lanham Act claim. Any higher threshold would endanger a manufacturer's investment in product goodwill and unduly subject consumers to potential confusion by severing the tie between a manufacturers's protected mark and its associated bundle of traits.²³
  
  
  
  Similarly, in Martin's Herend Imports v. Diamond & Gem Trading,²⁴ the Court found differences in the fact that an unauthorized importer offered for sale in the United States figurines the manufacturer chose not to offer for sale in the United States.²⁵ The grey-marketer also imported figurines that were sold in the United States but with a different color pattern. The Court found these differences to be material.²⁶
  
  Where the parallel imports consist of identical merchandise, the questions is more complicated. There is no real argument that the consumer is being deceived or misled as to the source of the merchandise. The Ninth Circuit dealt with this question in NEC Electronics v. Cal Circuit Abco.²⁷ In that case, NEC-Japan assigned its U.S. trademark rights to its U.S. subsidiary. NEC-U.S. sold Japanese-made computer chips under the NEC trademark in the U.S. Abco imported chips identical chips it purchased abroad and sold them in the U.S. in competition with NEC. NEC-U.S. claimed the sales (although not the importations) constituted infringement under sections 32²⁸ and 43(a)²⁹ of the Lanham Act.³⁰
  
  The Ninth Circuit began its analysis with a statement that trademark law generally does not address the resale of genuine merchandise. It relied on Coty and other cases for this premise³¹ and had to somehow distinguish the contrary holding in Katzel. The Court accomplished this by noting that in Katzel, the U.S. trademark owner was completely independent of the French trademark owner and, therefore, had no control over the nature of the product being produced abroad. The French company was free to begin producing an inferior product or even a completely distinct product. In which case, parallel imports bearing the U.S. mark would likely confuse consumers.³²
  
  NEC-U.S., to the contrary, was a wholly-owned subsidiary of NEC-Japan. Under these circumstances, the Court found that NEC-U.S. was not deprived of any right to control the merchandise sold in the U.S. The basis for this was the fact that NEC-Japan controlled NEC-U.S. and could dictate the nature of merchandise sold in the U.S. Further, the Court noted that the merchandise sold under the NEC trademark was at all times produced under the direction and control of NEC-Japan. Thus, the Ninth Circuit felt Katzel did not control and it permitted the grey-market sales.³³ The Second Circuit adopted a similar analysis in Olympus Corp. v. United States.³⁴ In its conclusion, the NEC Court stated that
  
  If NEC-Japan chooses to sell abroad at lower prices than those it could obtain for the identical product here, that is its business. In doing so, however, it cannot look to United States trademark law to insulate the American market or to vitiate the effects of international trade. This country's trademark law does not offer NEC-Japan a vehicle for establishing a worldwide discriminatory pricing scheme simply through the expedient of setting up an American subsidiary with nominal title to its mark.³⁵
  
  Other courts, however, have been less willing to merge a foreign corporation with its U.S. subsidiary or licensee. For example, in Osawa & Company v. B & H Photo,³⁶ the Court focused on the fact that the plaintiff, a United States corporation and the exclusive licensee of the trademark in question, was entitled to exercise its right to protect its trademark in the United States. Osawa involved the importation of grey-market Mamiya cameras from Japan. The defendants contended that their legal purchase of the genuine cameras in Japan precluded an action by plaintiff.
  
  The Court, however, noted the extensive services and quality controls available through authorized resellers in the United States.³⁷ In addition, the U.S. trademark holder engaged in significant advertising designed to enhance its reputation for quality and service and provided warranty service to its customers.³⁸ As a result, the plaintiff incurred a number of expenses defendant was able to avoid.³⁹ Taken together, these additional expenses, the resulting loss of revenue and decreased goodwill led the Court to find a danger of irreparable harm from the grey-market imports.⁴⁰
  
  On the merits, the Court's analysis focused on the territoriality of trademarks and the premise that trademarks symbolize the local goodwill of the trademark holder who should be protected against the use of the mark by others in domestic commerce.⁴¹ Plaintiff, having strived to develop substantial independent goodwill in the United States through its advertising and high-quality products and services was entitled to the protection of its trademark separate and apart from the same mark applied by the manufacturer in Japan.⁴² Thus, the Court granted a preliminary injunction against the importation of identical grey-market merchandise solely to protect the separate goodwill of the domestic trademark holder. This decision came over defendant's objections that the price disparity creating opportunities for grey-market entrepreneurs was entirely the result of price discrimination by the Japanese manufacturer. The Third Circuit reached a similar conclusion in Premier Dental Prods. v. Darby Dental Supply Co.⁴³ in which it held that:
  
  where a trademark is owned and registered in this country by an exclusive distributor who is independent of the foreign manufacturer and who has separate goodwill in the product, the distributor is entitled under Section 526 to prevent the importation even of genuine merchandise obtained from the same foreign manufacturer.⁴⁴
  
  
   
• COPYRIGHT
  
  A copyright owner has the exclusive right to distribute copies of the work.⁴⁵ Thus, a third party may not, without the authorization of the copyright holder, sell, rent, transfer or otherwise distribute copies of the work. Section 602 of the Copyright Act of 1976 identifies a specific form of the distribution right when it prohibits the importation of copies of a copyrighted work without the authorization of the copyright holder.⁴⁶ The statute further provides that an unauthorized importation is a violation of the distribution right of section 106 and is a copyright infringement under section 501. There are a number of exceptions to the importation right including imports for personal use with passengers returning to the United States. Those exceptions, however, are not applicable to commercial operations such as grey-market importers.
  
  Producers of goods facing grey-market competition have seized upon the importation right as a means of excluding their own goods from the U.S. market.⁴⁷ They argue that the unauthorized importation is a violation of the distribution right and, therefore, an infringement. In the case of consumer products, the claim for copyright normally rests on art or text on product labels. The plain language of section 602 seems to support this argument.
  
  The law, however, provides a number of exceptions to the distribution right embodied in section 106. Relevant to this article is the "first sale doctrine" of section 109.⁴⁸ Under the first sale doctrine, the legitimate owner of a copy of a work may freely distribute that copy by sale, lease, loan or other transfer.⁴⁹ Importers of grey-market merchandise have based their defense to claims of copyright infringement of the importation right on the theory that merchandise legitimately purchased abroad is subject to the first sale doctrine and, as a result, they may transfer that merchandise as they see fit including the importation of the merchandise for resale.
  
  The leading case on the interplay between the first sale doctrine and the importation right is Columbia Broadcasting Sys. v. Scorpio Music Dist., Inc.⁵⁰ In Scorpio Music, CBS held the United States copyrights on a number of sound recordings. A Japanese party related to CBS entered into an agreement permitting a Philippines-based company to manufacture and sell copies of those works exclusively in the Philippines. Scorpio Music, in the mean time, ordered sound recordings from a Nevada-based company that, in turn, purchased them from a Philippines company that purchased them from the authorized manufacturer in that country. CBS sued Scorpio for importing the phonorecords without its consent.⁵¹ Scorpio interposed a motion for summary judgment based, in part, on there having been a valid first sale in the Philippines.⁵²
  
  Looking to the language of section 109(a), the Court focused on the phrase "lawfully made under this title" to limit the scope of the first sale doctrine to goods legally manufactured and sold within the United States rather than imported goods.⁵³ The Court based this conclusion on the principal that U.S. law does not generally apply outside the borders of the country. The Court also found that if the first sale doctrine trumped the importation right, section 602 would be virtually without meaning as any third party seeking to sell copyrighted materials in the U.S. could circumvent the copyright holder by purchasing the goods abroad.⁵⁴ Thus, the Court denied summary judgment and permitted the case to go to trial.
  
  A different result was reached in Sebastian Int'l, Inc. v. Consumer Contacts (Pty) Ltd.⁵⁵ in which the imported merchandise was hair care products. Sebastian manufactured and sold its products in the United States. All of its U.S. sales were through professional salons rather than traditional retail stores. Sebastian had entered into an agreement to permit the defendant to distribute its products in South Africa, but not elsewhere. Upon receipt in South Africa, the defendant immediately shipped the goods back to an unrelated buyer in the United States. Sebastian sued claiming that the unauthorized importation was a copyright infringement. The District Court agreed and issued a preliminary injunction preventing further distribution in the U.S. by the defendant.⁵⁶
  
  The Court of Appeals started its analysis with a review of first sale cases holding that once the copyright holder has decided to sell a copy of the work, it has no right to control future transfers of the work.⁵⁷ These cases, according to the Court, are based on the principal that once the copyright holder makes a voluntary sale of a copy of the work, it has received its reward for the use of that work.⁵⁸ The Court then went on to find that the importation right of section 602 is not separate from that distribution right of section 106. As a result, the Third Circuit held that the first sale doctrine is applicable to importations as well as domestic sales.
  
  More recently, in Parfums Givenchy, Inc. v. Drug Emporium, Inc.,⁵⁹ the Ninth Circuit reached a contrary result. The facts there were similar to Sebastian. The merchandise involved was perfume produced in France and sold in upscale stores in a box subject to a U.S. copyright. Unauthorized parties purchased quantities of the merchandise abroad and imported it for sale in discount stores.⁶⁰ Drug Emporium argued that the first sale doctrine of section 109 supercedes the importation right of section 602. Thus, Givenchy had no right to prevent the importation of lawfully purchased merchandise. The Court disagreed. According to the Ninth Circuit, the Congress intended section 602(a) to provide a means of prohibiting the importation of lawfully made copies of copyrighted works purchased abroad.⁶¹ As a result, a U.S. copyright holder will be able to gain the full value of each copy sold in this country. The Court noted that it addressed this same issue previously and rejected similar arguments.⁶² The basis for this ruling was the "lawfully made under this title" language in section 109(a). The Court agreed with Scorpio Music that this language means the first sale doctrine applies only to sales made within the United States. A contrary reading, according to the Court would render section 602 meaningless.
  
  The Ninth Circuit addressed this question again in L'anza Research Int'l, Inc. v. Quality King Distributors, Inc.⁶³ L'anza is similar in most ways to Sebastian: the merchandise involved is hair care products, the plaintiff tried to limit its U.S. distribution to salons and colleges and the producer made sales to third parties abroad. In L'anza an additional fact was that the foreign sales were at a substantial discount when compared to U.S. sales.⁶⁴ L'anza is also different from Givenchy and BMG Music in that the merchandise was manufactured in the United States, presumably subject to sale here, exported and then imported without the authorization of the copyright holder. According to the District Court, this fact could make the first sale doctrine applicable to the merchandise. It found, however, that the sale did not take place in the United States and, therefore, the first sale doctrine did not apply.⁶⁵
  
  On appeal, the L'anza Court specifically refused to base its decision on the phrase "lawfully made under this title" in section 109(a).⁶⁶ Rather, it relied entirely on the principle that reading section 109(a) as superseding section 602(a) would render the latter provision meaningless and such a reading cannot be correct.⁶⁷ The Court went on to thoroughly discuss the Congressional intent behind the importation right.
  
  According to the Court, Congress enacted section 602(a) to protect U.S. copyright holders from legitimate as well as "piratical" copies entering the United States. Congress took this step at the urging of the domestic publishing and recording industries. These industries complained that the importation of legitimate copies was undermining their ability to control the distribution of their products within the United States through authorized channels of trade. This resulted in the inability of copyright holders to reap the full value of their copies in the United States.⁶⁸
  
  An example of this problem would occur where a video tape distributor sells copies of movies in the United States at $20 each. In order to be competitive in England, it sells the same tapes there for $13. If a third party purchases tapes in England and sells them in the United States at $18, the U.S. copyright holder is being denied the full U.S. value of those sales. It has, in effect lost $7 per sale.
  
  The L'anza Court found this analysis compelling. It did not find the location of production to be a relevant consideration in its decision. Even though the merchandise was manufactured here and sold by L'anza, the unauthorized importations prevented L'anza from controlling the distribution of its product in the United States. This, according to the Court, is contrary to the purposes of the distribution right, first sale doctrine and the importation right. The Court distinguished Sebastian on the grounds that the prior case did not mention whether the sales in South Africa were at a discount as was the case here. In addition, Sebastian did not recognize the loss of control of distribution and the downward force on resale prices as an evil Congress sought to remedy with section 602(a).
  
  The Supreme Court disagreed with the Ninth Circuit and Reversed.⁶⁹ The Court found that the first sale doctrine and the importation right are not coextensive. As a result, permitting the first sale doctrine to apply to section 602 does not render it superfluous. Rather, section 602 applies to a broader class a copies including those not subject to the first sale rule such as copies lawfully made under the laws of another country. The Court also held that the language of the Copyright Act does not support the argument that an unauthorized importation is a distinct infringement of the work. The Court felt that L'Anza's arguments went too far and would give a U.S. copyright holder unfettered rights to prohibit the importation of copies of the work. This is inconsistent with a number of other provision of the Act including the fair use exceptions. Justice Ginsburg, concurring separately, noted that this case did not involve merchandise manufactured abroad and implied that such merchandise may not benefit from the first sale doctrine. This may leave a small opportunity for copyright holders to protect their U.S. interests from unauthorized imports.
   
• SECTION 337
  
  An alternative<