Supreme Court Deadlocks on Decision Rejecting First Sale Doctrine to Overseas-Made Gray Market Copyrighted Goods

December 17, 2010

On Dec. 13, 2010, the U.S. Supreme Court deadlocked and affirmed Omega, S.A. v. Costco Wholesale Corp., 541 F.3d 982 (9th Cir. 2008), aff’d per curiam, No. 08-1423, 562 U.S. _____ (U.S. Dec. 13, 2010), a 9th Circuit Court of Appeals decision applying copyright law to prevent the unauthorized importation and distribution of a foreign-made product in the United States. In so doing, the Supreme Court upheld the appellate court’s ruling that a wholesaler had violated U.S. copyright law when it sold branded wristwatches well below retail price without the manufacturer’s permission.

The 9th Circuit’s decision rested on its interpretation of the “first sale” doctrine of 17 U.S.C. § 109(a) which essentially says that once a copyright owner sells a copy of a protected work, subsequent owners can sell it, rent it, or lend it out as they like. Even though the decision addressed the doctrine in the context of consumer products, the outcome potentially has far-reaching implications for the pharmaceutical and medical device industries, each of which has grappled for decades with the fallout from gray marketed products.

The products in question were made in Switzerland, far beyond the reach of American copyright law. They were sold to authorized dealers in Latin America who, in turn, diverted the products to a gray market distributor who subsequently imported them to the United States, where they were ultimately sold to a wholesaler at a price that allegedly undercut the manufacturer’s authorized American dealers.

Although the manufacturer had authorized the initial sale, it had not authorized the subsequent sales overseas, the importation of its copyrighted product, or its subsequent sale in the United States. The manufacturer filed claims against the wholesaler for infringing distribution and importation under 17 U.S.C. §§ 106(3), 109(a) and 602(a), asserting its products’ copyrighted logo to block their sale.

Discounters and off-price retailers who purchase imported products from middlemen and sell them at lower prices are engaged in an arbitrage practice known as grey market trading or product “diversion.” Diversion is essentially the distribution of legitimate products outside authorized channels of trade through illicit means, such as violation of contract, law or regulations. In simple terms, diversion is an abuse of a distribution system.

Consumers ostensibly enjoy the discounts that flow from diverted goods. However, diversion potentially impacts a manufacturer’s bottom line, jeopardizes relationships with authorized distributors, and potentially damages a brand’s reputation. In the case of regulated pharmaceutical and medical device products, diversion also creates channels through which counterfeit goods pass virtually unnoticed, thus posing a very real public safety threat.

Moreover, even legitimate diverted products falling into the wrong hands can present safety issues due to improper storage, and sales of expired or adulterated products. In the case of products manufactured overseas, diversion can result in the importation of products that have not received FDA approval.

Pharmaceutical and medical device manufacturers pursue diverters under various legal theories, such as fraud, breach of contract, and violations of the Racketeering Influenced and Corrupt Organizations Act, 18 U.S.C. § 1961–1968, and if applicable, the Lanham Act, 15 U.S.C. §1051, and under other trademark theories.

Although it was a split decision, and thus limited to the 9th Circuit, the Supreme Court’s decision now potentially provides pharmaceutical and medical device manufacturers with another legal mechanism to assert the right to control the distribution, price and resale of its products.