The so-called grey market for goods affects products ranging from Pepsi Cola to iPhones to Viagra. The accounting firm KPMG estimates that the grey market costs the information technology industry more than $40 billion in sales and $5 billion in profits. It has resulted in big losses for brand owners who sell pharmaceuticals, auto parts, medical devices, toys, cigarettes, apparel, cosmetics and personal care products.

Unlike counterfeiting, the sale of products on the grey market is not a criminal offence; therefore, the risks are minimal. Also, diverters know that many manufacturers do not enforce their rights against the grey market. Some brand owners do not even know that grey markets can be stopped by using trade mark law and copyright law. Others are concerned about asserting claims against their own rogue distributors who released the product into the grey market. Occasionally, some companies may even sell their product into the grey market at lower prices to meet quarterly sales goals.

As a result of the grey market, brand owners are forced to compete with their own lower-priced products in the marketplace. This causes problems with authorised resellers and distributors. A KPMG study of the IT industry found that 41% of authorised distributors regularly sourced product from the grey market. The rise of the internet has worsened the problem. The amount of counterfeit and grey goods being sold by wholesale B2B trade boards, such as Alibaba and DHGate, and by B2C sites including eBay and Amazon, is significant. In the recent case of Tiffany v eBay (2nd Cir 2010), the well-known jeweller Tiffany disclosed a survey in which it alleged that 73% of the Tiffany goods sold on eBay were counterfeit.

The Omega case

Omega globe design

Given the negative impact of the grey market on so many industries, the interest in the recent case Omega SA v Costco Wholesale Corp is not surprising. In Omega, the Ninth Circuit Court of Appeals ruled that the first sale doctrine of copyright law did not apply to copies manufactured abroad. Section 109 of the Copyright Act codifies the first sale doctrine in copyright law. It says: "The owner of a particular copy or phonorecord lawfully made under this title ... is entitled ... to sell or otherwise dispose ... of that copy or phonorecord."

How does the first sale doctrine become so important in grey market cases? Omega watches are manufactured in Switzerland. Engraved on the underside of the Omega watches is a US-copyrighted "Omega Globe Design". Omega sold the watches to authorised distributors overseas; however, Costco was able to buy the watches and then resell them through its stores at a discount. Omega sued Costco for copyright infringement claiming that Costco had no right to sell Omega's copyrighted design.

Costco defended itself by asserting the first sale doctrine, arguing that once Omega had sold the watches, it could not limit their distribution by downstream sellers. But Omega argued that the first sale doctrine does not apply to copies made abroad, pointing to Section 109 of the Copyright Act, which limits the first sale defence to copyrights that are "lawfully made under this title". Since the Omega watches were not made in the US, Omega argued that they were not "lawfully made under [Title 17]". The Court of Appeals agreed with Omega and held that application of the first sale doctrine to foreign-made copies would constitute extraterritorial application of US law.

Costco appealed to the US Supreme Court. In support of its petition for certiorari, Costco argued that the Ninth Circuit's interpretation of the first sale doctrine was wrong. Costco's petition for certiorari was supported by amicus briefs filed by eBay, Amazon, Target Corp, National Association of Chain Drugstores, the Entertainment Merchants Association and other parties who have an interest in acquiring grey market goods. They do not want brand owners to be able to use copyright law to hinder their ability to acquire goods from unauthorised sources. Accordingly, they argued that the Ninth Circuit's interpretation of the phrase "lawfully made under this title" was wrong.

The trade mark remedy

Although the Omega case will have an effect on goods being sold on the grey market, manufacturers do not have to wait for the Omega decision to see if they can stop grey market imports. Trade mark law has, for more than 20 years, provided an effective remedy.

A leading case for using trade mark law to fight grey goods involved grey market Perugina chocolates, which originated in Italy and are still manufactured there. They are sold throughout the world to sophisticated consumers of chocolate. In Societe des Produits Nestlé, SA v Casa Helvetia, Inc (1st Cir 1992), the defendant imported Perugina chocolates from Venezuela into the US. The Venezuelan Perugina chocolates were genuine and were manufactured by an authorised Perugina licensee. Nestlé, the owner of the Perugina trade mark, sued to prevent this unauthorised importation. The imported chocolates differed from the US chocolates in subtle ways, such as quality control, the arrangement of chocolates in a box, packaging and price. The First Circuit held that these differences could be "material" to a consumer, saying "the consumer who purchases what he believes is the same product expects to receive those special characteristics on every occasion". The First Circuit therefore, authorised an injunction against the importation and sale of the foreign Perugina chocolates.

The Nestlé opinion contains helpful points that enable a brand owner to stop unauthorised importation of its own foreign products, including:

1. The material difference can be subtle, "for it is by subtle differences that consumers are most easily confused". The threshold of materiality is low and can amount to minor differences in ingredients or packaging.

2. The material difference need not be physical. Differences in warranty protection, quality control or service commitments can suffice.

3. It is not necessary to show that the grey market products are inferior to the domestic products. Even if the infringer's product rivals or exceeds the quality of the domestic product, the sale of the unauthorised product still deprives the trade mark owner of his ability to shape the contours of his reputation.

4. The plaintiff need not prove actual consumer confusion: "A material difference between goods simultaneously sold in the same market under the same name creates a presumption of consumer confusion as a matter law."

Nestlé expanded

The case of Kia Motors America Inc v Autoworks Distributing (D Minn 2009) reflects the state of grey market law. Kia Motors, the Korean auto manufacturer, discovered that defendants were advertising and selling its auto parts below dealer net prices. As a result, Kia brought a claim under Section 43(a) of the Lanham Act. The Court quoted Nestle with approval and said that the grey market auto parts could be stopped if there was a "material difference" between the goods.

The defendants initially argued that the goods were identical, therefore eliminating Kia's assertion of a "material difference". Kia, however, countered that its warranty does not cover the defendants' auto parts and, therefore, constitutes a "material difference". The defendants responded that they do offer their own warranty on the auto parts; contending that there is no material difference. The Court noted that defendants' warranty was a limited parts replacement warranty. By contrast, Kia offered a genuine Kia replacement parts and accessories warranty. The difference in warranties was a sufficient "material difference" and the sale of the grey market Kia auto parts was barred.

A similar result occurred in Hyundai Constr Equip USA, Inc v Chris Johnson Equip, Inc (ND Ill 2008). The defendant had "imported 23 Hyundai wheel loaders and excavators that were intended for sale in the Chinese and Korean markets and sold these machines in the grey market". The "material differences" of the imported machines included:

1. Altered or defaced serial numbers

2. No manufacturer's warranty

3. Instruction manuals in Korean, not English

The Court stated that the absence of or a different warranty is, by itself, a sufficient material difference. Accordingly, it ruled that the defendant had violated Section 43(a) of the Lanham Act. The Court also awarded Hyundai the defendant's profits from the sale of the grey market goods in the amount of $1.2 million, and the defendant was required to forfeit all grey goods remaining in his possession.

The Hyundai case demonstrates the power of using the Lanham Act to defeat the grey market. In short, the successful plaintiff can obtain an injunction against the defendant's grey market activity and also recover substantial damages and all grey market goods remaining in defendant's possession. Trade mark law, therefore, provides a potent weapon against the grey market.

Red Bull's reasoning

US (left) and UK Red Bull cans

The popular energy drink Red Bull recently filed several cases in various states and at the International Trade Commission against unauthorised importers of the beverage from other countries. Red Bull asserts that it researches each market into which it sells its product, modifying the drink and the packaging accordingly. It employs batch code and tracking, rigorous importation standards and quality control at the distributor and retail levels. It has spent over $2 billion on advertising in the US since 1996.

In one of the Red Bull cases, the defendant was selling the drink intended to be sold in the UK. Red Bull asserted that that this drink was "materially different" from the US version of Red Bull in the following ways:

1. The can shows the British distributor, not the US distributor.

2. There is no US toll-free number on the can.

3. The information on the UK can is written in British English.

4. The nutritional information is per 100 ml rather than per serving.

5. The familiar "Nutrition Facts Box" does not appear on the British can.

6. The UK can shows a high caffeine warning, as required by British law. The US can does not have this warning.

7. The UK can does not have deposit information required by certain states.

Since the Red Bull cases are still pending as of the time of writing, there have not been any court decisions. However, it is noteworthy that the "material differences" relied on by Red Bull relate chiefly to the packaging and not to the product itself. Brand owners can draw important lessons from these recent cases to effectively fight grey market imports.

When grey goods get risky

Despite the increasing number of grey market cases, certain industries have not brought many cases against grey market diverters. Industries dealing with health and safety would appear to have strong "material difference" arguments, if the differences affect consumers' well being. However, there are few reported cases where the "material difference" affects the consumer's health and safety.

There are very few medical device cases despite a substantial grey market problem in the medical device industry. A prime example of the problem is in the glucose testing area. Frost & Sullivan estimated that in 2006, 20.7 million people in the US, or approximately 7% of the population, had diabetes, and reported that it expected this number to increase to 23.9 million people by 2011. Diabetics must monitor their blood for glucose levels several times daily, with each test requiring a new glucose test strip. Billions of glucose test strips are sold in the US each year; the individual retail value of each strip is about one dollar.

Unauthorised wholesalers obtain these test strips in foreign countries and import them into the US, where they are sold to domestic consumers by direct mail or through independent pharmacies. These test strips, however, are designed for sale in foreign countries and the packaging differs from that of domestic test strips. The instructions are often in a different language and the box does not include a US toll-free number to call for assistance. In addition, storage temperatures may be listed in Centigrade rather than Fahrenheit. It would appear that all these reasons would combine to make a compelling case to invoke the "material difference" rule.

Since consumers are likely to consider the absence of a toll-free number to call for help as a relevant factor in their decision to buy a product, especially when the product affects their health, it is puzzling to consider why there are almost no grey market cases involving medical devices or health and safety issues. These cases may present the next frontier in grey market litigation.

The grey market will be a focus of discussion in legal circles as the Supreme Court prepares to hear the copyright arguments in Omega v Costco. Companies such as eBay, Amazon, wholesalers and trade associations are likely to file numerous amicus briefs asserting that copyright law should not be used to hinder grey market imports.

Knowledgeable brand owners, however, should be aware that they already have a potent weapon against grey market imports by using trade mark law. They can use the "material differences" between domestic and foreign products as the lever to stop the unauthorised importation of foreign products into the US. These cases, if properly and carefully presented, can be effective in protecting consumers from variations in foreign products and, thereby, in maintaining the manufacturer's reputation.

Lessons learned

The cases discussed here provide several important lessons for brand owners:

• First, to invoke the material difference grey market remedy, the product itself need not be physically different. There is a worldwide emphasis today on product standardisation to save on manufacturing costs. Manufacturers can still fight the grey market even if the product is identical, so long as the packaging and instructions differ.

• Second, the grey market can be attacked if the brand owner does not warrant the grey market product or even if the warranty protection is different. Some will insist on honouring a warranty even for grey market products, perhaps because they feel responsible to stand behind all their products. Others openly declare that that they will decline grey market repairs. Several prominent computer and video game companies will honour their warranties on grey market products, if the serial number has not been defaced, altered or removed.

• Third, it is a clear violation of the Lanham Act to sell goods with bar codes or serial numbers removed. Grey marketers will often remove this information so that the manufacturer will not be able to track the source of the grey market products. This occurs frequently with cosmetics. For example, CVS was recently held liable for selling grey market Davidoff Cool Waters cologne. Since Davidoff refused to sell to CVS and other non-luxury outlets, CVS obtained the cologne elsewhere and removed the bar code labels. The Second Circuit held that removal of the bar code violates the Lanham Act because it interfered with Davidoff's quality control and because the altered packages are materially different from intact, authorised packages (Zino Davidoff SA v CVS Corp (2d Cir 2009)).

• Fourth, grey market goods are frequently mixed with counterfeit goods. In the CVS case, Davidoff found counterfeit versions of its cologne among the grey market goods. Similarly, in the Kia case, the automaker asserted that counterfeit Kia auto parts were being sold with grey market auto parts. Accordingly, manufacturers should be watchful for the presence of counterfeit goods in grey market investigations. The presence of counterfeits entitles the manufacturer to powerful remedies including the recovery of statutory damages up to $2 million, the ability to conduct ex parte civil seizures, and potential criminal liability of the defendants.

Mark Schonfeld

© Mark Schonfeld 2010. The author is co-chair of the Intellectual Property/SciTech Group at Burns & Levinson in Boston