Hey, Can I Keep Those Gray Market Goods Out of Here? The Unresolved Conflict Between §§ 109(a) and 602 of the Copyright Act Following the Supreme Court’s Deadlock in Costco v. Omega


First, my apologies to those who want a quick fix on this issue; I have miserably failed to shorten this piece. The conflict between §§ 109(a) and 602 of the Copyright Act divided the Supreme Court in Costco v. Omega as it has vexed the district courts. Because I try to fairly present both sides of the issue and the policy questions raised, I have gone way beyond recommended blog length.  So with that warning, let’s begin.

Does the first-sale doctrine applies to gray market goods: those made overseas and imported without the permission of the copyright holder? This is an issue the Supreme Court in Quality King Distributors v. L’Anza Research never decided. But with the gray market now a multi-billion industry, the copyright supply chain: those who make, distribute, import and sell copyrighted goods, were hoping that the Court in Costco would now finally decide this issue. Well, wait some more.

The Supreme Court’s 4-4 deadlock (with Justice Kagan taking no part) in Costco leaves us where we were with lots of questions and no definitive guidance. The Court in Costco issued a per curiam opinion affirming the decision in the Ninth Circuit, which ruled in favor of the copyright holders. As a result the Ninth Circuit’s decision only has precedential value in that Circuit.

How sound is the Ninth Circuit’s opinion? Will the 2d Circuit follow it in the three pending cases raising the same issue now before that court? What guidance does the present state of the law offer importers and domestic copyright holders now that the Court has deadlocked? Some answers below.

The Interplay between the Importation Right and the First-Sale Doctrine

At issue in Costco is the tension between two statutory rights in the Act. On the one hand, the copyright holder has the right to regulate the importation of its goods by §§ 602(a)(1) and 106(3). Section 602(a)(1) provides that “[i]mportation into the United States, without the authority of the owner of the copyright under this title, of copies . . . of a work that have been acquired outside the United States is an infringement of the exclusive right to distribute copies . . . under section 106.”

Section 106(3), in turn, states that “[s]ubject to sections 107 through 122 [of the Act], the owner of copyright under this title has the exclusive rights to do and to authorize … [the] distribut[ion] [of] copies … of the copyrighted work to the public by sale or other transfer of ownership, or by rental, lease, or lending.”

On the other hand, the owner of a copyrighted work “lawfully made under this Title” has the right under § 109(a) of the Act to sell the work without the permission of the copyright holder. That’s the first-sale doctrine. This section provides in essence that, once the copyright owner consents to the sale of a particular item lawfully manufactured with its authorization, that sale exhausts the owner’s §106(3) distribution right and the owner thereby loses control of the distribution of that work.

 

The Facts in Costco v. Omega

Let’s now see how the Ninth Circuit in the Omega case attempted to resolve the tension between these sections.  Omega made watches in Switzerland and sold them for exclusive distribution outside the U.S. To gain copyright protection, Omega placed on the back of the watches a small copyrighted logo called the Omega Globe Design. Unidentified third parties imported the watches without Omega’s authority into the U.S. where they sold them to Costco who retailed them to consumers at prices far below those Omega charged for the same watches it manufactured domestically.

When Omega discovered that Costco was undercutting its market, Omega sued Costco for copyright infringement under §§ 106(3) and 602 of the Act. Costco defended on the ground that its sales were protected by the first-sale doctrine.

 

The Ninth Circuit Finds for Omega

The district court without explanation granted Costco summary judgment. It is hard to believe that a case of this importance was dismissed at the district court level without an opinion but apparently it was. The Ninth Circuit reversed. It held that under circuit precedent § 109 (a) does not provide a defense to an infringement claim under §§ 106(3) and 602(a)(1) for imported copies made abroad and intended only for overseas distribution. The circuit court explained that the Supreme Court’s holding in Quality King neither overruled Ninth Circuit precedent nor undercut their theory or reasoning.

Quality King Involved Round-Trip Importation

The Circuit Court observed that Quality King rested on different facts- a round-trip importation involving copies made in the U.S., sold to a third party overseas and then shipped back into this country. The Ninth Circuit stated that, because Quality King only involved domestically made goods, it did not address the effect of §109(a) on claims regarding gray market goods.

The Presumption against Extraterritoriality

The Ninth Circuit then stated that the reasoning of Quality King did not undermine circuit precedent. Those earlier cases recognized that finding a copy made overseas as “lawfully made under this title” “would violate the presumption against the extraterritorial application of the act.” Quality King in cryptic footnote 14 had dismissed a similar concern with respect to foreign sales, stating that protecting them under the first-sales doctrine “does not require the extraterritorial application of the Act.” The Court never explained why extending that doctrine to a foreign sale is not an extraterritorial application.

But the Ninth Circuit found that applying the first-sales doctrine to foreign-made copies went too far and “would impermissibly apply the Copyright Act extraterritorially in a way that the application of the statute after foreign sales does not.” The circuit court explained, “[t]o characterize the making of copies overseas as ‘lawful[] . . . under [Title 17]’ would be to ascribe legality under the Copyright Act to conduct that occurs entirely outside the United States….”

I don’t see a distinction between a foreign sale (no extraterritorial application) and foreign manufacture (extraterritorial application); but the Ninth Circuit created that distinction to escape footnote 14 in Quality King.

“Lawfully Made” Refers to Those Goods Made in the U.S: the British Example

The circuit court added that Quality King had distinguished between copies lawfully made under United States and under foreign law.

In much-cited and followed dicta Quality King gave an example involving a U.S. copyright owner’s division of its distribution rights between an American and British publisher (which I refer to below as the “British Example”). In this Example, the Court stated that, if an auth0r gave exclusive U.S. distribution rights to publisher of the U.S. edition and exclusive British distribution rights to the publisher of British edition who then decided to sell in the American market, only the copies made by the publisher of the U.S. edition would be ‘lawfully made under this title.’”

The Court never explained why the copies made by the British publisher would not be lawfully made. But as the Solicitor General argued in its amicus brief in Costco, and as the Ninth Circuit assumed in Omega, the most “natural explanation” for the Court’s conclusion is that the British copies would not be lawfully made because they would be made in a jurisdiction where the Act does not apply.

Relying on that distinction, the Ninth Circuit concluded that “copies covered by the phrase ‘lawfully made’ in §109(a) are not those simply made by the owner of a U.S. copyright;” they are those made “within the United States, where the Copyright Act applies.”

The Ninth Circuit also cited to Justice Ginsburg’s concurring opinion in Quality King which noted that the goods in that case involved a “round trip journey” and which “recogniz[ed] that we do not today resolve cases in which the allegedly infringing imports were manufactured abroad.”

The Court Divides 4-4

In response to Costco’s certiorari petition, the Court invited the views of the Solicitor General, which urged the Court not to take the case, stating that the Ninth Circuit’s decision was consistent with Quality King and did not conflict with any circuit precedent. The Court rejected then Solicitor General Elena Kagan’s recommendation and granted certiorari forcing her to then withdraw from the case when she joined the Court. Because the Court then split 4-4,  §109(a)’s application to gray market goods remains unresolved, other than in the Ninth Circuit.

The Two Approaches Re When Is a Work “Lawfully Made Under this Title” for Purposes of § 109(a)

Because §109(a) only applies to goods “lawfully made under this title,” courts have struggled to decide whether gray market goods are lawfully made under this section. Almost all have concluded that “lawfully made” refers to the place of manufacture. But many of the courts that have reached this conclusion have done so with little enthusiasm.

Under this view a copy can be lawfully made only if the Act governs the act of manufacture. Because the rights granted by the Act extend no further than the nation’s borders, a copy manufactured outside the U.S. cannot be governed by the Act.

As the Ninth Circuit stated in Omega v. Costco, “[t]o characterize the making of copies overseas as ‘lawful[] . . . under [Title 17]’ would be to ascribe legality under the Copyright Act to conduct that occurs entirely outside the United States, notwithstanding the absence of a clear expression of congressional intent in favor of extraterritoriality.” In other words, under the view that the Act does not reach beyond the nation’s boundaries, the making of a copy abroad for distribution there does not implicate any of the exclusive rights granted under §106 and therefore is neither lawfully nor unlawfully made “under this title.” The copy instead remains in legal limbo.

Omega took this view before the Court in Costco (its brief is here) and won 4 votes.

A few courts, including the Third Circuit in Sebastian Intl., Inc.  v. Consumer Contacts, Ltd., are uneasy with the conclusion that “lawfully made” is territorial and refers to where the work is manufactured. These courts urge that “lawfully made” should instead be determined by the lawfulness of the work’s manufacture. Under this view (which Costco urged the Court adopt; its main brief is here), if the copyright holder authorizes the making of the copies, they are lawfully made and therefore governed by the Act wherever manufactured. Courts taking this view conclude that goods made abroad at the request of the copyright holder are therefore lawfully made and their sale abroad exhausts the copyright owner’s exclusive right under § 602 (a)(1) to control their importation into the United States.

Quality King appears to offer support for this view. It broadly stated that “the literal text of § 602(a) is simply inapplicable to both domestic and foreign owners of L’anza’s products who decide to import them and resell them in the United States.” Further, as Justice Scalia rhetorically asked during oral argument in Costco, if Congress intended that lawfully made under this title meant lawfully made in the United States, “why didn’t they [Congress] say” that?

Nevertheless almost all courts that have wrestled with this issue ultimately conclude, based on the British Example in Quality King, that the first- sale doctrine does not extend to copies manufactured abroad. 

 

The District Courts in the Southern District Have Applied § 602 to Bar Importation of Works Made Abroad and Imported without Authorization

 

In a series of copyright cases involving textbook arbitrage, a number of courts in the Southern District, as Judge Scheindlin observed in Pearson Education, Inc. v. Arora, have “unenthusiastically” applied the British Example to reject § 109(a) defenses. In each of those cases, publishers sued importers who brought lower prices textbooks made abroad for distribution there and resold them here in competition with the more expensive U.S. edition.

In finding infringement under §§ 106(3) and 602, the courts in the Southern District have expressed their reluctance with this result in various ways. In Pearson Education, Inc. v. Liu Judge Holwell stated that “nothing” “in the history and purposes of the first-sale doctrine” “suggests that the doctrine should not apply when a copy is manufactured abroad. First, the common law policy against restraints on trade and alienation which is not limited where a good is manufactured; a prohibition against selling books manufactured in China is just as much a restraint on trade and alienation as a prohibition against selling books manufactured in Chicago.”

Judge Pogue in John Wiley v. Kirtsaeng noted that the “legislative history surrounding sections 109 and 602” was “inconclusive. The court was also concerned about a “bright-line rule” that would result “in the phenomenon that, once imported, the goods manufactured abroad could provide the U.S. copyright holder with never-ending section 106(3) “exclusive distribution” protection against any subsequent sale, no matter how legitimate. … In other words, every time the owner of the imported goods sold such goods, he or she would be subject to liability for copyright infringement regardless of how far that sale is removed from the first-sale after importation.”

Nevertheless Kirtsaeng, relying on the British Example, prohibited defendant from relying on the first-sale defense at trial. A jury assessed defendant statutory damages of $600,000 for defendant’s willful infringement of 8 textbooks.

The Three Second Circuit Appeals

All three cases are on appeal to the 2d Circuit. Kirtsaeng was argued on May 19, 2010. Arora was argued on January 19, 2011 and Lui was argued on March 21.  The 2d Circuit had delayed decision in Kirtsaeng after the Court granted cert in Costco. Now that no guidance will be forthcoming from the Court, a decision is expected shortly. These three cases all deal with the heart of copyright: educational textbooks. This element may sway the Circuit Court to be even more solicitous of the § 602(a) interests of the copyright holders than the Ninth Circuit was in Omega.

 

The Two-Side of the Policy Debate

The policy issues divide the copyright community with each side making arguments that resonate.

Those favoring the first-sale doctrine argue that granting greater protection via § 602(a) to goods made abroad creates perverse incentives for U.S. copyright holders to manufacture their copyrighted works overseas, thereby eliminating American jobs. The problem is enhanced by the ease by which manufacturers can apply a copyrighted symbol or label to almost any package offered for sale here and thereby gain import protection under § 602(a). Failing to shelter gray market goods with the first-sale defense also distorts incentives for downstream retailers. That is because they often do not know nor can they ascertain whether the goods they distribute are subject to claims under § 602(a). Further, consumers are also hurt by the absence of the first-sale defense. That is because imposing § 602(a) liability on gray market goods subjugates retailer competition to copyright owner price controls resulting in fewer goods offered and at higher prices. Moreover, although Congress may have the power to create an incentive for foreign outsourcing, how does sending jobs to foreign countries “promote the Progress of Science and useful Arts” in the United States.

Arguments in Favor of Applying § 602(a)

Those arguing against applying the first-sale defense to gray market goods argue that the defense would undermine the value of U.S. copyrights harming copyright owners and consumers for several reasons. First, gray market imports “free ride” on the recognition and goodwill generated by a copyright owner’s investment in its copyrighted work. Businesses make significant investment in product design, services and promotion to gain brand recognition and consumer confidence. Free riders exploit this brand recognition and product appeal from the copyright owners and their authorized distributors.

Second, consumer dissatisfaction arising from gray market imports, which can differ in design, quality and intended usage, and warranty protection, further diminishes the value of U.S. copyrights.  Consumer dissatisfaction arises because gray market goods are designed to conform to the law, standards and culture of the foreign country in which they are manufactured. Thus, as Pearson v. Liu noted, foreign edition textbooks are printed on “thinner paper” with “fewer ink colors and lower quality photographs and graphics.” Consumer dissatisfaction is compounded because the manufacturer’s domestic warranty almost never covers gray market goods. In addition, despite the significant differences that may exist between authorized and gray market good, consumers are almost never told that the goods they are buying were not intended for sale in this country.

Third, the gray market devalues a copyright associated with an unauthorized import by depriving the copyright owner of the opportunity to control the manner and scope of distribution of the copyrighted work.

Fourth, § 602 makes for market segmentation allowing companies to sell their products in different markets at different prices to reflect varying demand conditions and distribution strategies. This segmentation permits distribution in lower-priced markets without undercutting the value of distribution rights in higher-price markets. This price discrimination enhances the value of a creator’s U.S. copyright. The American Watch Association presented these arguments to the Court in a well-drafted amicus brief which is here.

 

Finally, contract remedies are also inadequate. The U.S. copyright holder is often not in privity of contract with the foreign importer who is not bound by the restrictions placed on distribution by the copyright holder.

Some Guarded Predictions and Guidance for the Future

 

Absent additional Supreme Court guidance or Congressional action, courts and litigants will continue to struggle in an effort to reconcile §§ 109(a) and 602. But some guidance is possible.

First, goods involved in a round-trip journey, as in Quality King, will continue to enjoy the first-sale doctrine. Second, goods manufactured abroad and imported by the copyright holder will also enjoy the first-sale defense because § 602 by its express terms only reaches goods imported without the authorization of the copyright holder. Third, goods made abroad and then licensed by the copyright holder to third parties abroad for overseas use will not be sheltered by the first-sale doctrine because, as the Court stated in Quality King, that doctrine does “not provide a defense to a § 602(a) action against a non-owner such as a … licensee.” Fourth, although there are significant countervailing policy interests, it is likely that courts will continue to follow the Ninth Circuit’s Costco decision and subject gray market goods to § 602(a) liability based on the British Example in Quality King.

But what will the Court do with the next case that raises this issue? Although predictions on how the Supreme Court will rule are not for the faint of heart, four Justices sided with Costco. If the result in that case drives more copyright holders to manufacture overseas to gain § 602(a) protection as Costco warned, more than four Justices may be inclined next time to broaden the first-sale doctrine beyond the reach given it in Quality King.

Your thoughts and predictions are welcome.

And as a postscript, I wrote most of this to prepare for a talk sponsored by the Copyright Society on the Costco case that Randi Singer of Weil Gotshal and I gave.  Professor Beryl Jones-Woodin of Brooklyn Law School moderated. Randi and Beryl made excellent presentations and I was pleased to work with them on this.  (Program description here).

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One Response to “Hey, Can I Keep Those Gray Market Goods Out of Here? The Unresolved Conflict Between §§ 109(a) and 602 of the Copyright Act Following the Supreme Court’s Deadlock in Costco v. Omega”

  1. […] mentioned in my post yesterday that all eyes are on the 2d Circuit as we await the decision in the Kirtsaeng case […]

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