It’s an unconventional use of copyright law. But if Omega SA wins its case before the US Supreme Court, the famous Swiss watch company will have established a powerful new weapon against grey market goods in that country.

Grey market goods are legitimate branded products that are put onto the market with rights owners’ authorisation and eventually resold outside authorised distribution channels. Typically, goods intended to be sold at a relatively low price in one geographic area wind up resold in another area, where authorised distribution channels sell the branded goods at a significantly higher price.

Because grey market goods undercut sales of higher priced (and higher profit) goods, they are a boon to consumers, but they take a big bite out of many companies’ bottom lines. In 2007, grey market goods racked up $58 billion USD in sales just in the US IT market, and this cost IT companies $10 billion USD in profits, according to a December 2008 survey [pdf] by KPMG and the Alliance for Gray Market and Counterfeit Abatement.

Brand name companies have traditionally used trademark law to stop the importation of grey market goods, because countries often treated sales of trademarked goods outside their borders differently from sales inside their borders. Upon the first authorised sale of a branded item within the country, the trademark owner’s rights became exhausted; the mark owner lost its right to control further distribution of the item in the country. The purchaser could resell the item nationwide without fear of committing trademark infringement.

However, if the initial authorised sale occurred in a foreign country, that sale was not covered by the domestic nation’s first sale doctrine and thus did not exhaust trademark rights domestically. If such a foreign-sold item was resold and imported domestically, the importer would be liable for trademark infringement.

Some countries still apply the first sale doctrine only within their borders. Many countries, however, have extended this doctrine beyond their borders, so importing grey market goods into these nations often no longer constitutes trademark infringement.

The United States, for instance, largely applies the first sale doctrine to authorised sales worldwide. Once a branded item has been sold anywhere on earth, with the approval of the trademark’s owner, the mark owner has exhausted its right to control further distribution of that item. Thus the trademark owner cannot stop grey market resale of the item in the US.

There’s a caveat, however. A trademark owner can stop the importation of grey market items that are “materially different” from trademarked goods marketed in the US with the mark owner’s approval. As a result, brand companies have used a variety of means to differentiate products intended for the US and non-US markets. They have argued that grey market goods are materially different from authorised US goods because they have, for instance, different warranties, different packaging, or different inserts contained in the packaging (written in different languages). These arguments are sometimes accepted by US courts, but not always.

Japan similarly recognizes worldwide exhaustion of trademark rights, according to Ethan Horwitz, an IP attorney in the New York office of King & Spalding and author of a five-volume treatise, World Trademark Law & Practice. Grey market goods imported into Japan do not infringe under the country’s trademark law so long as the trademark on the goods was applied with the mark owner’s authorisation, the goods originate from the trademark owner (or its authorised licensee), and the goods are not qualitatively different than the goods that the mark owner authorises for sale in Japan.

The situation in the EU is a bit more muddled. There is clearly Community-wide exhaustion, according to Alexander Klett, an IP attorney in the Munich office of Reed Smith. If a trademarked item is initially brought onto the market by a sale in an EU member state, this exhausts the trademark rights everywhere in the EU (assuming the sale was authorised by the mark owner). Thus, a product initially sold in Italy can be resold in Spain without any fear of trademark infringement.

However, if a trademarked item is initially put on the market outside the EU area, it is unclear whether importing this item into the EU without authorisation of the trademark owner would constitute infringement. “There’s been a lot of case law over the years going back and forth on this,” Horwitz said.

New Tactic: Copyright

Because trademark law often cannot stop the import of grey market goods, a growing number of brand owners are trying a new tactic. They are using copyright law to protect their markets in the US. (This tactic doesn’t work well in Europe because the EU lacks a single, harmonised approach to copyright law, according to Klett.)

Consider the method used by Omega SA. The watchmaker inscribed a tiny, 0.5 cm globe design on the underside of its watches. This design is invisible when the watches are worn, so individuals are unlikely to purchase Omega’s high end watches in order to obtain copies of this inconspicuous design. Because this design is copyrighted, however, it may enable Omega to stop the import of grey market watches into the US.

Section 106(3) of the US Copyright Act grants copyright owners the right to control the distribution of copies of their works. This includes the right to control imports of copies of their works, according to Section 602(a) of the statute. So if someone imports a copy without authorisation, they are guilty of copyright infringement. And that is precisely what Omega has alleged against Costco Wholesale Corp., a major discount retailer with stores throughout the US.

Omega makes its watches in Switzerland and sells them in Europe at prices well below its authorised US prices. Some watches that were initially sold in Europe and intended for that market were resold to Costco, which imported them into the US. Omega objected and sued Costco in 2004 for infringement.

Costco asserted that importing the watches does not infringe because of Section 109(a) of the Copyright Act. This statute codifies the copyright first sale doctrine, which is similar to the one in trademark law: upon the first sale of a copy of a copyrighted work, the copyright owner loses its right to control any further distribution of that particular copy. The copyright owner’s right of distribution has been extinguished, so the purchaser can resell, lend or give away the copy without committing copyright infringement.

There is, however, one significant difference between the first sale doctrines in US copyright and trademark law. Copyright law has an added qualification. Its first sale doctrine, Section 109(a), applies only to copies “lawfully made under this title.”

Omega argued that because the copies of its watch design were made outside the US, they were not made under US copyright law and were thus not covered by the first sale doctrine. Costco argued that because the copies were made by the US copyright owner, they should be considered “lawfully made” under US copyright law.

The 9th Circuit US Court of Appeals agreed with Omega’s interpretation of the statute. The court ruled [pdf] in 2008 that applying the first sale doctrine to goods made overseas “would impermissibly apply the Copyright Act extraterritorially.”

Costco has asked the US Supreme Court to review this decision. That court in October asked the US Department of Justice to file a brief on the case. Many observers see this as a sign that the court may take the case.

If the 9th Circuit ruling is left in place, it would be a huge win for companies that wish to stop grey market goods from being imported into the US. It would, similarly, be a big blow to consumers and to many businesses that import or sell grey market goods in the US. Moreover, according to some experts, it would be a misuse of copyright law.

“[U]sing copyright to prop up geographic price discrimination is bogus,” said Eric Goldman, who teaches IP law at Santa Clara University in California. “From an economic standpoint, I don’t have any problem with price discrimination, but … using copyright to stop the transport of goods – which people aren’t buying because of their copyrighted aspects – makes no sense to me.”