The Impact of COVID-19 and Accelerated Growth of E-commerce on Gray Market Sales
COVID-19 has impacted almost every aspect of society—our lives, our jobs, and our businesses. In addition to dominating decisions relating to consumer spending and purchasing, COVID-19 has created surpluses of goods, increased demand for previously unnecessary goods, and disrupted supply chains. Such consumer behavioral changes, economic uncertainty, and demand for new products to combat COVID-19, create an environment that is ideal for opportunistic authorized and unauthorized distributors alike to divert genuine products through unauthorized distribution channels.
As e-commerce continues to grow, the opportunity for both gray and black market (i.e. counterfeit) goods to enter the stream of commerce increases. In a survey conducted by KPMG, in 2009 alone, it was estimated that the gray market cost brand owners up to $63 billion in United States sales (or 4.5 percent of total sales).1 In 2011, gray market goods were estimated to cost individual high-tech companies, like Samsung and Hewlett Packard, $1.4 billion each year.2 In 2016, gray market sales accounted for 20% of the global market for luxury watches.3 And in 2020, while it is yet unknown what affect the gray market will have on sales in the United States and worldwide, what is clear is that the global pandemic has radically altered the retail e-commerce landscape creating the necessary conditions for an exponential growth in gray market activities.
The Organisation for Economic Co-operation and Development (“OECD”) reports “the COVID-19 crisis has enhanced dynamism in the e-commerce landscape across countries and has expanded the scope of e-commerce, including through new firms, consumer segments (e.g. elderly) and products (e.g. groceries). Meanwhile, e-commerce transactions in many countries have partly shifted from luxury goods and services towards everyday necessities, relevant to a large number of individuals.”4 And further, the OECD indicates that “some of these changes in the e-commerce landscape will likely be of a long-term nature, in light of the possibility of new waves of the epidemic, the convenience of the new purchasing habits, learning costs and the incentive for firms to capitalise on investments in new sales channels.”5
Digital Commerce 360 states “COVID-19 has spurred seismic shifts in buying behavior this year as consumers have avoided stores and shopped online, causing ecommerce sales to skyrocket. Nonstore sales growth has been elevated for the majority of 2020.”6
By the numbers:
What does the growth in e-commerce during the global pandemic mean for brand companies? It means an increased customer base that creates a shortage in certain goods and surpluses in other goods. It means distributors and resellers seeking out opportunities to meet the needs of this broader customer base. And as the United States’ economic recovery appears shaky until, at a minimum, widespread vaccinations can be achieved, it means a customer base whose top priority is to obtain the lowest price.
All of these factors create an environment ripe for a surge in unauthorized goods (or gray market goods) to be sold alongside authorized goods as both authorized and unauthorized distributors will seek out ways to meet the needs of the customer. Any potential surge in gray market activity means brand owners should not simply rely upon their long-term brand protection strategies, but reevaluate and implement new selective distribution strategies based on the current market. And if necessary, consider legal enforcement actions that brand owners have generally been reluctant to pursue.
Gray market goods, otherwise known as parallel imports, may be defined in a variety of ways, but in its broadest sense gray market goods are genuine, authentic products produced by a brand owner (generally the holder of a product’s intellectual property rights (e.g., patent, trademark, and copyrights)) that have been diverted from authorized distribution channels without the authorization of the brand owner and imported to the United States.21 Gray market goods are not counterfeit goods and they are not sold on the black market.22 Under most considerations, gray market goods are legal as the goods entered the stream of commerce through an authorized distributor, such that the Federal Circuit has found that downstream sales introduced into the distribution channel by an authorized distributor are presumed to be authorized by the brand owner.23
Gray goods may enter the United States through a variety of avenues from both authorized and unauthorized distributors, including the purchase of return and sale items from authorized distributors by resellers; the purchase of products at a lower price overseas and then imported to the United States; the acquisition of stolen goods that were diverted from a brand owner’s supply chain; or the purchase of volume products at a bulk discount from an authorized distributor. Gray goods may even enter the United States by actions of the brand owner themselves (e.g., as when a brand owner provides brokers with access to end-of-life stock which may be sold to consumers online through unauthorized channels).
Regardless of how the gray goods enter the United States, the same problem for brand owners will result—direct competition with genuine goods generally offered at a lower price point. Such result will not simply reduce a brand owner’s revenue and profits, but will also undercut the trust of their customers impacting any goodwill established by the brand owner and negatively affect the brand owner’s partnerships.24 It may also require the brand owner to offer additional services or change packaging to differentiate from those products on the gray market. And even more concerning, gray market goods (such as pharmaceuticals (e.g. drug importation schemes)25 and medical devices (e.g., PPE26)) may harm the health and well-being of customers.
Once a brand owner is aware that it must contend with the challenges of the gray market, the brand owner must also understand that any inaction may only intensify the problem (e.g., marketing conducted by the brand owner may also benefit such goods found on the gray market) and bolster the conduct of unauthorized distributors.27
There is no one size fits all strategy that will solve the challenges created by the gray market. There are though, as brand owners and manufacturers have known for years, approaches that are more effective than others. Thus, either in establishing brand protection strategies, or simply reevaluating current brand protection programs, a brand owner should look to the totality of their approach in determining the success of their program in preventing gray market abuse.
Especially given the current environment with the growth of e-commerce amid a global pandemic, brand owners should develop or strengthen a brand protection program. Any brand protection program, whether during a global pandemic or not should focus on: Assessment; Education; Monitoring; and Enforcement.
A brand protection program should focus on conducting an internal audit that identifies how well the brand owner and its products are secured in terms of legal protection during the global pandemic. At a minimum, this includes: (1) an evaluation of each distribution partner and/or authorized reseller focusing on maintaining relationships with reputable businesses; (2) an assessment of the brand owner’s supply chain that should address potential vulnerabilities; and (3) an assessment of the brand owner’s distribution and reseller contracts as there are key terms and conditions that can be crafted to prohibit gray market activity.
Such key terms and conditions typically include: explicit prohibition of gray market activity by the distribution partner; the right for the brand owner to audit the records of the distribution partner and conduct security audits; express identification of any territorial exclusivities or limitations; quality control and warranty policies; and the right to damages and attorney fees for any breach of the contractual obligations.
Under any brand protection program, a brand owner should also undertake and identify any gaps in the registration of its intellectual property everywhere the brand owner’s products are sold, manufactured, or assembled. Any such trademarks and/or copyrights should be recorded with the U.S. Customs and Border Protection.
Another element for the brand owner to consider is whether it would strengthen their brand protection strategies to implement either an incentives initiative for compliance (i.e., increased territorial exclusivity and price protection) and/or a penalties initiative for noncompliance (i.e., monetary penalties, and probation, suspension, or termination).
In order to implement an effective brand protection strategy, a company must reinforce an environment among its employees and management that makes brand integrity and protection a priority. There must be agreement that “[t]he brand is the most important and sustainable asset of any organization—whether a product- or service-based corporation or a not-for-profit concern—and it should be the central organizing principle behind every decision and every action.”28 This is a principle that is common among the most successful brand owners.
Beyond such agreement, the brand owner should focus on the education of its employees and its distribution partners and resellers. An education initiative should address: (1) both the benefit, namely short-term sales, as well as the long-term harm that gray goods may impose on the brand owner; (2) that gray market activity will not be tolerated by the brand owner; and (3) the consequences of failing to meet contractual obligations. However, given the rapid-growth of e-commerce during the global pandemic, brand owners should also inform employees and its distribution partners and resellers of changes affecting consumer’s purchasing habits and general attitude toward gray market goods, any new threats from unauthorized channels, and any new strategies resulting from the brand owner’s internal audit.
Without many alternatives effective to eliminate the gray market (as staggered distribution, worldwide pricing, and IP licensing offer limited relief), brand owners will need to increase current monitoring activities to curtail the sale of gray goods during this time of exponential e-commerce growth.
Brand owners should begin by heightening monitoring activities of its supply chain. This could include identifying and understanding any geographical vulnerabilities that may exist in the country’s laws or marketplace, and developing strategies to overcome such vulnerabilities. Here, a brand owner may begin by reviewing the Office of the United States Trade Representative annual Special 301 Report on the adequacy and effectiveness of certain countries’ protection of intellectual property rights and the findings of its Review of Notorious Markets for Counterfeiting and Piracy, which highlights online and physical markets that reportedly engage in and facilitate substantial trademark counterfeiting and copyright piracy.29
In addition, a brand owner may choose to monitor on-site security as well as implement product control and tracking procedures for non-U.S. distributors.
While brand owners have certain legal options in the United States at their disposal—specifically litigation,30 arbitration, and other actions—many brand owners seek not to enforce their rights through legal actions as gray goods often enter the marketplace through one of the brand owner’s own authorized distributors. Nonetheless, brand owners should ensure that it has created the necessary legal foundation for enforcement should it ever seek redress.
In order to create a sound legal foundation, a brand owner cannot simply tolerate gray market activity, it must appropriately police their distribution channels. Courts in the United States have indicated that any inaction to seek redress for gray market abuse may potentially harm any future enforcement actions.31 Accordingly, a brand owner must be proactive in understanding how gray market activity harms their brand and implement strategies to protect its brand from such harm.32
Given that sales of gray goods often originate from authorized distributors, options for enforcement are often limited if a brand owner seeks to not commence an action against such distributor. This is due to the “doctrine of exhaustion” under patent law and the “first sale” doctrine under trademark and copyright law.33
Where an unauthorized distributor purchases a patented product through lawful means, thus affectively transferring title to the distributor, pursuing an action for patent infringement is not possible for any later gray market transactions. The doctrine of exhaustion precludes that a patent owner (or brand owner) “exhausts” its patent rights when it sells a patented product to another.34 To the extent, the patented product was merely licensed by the brand owner, and not sold, no exhaustion has occurred. If the brand owner’s patent rights have not been exhausted, then the brand owner may have a cause of action if such product is re-sold outside the scope of the license.35
Similar to patent law, under the “first sale” doctrine, a party may resell a trademarked product without incurring liability for infringement because a “genuine” article that bears a true trademark does not deceive consumers as to its origin even though the reseller does not have permission from the brand owner.36 The court in Yamaha Corp. of America v. U.S. defined genuine goods as follows: “Genuine goods are goods that are in fact manufactured by the same manufacturer that supplies the U.S. trademark holder. In other words, they are to be distinguished from goods that ‘copy or simulate’ the genuine article; they are the genuine article, although they may not have been intended for distribution in the U.S. market.”37 Thus, a trademark holder does not have a right under the Lanham Act38 to control unauthorized resales as long as the goods sold are genuine.39
The first sale doctrine, however, has an important limitation pertinent to gray market activity. Goods that are not intended for domestic sale and are materially different from domestic goods are not considered genuine and may give rise to liability under the Lanham Act.40 A material difference can be “any difference between the registrant’s product and the allegedly infringing gray good that consumers would likely consider to be relevant when purchasing a product.”41 Any consumer confusion is likely to injure the goodwill associated with the trademark. “Because the likelihood of confusion increases as the differences between products become more subtle, the threshold for determining a material difference is low.”42 Courts have found that “it is by subtle differences that consumers are most easily confused.”43 Because a material difference is one that consumers would consider important in deciding whether to purchase the product, it follows that not all differences are necessarily “material.”44 Moreover the unauthorized distributor of a gray market good can avoid trademark infringement by providing adequate notice of differences between the genuine and gray market goods.45 However, the adequacy of any such notice is a question of fact.46
Another way of proving material differences is to show that the trademark owner adheres to certain quality control procedures in the distribution of its products.47 A “quality control” procedure is “any method that a company uses to oversee the quality of the products that it sells, such as inspections, tests, or protective measures.”48 The Second Circuit has “held that goods are not genuine if . . . they do not conform to the trademark holder’s quality control standards.”49 “That is because the interference with the trademark holder’s legitimate steps to control quality unreasonably subjects the trademark holder to the risk of injury to the reputation of its mark.”50 Thus, “[i]f the goods were . . . not in keeping with the trademark owner’s quality standards, a valid claim for trademark infringement is established.”51 Ryan, 107 F. Supp. 2d at 382
Another legal recourse for brand owners to stop the importation of gray market goods is to initiate a proceeding before the United States International Trade Commission (“ITC”).52 The ITC has the right to conduct investigations involving claims of patent and trademark infringement. The authority to conduct such investigations and issue rulings can be found in Section 337 of the Tariff Act of 1930. Remedies under Section 337 investigations that are available to brand owners include general exclusion orders against all infringing imports, limited exclusion orders against certain importers, and cease and desist orders against certain importers to prevent the sale of already imported articles. Unlike a civil lawsuit, under a Section 337 investigation a brand owner is not entitled to an award of money damages and typical proceedings before the ITC are shorter than civil lawsuits.
As an alternative to litigation, brand owners are able to report illegal trade activity directly to the U.S. Customs and Border Patrol (“CBP”) once trademarks and copyrights are registered and recorded with the CBP. Additionally, by recording registered trademarks and/or copyrights with CBP, the U.S. government monitors imports for counterfeits and restricted gray market goods with the capacity for detaining and possibly seizing infringing goods at over 300 ports of entry before they even enter United States commerce.
With all that is going on in the world, it is easy to simply stay the course, relying on current policies and practices with respect to gray market activity. However, the growth of e-commerce in the marketplace suggests that a brand owner should not become complacent with its long-standing, anti-gray market programs as complacency about the gray market may only exacerbate the challenge. As the vice president of Shopify Inc., Loren Padelford stated in a recent article in The Wall Street Journal, “‘Covid has acted like a time machine: it brought 2030 to 2020 . . . . ‘All those trends, where organizations thought they had more time, got rapidly accelerated.’”53 The accelerated growth of e-commerce requires brand owners to not only reassess but implement new strategies to effectively manage and mitigate risk associated with the presence of unauthorized gray market goods in the marketplace.