Omega vs. Costco: Consumers Will Pay If Gray-Market Goods Get Banned

If the U.S. Supreme Court sides with Swatch Group's Omega watchmaking unit in its war with wholesale club giant Costco, U.S. consumers -- and perhaps workers -- could lose big. Luckily for consumers, however, the tea leaves suggest that Costco (COST) will beat Swatch's (SWGAY) Omega.

At issue are "gray market" goods -- items originally sold abroad, brought into the U.S. and resold here. Why would a retailer go to the trouble to buy something overseas -- say, a very expensive Omega Seamaster watch -- to resell here? Because in many foreign markets, that watch is much cheaper than it is here. That means the retailer -- say, Costco -- can make a profit by importing it and selling it for a third less ($1,299 versus $1,995 in the Seamaster's case) than the suggested retail price of the identical watch intended to be sold here.

The watches are literally identical because the imported ones are still brand new, not used. The foreign purchaser is essentially a middleman, buying them new with the intent of selling them to a U.S. retailer. As USA Today explained a few years ago, one way gray-market goods can differ, however, is that the manufacturer can refuse to honor the product's U.S. warranty. That's not an issue with the Omega watches sold by Costco, however, because according to its brief, Costco gives the watches a better guarantee than Omega itself does.

Stakes High All Around -- Even for Libraries

From a consumer's standpoint, gray-market goods offer substantially reduced prices, although consumers need to pay attention to warranties. As a result, if the Supreme Court agrees with Omega that U.S. copyright law prohibits Costco from selling the foreign-manufactured, foreign-sold watches, many bargains will disappear from store shelves. Arguing against that result, Public Citizen claims that giving Omega the ability to "control downstream sales might allow it to more effectively control prices among different markets. But protection of Omega's preferred business model is not an interest that the Copyright Act protects."

In addition, consumers' ability to use the property they purchase in whatever way they wish is also at stake, argues Public Citizen and, separately, a group of librarians and public interest groups. The librarians claim that an Omega win could jeopardize "used bookstores, libraries, yard sales, out-of-print book markets, movie and video-game rental markets, and innumerable other secondary markets." That's because such markets depend on the "first-sale" doctrine, which says someone who legitimately buys a copyrighted work can do what they like with it -- including sell it to someone else -- without getting the copyright holder's permission.

That makes intuitive sense, has a centuries-long legal basis and is codified in federal law. An Omega win would limit the first-sale doctrine and, the argument goes, endanger secondary markets.

Losing Billions of Profits

The stakes for manufacturers are huge, too, because the gray market is estimated to cost them billions. A 2003 study by KPMG and an anti-gray-market alliance of info-tech companies found the gray market cost the IT industry $5 billion in profits each year. Deloitte did a study for Bloomberg last year and found that the gray market cost companies $63 billion in lost sales (not profits) a year, though not a large percentage for any one company. A company with $10 billion in sales would lose $450 million, or 4.5%.

And it's not just watches (or other goods) at issue, warns an Omega-supporting brief from the Association of American Publishers. Rather, a Costco win would "substantially harm copyright owners and the public, impairing the incentives to create and disseminate copyrightable work, the quality of published works, and the vitality of domestic publishers."

Nor is Omega's "preferred business model" the only one at stake. The movie and music industries explain how a Costco win threatens them:

A Blow to the U.S. Economy?

One group that could feel the impact of the Court's ruling-to-be is manufacturing workers. Costco claims that if Omega wins, manufacturers have an incentive to move factories overseas because then they'll enjoy greater copyright protection. That's because the key Supreme Court precedent in this case, Quality King Distributors, Inc. v. L'anza Research International, Inc., decided at a minimum that it was OK to make something in the U.S., sell it for the first time overseas to one of these middlemen and have it be resold here. That is, the first-sale doctrine did apply to imports of goods made here but sold for the first time overseas. So if Omega was making the watches sold by Costco here, it would have no basis for complaining.

Indeed, the key legal question is whether Quality King applies only to copyrighted goods sold abroad for the first time regardless of where manufactured, or does it apply only to goods that were manufactured here. Would manufacturers relocate factories they otherwise wouldn't to ensure they could control the distribution chain of their products in the U.S.? I'm not sure that losing 4.5% of total sales would be enough to do that, but the incentive certainly exists.

Google (GOOG), eBay (EBAY) and a couple of Internet trade groups forcefully make the argument that an Omega win would hurt the U.S. economy by shifting factories overseas, endangering small businesses that don't know where their distributors got their merchandise and stifling secondary markets, including consumer-driven ones.

Libraries also sided with Costco because the first-sale doctrine is essential to libraries' existence. Because many books are now manufactured overseas, often with no indication of that, librarians worry that they won't know if they're buying gray-market books illegally and would incur substantially higher costs by obtaining lending licenses for books not clearly made here. At a time when libraries face funding cutbacks nationwide, that would have a big impact on their collections. As a result, the librarians are asking that if Costco loses, the Court protect libraries by ruling, for example, that library lending constitutes "fair use."

Maybe This Isn't Even a Copyright Case

One interesting brief filed in support of Omega by the Intellectual Property Owners Association (IPO) points out that perhaps this case shouldn't really be a matter of copyright law, because the only thing copyrighted on the Omega watch is a tiny logo Omega put on the watch's back for the sole purpose of invoking copyright protection to stop gray-market goods. That is, the copyrighted material is purely incidental. As Costco points out in its brief, for years Omega didn't mind what Costco was doing. But after U.S. retailers selling full-price watches in competition with Costco complained, Omega added the symbol and objected to what Costco was doing.

The IPO supports ending such game-playing and allowing gray-market goods, but it wants to avoid using the first-sale doctrine to achieve that end. As a result IPO would have the Court send the case back to determine if copyright law really should apply to the watches in the first place.

Unfortunately for libraries and consumers, the IPO defines books as among the goods that, unlike watches, should have copyright protection, and if the Court agrees with IPO's logic, libraries and secondary markets would be threatened, at least as far as goods like books are concerned. And because it's possible that courts would ultimately decide that copyright law did cover the watches, all of the other concerns at stake wouldn't be definitely resolved.

Applying U.S. Law Overseas?

Generally speaking, U.S. law -- including copyright law -- isn't supposed to be used "extra-territorially." That is, outside the U.S., foreign laws apply, not U.S. law. So when the first-sale exemption speaks of items "lawfully made under [U.S. Copyright law]," does that mean goods made in the U.S. only, or also goods created in compliance with U.S. copyright law regardless of where they're made?

That question is complicated by another provision of copyright law that allows copyright holders to control imports so that if the first-sale doctrine applies to goods manufactured overseas, that import control right is very limited.

Costco also has support, perhaps surprisingly, from Intel because patent law has a very similar doctrine that's important to the chipmaker. However, Fuji Film and others side with Omega and take Intel (INTC) on directly, accusing it of trying to hijack the case and turn it into one about patent law. (Fuji disagrees with Intel on the patent issue.)

Good Omens for Costco

The federal government supports Omega because it believes a Costco win would apply U.S. law extra-territorially. But the U.S. supported Omega while Justice Elena Kagan was the government's top litigator as the Solicitor General, so she won't help decide this case. That makes a 4-4 tie theoretically possible. While it's a fool's game to bet on how the Supreme Court will ultimately decide a case, some omens look good for Costco.

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First, the Court rules for the party seeking to change the lower-court outcome most of the time, and it reverses decisions of the Ninth Circuit Court of Appeals (where this case came from) slightly more often than cases from other circuits. Second, although when the U.S. weighs in, the Court usually agrees with it, so far this time it hasn't: The U.S. opposed the Court's decision to hear the case. So maybe the Solicitor General's mojo isn't working this time. Third, the Quality King case was a unanimous decision, with Justice Ruth Bader Ginsburg filing a one-paragraph concurrence, not joined by any other justice, suggesting that extra-territoriality might be a big concern in a case like the one today. That suggests a majority in 1998 might have seen things Costco's way.

Of course, four of the Quality King justices are no longer on the court -- Justices William Rehnquist, Sandra Day O'Connor, David Souter and John Paul Stevens -- and perhaps their replacements -- Justices John Roberts, Samuel Alito and Sonia Sotomayor -- won't see the issues similarly. (Again, Justice Kagan is sitting this one out.)

Good omens for Costco aside, it'll be a few months before we really know how this one turns out.

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