Chapter 5 Exhaustion and Parallel Trade: Patent Exhaustion

In: Patent Exhaustion and International Trade Regulation
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Santanu Mukherjee
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5.1 The Effect of Patent Exhaustion on Parallel Trade

On careful study of the evolution of the doctrine of ‘exhaustion’ it is recognised that even in the early 19th century when the doctrine of exhaustion was propounded by Josef Kohler, the aim was to facilitate free trade within the German ‘Länders’.280 Today as distinct forms of exhaustion can be identified it might seem that since the principle of exhaustion referred to by Kohler was within Germany, it was ‘national exhaustion’ commensurate with the understanding of a Nation State. However, given the fact that Kohler had no objection in exports being re-imported to the local market, it would be erroneous to categorise the mode of exhaustion as national exhaustion.281

The most important question which is related to the issue of exhaustion of patent rights is regarding its effect on international trade since it determines whether a country would allow or disallow parallel importation.282 It is quite prevalent among multinational companies to licence their patent rights to manufacturers in different countries on payment of royalty/licence fee, whereby the goods produced in the second country are then legitimately manufactured often at a considerably lower price. The producer might choose to sell the product at different prices in different markets as a marketing strategy. In such scenario the manufacturer in the second country might also export the patented products manufactured under license outside its own country. Further, a third party might buy the patented product in the country where it is cheaper and export it to the country where it is more expensive. Thus, establishing a parallel channel of distribution of a legitimate product separate from the authorised distributor.

Some of the illustrations of ‘Parallel Imports’ below can provide clarity and practical effect on the markets:

In Case 1 the original patent holder in country ‘A’ manufactures the patented products in country ‘A’ and at the same time grants non-exclusive patent license to a manufacture it in country ‘B’. Parallel trade occurs when importer in country ‘C’ imports the patented product from the licensee in country ‘B’ at a much lower price and sells it in country ‘C’ at a price lower than that of the authorised importer from country ‘A’. Usually, this type of parallel importation takes place since the cost of importing from country ‘C’ even after paying transportation and ancillary costs is much lower in terms of the price at which the authorised importer from country ‘A’ sells it in Country ‘C’.

In Case 2 the patent holder manufactures the patented product in country ‘A’ and exports the product through its authorised distributor to country ‘B’, at one price and to country ‘C’ at a higher price than in county ‘B’. An unauthorised trader in country ‘C’ buys it from the authorised distributor in country ‘B’ and imports it back to country ‘C’ to sell it at a price cheaper than being sold by the authorised distributor. Unlike the previous case based on comparative advantage of the licensee in country ‘B’, this is a case of price differentiation in different markets by the manufacturer.

In Case 3 the patent holder manufactures the patented product in country ‘A’ and sells it through an authorised distributor. It also exports to country ‘B’ through its authorised distributor/licensee at a lower price than in country ‘A’. An unauthorised importer in country ‘A’ buys the patented product in country ‘B’ at the lower price and re-imports back to country ‘A’ to sell it in an unauthorised outlet at a lower price.

Case 4 is when the patent holder manufactures the patented product in country ‘A’ and sells it through an authorised distributor. At the same time, it exports the product to country ‘B’ at a higher price and where it is sold through its authorised distributor at a higher price than in the home country (country ‘A’). An unauthorised importer in country ‘B’ buys the patented product in country ‘A’ (at the lower price) from the authorised dealer of the patent holder and imports back to country ‘B’ to sell it in an unauthorised outlet at a lower price.

Thus, parallel trade occurs when an independent trader acquires legitimate (ip protected) goods in one country and exports them to another country for sale without any specific licence from the patent holder to distribute the goods. As we have noticed the case of parallel trade is common and can occur due to variations of market conditions either because the patent holder licenses others the rights or adopts price differentiation. The trade in ip protected products that are sold through a channel parallel to the authorised channel is then referred as ‘Parallel trade’ and the imports as ‘Parallel Imports’.

From the nature of parallel trade, it is evident that if a country allows it, then a business chain can buy legitimate goods from any market where it is cheaper and sell it where the price is higher at a competitive price. It is noticed that in most cases the patent holder resists parallel imports of patented goods since the patent holder finds its products competing with its own licensed products which are marketed at a lesser price.283 The patent owner adopts national exhaustion of the iprs based on territoriality to restrict such competition using ip enforcement mechanisms treating the legitimate imports as infringed products.

In countries that follow national exhaustion mode, since the patent owner relinquishes his right to restrict others from selling or distributing or manufacturing his product within the boundaries of the country, exhaustion is limited nationally and as such he would be able to restrict parallel imports from third countries. The argument in support of this is that parallel traders must be restricted because markets are different in nature and so different markets require different levels of promotion and support which is reflected on the price of the patented product. The parallel trader can avoid this cost and as such is able to produce at a competitive price which according to the advocates of this mode is an unfair exploitation which should not be allowed.

On the other hand, in countries that follow the international exhaustion mode, since patent rights are exhausted internationally, the patent holder relinquishes his/her rights as soon as the patented product is put on the market, whether within the country or abroad. This means that in case of international exhaustion, a patent holder would not be able to restrict parallel trade and as such parallel imports might be marketed side by side with the original product enjoying same status as the product of the patent owner in that country. The purpose of patent rights is to incentivise innovation and not to artificially partition markets and maintain high price that distorts markets. On comparing international exhaustion and regional exhaustion from the perspective of multilateral trade, the former stands out as more trade-friendly. By enabling intra-brand competition and restricting multiple monetary gains from same patent, international exhaustion removes the possibility of iprs becoming a non-tariff trade barrier.

The third mode of exhaustion, the regional exhaustion is a hybrid of both national and international exhaustion to allow parallel trade within a regional trade bloc at the same time restrict parallel trade from outside the bloc. Based on the principle of regional market or community market, in case of regional exhaustion, a patent holder from one of the member countries of the regional block exhausts the patent right when the patented product is placed in the community market. However, the patent does not exhaust when it enters the market from outside the bloc, i.e. the patent holder can restrict any import of the patented product from any country outside the regional bloc.

On 7th January 2000, the International Chamber of Commerce (icc) published its survey on the views of its members on exhaustion of iprs. After looking into the details of the background of the exhaustion issue in the context of international trade and investment and based on the response to its questionnaire it decided against the principle of international exhaustion. According to the report there was no single global market like that of the European market hence there were no reason to introduce international exhaustion. However, there was a small group of members within the target of the study that supported international exhaustion which opined that it would allow more market competition and hence would be beneficial to the consumers as well as would support international trade by removal of trade barriers. The matter was also brought up in the Melbourne Congress of the International Association for the Protection of Industrial Property (aiipi) where the views of different countries were different thus the matter was not taken further and the status quo of not supporting any mode of exhaustion was accepted.284

As far as trademarks are concerned, there is strong opinion in several countries that parallel imports should not be restricted unless it causes confusion in the minds of the consumers. Here it is worth considering the final report of the Committee on International Trade Law of the International Law Association where it was stated,

In case of trademarks, no persuasive argument or data has been presenting for treating the ec market and the wto market differently. Vertical allocation of distribution markets by manufacturers may have a positive effect on consumers by strengthening inter-brand competition. In both contexts, parallel imports will police against price discrimination.285

The owners of iprs obviously try to achieve as much profit as possible from their iprs and since it is gradually becoming difficult to partition the markets through trademarks, they are trying to obstruct parallel imports through copyrights and patents. Here, it is worth noting that even in case of copyrights there is a growing tendency to allow parallel imports given the market has expanded internationally.286

The issue of parallel trade and its importance is widely felt in relation to multilateral trade under the auspices of the wto. Before analysing exhaustion of patents and its effect on parallel imports from the perspective of multilateral trade under the wto regime, it is important to understand how the exhaustion of some of the iprs other than patents can influence parallel imports.

5.2 The Effect of Exhaustion of Other iprs on Parallel Trade

Different types of iprs have different characteristics and so the effect of exhaustion in each case will differ. As mentioned in the introduction (Chapter 1), this book analyses only the exhaustion of patents and how it affects the possibility of parallel trade. Here it is also important to mention that ‘patents’ refer exclusively to conventional patent rights which are conferred for a period of 20 years. Exhaustion of any patent right which is for shorter period (e.g. Petty Patents or Utility Models or any similar type of sui-generis protection) may have different impact and hence is not studied. However, given the fact that patented products are often marketed under trademarks and the get-up on packaging might be copyright protected, exhaustion of different other iprs affect parallel trade. For this reason, trademarks and copyrights have been briefly discussed in relation to parallel trade to present it in appropriate perspective.

5.2.1 Exhaustion of Trademarks

Trademarks are different from patents or copyrights because, while patents and copyrights are granted as a reward for innovative work, trademarks are not awarded for any such innovation. Trademarks are marks or words that are coined to distinguish products of different manufacturers portraying the quality of the product. Thus, it is more of a marketing tool in the hands of the manufacturer of the product. If the quality of the product is good and/or there are inherent characteristics of the product uncommon to the others, it will be distinguished from the product by its trademark or the coined trade name. For this reason, once these good quality products are identified with their trademarks for some time, the marks create certain goodwill of their own and ascertain the origin of the product.

By the nature of trademark right, it will be clear that a patent holder or copyright owner can expect royalty or license fee for the invention, the innovation. A trademark owner on the contrary, can expect such royalty or license fee only when the trademark has acquired sufficient goodwill attached to the product marketed under the trademark. There is no reward to the trademark owner for coining the mark, the mark is just a tool. It is only when someone else tries to dishonestly pass of another product as that of the trademark owner, that the law is enforced and such unfair competition restricted. This type of infringement of one’s trademarks can very well occur after the first sale of the trademark product or any time later. For this reason, exhaustion in trademarks is not the same as that of patents or copyrights. In case of trademarks when the owner of the trademark authorises another person to use the same trade mark through a license contract, the issue is settled contractually. So legitimately the licensee of the trademark can sell his or her products under that trademark anywhere in the world. The question is whether such ability to market the product globally, practicing international exhaustion should be allowed to be restricted via contracts.

Article 15 of the trips Agreement while elaborating the protectable rights in a trademark, states that a trademark would constitute in any sign, combination of signs that distinguishes a goods and services of one undertaking from another and acquired through registration.287 The intention of according protection to the trademark is to uphold the quality of goods and services by identifying them with the concerned mark. Hence the same trademark can be registered in different member countries of the wto. In terms of wto’s legal principles as established through trips Article 15, given that the same owner registers the trademark in different member countries of the wto, there cannot be any consumer deception in case parallel importation of the trademark goods and services. This results in de facto international exhaustion and following any mode of exhaustion other than international exhaustion, thus restricting parallel imports, would amount to a non-tariff barrier. One might argue that under Article 16(1) of the trips Agreement, a trademark owner can prevent third parties from non-consensual use. However, given that the parallel imports are legitimately licensed intra-brand goods, it is untenable that such goods are non-consensual unless its due to their inferior quality subject to proof of the same.288

Within the ec and the efta member states, there are also consistent ideas about what constitutes the specific subject matter of the respective property rights. In addition, the agreements were signed after the ecj judgment in the Deutsche Gramophone case. Moreover, since the case law on the exhaustion was already established by the ecj at the time the free trade agreement was concluded, different interpretations could have also been presented. It should have been clarified that adoption of regional exhaustion over international exhaustion was essentially based on the principle of free movement of goods within the internal market. However, the free trade agreements of the ec are also international agreements with third countries for which the international interpretation rules apply. According to Article 31(1) of the Vienna Convention on the Law of Treaties (vclt), a contract is to be interpreted in good faith in accordance with the ordinary meaning of its terms in their context and not regarding its aim and purpose. It is questionable as to whether it is enough to rely only on the corresponding or similar relevant ec regulations on exhaustion.289

For these reasons, practically there is no reason to restrict parallel imports of trademark goods. Parallel import of trademark goods is consumer friendly and restricts partition of markets. But trademark owners usually often try to justify restricting parallel imports on the grounds that costs of different markets are different, promotion and advertising expenses for the marks also vary in different countries and are locally borne.290 Such an argument cannot hold ground since even if there is localisation of promotional expenses for the trademark identified product, it promotes the trademark of the product. All expenses (in different countries) are used to promote the trademark and parallel imports do not affect the trade mark negatively as counterfeits do. Moreover, the restriction of parallel imports can be considered as a constraint on competition and given the purpose of trademarks to identify the products, it is extremely difficult to support maintenance of such exclusive territories.291 The products that are manufactured and/or marketed by the authorised licensee cannot be held different from that of the parallel importer since both have the legitimate trade mark. In case there are material differences between the products marketed by the parallel importer and the authorised licensee then the onus is with the authorised licensee to prove that the quality of the parallel product is inferior. There is no legitimacy in restraining products from being marketed under the trademark if they are not of inferior quality.

One of the early cases and an important case of parallel import of trade marked products is the Habanos Cuban Cigars case.292 Decided by Justice Fysh at the Patents County Court in UK (which stands as the High Court in the relevant jurisdiction), it required the plaintiff to establish trademark infringement. The matter went to the Court of Appeals where the decision was overturned. The decision was a move towards international exhaustion although more in line with the doctrine of implied licence since Lord Justice Jacob opined that this was a case of implied consent. Here it cannot be overlooked that given the fact that because of its eea wide effect, the judgement is of utmost importance, laying down a path for others to follow.

The case involves Hunters & Frankau a company established in 1790 in the UK and MasterCigars Direct which was only 5 years old. Under an agreement with a partly Cuban government owned company, Corporacion Habanos, Hunters & Frankau was the exclusive importer and distributor of Cuban Cigars in the UK. Corporacion Habanos had the exclusive dealership in authentic Cuban cigars as well as owned some UK and European Community trademarks for different brands of cigars. Seven years earlier a Franco-Spanish tobacco company had bought 50% stake in Habanos and also bought some cigar distributorships in different parts of Europe. The price of a box of 25 Cuban Esplendidos cigars was less than US $170 whereas the price of the same in UK was about US $1240. MasterCigars imported Cuban cigars directly from Cuba and sold them in the UK markets at a price nearly 40% less than the marked retail price of Hunter.

Cuba followed the doctrine of international exhaustion and as a Cuban company there was no restriction on exporting or importing legitimate goods. As a matter of policy, Habanos sold cigars to foreigners through specific outlets (casas) and allowed them to purchase cigars worth US $ 25,000 in a single transaction, wherein the official identity documentation of the foreigner (passport number, etc.) was recorded. A consignment of cigars imported by MasterCigars legally purchased and well within the allowed quantity was confiscated by the Customs and Excise department of the UK on charges that they were counterfeits or illegal parallel imports of cigars imported by Hunters & Frankau. The matter was taken up first at the patent county court which held the importation as infringement. However, on appeal it was held that the county court erred in its decision.

The court considered that the trademark owner allowed foreigners to purchase cigars worth of US$ 25,000 (maximum) at a single time. It was clear that with such high amount of money large number of cigars could be bought legally and such large numbers obviously could not be intended solely for personal consumption. This meant that the company had given implied consent to the export of the cigars. By deciding on this line, the court specified the scope of the implied consent.

It was also an established fact that the sale was authenticated by issuance of invoices for both the parties (purchaser and the vendor) as well as for the customs department. The invoices had been printed not only in English but also Spanish, French and German catering to purchasers from different European countries and their documentation requirements for importation. This also established that the sale was controlled and legitimate and not as if a third party had purchased it from the open domestic market and imported it to their respective countries in Europe. Further, the defendant could also establish the fact that Corporacion Habanos had exercised control over the commercial market of Cuban cigars (Minutes of internal meetings of Corporacion Habanos was presented to substantiate such claims).

It must be noted here that although this case seems to be following the doctrine of international exhaustion, it is not so. The practice of regional exhaustion was still very much relevant however the judgment made it clear that the parallel imports could be legitimate in the eea if the trademark owner consented to such imports (whether contractually or by implied consent). In any other case the parallel imports would be considered illegitimate and thus can be restricted through measures provided under the trademark laws and directives. Here it is worth mentioning that the European Parallel Importers Coalition (epic) had been making concerted efforts in re-introducing international exhaustion of trademarks in the EU.293

5.2.2 Exhaustion of Copyrights

Like patents, copyrights are exclusive rights that are awarded for new literary contributions and protection granted from unauthorised copying of such work. A unique character of copyright not common to patents is that the protection is available to the creator of the innovative work immediately from the time of creation without any registration or other formality.

The issue of exhaustion of copyright can be complicated since copyright is a bundle of rights that not only includes the right to sell or distribute it, but also to reproduce it or even adapt it or make a public display of it. The literary work need not necessarily be sold in the form of hard copies in printed form. For such reasons, depending on circumstances the copyright might not exhaust with the first sale or distribution if such sale did not comprise sale of hard copies. Further, in case of additional rights or related rights that are often bundled with a copyright, the copyright would not be exhausted with the first sale or distribution.

With reference to parallel importation of copyrighted products, some jurisdictions follow the doctrine of ‘split distribution rights’ which is like exhaustion principle and the principle of implied licence but based on the right to distribute. This is because parallel imports can take place only when there is a parallel exporter holding copyright or exclusive licence to market the copyright materials in the exporting country. Thus, the parallel importer holds the same right as that of the parallel exporter. So, if the distribution rights are retained by the copyright owner or granted to the parallel exporter by the copyright owner or licensee, then parallel import would be allowed. But if the distribution rights to the parallel exporter is split between the exporter and importer, then it is not possible.

5.2.3 Exhaustion of Trademarks and Copyrights in Relation to Patent Exhaustion and Effect on Parallel Trade

The importance of the effect of the other iprs on parallel trade can be significant. In case of patented products if a country follows international exhaustion of patents and national exhaustion of trademarks, copyrights, or others, it would still be possible to restrict parallel trade of the patented products if they are packaged under trademarks where the trademark followed national exhaustion. On the other hand, international exhaustion in trademarks can be undermined if there is a patent component in the product in cases of differentiated exhaustion regimes for trademarks and patents.

Proponents of national exhaustion of copyrights base their arguments on restriction of free-riding of parallel importers on authorised dealers.294 They state that the copyright owners should be allowed to control parallel imports of copyright products because otherwise there would not be sufficient incentive for further creativity. Arguing that restricting parallel imports promotes competition and encourages local copyright-based industries.295 It is difficult to argue how parallel trade would restrict the growth of local copyright-based industries, except the fact that the parallel imports would add competition in the market. On the contrary, parallel importation would allow considerable price competition in international markets and thus it is beneficial.296 Research, particularly in the sound recording market has already shown that parallel imports can provide a competitive force via intra-title competition.297

For this reason, following a uniform policy of exhaustion across different iprs is essential. However, industry lobbies try to exert pressure on governments to take a position that help them in profit maximisation through the iprs to the extent that the country accepts such policies often overlooking consumer interests. Sometimes such influence can result in differentiated approach to exhaustion for different iprs in the same jurisdiction. For example, Switzerland which has very strong pharmaceutical and precision instrument (e.g. watch and scientific tools) industries that depend heavily on patents, had convinced their government to follow national exhaustion in case of patents while international exhaustion for others. Given that it does not have a strong manufacturing base of retail consumer products, it followed international exhaustion in case of trademarks and copyrights. This allowed the traders in Switzerland to import products protected by trademarks and copyrights from the cheapest source in the world. It is noticed in the Kodak case (discussed later in this book) although the Zurich Commercial Court had relied on the uniformity of exhaustion of patents, trademarks and copyrights, this was not accepted by the Federal Supreme Court of Switzerland in Lausanne.298 However later with codification of exhaustion within EU, the Swiss practice of exhaustion was also brought in-sync with EU.

From the above one can deduce that on narrow interpretation from exclusively an ip perspective, one might sometimes be prompted to argue in favour of national or regional exhaustion given the territorial nature of the rights. However, all such arguments ignore the perspective of international trade that completely changes the dimension. With the trips Agreement in operation, one cannot ignore the effect of international trade law and hence this needs to be analysed from the perspective under the multilateral trade regime of the wto.

As has been discussed in this book, the foundational basis of international trade law lies in the economic principle of ‘Comparative Advantage. This theory is based on price mechanisms where every country produces goods and services and the price for these goods and services depend on the different factors of production. It is efficient and obvious that when the price of goods in a particular country is less than that for the same goods in another country, there will be a tendency to manufacture more of these products where it is cheaper and trade with the countries where they are more expensive. Thus, the producers in both countries will shift from producing less efficient and less cost-effective areas of production to those that are more efficient and international trade will thrive. Based on this, one would need to assess how the different wto Agreements can impact the exhaustion regimes of wto members and what should be the ideal exhaustion mode.

280

During the period 1871 to 1918, the form of government was the German Empire, a federal monarchy in which there were different federated monarchs each ruling their kingdoms, Grand Duchies, Duchies and Principalities as well as Free cities. These all together formed the federated states or ‘Bundesstaaten’ and later during the Weimer Republic was termed as ‘Länders’. Here the reference is made regarding free trade between these federated states. (https://www.britannica.com/place/German-Empire).

281

Ibid at 140.

282

Govaere Inge and Demaret Paul, “The trips Agreement: A Response to Global Regulatory Competition or an Exercise in Global Regulatory Coercion?”, in Esty Daniel and Damien Geradin (eds.) “Regulatory Competition and Economic Integration”, Oxford University Press, pg. 379, 2001.

283

Some cases of parallel trade have been already discussed earlier in chapter 4 while elaborating on the evolution of the exhaustion principle in different countries and also in Chapter 8.2 on the EU regime of regional exhaustion.

284

See International Chamber of Commerce Policy Statement issued by the Commission on Intellectual and Industrial Property, dated 7th January 2000. Also, Ganguli Prabuddha, Pgs. 268–269, Summary Report of the International Association for the Protection of Intellectual Property (aippi) released at the aippi Congress in Melbourne 2001.

285

Ibid at 122, pg. 607, (607–636).

286

Moens Annelis, “ip Rights loosening grip on parallel imports”, Les Nouvelles pgs. 26–29, March 1999.

287

Article 15: Protectable Subject Matter. https://www.wto.org/english/docs_e/legal_e/27-trips_04_e.htm.

288

Cottier Thomas, “Current and Future issues related to the trips Agreement: A European Perspective” in “Trade and Intellectual Property Protection in wto Law Collected Essays”, Cameron May, pg. 321, (317–330), 2008.

289

Freytag Christiane, “Parallelimporte nach eg und wto Recht”, pg. 99, (98–100), Dunckler and Humblot, Berlin 2001.

290

Prahl Dennis, “Exhausted and gray, but still going strong: A comparative view of parallel imports from the trademark perspective”, pg. 1, 26–35, presentation at the Intellectual Property Association’s Annual Meeting of 2001.

291

O’Toole Francis and Treanor Colm, “The European Union’s Trade Mark Exhaustion Regime”, 25 (3) World Competition, pg. 302, (279–302) 2002.

292

MasterCigars Direct v. Hunters & Frankau and Corporacion Habanos v. MasterCigars Direct and Christopher Kenyon. Details of the facts of the case is available at, https://www.lawgazette.co.uk/law/law-reports/4308.Article.

293

European Parallel Importers Coalition (epic), “The Case for re-introducing Global Trademark Exhaustion in EU legislation”, Position Paper, epic January 2001.

294

Unauthorised distributors obtain the copyright products from outside the local market and thus do not reflect the legitimate costs of the authorised distributors who needs to consider pre-sale marketing and service costs.

295

Barfield Claude and Groombridge Mark, “The Economic Case for Copyright Owner Control over Parallel Imports”, 1 (6) The Journal of World Intellectual Property, pg. 905 (903–939) 1998.

296

Ibid at 122, pg. 607, (607–636).

297

Theo Papadopoulos, “The Economic Case against Copyright Owner Control over Parallel Imports – The Market for Sound Recordings”, 6 (2) The Journal of World Intellectual Property, pg. 356 (329–357) 2003.

298

Zurich Commercial Court, 23 November 1998 in Kodak Photographic Material case.

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