The copyright case that brought Costco and MoMA together

October 29, 2012: 10:42 AM ET

The Supreme Court is hearing a case about gray-market textbook sales with ramifications far beyond publishing.

By Roger Parloff, senior editor

FORTUNE -- On Monday the U.S. Supreme Court will hear a copyright case that is attracting great interest not just from the usual suspects -- publishers, movie studios, digital rights groups, and free culture advocates -- but also from merchants like Costco and eBay, luxury purveyors such as Omega, thrift-shop Goodwill Industries, as well as cultural icons including the Museum of Modern Art.

The case, which pits former University of Southern California grad student Supap Kirtsaeng against textbook publisher John Wiley & Sons, involves the murky status of gray-market goods in a world of global e-commerce. Gray-market goods are authentic products that are sold in the United States outside their authorized distribution channels. (In other words, they are not knock-offs.) The phenomenon often arises when a U.S. manufacturer markets a premium product in the U.S., sells a cheaper version abroad, and then sees its strategy undermined when an opportunist resells the foreign versions in the U.S. at a markup.

A provision of the Copyright Law, known as Section 602(a)(1), gives copyright holders strong powers to combat gray-market trafficking. Any unauthorized "importation" of a copyrighted work, according to that section, infringes the copyright holder's exclusive distribution right. As a consequence, rights holders can sue any unauthorized U.S. seller of their imported products -- or, at least, they have been able to up until now.

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Theoretically, consumer goods manufacturers don't have as powerful tools to police their favored distribution channels and must rely, instead, on their licensed foreign distributors to honor contractual obligations. But these manufacturers have learned to ride piggy-back on the stronger copyright protections by claiming infringement of a copyrighted component of their otherwise noncopyrightable product. A bottle of shampoo, for instance, will have a copyrighted label pasted on the front; a watch may have a copyrighted logo on the back; almost any electronics product these days will have copyrighted software inside. For this reason, Section 602(a)(1) is now invoked more promiscuously than Congress may have originally envisioned.

The targets of these suits -- be it an individual like Kirtsaeng or a giant company like Costco (COST) -- often seek shelter from a different provision of the copyright law: the so-called first-sale doctrine (also known as "copyright exhaustion"). Though relatively few readers may have heard of this doctrine, almost all readers intuitively understand its gist, which amounts to simple common sense. It is implicated every time you pass an aging baby-boomer trying to sell a stack of Creedence Clearwater Revival records from a blanket on the sidewalk. Assuming the individual hasn't sought prior permission from Creedence's old record label, Fantasy Records, is he violating that company's exclusive right to distribute those recordings?

The answer is "of course not" and the reason is the first-sale doctrine. Adopted by the Supreme Court in 1908 and then codified by statute the following year, the doctrine holds that once a copyright holder sells a copy of his work, the buyer is free to resell that copy (or rent it or give it away) as he sees fit.

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Here's how Kirtsaeng's activities implicated each of these seemingly conflicting copyright provisions -- the importation restriction and the first-sale doctrine. While at Cornell college and, later U.S.C. graduate school, he decided that university professors and their publishers had a bit of a racket going where the professor could write a textbook, update it modestly every year, and then assign the most recent edition to his classes, leaving students little choice but to buy the latest version at a seemingly exorbitant price. A math major raised in Thailand, Kirtsaeng saw an arbitrage opportunity. He asked family members in Asia to buy and send to him the much cheaper versions of English-language textbooks that publishers print through foreign subsidiaries and market for foreign distribution only. (These often use inferior materials and printing techniques, but have largely identical text.) He then resold these foreign editions to American students over eBay (EBAY) for a handsome profit. His gross revenue, he later acknowledged, was at least $900,000.

Eight of the titles he arbitraged in this way were published by an Asian unit of John Wiley & Sons, which sued him in Manhattan federal court in 2008. Wiley said Kirtsaeng had violated Section 602(a)(1)'s ban on unauthorized importation of copyrighted works. Kirtsaeng invoked the first-sale doctrine in his defense. So the question became, basically: Which provision trumps which?

In October 2009, a federal district judge ruled for Wiley on that legal issue, and a jury ordered Kirtsaeng to pay $600,000 in damages. In August 2011, a panel of the U.S. Court of Appeals for the Second Circuit affirmed by a 2-1 vote. The majority ruled that because the provision defining the first-sale doctrine specifies that it only covers works "lawfully made under this title," it only applies to works made in the U.S., not to works made overseas.

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Kirtsaeng appealed to the Supreme Court, protesting that a more sensible reading would be that the first-sale doctrine applies to any work for which U.S. copyright protection is claimed, regardless of where the work happens to have been manufactured. Since Wiley claims U.S. copyright protection for all its textbooks, including the ones printed in Asia, the foreign-made books should be covered, according to Kirtsaeng's lawyers at Orrick Herrington & Sutcliffe. (Orrick's E. Joshua Rosenkranz will argue the case for Kirtsaeng.)

In fact, Kirtsaeng's lawyers argue in their brief, if the rule were otherwise, an overreaching movie studio -- the inevitable bogeyman of all contemporary copyright hypotheticals -- might perversely set up a factory abroad to print DVDs intended for reintroduction to the United States, hoping to then control all downstream resales of its products, and enabling it to spring lawsuits on unsuspecting librarians, flea marketers, used-book stores, and Goodwill thrift store managers.

"If Wiley's right," says Rosenkranz in an interview, "car manufacturers can shut down used-car sales, publishers can shut down used-book stores and libraries, and movie makers can shut down Netflix (NFLX). All they have to do is make their products outside the United States."

Wiley counters that such hypothetical abuses are improbable in the extreme, impractical as a business proposition, and have never arisen in the real world. It adds thatKirtsaeng's interpretation would gut Section 602(a)(1)'s importation restriction in precisely the situation it was most obviously designed to apply: where a bona fide copyright holder's market segmentation strategies are being torpedoed for commercial gain.

If the U.S. higher-education textbook market can be undermined by gray-market goods, argues Tom Allen, the CEO of the American Association of Publishers in an interview, it will diminish the capacity of publishers to maintain quality, put American jobs at risk, lower compensation for textbook authors, and prevent publishers from selling textbooks in secondary markets at locally affordable prices. Ted Olson of Gibson Dunn & Crutcher will be arguing the case for Wiley. Deputy U.S. Solicitor General Malcolm Stewart, representing the U.S. Copyright Office and the Justice Department, will argue in support of Wiley's position.

While the reader can probably see why Costco and eBay care about this case, he may still wonder about those art museums. Well, in addition to the right to control distribution, copyright holders enjoy a right to control public display of their works. So if a museum pays $80 million to buy a Picasso that was painted in Paris, it doesn't want some heir of the painter showing up and demanding payment every time it tries to display its treasured acquisition to the public. (Original artworks count as "copies" under the copyright law.)

Had such a situation arisen in the past, museums could have invoked the first-sale doctrine, but if Kirtsaeng is upheld, they may lose that argument, according to Stefan Mentzer of White & Case, who has filed an amicus brief for more than two dozen art museums and the Association of Art Museum Directors. (Mentzer does acknowledge, however, that no matter how Kirtsaeng comes out, museums could maintain that they still have a "fair use" right to exhibit their foreign-made acquisitions.)

With so many businesses sweating this case for so many different reasons, the justices have a lot to juggle in their minds at once. We know they find the task difficult because they were presented with it just two years ago in a case in which Omega sued Costco for selling its imported watches (with a copyrighted logo on the back) without permission. On that occasion, with Justice Elena Kagan recused, the justices deadlocked 4-4. That result automatically affirmed the decision below (for Omega) but set no precedent.

This time around, with a full complement of justices, the court should settle some long simmering questions with far-reaching repercussions.

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