The Law Protects Alleged Gray Market Distributor

A recent case in which I was a lead team member serves as a reminder that in the sometime cruel business of distribution, the underdog – the smaller distributor or even third tier indirect sub-distributor can avoid significant threatened liability based on basic legal principles. In this case, a behemoth manufacturer and distributor operating in the internet networking equipment space brought a full sweeping lawsuit against a downstream reseller operating allegedly illegally in the so-called gray market. In our eyes, the lawsuit was intended to essentially drive the downstream reseller out of the market, including because it was laced with substantial bad faith allegations. Our clients did not even have to answer the complaint, or engage in any discovery, as the Court ultimately dismissed the case with finality, and stayed discovery while it was considering dismissal papers.

The integrated manufacturer alleged in the lawsuit that the defendants orchestrated schemes to exploit its discount and distributor programs by purchasing genuine manufacturer products at reduced prices and reselling them outside the manufacturer’s preferred channels. According to the integrated manufacturer, these practices amounted to fraud, tortious interference with its business, breach of contract, negligent misrepresentation, and conversion – old fashioned claims shoehorned into a lawsuit trying to redefine the “gray market.” In this case, the integrated manufacturer relied on classic damage theories to recover alleged “lost revenue” and claw back discounts, but they were not viable damage theories in the eyes of the law.

Gray market goods in this case were genuine internet networking products sold outside the integrated manufacturer’s general distribution system. Unlike counterfeit goods, gray market products may be lawfully bought and sold – so long as they are not materially different, misrepresented, or obtained through fraud. Price disparities alone, or resale without manufacturer consent, do not automatically make such transactions illegal.

Here, the court rejected the manufacturer’s attempt to transform aggressive channel policing into actionable claims. Most notably the court accepted the following premises:

•  Discounts Are Not “Losses.”

The manufacturer argued that it was harmed because it gave discounts it otherwise would not have offered. The court rejected that outright. If a company willingly sells a product – even at a steep discount – it has not been automatically harmed, i.e., “lost” profits in the eyes of the law.

• No Contract, No Blame.

The integrated manufacturer also sued companies it never had contracts with, claiming that they, as third parties with knowledge, interfered with the integrated manufacturer’s distributor relationships. The court disagreed: you cannot hold a person liable for breaking rules they never agreed to and were not clearly shown to know them or were otherwise not known by the party. Some understanding, within a contractual relationship, was required, and no such relationship was or could be alleged, at not in good faith (as is required by pleading standards).

• Once Sold, the Product Is Not Yours.

The integrated manufacturer claimed the defendants “converted” its products. The court responded with a basic principle of commerce: once a product is sold, the manufacturer no longer owns it. So, no conversion of another’s property could ever occur.

• No Special Duties Owed.

The integrated manufacturer tried to argue that downstream resellers had a legal duty to it. The court rejected this as well – those duties arise only in special trust based relationships, not in ordinary marketplace transactions. Arms-length relationships are just that; and no special duties exist due to an arm’s length relationship.

Manufacturers, such as the integrated manufacturer in this case, do not own their products forever, and they cannot use litigation to bully lawful market participants simply because they dislike secondary sales. This decision reinforces a core principle of gray market law: absent materially different goods, misrepresentation, or actual contractual obligations, downstream resellers are entitled to compete.

For businesses operating in the gray market, or even if not, but are outweighed by an integrated manufacturer and/or distributor with whom they do business, this decision (one from a court of complex commercial disputes) is a powerful reminder that courts will enforce legal limits on brand control – and will not allow manufacturers to weaponize tort law to suppress lawful competition.

Our legal teams stand ready to assist distributors through complicated supply chain and market channel issues, and can say with certainty that just because the claiming party has unlimited resources, does not mean that party can run rough shot over smaller distributors or sub-distributors by using the courts to control or influence the supply chain and relevant markets.

For those distributors challenged by similar issues, or who face them in the future, surrender is not the only option. Calculated, precision analysis and handling of applicable law may well turn a seemingly dismal situation around, full circle.

Should you have questions as to your legal protections as a distributor or other supply chain member, especially in the wake of a far-reaching or wide-sweeping lawsuits or even threatened ones, please contact me at 312-840-7004 or fmendelsohn@burkelaw.com.