WHAT ANTITRUST LAW CAN (AND CANNOT) TEACH ABOUT THE FIRST SALE DOCTRINE Ariel Katz* ABSTRACT The first sale doctrine (or exhaustion) limits the exclusive rights that survive the initial authorized sale of an item protected by such rights. The first sale doctrine has always been under pressure by owners of intellectual property rights, and courts have never been able to precisely outline its contours, or fully articulate its rationale. Recently, and somewhat counter-intuitively, insights borrowed from modern antitrust law and economics are invoked to provide a seemingly robust theoretical foundation for undermining exhaustion rules or narrowing their scope, and thereby strengthen IP owners’ control over downstream distribution and use of the goods they produce. This article shows why this trend is misguided and agues that it should be resisted, not because the insights from modern antitrust are irrelevant, quite the contrary. Indeed, the insights from modern antirust law and economics can help underpin some of the first sale doctrine’s missing theoretical foundations and help drawing its proper contours. However, as this article demonstrates, the insights from modern antitrust do not support the case against the first sale doctrine. When taken seriously, these insights ultimately support its continued vitality. I. Introduction .......................................................................................................... 2   II. The Origins ......................................................................................................... 5   A. The Antitrust Legacy of Bobbs-Merrill ...................................................... 7   III. Modern Antitrust Approach towards Post-Sale Restraints ............................... 11   IV. The First Sale Doctrine: Different Versions ..................................................... 14   V. The Flaw in the Parallel Trade Debate ............................................................... 17   A. Price Discrimination ................................................................................... 18   * Associate Professor, Faculty of Law, University of Toronto. Director, Centre for Innovation Law and Policy. This article is based on a paper given at the Exhaustion and First Sale in IP Symposium, High Tech Law Institute, Santa Clara Law School, Nov. 5, 2010. I wish to thank Eric Goldman, Mark Lemley, Mark McKenna, Anne Layne-Farrar, and other symposium participants for their valuable comments and insights, as well as to thank my colleagues Peggy Radin, Abraham Drassinower, Ed Iacobucci and Michael Trebilcock for their advice. Special thanks go to Michael Laskey and Nicholas Van Exan for their superb research assistance. EElleeccttrroonniicc ccooppyy aavvaaiillaabbllee aatt:: hhttttpp::////ssssrrnn..ccoomm//aabbssttrraacctt==11884455884422 2 WHAT ANTITRUST CAN TEACH [DRAFT 18-May-11 B. Other Efficiencies of Post-Sale Restraints .................................................. 26   1.   Parallel Trade and Pre- and Post-Sale Services ................................. 26   2.   Parallel Trade and its Effect on Positional Goods ............................. 26   C. The Irrelevance of Antitrust Insights to the Parallel Trade Debate ............. 27   VI. The Property/Contract Flaw .............................................................................. 30   A. The Costs and Benefits of Infringement Remedies .................................... 34   VII. The (Non)-Coasian Flaw ................................................................................. 38   VIII. Justifying the First Sale Doctrine ................................................................... 46   A. Preservation and Resource Waste ............................................................... 46   B. User Innovation ........................................................................................... 48   IX. Application ........................................................................................................ 52   A. Costco v. Omega ......................................................................................... 52   B. Vernor v. Autodesk ..................................................................................... 53   C. UMG Recordings v. Augusto ...................................................................... 55   X. Conclusion .......................................................................................................... 57   I. INTRODUCTION Preparing for the new academic year, you find that some of the textbooks you are required to buy are available more cheaply abroad—can you import them, or do you need the copyright owners’ permission? You recently installed the latest version of your preferred word processing software—are you allowed to resell the copy of the older version? You are an electronics geek, enjoying disassembling old computers and building new devices from their components—do you need to get permission from the owners of the numerous patented inventions embodied in these components? The answers to these questions depend, in large part, on the scope of the first-sale doctrine. The first sale doctrine in copyright law, or exhaustion rules of other intellectual property rights, limit intellectual property owners’ power to control the downstream distribution and use of products or copies embodying their inventions or their works, or bearing their trademarks. EElleeccttrroonniicc ccooppyy aavvaaiillaabbllee aatt:: hhttttpp::////ssssrrnn..ccoomm//aabbssttrraacctt==11884455884422 18-May-11] WHAT ANTITRUST CAN TEACH 3 When such rules apply, the patent owner’s right to sell a product embodying the invention,1 the copyright owner’s right to distribute copies of her work,2 or the trademark owner’s right to sell products bearing the trademark,3 are terminated after the first authorized sale of the genuine product or work. As a result, any further sale, rental4 or other disposition of ownership or possession (and in the case of patents, use of the patented invention)5 does not require the authorization of the owner of the intellectual property right. Exhaustion rules are under pressure. They have always been. Understandably, intellectual property owners have never been great fans of such rules. While they do not always wish to control tightly the distribution of their products or copies, in some cases they might. All things equal, IP owners would rather have the legal power to exercise such control, and many of them argue against exhaustion rules and have tried working around them by various legal or technological means. So far, these attempts have only been partially successful. In copyright law, this partial success is reflected in ambiguous statutory language with regard to whether or not the doctrine applies to copies made outside the US,6 with language that ostensibly limits its application to copies that are owned by the downstream user, rather than licensed,7 and with uncertainty with regard to how freely transacting owners and users can contract around the doctrine, and the effect of such contracts on third party purchasers.8 In patent law, even though the statutory language is simpler,9 court still grapple with defining 1 Patent Act, 35 U.S.C. §§ 1-376 (2010). 2 Copyright Act, 17 U.S.C. §§ 101-1332 (2010). 3 Lanham Act, 15 U.S.C. §§ 1051-1141 (2010). 4 Exception in the case of software and sound recordings. Copyright Act, 17 U.S.C. § 109; Computer Software Rental Amendments Act of 1990, Pub. L. No. 101-650, 104 Stat 5089 (codified as amended at 17 U.S.C. § 109 (1994)). 5 In addition to making, offering for sale and selling the patented invention, the Patent Act grants the patentee an exclusive right to “use” the patented invention, 35 U.S.C. § 154 (2010). Copyrights or trademarks do not confer such general exclusive right to “use”. 6 Costco v. Omega, 541 F.3d 982 (9th Cir., 2008), affm’d by an equally divided court, 562 U. S. ____ (2010). 7 Vernor v. Autodesk, Inc., 621 F.3d 1102, (2010). 8 Quanta Computer, Inc. v. LG Electronics, Inc., 553 U.S. 617, (2008) (leaving unanswered the question of contracting around). 9 Exhaustion rules haven’t been codified. The Act unambiguously grants an exclusive right to sell, and exhaustion rules, developed by the courts, do not require grappling with the ambiguous language such as the language of the copyright act. 4 WHAT ANTITRUST CAN TEACH [DRAFT 18-May-11 the exact scope of exhaustion.10 If there is one thing that all can agree on, is that consensus on exhaustion, or a set of coherent rules delineating the doctrine, are difficult to come by. Confusion and ambiguity abound; not only in the US, but on a global level too.11 This is old news. The real news is that increasingly (and perhaps somewhat counter- intuitively) modern antitrust law is relied on to heighten the pressure on exhaustion. Not that antitrust law can directly abolish such rules; obviously, antitrust law is incapable of granting new intellectual property rights or expand existing ones. However, insights derived from modern antitrust law, and especially modern antitrust law’s growing tolerance towards vertical restraints, are invoked increasingly to provide a seemingly robust theoretical foundation for undermining exhaustion rules or narrowing their scope.12 In this article I argue that we should resist this pressure, but not because the insights from modern antitrust are irrelevant, quite the contrary. Rather, these insights can help underpin the doctrine’s missing theoretical foundations and can help draw its proper contours. However, as this article shows, the insights from modern antitrust do not support the case against exhaustion. When taken seriously, these insights ultimately support its continued vitality, albeit in a more nuanced way. In a nutshell, a closer look into the economic theory that has informed modern antitrust law’s growing tolerance towards vertical restraints reveals that the recognized benefits of most such restraints occur primarily: (1) in situations involving joint-production between firms that are not fully integrated along the production and distribution chain; and (2) immediately after the first authorized sale or shortly thereafter. In such situations, parties should be generally permitted to contract around exhaustion rules when such agreements promote efficient production and distribution. However, the law should be generally averse to attempts to impose post-sale restraints on parties that are not joint-producers (e.g., consumers), and attempts to impose long-term post-sale restraints. For ease of proposition, this article focuses primarily on the first-sale 10 Quanta, 553 U.S. 617. 11 See e.g., Euro Excellence (Canada), Article 6, TRIPS; EU rules creating EU exhaustion, etc. 12 See e.g., The First Sale Doctrine, Intellectual Property Colloquium (2010), at http://www.ipcolloquium.com/Programs/12.html (discussing the first sale doctrine and comparing copyright’s approach to that of antitrust law). 18-May-11] WHAT ANTITRUST CAN TEACH 5 doctrine in copyright law, but much of its analysis is equally applicable to other IP rights.13 The article is organized as follows. It very briefly traces the origin of first-sale doctrine in copyright law and identifies one immediate lesson that antitrust law can teach, namely that unexhausted IP rights can facilitate anti-competitive practices. It then describes the modern view of antitrust law of vertical restraints, and how this view can inform the debate about the first sale doctrine. The article then proceeds to identify three common flaws in the application of the insights derived from antitrust law and economics and finally demonstrates how the insights, combined with more recent contributions to innovation theory, actually support the continuing vitality of the doctrine. More specifically, the article shows that contrary to the view of some commentators economic theory provides very limited support for laws banning parallel imports (i.e., the unauthorized importation of genuine goods sold abroad with the authorization of the IP owner). It explains why even when post-sale restraints increase efficiency and ought to be enforceable, they should be enforced primarily as a matter of contract law, not on the basis of intellectual property entitlements. Further, the articles demonstrates that while exhaustion rules should be treated as default rules, they should be treated as de jure sticky defaults, meaning that contracting around the first-sale doctrine should be presumptively invalid. Courts should refuse to enforce license conditions or contract terms limiting the ability of the user to resell goods embodying IP rights, unless the IP owner can demonstrate that the restraint is necessary and superior to other means to achieve efficiency. Let me turn to the origins of the first-sale doctrine. II. THE ORIGINS Bobbs-Merrill v. Straus14 is often considered as the grand entry of the first-sale doctrine into American copyright law, following a similar principle of exhaustion in patent law.15 But like many legal rules, its genesis 13 The analysis can be applied even more broadly to all restraints on alienation of property, whether or not IP rights are involved. 14 Bobbs-Merrill Co. v. Straus, 210 U.S. 339 (1908). 15 See Motion Picture Patents Co. v. Universal Film Mfg. Co., 243 U.S. 502 (1917); United States v. Univis Lens Co., 316 U.S. 241 (1942); see also Katherine J. Strandburg, Users as Innovators: Implications for Patent Doctrine, 79 UNIVERSITY OF COLORADO L. REV. 467, 495 (2008) (“The first sale doctrine holds that a patentee’s rights are ‘exhausted’ when a patented product is sold, leaving the purchaser free to do with it as he or she wishes.”) 6 WHAT ANTITRUST CAN TEACH [DRAFT 18-May-11 can be traced to more than a single source or event. As others have noted, the genesis of the first-sale doctrine could be understood as a confluence of different legal streams: the common law hostility to restraints on alienation, to servitudes in general and servitudes in chattels in particular; the emergence of antitrust and its contemporaneous hostility towards all restraints: horizontal and vertical; and an era in which IP rights were more modest in their scope16 and greater regard was given to their limited nature.17 And perhaps, these early cases were decided in a more formalist era when legal thinking and reasoning tended to appreciate the distinction between legal categories and were averse to blurring the lines between them. Each of these strands has gone through substantive transformation over time. The common law's aversion to servitudes has waned; we have grown to become accustomed to expansive IP rights and many of our policies have been shaped by a misguided full appropriability paradigm;18 complex regulatory systems have been part of our modern state, and while preachers of free enterprise continue to bemoan excessive government control some of them express no concern about excessive corporate control of individuals. Lastly, antitrust law, influenced by antitrust scholarship, not only has relaxed its hostility toward vertical restraints, but in some sense has turned to embrace them enthusiastically. Therefore, it is possible that just as the confluence of different legal streams bred the first-sale doctrine, a new confluence of these streams, flowing in reverse direction, will lead to its demise. Antitrust law has played and may play pivotal roles in these processes.19 16 See e.g., Neil Netanel, Copyright and a Democratic Civil Society, 106 YALE L. J. 283, 294 (1996) (characterizing modern copyright law as “Bloated”); see also Lionel Bentley, R. v. The Author: From Death Penalty to Community Service, 20th Annual Horace S. Manges Lecture (Tuesday, April 10, 2007), 32 COLUM. J.L. & ARTS 1, 3 (2008) (describing the consensus among academic about the expansion of copyright). 17 Bobbs-Merrill, 210 U.S. at 346 (“The copyright statutes ought to be reasonably construed, with a view to effecting the purposes intended by Congress. They ought not to be unduly extended by judicial construction to include privileges not intended to be conferred, nor so narrowly construed as to deprive those entitled to their benefit of the rights Congress intended to grant”). See also Motion Pictures Patents Company v. Universal Film Manufacturing Company, 243 U.S. 502 (1917). 18 See generally Brett M. Frischmann and Mark A. Lemley, Spillovers, 107 COLUM. L. REV. 257, (2007). 19 Herbert Hovenkamp, Post-Sale Restraints and Competitive Harm: The First Sale Doctrine in Perspective, NYU ANNUAL SURVEY OF AMERICAN LAW 1, 17 (2010) (“Over 18-May-11] WHAT ANTITRUST CAN TEACH 7 A. The Antitrust Legacy of Bobbs-Merrill Bobbs-Merrill, decided in 1908, is often described in the antitrust literature as a resale price maintenance (RPM) case: an attempt by a manufacturer (publisher) to maintain the resale price of her product (book). Bobbs-Merrill was the publisher of a novel titled The Castaway by Hallie Ermine Rives.20 A notice printed on the book prohibited anyone from reselling it for less than $1, and threatened to treat any violation of this condition as copyright infringement. Macy’s, the department store, purchased copies of the book from a distributor and sold them for ¢89 each. At that time Macy’s was a discounter—think of it as a Wal-Mart of old— and Bobbs-Merrill sued for copyright infringement. The Supreme Court dismissed the action, relying on the principle of exhaustion borrowed from earlier patent cases, as well as on the general policy against restraints on alienation. Strictly speaking, Bobbs-Merrill was not an antitrust case, because Bobbs-Merill sued for copyright infringement and the Court’s decision focused on the scope of a copyright owner’s exclusive right to vend copies. However, conventional wisdom holds that the decision reflects the contemporaneous hostility of the Court to all post-sale restraints. Three years after Bobbs-Merrill, the Court reiterated this hostility, this time as a matter of antitrust law, when it held, in Dr. Miles v. John D. Park,21 that resale price maintenance was illegal per se under the antirust laws.22 According to Hovenkamp, this trend culminated in a duo of cases, Straus v. Victor Talking Machine and the Motion Pictures Patents case, issued on the same day in April, 1917, which effectively created a merger between the first sale doctrine and antitrust policy, and further planted the seeds of what would later become the related doctrine of intellectual property misuse.23 Viewed from this perspective, namely, that the first-sale doctrine is the IP mirror image of antitrust law’s per se prohibitions on RPM and tying, it is tempting to view antirust law’s shift away from such per se rules as a history, most of the Supreme Court’s decisions on the first sale doctrine have attached its rationale to competition policy.”) 20 HALLIE ERMINE RIVES, THE CASTAWAY (The Bobbs-Merrill Company 1904). 21 Dr. Miles Med. Co. v. John D. Park & Sons Co., 220 U.S. 373 (1911) 22 Id., at 408, overruled by Leegin Creative Leather Prods., Inc. v. PSKS, Inc. 551 U.S. 877 (2007) (holding that resale price maintenance is subject to rule of reason analysis rather than per se illegality). 23 Hovenkamp, supra note 19, at 20. 8 WHAT ANTITRUST CAN TEACH [DRAFT 18-May-11 basis for similar leniency in IP law, in the form of a weakened (or even repealed) first-sale doctrine. After all, one might argue, if modern antitrust law is no longer hostile to post-sale restraints, IP rules rooted in the same hostility should be regarded as equally anachronistic. In the rest of this article I will explain why such an argument would over-simplify modern antitrust law and its bearing on the first-sale doctrine, but before this, I wish to highlight a less familiar point about Bobbs-Merrill’s antitrust legacy, as this hidden point can teach an important lesson as we proceed to discussing the first-sale doctrine’s future. The truth is that Bobbs-Merrill wasn’t just an RPM case. The Supreme Court’s decision ends with a remark explaining that in light of the Court’s conclusion dismissing the copyright infringement claim, “it [is] unnecessary to discuss other questions noticed in the opinion in the circuit court of appeals, or to examine into the validity of the publisher's agreements, alleged to be in violation of the acts to restrain combinations creating a monopoly or directly tending to the restraint of trade.”24 This statement is the Court’s single allusion to antitrust, but it hints at a much richer antitrust history, which the opinion of the District Court below actually reveals. It turns out that Bobbs-Merrill was not about a publisher preferring, for whatever reason, to exercise control over the distribution system of its books. What the case was truly about was a double-layered industry-wide cartel, established in 1900 under which the book publishers and the booksellers conspired to “correct some of the evils connected with the cutting of prices on copyright books” by requiring all publishers to fix the retail prices of their respective books, prevent discounting and eliminate discounters by collectively refusing to deal with them.25 RPM was just the means to enforce the cartel, and copyright was just an effective method to enforce the RPM. In fact, litigation started in 1903 when Macy’s sued the American Publishers’ Association and the American Booksellers' Association. Relying on the Sherman Act and its equivalent New York Anti-Monopoly Act, Macy’s attempted to enjoin the cartel.26 Macy’s bid, however, was only partially successful. The New York Court of Appeals found in favor of Macy’s on the basis that the publishers’ and booksellers’ rules sought to 24 Bobbs-Merrill Co. v. Straus, 210 U.S. at 351. 25 Bobbs-Merrill Co. v. Straus, 139 F. 155 (C.C.N.Y. 1905). 26 Straus v. American Publishers' Ass'n, 177. N.Y. 473, 69 N.E. 1107 (N.Y., February 23, 1904). 18-May-11] WHAT ANTITRUST CAN TEACH 9 prevent the discounting of all books, copyrighted and non-copyrighted alike.27 Relying on Bement v. National Harrow,28 however, the court held that a combination to fix the prices of copyrighted books alone would be legal. Soon thereafter, the respective associations’ rules were amended to cover copyrighted books only,29 and Bobbs-Merrill commenced its copyright infringement suit against Macy’s. In its defence, Macy’s argued that the notice did not restrict the right of an owner of a lawfully printed and sold copy of a book to sell it as it saw fit, and further defended on the grounds that the lawsuit was an attempt to enforce an unlawful combination.30 The Circuit Court sided with Macy’s on both issues, and refused to construe Bement v. National Harrow as broadly as the state court did. On appeal, the Second Circuit affirmed, but addressed only the copyright question.31 The Supreme Court, as noted above, mentioned the antitrust issue only in passing and based its decision solely on copyright grounds. Nevertheless, this antitrust history of Bobbs-Merrill can teach an important lesson about the merit of the first-sale doctrine and the perils of abandoning it. It is well known that while cartels can be highly beneficial to their members (and detrimental to consumers) they are unstable because each of their members can do even better by cheating. Therefore, in order to be sustainable, cartel members need to be able to monitor cheating and enforce adherence to the cartel rules. RPM can be used as a means to enforce cartels. Retailers can use their collective power vis-à-vis a manufacturer and have the manufacturer “impose” RPM. If retail prices are fixed, cheating may be easily monitored, and the colluding retailers may demand that the deviant retailer be disciplined.32 RPM can also sustain a 27 Id, at 477-81. 28 E. Bement & Sons v. National Harrow Co., 186 U.S. 70, 91 (1902) (“[t]he general rule is absolute freedom in the use or sale of rights under the patent laws of the United States. The very object of these laws is monopoly, and the rule is, with few exceptions, that any conditions which are not in their very nature illegal with regard to this kind of property, imposed by the patentee and agreed to by the licensee for the right to manufacture or use or sell the article, will be upheld by the courts. The fact that the conditions in the contracts keep up the monopoly or fix prices does not render them illegal.”) 29 Bobbs-Merrill Co. v. Straus, 210 U.S. at 172. 30 Id., at 156. 31 Bobbs-Merrill Co. v. Straus, 147 F. 15 (2nd Cir. 1906). 32 See Ittai Paldor, The Vertical Restraints Paradox, 58 U. TORONTO L. J. 317, 328 (2008); see also Edward Iacobucci, The Case for Prohibiting Resale Price Maintenance, 19 WORLD COMP. L. & ECON. REV. 71 (1995). 10 WHAT ANTITRUST CAN TEACH [DRAFT 18-May-11 manufacturers’ cartel, by reducing individual manufacturers’ incentive to cheat and by providing means to monitor cheating.33 While cartels may employ contractual RPM to stabilize or enforce their rules, the utility of RPM is limited because it depends on the ability to enforce the contractual obligation, and the obligation will not be binding on third parties who purchased the goods from a cheating member and resell them at a lower price. In such situations IP rights, if unexhausted, can prove much more useful (hence dangerous). Bobbs-Merrill is a case in point. Despite being blacklisted for being a price-cutter, Macy’s had been able to procure copies of the book and offer them for sale at a lower price. This, of course, could destabilize the cartel because other booksellers would have to face the competition and would have to lower their prices too. Macy’s, however, was not bound by any RPM agreement and the Supreme Court holding guaranteed that it could, at least as a matter of law, continue to cut prices and destabilize the cartel. Had the Court ruled otherwise, that is, had the publisher been able to enjoin Macy’s from selling at a lower price on pain of copyright infringement, maintaining the cartel would have been much easier. It could be argued that this hardly provides a justification for the first- sale doctrine, because if the problem is an underlying cartel, antitrust law will have no problem condemning it. The answer, however, is that the outright condemnation of cartels is only as good as there is evidence for its existence, and furthermore, tacit collusion, whereby competitors in an oligopolistic market can, without an agreement, lawfully coordinate their behavior to achieve a cartel-like outcome can also be bolstered by IP-based RPM. The fact that many IP based markets comprise a small number of large competitors,34 and that virtually any product can be sold accompanied by a trademarked and often copyrighted logo,35 should give rise to a concern that unexhausted IP rights can facilitate tacit collusion in such markets. The full antitrust history of Bobbs-Merrill should make us wary of unexhausted IP rights, and we can summarize this lesson in the following proposition: 33 Id. at 329. 34 see Ariel Katz, Making Sense of Nonsense: Intellectual Property, Antitrust, and Market Power, 49 ARIZONA L. REV. 837 (2007). 35 Costco Wholesale Corporation v. Omega, S.A., 131 S. Ct. 565 (2010); Euro- Excellence Inc. v. Kraft Canada Inc., 2007 SCC 37, [2007] S.C.J. No. 37.